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Understanding Business Ratios


    Peter J. Patsula, Knowledge Level: Moderate, Keywords: business, ratios

SIC codes, operating ratios, performance indicators, and more.

Business ratios are tools to evaluate your business. They come in many guises including the popular operating ratio, financial ratio, performance indicator, and benchmark.

OPERATING RATIOS

Operating ratios are usually shown as a percentage of some income statement item divided by total sales. The US Census loves these ratios and compiles them every five years for hundreds of business categories. The most important of these ratios is your Net Profit to Total Sales. This is calculated by dividing net profit by total sales and multiplying by 100% to express the ratio as a percentage. A supermarket may have a net profit ratio of 2% while business services tend to be higher at 20%. This however doesn't mean a business service is more profitable. Supermarkets have HUGE revenues. Thus, their annual net profit dollar value (the money they put in their bank account at the end of the year) may actually be much higher.


FINANCIAL RATIOS

A financial ratio is a mathematical comparison between two or more items from your balance sheet or income statement. You can use these ratios to measure the progress of your business, uncover trends, and point to potential problem areas. Bankers and investors often analyze these numbers to decide if they want to lend you money or invest in your company.

The Debt to Assets Ratio is probably the easiest to understand. It is calculated as its name suggests by dividing total debt by total assets, as found on your Balance Sheet. The more debt you have the higher the ratio and the worse off you are. A good ratio is 1:2 or 50%. Anything over 2.0 and bankers start to get jittery. The funny thing though is investors sometimes like a high debt to asset ratio, because then they figure they are leveraging their investment (like buying real estate with 0% down).

Other popular ratios are:

- Current Ratio (current assets divided by current liabilities)
- Quick Ratio (current assets less inventory divided by current liabilities)
- Sales to Inventory (annual sales divided by inventory)

A current ratio of 2 to 1 or higher is looked upon well. A quick ratio of 1 or higher is also favorable. These ratios mean you should be able to meet all debts AND if your business gets in trouble, they can liquidate your assets and get their money back.

Your sales to inventory should probably be around 6 to 1 which means you need to order new inventory about six times a year. This ratio is commonly referred to as your "Inventory Turnover" ratio. This ratio will be higher if you sell consumables and lower if you sell expensive items like jewelry or cars.

PERFORMANCE INDICATORS & BENCHMARKS

Performance indicators and benchmarks are the "everything under the sun" category. They can include both operating and financial ratios, as well as stats and activity measures like website traffic, segmented market sales, and even the number of customer complaints your business gets every month. Performance indicators and benchmarks are fun. They help evaluate your progress, like a report card, and give you goals to aspire to. A business owner should pick out several PI's and benchmarks that best evaluate their business. Six to eight PI's is a good target MORE is not necessarily better, as it takes time and money to accurately compile and analyze PI's and benchmarks.

RESEARCHING RATIOS: Finding Your SIC CODE

Industry associations, trade journals, and the US government are the first place you should look for ratios (see links at the end of this article) and www.bizratios.com.

To do this properly, you need to know your SIC code. SIC code stands for "Standard Industry Classification" code. It is a four to nine digit number that the US Census has assigned to industries and industry segments to keep track of figures like revenues, net profits, and operating costs.

The first two numbers indicate the general industry category; the next two numbers indicate the segment. For example, "Health Services" comes under 80 (or 8000), while "Personal Services" come under 72 (or 7200). "Health and Allied Services" come under 8099. A fast way to find your SIC code is to visit www.bizminer.com and use their database.

The rest of the numbers break down the categories into even smaller segments. For example 8099.0101 is for "Blood Banks."

Another way to find your industry's SIC code is to go to your library and refer to the "Standard Industrial Classification Manual." Once you have your SIC code, searching for information about your business gets a whole lot easier.

Of course, the government has recently changed to a new system: The "North American Industry Classification System." NAICS has replaced the SIC system (it is being used in Mexico, Canada, and the U.S.). Information about this new system is available at http://www.census.gov/epcd/www/naics.html.

INDUSTRY ASSOCIATIONS

Once you have your SIC code, you can reference materials like the "Encyclopedia of Associations" (available at your library) to find an association closest to your type of business. If you are lucky enough to find an association matching your business, then you will likely be able to get more accurate information than what the U.S. government has to offer.

Peter J. Patsula is author of Successful Business Planning in 30 Days, currently the top selling business planning guide on Amazon. He is also creator of Smallbusinesstown.com, The Entrepreneur's Guidebook Series, and Successful Business Planning in 30 Days. Provided by: Smallbusinesstown.com. Article on business, ratios by Peter J. Patsula
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