Understanding how financial ratios tell the story
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Introduction:
Owning a business is more than buying and selling, more than trying to sell services to clients. You must understand every aspect of the business. Every year, your CPA provides you with your financial statements either compiled, reviewed or audited. You know your basics of financial statements, there are four: Balance Sheet Statement, Income Statement (Profit and Loss), Statement of Cash Flows and Statement of Retained Earnings. When it comes down to measuring and understanding your financial results, you get a sense of uneasiness because you feel that numbers might tell more than you see.
Why analyzing the numbers?
Yes, the numbers tell the story of your business. How is that possible? There are two basic ways: (1) comparing your business current results with past results; (2) comparing your business with your competition. Both are important comparisons. For instance, if you open a new warehouse you want to know if your sales improved versus the additional cost / expenses incurred. In addition, a new competitor shows up in the area, you want to know how it affected your business.
Financial Ratios:
Bankers, financial specialists, accountants and several others use financial ratios to analyze businesses. What are financial ratios? These are mathematical relationships between financial statements accounts. Thus, you can analyze your business and compare it to your competition or industry. There are hundreds of ratios available, but it is not necessary know all of them. You just need to understand the main ones. Financial ratios are divided in five groups:
- Liquidity Ratios
- Asset Management
- Debt Management
- Profitability
- Market Value
Each group allows you to measure and analyze businesses in a way that numbers in financial statements will make sense. These mathematical ratios represent either percentages or plain numbers; thus, comparisons could be drawn. For instance, take two companies with different sizes, dollar values might not be comparable. However, having dollar values converted to percentages or plain numbers, help in the analyzing process.
Conclusion:
Financial statements provide business results; however, financial ratios provide the meaning. You should use financial ratios to improve your business and competitors’ knowledge. Comparisons between years, show possible trends and assist you in planning. Industry comparisons allows you to understand your industry and work towards better positioning thru strategic decisions.
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