It’s important to be able to read your financial statements. But where do you go from there? What are some ways to dive deeper into understanding your business’s finances?

A common first-step in financial statement analysis is “ratio analysis.” At its most basic level, ratio analysis is taking numbers in your financial statements and dividing them by another in meaningful ways. It is a quantitative analysis that provides you with additional objective information about your financial performance and position.

This post is not intended to be a list of key ratios that you should look at; rather, it is an explanation of why you should look at ratios in the first place!

Ratio analysis is a versatile tool that opens the door to further analysis of your financial statements. It can be done with stand-alone documents or in contrast to other financial statements or companies. Additionally, it allows you to compare your financial information with other companies that are a different size than yours. It also allows you to evaluate your own company over time, regardless of changes in size.

Four Ways to Use Ratios

1. Stand Alone Analysis

One way to use ratios is to evaluate numbers within one set of financial statements. This type of analysis provides you with additional insight about numbers.

You can compare a P&L number to a Balance Sheet number. For example, dividing net income by average total assets gives you the ratio “Return on Assets” (ROA). This ratio shows you how much profit you generated with your resources (assets).

You could also see how much coverage you have for your outstanding debt obligations by dividing your operating net income by total debt (interest + principal).

2. Trends

A helpful way to view financials and ratios is to compare them over time. By lining up year-over-year ratios or financial data, you can see how your financial landscape is changing over time. While it is helpful to know that your labor costs were 65% of total income, it may be even more helpful to know that from 2018 to 2019, your labor costs went from 45% of total revenue to 65% of total revenue.

You can see that Cost of Goods is higher in Year 5 as a % of Total Income by 10%! That means that in Year 5, while the dollar amount is larger, profitability is actually lower.

This is a simple exercise, but it demonstrates the function of ratios in controlling for size in an organization. The same concept applies for comparing to other companies.

3. Comparisons

Just as growth over time makes it difficult to compare its financial performance, the relative size of different companies makes comparison difficult. Converting financial statements to ratios enables a company to compare itself to other companies, industry standards, and benchmarks.

For franchise accounting, this is very helpful because ideally there are benchmarks being tracked. With the help of ADS (Accounting Data Standardization), a franchisor can collect, compile, and communicate standards to its franchisees. Not all franchise locations are going to be of comparable size, so it is important to use ratios to compare one location to the others.

4. Key Performance Indicators (KPI’s)

Ratios are often used when establishing and monitoring KPI’s. KPI’s are measurements used by companies (or franchises) to evaluate success in meeting various performance objectives. While KPI’s are a much larger topic requiring a dedicated post, I mention them here because they represent a big benefit of ratio analysis. Since ratios allow you to measure your financial performance over time and over company lines, they also allow you to establish and track your progress toward financial goals.

If you know that your Gross Profit Margin (Gross Profit ÷ Total Sales) is 35% but your franchise average is 50%, Gross Profit Margin becomes a KPI for your company and your goal is 50% or more. You may also identify smaller KPI’s within the Gross Profit Margin that will help you along the way!

Ratio Analysis is a critical tool for financial analysis. It opens the doors to comparisons and insights that would otherwise be missed in reviewing financial statements. It is the gateway to more in-depth analysis, but even on the surface level it can provide you with valuable insight into the financial performance of your company.

Stay tuned for more content on some of the most critical ratios to monitor and what they mean for your business!