There's no doubt that Using financial ratios in business are one of the most important tools that business owners have in their toolkit. By using financial ratios, you can get a better understanding of how your business is performing, and make changes to improve your bottom line. But what are financial ratios, and how do you use them?

Are you curious about what financial ratios are and how they're used in business? Wonder no more! In this podcast I will

• Firstly, look at what a ratio is
• Secondly, the source documents, where the information comes form
• Thirdly, the four areas traditionally examined
• Finally, limitations of using financial ratios in business

I’ll explain why they're important.  Stay tuned - your business savvy is about to get a major boost!

In weeks I Hate Numbers podcast I'll break it all down for you! So listen on to learn more about financial ratios, and how to put them to work for your business.

Conclusion

Financial ratios are important tools that business owners can use to make informed decisions about their businesses.

In this podcast, I looked at financial ratios , what they are, where the information comes from, and the four areas traditionally examined.

However, it's important to note that financial ratios should not be used in isolation and should be considered along with other sources of information.

Check this link to learn more about financial statements.  I invite you to join my Numbers Know How Financial Story Plan Community. I'd love to have you there!

Check out my I Hate Numbers YouTube channel,  Subscribe to I Hate Numbers now so you don’t miss an episode.  My book, I Hate Numbers will change your relationship with numbers and money, in a good way.  Check out what people have said, buy the book and make your own mind up, you won’t be disappointed.

If you found this podcast useful then share this episode on social, leave a review on Apple podcast.  Connect with me on Instagram, YouTube, Twitter, LinkedIn and Facebook.

If you are running a business, if you're managing a business, it's critical that you understand how your business is performing. A common technique that is adopted to help understand how the financial performance is doing is to use a technique called ratio analysis. In this podcast, I’m going to dive in and explain the technique of ratio analysis. We're going to be discussing the source documents. Where does that information come from?

So we're going to have a look under the bonnet of the three primary financial statements. I'm going to talk about the four key areas that financial people, financial analysts, tend to look at when it comes to understanding, reviewing and comprehending financial performance. And I'm also going to be mentioning the limitations of this technique as well.

You're listening to the I Hate Numbers podcast with Mahmood Reza. The I Hate Numbers Podcast mission is to help your business survive and thrive by you better understanding and connecting with your numbers. Number love and care is what it's about. Tune in every week. Now, here's your host, Mahmood Reza.

Hi, folks. My name is Mahmood, and welcome to another weekly episode of I Hate Numbers. My background: I'm an accountant, I'm an educator, and I'm the proud author of the book I Hate Numbers. I've been an accountant for over 27 plus years, running my own businesses, and I've helped thousands of businesses, private, arts and social and charities over the years to get closer to their numbers, reduce the anxiety they face, and help them navigate towards a business future they aspire to.

I'd love it if you folks could subscribe to this podcast. Give me your feedback if you like it. If you don't like it, let me know why. Let's crack on with the podcast now, numbers. Let's get some sanity check here. The figures that we see in the financial statements, more of that in a second or two, fundamentally reflect the activity that your business is going through. So every time you buy something, every time you sell something, every time you engage and pay for a freelancer, pay for wages of your staff, every time something goes wrong,

every time something succeeds, ultimately that will feed through and be captured in the numbers of your organisation. Those transactions will be recorded. Those transactions will then be used to help generate the three financial statements, typically, that a lot of organisations will be generating. Now, before we dive into what those statements are, before we look at the areas that ratios will look at, let's first of all understand why ratios are used in the first place. Now, just as a flashback to the understanding of the term ratio, a ratio is just a relationship between two or more numbers.

For example, if I generate a level of profits of, say, £50,000, that is a number in itself and that's what mathematicians would call an absolute number. It's the figure. If, however, I want to get some more meaning out that £50,000, I might relate that to perhaps how much I've generated by way of sales, by way of turnover. So using that same level of profitability, if I've generated a turnover of £200,000, then I can say out of that £200,000 worth of sales, I've generated a profit of 50,000. So if I divide one by the other, that gives me a 25% figure

i.e. of that sale, 25% is the profit that I've generated. What we've just done there, we've calculated a ratio. A ratio can be expressed in percentage terms. It can be measured and expressed as a raw number, it can be expressed as a fraction. Anyone remember those? I certainly do. So a ratio is just a relationship between two numbers. Now, you might be thinking to yourself, well, why do we bother with ratios? Well, one of the main benefits of ratios is it can condense lots of numbers that might make our head hurt.

If we look at a sheet where we got numbers coming from all over the place, we look at our financial statements here, we want to try and get some meaning. So we relate one thing to another and we make an effective relationship. First of all, it condenses all those big numbers to something that's more visible, more manageable. Secondly, we can use those figures to compare against previous years, against other organisations that we might have access to data on, and ratios will condense and able us to give much better insights. There are obviously limitations, which I'll address towards the end of this podcast.

The next thing I want to address and talk about is what's the source of the information where analysts, numbers, people and yourself will access to actually help us calculate the ratios. Later on in the podcast, I'm going to discuss and mentioned the four key areas that most financial analysts tend to look at when they analyse the performance and understand the performance of a business. The three primary documents that are used are the profit and loss. For those jargon people out there, profit and loss is one term that's expressed. You can call it a P&L, you can call it an income and expenditure, and that is a document that summarises effectively the level of sales activity that your business has undergone, what the related expenses are,

and the primary performance measure that comes out of that is the profit. And a profit or loss account is fundamentally a performance statement measuring how well a business has done over a period of time. Statement number two is what's called a balance sheet. Now, a balance sheet is purely a statement. It's a snapshot in time, it's a freeze frame. Say, if I made a list, if I represented this as a see-saw on the left hand side of my see-saw, I'm going to list all the items of value in my business, what we may call assets. So things like equipment, machinery, fixtures, fittings.

If you happen to own a building as well throw that into the mix as well. On the right hand side of the seesaw, I'm going to position and make a list of all the debt that I have, the more depressing side of your business. So there could be loans, overdrafts, mortgages, monies owed to suppliers and that will give you your debt. And again, if you want a bit of technical terminology here, you may express that as liabilities. Now, if they balance themselves out perfectly, which is very unlikely, that means your business at that point has no monetary value overall.

What we typically expect is that the assets, as we call them, are going to outweigh the liabilities. There's a link in the show note, folks, by the way, for a previous podcast where we've looked at those financial statements. The last financial statement that you are likely to be looking at is what's called the cash flow statement. And that connects the dots, that shows the flow of hardcore cash flowing in through the company's bank accounts. The money coming in and the money going out, and that will be from selling things, goods and services, surplus assets. It will be detailing the money that goes out in cash. So whether that’s buying equipment, paying suppliers,

paying for operating costs, paying yourself and the like. So what have we covered so far? We've looked at the idea of ratios, we've looked at what they can lend to us or they can give us. We look to the financial statements from which this data is extracted. Now, let's have a look at the key areas that financial analysts and numbers people tend to look at when they analyse the performance of a company. The four key areas that are examined are typically profitability, efficiency, liquidity and what's called risk and return.

Now, bear with me as we explore each one of these in turn. Now, profitability is a very popular measure and anyone in business, whether that's a private business, arts or social, should aspire to be making a return to making a profit in their business. So whatever your’re incurring by way of costs to deliver to your end customers, to support your business, you need to recoup those costs and have something on top to compensate you for your time, your energy, to help build up reserves and to reward yourself and your team. So profitability is a key measure.

Now, efficiency, it's not saying about you necessarily as an individual how efficient you are, it's saying of all the resources you have at your disposal, your assets if you wish, how efficiently are they being used to generate value? How efficiently are they being utilised in your business? The third number we're going to comment on here is what's called liquidity. And liquidity is just an alternative term for saying the availability of cash.

It's a fundamental truth that if your business does not have access to cash resources, if your business does not have cash in the bank, does not have those facilities there, then it's going to be very, very difficult for it to survive, let alone prosper. Ultimately, a lack of cash, a lack of access to cash means that your organisation is likely to face big challenges, which pretty much will mean that's the end of the road for your business. So liquidity is a key item. And the last area that we look at is what's called risk and return. All business owners will incur a level of risk by nature. Nothing in life is risk free.

There will always be a risk in running a business. And what we are thinking about is if we undertake that risk, if we go into our business incurring the risk, and all businesses have different levels of risk, what's the return that's likely to be generated as a result? Now, typically, in those four metrics here, we can have a bunch of ratios that we can calculate. And the key thing to remember here, folks, is under these umbrellas - this is just a general framework here - if you're using these numbers internally, you need to adapt them for your particular circumstances.

So if I take as an example the area of profitability, the two most common measures used in profitability are to measure the level of gross margin or gross profit. That's the profit that you generate from your goods and services that you're supplying, less any costs that are matched and more immediately against them. What does that mean? So if I'm a retailer selling stock, I will look at the cost of an item, let's say £10. If I sell that for 30, I've made a gross margin of £20. In ratio terms, the gross margin would be effectively two thirds, which is just approximately 67%.

That would be my gross margin percentage. That is the ratio. The original numbers that I've expressed earlier, those are the figures expressed in power notes. What I'm looking for is to get that in terms of percentages and a ratio. Now ultimately, the gross margin is there to help feed in and cover the support costs. Typically, you might call them overheads, things like the rent, wages to your team, delivery and the like, marketing, PR, HR, IT… you know, add your own items in there to make up that list.

Once we've covered all those, then we have what's called a net profit. You may also come across it is called an operating profit or operating margin. Now, in terms of adapting that, you may want to then measure the profitability in relation to your own business. So what's the profit perhaps, per staff member? What's the profit perhaps per square meterage? If you've got a facility, if you've got a shop, you might want to measure the profits that you're generating on those here. You might want to measure it in terms of per customer. Adapted, by all means, but here we're just talking about the general framework.

The efficiency is just that. It's saying, how well do we use the assets at our disposal. Typically efficiency, if you are, say, a manufacturing business or a retailing business, you might want to say how quickly can I empty my store, get it converted into a sale to my end customer? So the ability to turn that round, how effectively all my assets, generating value, generating turnover and those might be areas that I look at there. Now, liquidity is not just cash in the bank that we mentioned earlier, that's really important. We tend to, especially if we are selling things, have monies wrapped up, tied up in inventory.

If we offer credit facilities to customers, again, that's a strain on the cash flow and it's a true system. Every time we offer credit facilities to a customer and they take them, that means there's a negative impact on our own cash flow. We look at how much money is tied up in customer accounts, how much money is tied up in the inventory. We don't just look at the actual physical amount, which is important, but we actually look at that in terms of ratios. We might measure things called receivable or debtor days.

How long does it take our customer to pay us for the date they get the invoice? Obviously we're looking for a smaller figure as possible so that the bigger that goes up and it's measured typically in days, the more problems we are likely to face. Likewise, when we buy inventory for resale, we buy in raw materials to convert it into a product. That's money that's tied up in those items. Until we actually get it out the door, sell it and get the cash from a customer, that's money tied up and that's a big impact potentially on our cash flow.

Risk in return would be looking from an investor's perspective, how much are they likely to get from the investment they are making in their business, in your business? Now, if we look at those four quadrants together, that will give us a bunch of numbers and there's a few things that is worthwhile mentioning here before we start to wrap up the podcast. Now, we can quite easily with technology, with our accounting software, accounting systems, tapping into the financial planning story planning community, that is Numbers Know How, link in the show note folks there, by the way, we can calculate numbers till they come out of our ears.

However, that's not going to help us much in understanding performance. What we need to do is to be aware and we're looking at things like trends, we're looking to make sure we are comparing like for like we need to take into account the relevance and reliability of those numbers. The credibility of your financial statements is going to have an impact obviously then of the ratios that are calculated. In next week's podcast, I'm going to go through a worked example specifically looking at an organisation, I'll publish the case study within the show notes and we can then draw out some more meaningful conclusions.

Folks, I hope you got some value from this particular podcast today. What have we looked at? We've looked at the power of ratios. We've looked at the typical areas that are examined by financial ratios. We looked at the source documents that those numbers are extracted from, and we've also added a cautionary note about the limitations on financial ratios as well. I hope you've got some value out this podcast. If you have, obviously I'd love to hear your feedback. I'd love it even more if you could leave a comment or perhaps share that with friends or colleagues. Until next week, folks, have a good week.

We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you got some value. If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.