If you are about to approach a bank or investors whom you expect to invest in your business, you need to show them that you have considered the big picture. Your business idea might be great but what is more important is the base on which they will make their decision to invest in your business.
Financial Ratios are useful in this case. They are used to come up with mathematical interpretations of the financial outlook. The relationships between these financial ratios do not just help impress your investors who can compare them with many other companies, they also help the internal management understand how well the business is performing and the areas where it needs improvement. This process known as the Ratio Analysis, is a great tool for understanding the strengths and weaknesses of a business.
There are quite a few Financial Ratios used in Ratio Analysis and they are often categorised as below.
- Profitability Ratios
- Liquidity Ratios
- Efficiency Ratios
- Working Capital Ratios
- Asset Usage Ratios
If you study ratios further, you would find different categorisations. However, if you are not willing to dig deeper into the subject, you might as well stop at having an understanding on some key ratios from those categories above, that are common and vital for any business. If your business is showing steady growth and if the debts are kept minimum, these ratios are likely to be within an acceptable, healthy range. If for example you have excessive debts and your expenses are higher than your income, then these won’t be in an acceptable range. You will be able to find lots of literature on each of the categories above with a simple web search, so we won’t duplicate them here.
As financial ratios are raw computations of your business’s performance, it is always good to maintain an acceptable range when reaching out to investors and banks. If the ratios are not healthy, banks would offer loans under less favourable terms and conditions or they might not offer loans at all.
Some investors, however, tend to take the risk and invest in the business even if the ratios are not in an acceptable range. They tend to be convinced by the vision and the capability of the owner or they can be convinced by the long-term potential of the business. At the same time, some investors would not invest in your business sometimes even if the ratios are maintained well, as some of them tend to have their own criteria regarding business valuation. You should understand that ratios are not a silver bullet, as investment decisions depend on many other factors as well. However, it is wise to be regularly checking your ratios and maintaining healthy levels, as they are generally regarded as primary indicators of a well-functioning business.