Financial ratios are one of the most important tools available to business owners, enabling them to evaluate their company's performance and health. Financial ratios are calculated by using the information provided in historical and/or forecasted balance sheets and income statements. Ratios are most commonly used for trend analysis - tracking your company's financial figures over a period of time. Financial ratios allow companies to compare performance in a given period versus financial results in previous periods, and against the finacial results of other businesses in similar industries.

Financial ratios put financial statement information into perspective, and allow businesses to spot financial issues that may threaten cash flow, or even the overall viability of a business. Financial ratios, particularly for privately held companies, fall into four general categories: liquidity, profitability, turnover and leverage.

Liquidity Ratios
Liquidity ratios focus on a company’s ability to pay its bills when they come due. Bankers and suppliers use liquidity ratios to measure a company’s creditworthiness. If liquidity ratios remain relatively high for a prolonged period, too much capital may be invested in liquid assets (for example, cash, short-term investments, accounts receivable, inventory) and too little capital may be devoted to increasing shareholder value. If liquidity ratios remain relatively low, a company may not have sufficient liquidity to meet ongoing financial obligations.

Profitability Ratios
Profitability ratios offer a glimpse into a company’s operational performance and help business owners determine if they are maximizing their bottom line. They also offer insights into the return a company is generating from its assets and invested capital. These ratios should be compared on a period over period basis (i.e. year to year). While these ratios may vary from industry to industry, standard ratios include Return on Assets, Return on Equity and Return on Sales.

Turnover (Efficiency) Ratios
Turnover or efficiency ratios measure the activity or changes in certain assets, including accounts receivable, accounts payable and inventory. Poor turnover generally indicates resources are invested in non-income producing assets.

Leverage Ratios
Leverage ratios indicate how well a company’s uses borrowed funds (rather than stockholders’ equity or investments) to expand its business. The goal is to borrow funds at a low interest rate and invest in a business activity that produces a rate of return exceeding the target rate of return for investments.

For more information about preparing the financial projection section of your business plan, check out:

• Financial Projections Mistakes to Avoid
• Financial Projections Business Plan Basics

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