What are financial ratios and why financial ratios are important?
Managers and decision makers in every business deal with a lot of information on a daily basis. Average manager deals with a lot of financial data, reports, spreadsheets, targets, performance results…
…overloaded with too much data managers can easily lose track of what is really important for the business.
The reason being that it is hard to distinguish between what is relevant for the business and what is not. Understanding the meaning of all the data you go through is both an art and science.
It is art because experienced business leaders know how to work with the data and identify the key relationships, correlations and ratios among all the numbers in their spreadsheets and financial statements.
What are the key financial ratios for your business
There are standard financial ratios that are used across industries. However you should identify the most important financial ratios for your business.
The key financial ratios you identify are the ones that you can measure accurately and you can act upon them. You cant manage what you cant measure but it is even worse to measure the wrong financial ratios. One of the most effective ways to start identifying your key financial ratios is to review what drives your business success, your goals and objectives and your industry financial ratios.
Do you know your industry financial ratios
There are many ways to obtain financial ratios by industry. Some of these sources are free public information and for more detailed analysis and information there are specialized financial institutions able to provide you with the benchmark numbers and financial ratios for your industry. It is critical for managers to know their industry. What is a good score and financial ratio value for one industry is not good for another. For example, gross profit margin of 18% can be great for one industry but might be a very poor ratio for another industry.
The difference between financial ratios and financial statements data
Financial ratios are formulas or relationships between two or more quantities. For example, financial ratios can calculate relationships from the same financial statement or different financial statements such as Income Statement and Balance Sheet. Financial ratios are critical for measuring investments, returns, risk, cash flows…
While there are many financial ratios used as standard KPIs and metrics most of them fall into a few categories. The main categories of financial ratios are profitability, debt, liquidity and activities.
Financial ratios are used for tracking trends of financial performances over time, comparison with industry standards or benchmarks and measuring company's progress towards achieving the goals, objectives and targets.