Liquidity ratios to measure your ability to pay your bills. Profitability ratios to determine whether you are making any money. Financial leverage ratios to capture how you are financing your business. And efficiency ratios that show you how effectively you are using your cash and other financial assets.
The ratios have been developed and fine tuned over many years by banks and investors. The focus of the financial ratios is determining the relative worth of a company.
So, What do standard financial ratios measure?
Money. How much you have. How much you use. How efficiently you use it. These numbers take the financial pulse of you business. They should be sufficient to effectively manage your business. When asked why they use these numbers the answer is “These are the measures our bankers and investors use to track our performance.” The assumption is if you manage your business by standard financial ratios you will grow your business successfully.
But You Can’t Drive Growth With Standard Ratios
Being able to pay your bills doesn’t ensure your business will grow. Although not being able to pay your bills makes it almost certain you will fail. Measuring your profit tells you whether you are making money. But it doesn’t increase the likelihood of you increasing sales or profit. Whether you borrow money or issue stock doesn’t affect you ability to increase sales. Measuring the efficiency with which you use your cash and other assets will help keep you from tying up cash unnecessarily. Free cash flow is good. But free cash flow will not guarantee your business will grow. None of these measures were designed to help your business grow.
The standard financial ratios were designed so bankers and corporate treasurers could manage a portfolio of companies. The perspective of your investors and bankers is to look at a business as a financial investment. The ratios allow comparison of different companies as investments. They help bankers to decide whether or not to give a company a loan. Or help a treasurer to determine whether to buy a company and what to pay for it. Unless your company is a bank, investment bank, Mutual Fund, or a large conglomerate, standard ratios give you the wrong perspective.
Why Is The Perspective Important?
The perspective is the way you look at business. Perspective drives what you measure. A banker looking at multiple businesses needs a perspective that makes comparisons between very different businesses possible. The standard ratios provide the common measurements needed. But not without a cost.
By looking at what all businesses have in common the standard ratios must be raised to the common denominator. All of the detail is lost. Using the standard ratios a banker can tell which companies are making money. But not why.
You Need A Detailed Perspective To Manage
Managing your business is about taking actions to grow your business. You need a perspective focused on the uniqueness of your business to know which actions will affect change. The perspective you choose will lead to different measures depending on what is important to the business function you want to change.
A sales organization will have one set of measures. Expenditures, actions, channels, the number of advertisements you place, and sales events. All are measures of what drives sales.
A production organization will require a different set of measures. Down time hours per machine , units of scrap, overtime hours, the number of impressions a printer makes and units produced are measures of what drives production.
Remember why you are measuring anything at all is to see if you will reach your goals. The perspective helps you define unique measures to assess your performance toward a goal.
To Reach Your Goals You Need To Manage The Uniqueness Of Your Business
Specific measures defined based on a focused business function perspective, provide you with the tools to make business growth a reality. Standard ratios will only give you a generic level of insight into your business. When you need to take action, leave the financial ratios alone. Select a perspective that meets your needs. Then select measures that will track the effectiveness of your actions. The measures will give you the feedback you need to reach your goals.