Many small and mid-sized business are run by entrepreneurs who are highly skilled in some key aspect of their business perhaps technology, marketing, or sales—but are less savvy in financial matters. The goal of this document is to help you become familiar with some of the most powerful and widely used tools for analyzing the financial
the health of your company.
Some of the names; “common size ratios” and “liquidity ratios,” for example, maybe unfamiliar. But nothing in the following pages is very difficult to calculate or very complicated to use. The goal of this document is to provide you with some handy ways to look at how your business is doing compared to earlier periods, and how its performance compares to other businesses in your industry. Once you get comfortable with these tools you will be able to turn the raw numbers in your business’ financial statements into information that will help you to better manage your business.
A ratio, you will remember from secondary school, is the relationship between two numbers. As your mathematics teacher might have put it, it is “the relative size of two quantities, expressed as the quotient of one divided by the other.” If you are thinking about buying shares of a publicly-traded company, you might look at its price-earnings ratio. If the stock is selling for NGN60 per share, and the business’ earnings are NGN2 per share, the ratio of price (NGN60) to earnings (NGN2) is 30 to 1.
One of the most useful ways for the owner of a small business to look at the company’s financial statements is by using “common size” ratios. Common size ratios can be developed from both balance sheet and income statement items. The phrase “common size ratio” may be unfamiliar to you, but it is simple in concept and just as simple to create. You just calculate each line item on the statement as a percentage of the total.
As a small business owner, you should pay particular attention to trends in accounts receivables and current liabilities. Receivables should not be tying up an undue amount of company assets. If you see accounts receivables increasing dramatically over several periods, and it is not a planned increase, you need to take action. This might mean stepping up your collection practices, or putting tighter limits on the credit you extend to your customers.
But you may wonder, “How do I know if my current ratio is out of line for my type of business?” You can answer this question (and similar questions about any other ratio) by comparing your business with others in a similar sector. You may be able to convince competitors to share information with you, or perhaps a trade association for your industry publishes statistical information you can use. If not, you can use any of the various published compilations of financial ratios.
Remember, your goal is to use the information provided by the common size ratios to start asking why changes have occurred, and what you should do in response. If profit margins have declined unexpectedly, you probably will want to closely examine all expenses again, using the common size ratios for expense line items to help you spot significant changes.