Bottom Line Business Insights : Maryland Business Lawyer & Attorney : Wagonheim Law Firm : Mergers & Acquisitions & Contractual Negotiation

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There is perhaps no facet of business management that is more critical, yet more intimidating, than financial management. Most business owners would sooner spend a day playing in traffic than trying to read and interpret the confusing array of numbers that make up their company’s balance sheet or income statement. Yet the fact of the matter is that playing in traffic is probably less risky than ignoring the company’s numbers. Being able to interpret a financial statement will enable your company to better plan for its future and efficiently allocate valuable resources. It is also essential because your company should never enter into a major transaction with another company (say, a vendor or a customer) without confirming the other company’s ability to fulfill the contract. That means reviewing and understanding the other entity’s financial statements.

So, what’s the best way to make quick work of financial statements while taking the intimidation factor out of the picture? Simply put, it is understanding certain basic Financial Ratios. Most people have heard of “Earnings per Share” or “Price to Earnings,” which are two of the more common financial ratios regularly discussed on networks such as CNBC and other financial programming. But fewer business owners are familiar with the more obscure (and for most privately held companies, infinitely more useful) financial ratios which measure the four basic attributes of any business:

1. Liquidity: a short-term view of the ability of the company to satisfy its currently maturing obligations
2. Leverage: a longer term view of the use of debt by the company and its ability to service that debt
3. Activity: a measure of the efficiency of the utilization of the company’s resources, such as measures of inventory turnover
4. Profitability: as compared with investment, or profit margins based on sales

What are acceptable ratios in each of these four categories of measurement? Generally, there are no hard and fast rules. Ratios are valuable because of what they can tell you about the current state of your company and the direction it is moving, rather than whether a company is in imminent danger of failure or can coast without another sale for the next two years. In that sense, it is useful to compare ratios over time.

What constitutes an acceptable ratio also depends on a number of outside factors, including (1) the company’s industry, (2) its accounting practices, (3) its goals, and (4) quite simply, what the company’s owners feel are acceptable ratios in light of those goals. Most business owners should have a discussion with their financial advisor or accountant in order to set acceptable ratios within the four attributes described above, and then formulate a plan to adhere to those ratios.  

While many business owners simply slough these matters off onto their accountant, the savvy business owner will understand (and should want to understand) the numbers that make his or her business work. Additionally, and no less important, not understanding the numbers is an invitation to corporate fraud and embezzlement by less than scrupulous company officers, directors and accountants (and believe it or not, these folks are out there).