The Importance of Financial Ratios

WILLIAM SWANSTROM

Executive Vice President/Market President

MINNWEST Bank

williams@minnwestbankgroup.com

minnwestbank.com

Topic: Banking / Finance

For example, there’s a net profit of $200,000 on an income statement. Is this good? Look at the ratios. If this is earned on sales of $600,000, it could be good. But if sales were $2.5 million, then the ratio is certainly less appealing. More sales were needed to produce that result. In other words, net income of $200,000 is 33.3% on sales of $600,000, and only 8% on the $2.5 million sales figure.

These ratios, therefore, become powerful tools because one can easily determine what is happening in the business.

Using ratios to track performance. Comparison of the same ratios from one year to the next, or even over a series of years, charts a progression pattern and helps businesses plan for the future. Even more valuable, is comparing those ratios to other businesses within the same industry. Dun & Bradstreet publishes key business ratios.

Free industry statistics and financial ratios are available online at www.bizstats.com Corporations, S-corps and sole proprietorships can all find stats for various industries on this site. And, accountants may be able to furnish their clients with comparative ratios as well. There are quite a number of ratios floating in the financial world and many will not affect the typical small business. But, in general, financial ratios fall into four categories: liquidity, efficiency, profitability and solvency.

Liquidity ratios look at cash flow. As bankers, we’re most interested in reviewing a business’ liquidity ratios or sometimes referred to as working capital ratios. Essentially, that’s what this ratio does . . . measures working capital. These are also the most common of financial ratios. They show the ability of a business to quickly generate cash for bill payments. For the business owner, this ratio can serve as a first alert if the business has a problem.

Bankers review liquidity ratios when reviewing loan requests. And, lenders may require a business to maintain a certain ratio after obtaining that loan.

Two types of liquidity ratios - current vs. quick ratios. The current ratio measures short term solvency, an important aspect of liquidity. It measures current assets against current liabilities. For example, if current assets including cash are $100,000 and current liabilities are $50,000, the current ratio is 2:1. By simply paying off some of the liabilities with the cash assets and changing the mix from current assets of $75,000 to current liabilities of $25,000, the new current ratio is bumped to 3:1 . . . or a more favorable ratio. Remember, that a decline in decline in this ratio points to an increase in short term debt, a decrease in current assets or a combination of both.

The quick ratio is also referred to as the acid test. It gets to the nitty gritty of a business quickly. The quick ratio subtracts inventory from current assets and then compares the figure to current liabilities. This ratio gives businesses and bankers a better picture of ability to meet short term obligations since inventory can only be turned into cash after it is sold. And, that could take time. A stable current ratio with a declining quick ratio may indicate that too much inventory is on hand. A good acid test is a ratio of 1:1.

Learn more about ratios from a good business banker. A good small business banker should be able to inform clients about ratios and what steps to take to improve them.