Ratios are useful yardsticks when measuring a small firm’s performance and can point out potential problems before they develop into serious crises. But calculating these ratios is not enough to ensure proper financial control. In addition to knowing how to calculate these ratios, entrepreneurs must understand how to interpret them and apply them to managing their businesses more effectively and efficiently.
Not every business measures its success with the same ratios. In fact, key performance ratios vary dramatically across industries and even within different segments of the same industry. Entrepreneurs must know and understand which ratios are most crucial to their companies’ success and focus on monitoring and controlling those.
A valuable way to use ratios is to compare them with those of similar businesses in the same industry. By comparing their companies’ financial statistics to industry averages, entrepreneurs are able to locate problem areas and maintain adequate financial controls. “Knowing your own numbers is only half the story,” says Brian Hamilton, founder of Sageworks, a company that tracks financial data for thousands of private companies. “When you look at how you compare to your peers, you can see where you are strong and what you need to work on.
The principle behind calculating these ratios and comparing them to industry norms is the same as that of most medical tests in the health care profession. Just as a healthy person’s blood pressure and cholesterol levels should fall within a range of normal values, so should a financially healthy company’s ratios. A company cannot deviate too far from these normal values and remain successful for long. When deviations from “normal” do occur (and they will), a business owner should focus on determining the cause of the deviations. In some cases, deviations are the result of sound business decisions, such as taking on inventory in preparation for the busy season, investing heavily in new technology, and others. In other instances, however, ratios that are out of the normal range for a particular type of business are indicators of what could become serious problems for a company. When comparing a company’s critical numbers to industry standards, entrepreneurs should ask the following questions:
When used properly, critical numbers can help owners to identify potential problem areas in their businesses early on before they become crises that threaten their very survival. Several organizations regularly compile and publish operating statistics, including key ratios, that summarize the financial performance of many businesses across a wide range of industries.
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