A ratio basically quantifies the relationship between two amounts. In a business sense, for example, we can use ratios to compare the relationship between sales and the costs of generating those sales; or between the cost of an investment and the amount of profit generated by that investment.
Because ratios are concerned with the relationship between two amounts, they are not expressed in absolute financial terms. However a business can use ratios to identify trends or patterns that may not be apparent just from looking at the accounts. And ratios can also be used to benchmark a business against its competitors or industry standards.
Ratio analysis therefore offers a way to gain deeper insight into a business and highlight problems and issues that may require further attention.
Financial management ratios tell us about the financial performance and position of a business. Performance ratios are key to increasing the perceived value of a business to lenders, investors and suppliers; position ratios are important to monitor and manage because adverse movements might impact the business's ability to obtain credit.
Financial performance ratios are further subdivided into profitability ratios, which describe how profitable the business is, and efficiency ratios, which analyse how effective the business is in generating sales from its resources. An important subset of efficiency ratios known as the working capital ratios offers insights about a business's working capital needs and cashflows.
Financial position ratios are subdivided into liquidity ratios, which tell us about a business's ability to meet short term financial commitments, and stability ratios, which are concerned with the longer term sustainability of a business's financial model.
Arguably the single most important financial management ratio for a small business is Return on Capital Employed (ROCE). This is calculated as (operating profit / (total assets - current liabilities)), expressed as a percentage. ROCE tells us how well a business uses its capital to generate profits - in other words how good is the business at generating value?
If you're interest in finding out more about ratio analysis and how to apply it to your business, contact us today.