Financial ratio analysis is now recognized as a powerful and accurate financial tool and is often used:

• by business owners when evaluating the creditworthiness of their debtors;
• by investors when considering the merit of investment opportunities;
• by banks and other lenders prior to granting approval for loans;
• by auditors when conducting an analysis of their clients; and
• by merger and acquisition teams when assessing a potential target.

The sheer mention of financial ratios can raise your stress levels if you do not understanding the purpose of financial ratios for keeping your business on track.

Put simply, much of the use of ratios is in looking at historical data and analyzing what has happened in the past. If that information is gathered and assessed properly, it can be a valuable tool in predicting future trends.

Financial ratios are commonly grouped into three categories as follows:

• Profitability - "Bottom line" ratios are designed to measure the income generation and profitability record of the business. The three most common are return on sales, return on investment (ROI), and return on equity.
• Liquidity - These ratios are designed to measure the ability of the corporation to meet its short-term liabilities - or debts - as they fall due.
• Operating efficiency - These ratios are measures of the efficiency with which the business uses its existing resources to earn a profit.

Knowing what to look for and how to analyze it is the key to charting the future success of your business.