Making Financial Ratios work for your Business

When it comes to understanding trends or issues that are taking place within your business or industry, there’s no simpler or more valuable method than tracking financial ratios.

While calculating the most commonly used ratios is relatively straightforward, to get ahead, you should challenge your CFO or finance team to go beyond the basic computation of data and uncover insights that lead to strategic action.

A typical monthly trend analysis for an organisation will include key ratios on liquidity, profitability, efficiency and solvency. But arriving at the figures is just the beginning; there are two further steps that every finance team should undertake to ensure they’re getting to the meaning behind the numbers.

 

Dive Deeper

Firstly, ask your finance team to dive deeper, providing analysis or interpretation of the data and explaining any relevant or unexpected movements in the ratios. Simply stating that gross margin has reduced by a certain percentage is not sufficient. Liaising with other divisions across the organisation should allow your team to substantiate changes with non-financial data where possible.

As an example, when looking at your gross margin analysis, your finance team may discover from talking with the operations manager that a particular machine was not operating at full capacity due to maintenance issues. This will have contributed to the decline in gross margin and can explain the movement.

You might then ask them to look more closely at the hours of downtime verified to maintenance records and also report on the cost incurred to repair the equipment (depending on the timing of the repair, you might expect your gross margin to be down for some time, together with ongoing repair costs).

Trend Analysis

A report on your business’ financial ratios rarely has any meaning in isolation. Your financial team should be well-versed in identifying trends in the data recorded.

Using the aforementioned example, peaks and falls in gross margin may lead to the determination that there are maintenance issues on a particular piece of equipment every second month. The figures might prompt you to meet with the maintenance manager to understand the reason for this systemic issue and identify options to address the issue.

Outside of monthly analysis

Aside from the typical monthly analysis of results to budget, trends in financial data can be useful when setting strategy. Historical financial data can demonstrate trends that may need to be addressed.

For example, have margins changed on specific goods or services, and why? To answer these types of questions, you need the ability to look at the ratios over time and consider the broader industry and economic conditions.

Have you been impacted by digital disruption, innovation, competition or new markets? Are there opportunities arising from this? The robust analysis on longer-term trends is the perfect place to start when setting strategy.

Other considerations

In a world of Big Data, it’s important to focus only on the core drivers and ratios that impact your business. It’s better to understand the key factors, as opposed to risking information overload or using ratios that essentially report the same figures.

As the leaders of the business, you should provide guidance for your CFO or finance team on what the core drivers are. As a guide, we would expect your typical monthly report to include five key ratios accompanied by robust analysis.

On a periodic basis, it’s useful to complete a high-level benchmarking exercise against other organisations in your industry. This can provide you with some insight or, at the very least, an understanding of areas of opportunity or weakness.

Whatever ratios you choose to monitor, it’s important to remember they are only as good as the analysis supporting them, and the quality and consistency of the information used to generate them.

Financial indicators (lagging indicators) are important, however there there are other Key Performance Indicators (KPIs) that drive business growth. Learn more about other KPIs your business should consider, by downloading our ‘measures that matter’ KPI tool 

William Buck assists management teams to uncover the truth behind the numbers. For more information, please contact your local advisor.

Download our KPI Ready Reckoner here.