What is Ratio Analysis and Why is it Important for Small Business Owners? – Dr. Eric Bonaparte

The old adage is true, what cannot be measured can not be improved, and businesses who take the time to measure what matters gain a clear competitive advantage in today’s marketplace. On this week’s episode of The Playbook, host Mark Collier, business consultant for the UGA Small Business Development Center, is joined by Dr. Eric Bonaparte, the former Associate State Director for the University of Georgia Small Business Development Center. Dr. Bonaparte is a true subject matter expert on business analytics, and today we are going to peel back the layers on one of the most important measures of business analytics, ratio analysis.

Transcription: 

Mark Collier:
Welcome into The Playbook, Dr. B.

Dr. Eric Bonaparte:
Thanks, Mark. It’s great to be here and great to be here with your viewers as well.

Mark Collier:
Absolutely. Well, I hope you don’t mind calling you Dr. B. I hope I have earned the term, friend.

Dr. Eric Bonaparte:
That’s perfectly fine. I’m good with that, for sure.

Mark Collier:
All right. Very good. So, as I said in my lead in, ratio analysis, business analytics, there’s very important, but oftentimes business owners kind of overlook them.

Dr. Eric Bonaparte:
Absolutely. They are taught to look at bookkeeping information, accounting information, general financial information…

Mark Collier:
Right.

Dr. Eric Bonaparte:
But not at the specifics as it relates to the ratios that’s inherent when they run their business.

Mark Collier:
That makes sense.

Dr. Eric Bonaparte:
And so that has been a focus to look at that topic all to itself.

Mark Collier:
Okay. Well, in terms of the general viewpoint, financial tools, they’re out here.

Dr. Eric Bonaparte:
Mm-hmm

Mark Collier:
And I just kind of… I guess that’s the first question I’ll begin with. What type of financial tools exist to help small businesses grow in scale?

Dr. Eric Bonaparte:
Well, there are lots of financial tools, anything from accountant software, automated systems that will check how a business is doing, takes various looks at the mechanics of the actual operation.

Mark Collier:
Okay.

Dr. Eric Bonaparte:
And then a business owner can purchase software packages. They can get consulting in those areas.

Mark Collier:
Sure.

Dr. Eric Bonaparte:
But the thing that ratio analysis brings is that it’s so simple that a business owner could do it themselves. It just involves doing a calculation of math…

Mark Collier:
Understood.

Dr. Eric Bonaparte:
On their financial statements. So that’s something that’s really simple for them to do, but there are tons of financial tools out there…

Mark Collier:
Okay.

Dr. Eric Bonaparte:
To do sophisticated things, anything from spreadsheet packages to, again, templates that will look at sales and revenue, and all these other specific things.

Mark Collier:
All that stuff is very important.

Dr. Eric Bonaparte:
Yeah.

Mark Collier:
So drilling down one of my favorite topics that I’ve grown to love from your tutorials at our signature program Grow Smarter at the UH SBDC, ratio analysis.

Dr. Eric Bonaparte:
Yes.

Mark Collier:
So let’s begin with kind of the basics. What exactly is ratio analysis? And I guess we’ll get the academic definition, and then of course your take on it?

Dr. Eric Bonaparte:
Okay. Well, great. Academic definition is just looking at numbers…

Mark Collier:
Okay.

Dr. Eric Bonaparte:
To get comparisons, that’s the simplest way to do it. Essentially, it’s going to be looking at the financial statement for a company…Taking out specific numbers from the financial statement…

Mark Collier:
Yep.

Dr. Eric Bonaparte:
Doing a little bit of math…

Mark Collier:
Okay.

Dr. Eric Bonaparte:
Basically, it’s division and getting a number…

Mark Collier:
All right.

Dr. Eric Bonaparte:
And having that number tell us something about how the business is doing. So one step is the calculation, the second step will be the interpretation of the number.

Mark Collier:
Okay. Well, fantastic. Well, listen, ratio analysis, obviously, has a genesis, has a beginning.

Dr. Eric Bonaparte:
Yeah.

Mark Collier:
I went to business school, we talked about it a lot, but I never really understood the history of it.

Dr. Eric Bonaparte:
Okay.

Mark Collier:
So where exactly the ratio analysis began, kind of what’s the genesis of it?

Dr. Eric Bonaparte:
Okay, great. Well, financial gurus will tell you, it began in 300 BC, right? And somebody will say, “God, what are they doing with ratios in 300 BC?” Was very simply comparing basic financial information.

Mark Collier:
Okay.

Dr. Eric Bonaparte:
But it really began in the 1920s. In the 1920s, the advent of the tax code and the Federal Reserve System, called for a system of being able to compare companies and their performance.

Mark Collier:
Okay.

Dr. Eric Bonaparte:
And so later on in the 1920s, you had the advent of banks looking at companies to loan money to, you had credit unions doing the same. And you had unions, industrial unions that wanted to get an idea of how their companies within the unions were doing. So everybody wanted a benchmark.

Mark Collier:
Sure.

Dr. Eric Bonaparte:
Everybody wanted a way to see which companies are good, which companies are bad, which companies need help? And so the 1920s was the explosion of ratio study and ratio analysis.

Mark Collier:
That’s a good history, and I appreciate the feedback on that. So ratio analysis, what typical ratios can be performed on a company’s finances, and exactly what can it tell a business owner? Because those things are important.

Dr. Eric Bonaparte:
Absolutely. So ratios are divided up into groups. There are profitability ratios that kind of looks at the margins that a company would have.

Mark Collier:
Okay.

Dr. Eric Bonaparte:
So when you do the calculation, you look at the margins, is that a healthy margin? Are the margins too thin? Are the margins really wide enough to look at profit? And that’s why they call it profitability ratio.

Mark Collier:
Sure.

Dr. Eric Bonaparte:
Then there are liquidity ratios. Liquidity ratios is basically how quickly a company can do what they do and turn that into cash.

Mark Collier:
Yes.

Dr. Eric Bonaparte:
How liquid is the company?

Mark Collier:
Okay.

Dr. Eric Bonaparte:
And so when you do some analysis, sometimes there’s short-term liquidity analysis, sometimes long-term. Short-term will tell a person doing the analysis if a company can quickly turn cash…

Mark Collier:
Yes.

Dr. Eric Bonaparte:
Or if it takes a little bit longer. And then you have solvency ratios. Solvency ratios will tell someone doing analysis whether the company is strong with the debt that they carry…

Mark Collier:
Mm-hmm.

Dr. Eric Bonaparte:
Or even the debt that they don’t carry.

Mark Collier:
Okay.

Dr. Eric Bonaparte:
That if that’s going to cause a problem. And finally, there’s something called efficiency ratios, tells a company or manager of a company, whether they collect it on the receivables…

Mark Collier:
Yep.

Dr. Eric Bonaparte:
Whether their working capital to run the businesses is healthy, at a healthy state. And as you know, working capital helps pay for the day-to-day operations of the business. So those are the four common ones that will allow a manager to really know how the company’s performing.

Mark Collier:
That’s great. I’ll tell you another thing, or two other things, not only the managers important for them, but if that company is going for any type of bank loan or audit, those bankers, they examine those ratios, they examine them very, very circumspectly.

Dr. Eric Bonaparte:
Absolutely. Mark, that’s a great point. Banks now use something called a bankruptcy predictor…

Mark Collier:
Okay.

Dr. Eric Bonaparte:
Or a Z-score.

Mark Collier:
All right.

Dr. Eric Bonaparte:
And that allows them to do some ratio analysis that will tell them, “Is the company healthy enough to survive the payback of a loan?”

Mark Collier:
Yes.

Dr. Eric Bonaparte:
So if they do that analysis and find a company is close to bankruptcy, or bankruptcy is near, then they may hesitate investing via a loan product…

Mark Collier:
Yep.

Dr. Eric Bonaparte:
Into that particular company. They may choose to wait a little bit, have the companies’ owners do some strategy to get that business on a stronger foothold before they invest. Also, investors do the same thing as well. People buying businesses do the same thing as well.

Dr. Eric Bonaparte:
We know, Mark, that people can listen to words and in a narrative can talk about this glowing company, right? But numbers don’t lie.

Mark Collier:
No, they don’t.

Dr. Eric Bonaparte:
Especially if they’re accurate.

Mark Collier:
Yes, absolutely.

Dr. Eric Bonaparte:
So if they’re accurate numbers, with ratio analysis you can perform these analysis on those numbers to see exactly what’s happening, to give you a truer picture. And that’s one of the stronger things, so you hit it right on the nose, the stronger things about ratio analysis.

Mark Collier:
A lot of business owners, they miss that part.

Dr. Eric Bonaparte:
Yes.

Mark Collier:
They miss the part, the banker is going to look at those ratios as well. So they better look at them on the front end.

Dr. Eric Bonaparte:
Absolutely, absolutely.

Mark Collier:
All right. So after looking at the ratios, going through the analysis and interpreting their meaning, then what? What’s the next step?

Dr. Eric Bonaparte:
Well, let’s take a step back…

Mark Collier:
Sure.

Dr. Eric Bonaparte:
In interpreting the meaning, a lot of small business owners don’t know how to figure this stuff, how to learn, how to figure out what this number is telling me?

Mark Collier:
Okay.

Dr. Eric Bonaparte:
If they do… One of the ratios does a division of assets and liabilities…And they get a number of, let’s say one, what does that one mean? Well, it means for every debt dollar that they have, they have $1 of asset to pay that debt…

Mark Collier:
All right.

Dr. Eric Bonaparte:
In case they have to pay that debt. So that’s a very way of looking at it. So once they determine, or they learn how to interpret the assets, the ratio number, then they can develop a strategy, a management strategy to figure out, do they need more debt? Do they have to get paid down on their debt?

Mark Collier:
Yep.

Dr. Eric Bonaparte:
Do they have too many assets? If something happened, would they have to borrow money in order to do something else, hire employees or whatever else?

Mark Collier:
Sure.

Dr. Eric Bonaparte:
So it kind of gives them a strategy as to what to do, right? And interpreting ratios, it’s practice.

Mark Collier:
Okay.

Dr. Eric Bonaparte:
It’s someone who has done this stuff before…

Mark Collier:
Sure.

Dr. Eric Bonaparte:
Whether it’s an accountant, a counselor, or just the research that an owner can do to figure out, “Okay, this is what this means for my company right now. Is that a healthy way to be?”

Mark Collier:
Absolutely.

Dr. Eric Bonaparte:
And doing ratio analysis, a company just doesn’t do it just at one time. They want to do it over time to see how that’s improving, or if it’s getting worse.

Mark Collier:
Absolutely. It’s part of the trend analysis.

Dr. Eric Bonaparte:
Absolutely, absolutely.

Mark Collier:
You have to examine your trends over time and see where you’re going, and how you’re going to get there?

Dr. Eric Bonaparte:
Absolutely, absolutely. That’s a great way to identify it.

Mark Collier:
All right. So what is essential to know about ratios? I want to peel back the layers here in saying, okay, after we’ve done all this analysis, what is essential for business owners to know about the ratios that they’ve uncovered?

Dr. Eric Bonaparte:
Well, the biggest thing is that there are a lot of ratios out there. There’re some ratios for service companies, for manufacturing companies, specifically for companies that deal with a lot of cash, a lot of investors. The biggest thing to know is that not all ratios fit your business.

Mark Collier:
Mm-hmm.

Dr. Eric Bonaparte:
You might be looking at numbers that makes no sense to you because it just doesn’t fit.

Mark Collier:
Sure.

Dr. Eric Bonaparte:
So you have to look at the numbers that’s going to make sense to your business and your industry.

Mark Collier:
Yes.

Dr. Eric Bonaparte:
The other thing that you have to know is there are industry ratios that you should be looking at as well. There’s one thing to be performing, whether you’re an athlete or a small business owner. There’s one thing to be performing and thinking that you’re doing well…

Mark Collier:
Yeah.

Dr. Eric Bonaparte:
But then you got to look at somebody else to know how well are you doing?

Mark Collier:
That’s right.

Dr. Eric Bonaparte:
Right?

Mark Collier:
That’s right.

Dr. Eric Bonaparte:
So, as I talked about in the 1920s, this whole ratio study really started just blowing up, so to speak. A lot has been done to compile industry information on what a healthy company should be looking like in terms of their ratios.

Mark Collier:
Yep.

Dr. Eric Bonaparte:
And it’s done in such a way that whether you’re a small company or a large company, you can still look at the same ratio as a benchmark.

Mark Collier:
Sure.

Dr. Eric Bonaparte:
Right?

Mark Collier:
Yep.

Dr. Eric Bonaparte:
So peeling it back, you want to make sure that you’re looking at the right ratios. You want to make sure that you’re not looking at the ratios for yourself and doing trend analysis as you said, but also looking at how is the industry doing?

Mark Collier:
Yes.

Dr. Eric Bonaparte:
Right?

Mark Collier:
Yes, yes.

Dr. Eric Bonaparte:
Especially coming through tough times like we had just been coming through…

Mark Collier:
Absolutely.

Dr. Eric Bonaparte:
You want to know a ratio that may not have been so good in 2019, may be pretty decent now because of the economic struggles we’ve had to deal with over the last year.

Mark Collier:
Correct.

Dr. Eric Bonaparte:
So you want to look at that. So you don’t want to look at things that’s going to just send you on a wild goose chase.

Mark Collier:
Right.

Dr. Eric Bonaparte:
And so that’s one of the major things you want to do. For looking at specific ratios, you want to look at industry information, trade union information. You want to talk to your consultant and accountant to make sure that you’re looking at the right ones, and that it makes sense to you.

Mark Collier:
Well, that’s a perfect segue into my next question. We’re going to talk about who else uses ratios? We’ve already discussed banks…

Dr. Eric Bonaparte:
Mm-hmm

Mark Collier:
But you brought up a very important point in terms of benchmarking.

Dr. Eric Bonaparte:
Yes.

Mark Collier:
We use an important tool at the UH SBDC called industrial CFO…Where companies can examine their ratios and then go look at them against other similar companies within their industry or business sector.

Dr. Eric Bonaparte:
Absolutely.

Mark Collier:
And that will provide insight, as you said earlier, about what they’re doing right? What they’re doing wrong? And what they need to be doing better?

Dr. Eric Bonaparte:
Absolutely. And more and more people are looking at ratios. It’s something that’s had this mystique about it…

Mark Collier:
Yeah.

Dr. Eric Bonaparte:
Because it was numbers and people were scared about it…And didn’t know how to interpret it.

Mark Collier:
Yep.

Dr. Eric Bonaparte:
But you have lots of people now who are not starting businesses from round one, that they buying businesses.

Mark Collier:
They are, correct.

Dr. Eric Bonaparte:
And as I said before, you could walk into a business if it’s a physical business and it looks great, it’s got customers and it’s doing well. But until you look at the finances…

Mark Collier:
Yeah.

Dr. Eric Bonaparte:
There’s a quote that talks about that 54% of the small businesses have record sales before they go bankrupt. And so they have customers that are buying and then placing orders, and all this stuff, but what is really happening in the business?

Mark Collier:
Yeah.

Dr. Eric Bonaparte:
So the other users of ratios as somebody who’s thinking of, “Okay, I don’t want to start a business from scratch. I want to buy a business…”

Mark Collier:
Sure.

Dr. Eric Bonaparte:
“But I want to get the true picture.”

Mark Collier:
Yep.

Dr. Eric Bonaparte:
So a person interested in buying a business, it could be an employee, it could be somebody from the outside of the business, will look at ratios or have somebody look at ratios to see how healthy the business is really operating? Certainly, investors are looking at it as well. If they’re not buying a business, but they invest in a business, they’ll want to see if everything is good.

Dr. Eric Bonaparte:
And then competitors now are doing it.

Mark Collier:
Yes they are, absolutely.

Dr. Eric Bonaparte:
So if you have a business, if I could get ahold of your financial statements, I want to look to see how is my competitor doing?

Mark Collier:
Yes, exactly. Back to that benchmarking.

Dr. Eric Bonaparte:
Exactly.

Mark Collier:
Yep.

Dr. Eric Bonaparte:
So is my competitor doing better in a certain area than I am? We had a similar sized business, how come he or she is doing better? What specific things within their finances?

Mark Collier:
Yep.

Dr. Eric Bonaparte:
Is it that they have controlled their debt?

Mark Collier:
Yeah.

Dr. Eric Bonaparte:
Is it that they haven’t been afraid to take on debt?

Mark Collier:
Mm-hmm.

Dr. Eric Bonaparte:
To buy things, assets or whatever else to run the business? So that’s happening a lot too, where competitors are even looking at another company’s ratios.

Mark Collier:
Makes sense, makes sense. All right. So any last words on ratios, tips, tricks, words of advice?

Dr. Eric Bonaparte:
With all the tools that’s out there, if they want to look at ratios, it’s a very powerful tool. Don’t waste your time on looking at all of them. As I mentioned before, look at the ones that kind of relates to your small business.

Mark Collier:
Correct.

Dr. Eric Bonaparte:
Most of all, when it’s calculated for you or you calculate the ratio, and there are lots of tools out there to help you calculate ratios, make sure that you develop a strategy behind what you have found.

Mark Collier:
Yes, absolutely.

Dr. Eric Bonaparte:
So if you see a positive ratio, it looks good. It looks good for the industry…

Mark Collier:
Mm-hmm.

Dr. Eric Bonaparte:
Means that you’re doing something right, keep on doing that.

Mark Collier:
There you go.

Dr. Eric Bonaparte:
If it’s a negative ratio, and as you mentioned, trend analysis, if the ratio is a negative and it’s a bad thing, and it’s not getting better, develop a strategy to improve that. Talk with someone, whether it’s the Small Business Developments Center, consulting an accountant, or some other consultants, — consultant, tell you what you have to put in place in order to do that.

Mark Collier:
Makes sense.

Dr. Eric Bonaparte:
Mark, something as simple as one of the ratios talks about accounts receivable. How quickly do you get paid for the work that you’ve done?

Mark Collier:
Yeah.

Dr. Eric Bonaparte:
How quickly do you collect that?

Mark Collier:
That’s a turn rate, huh?

Dr. Eric Bonaparte:
That’s a turn rate, right. If that turn rate is really bad, that tells you, okay, you’re selling your services and your products and all that, but you’ve got to spend time to develop a strategy to collect that money.

Mark Collier:
Yes.

Dr. Eric Bonaparte:
And so it can tell you some specific things within the management of your company that you have to turn around in order to improve that ratio, but in order to survive as well.

Mark Collier:
All right. So last question, what resources are available to help business owners learn more about ratios? Where can they go?

Dr. Eric Bonaparte:
Absolutely, Mark. Well, we are blessed to have a time where you can just get on a computer and Google a topic. Tons of articles, tons of how do… YouTube and all that, on what ratios mean?

Mark Collier:
Yep.

Dr. Eric Bonaparte:
How to calculate them? So that’s the first source, easy source. There are technical assistance organizations like the Small Business Development Centers…

Mark Collier:
Yep.

Dr. Eric Bonaparte:
And others around your city, wherever you are, to help you figure out what this means. And obviously accountants.

Mark Collier:
Yep.

Dr. Eric Bonaparte:
Accountants can tell you what these mean? How to calculate it? One of the easiest things that’s a resource too, is your financial software.

Mark Collier:
Yes.

Dr. Eric Bonaparte:
I’m not going to mention specific names, but there are various automated accounting software packages now…

Mark Collier:
Mm-hmm

Dr. Eric Bonaparte:
That will calculate these things automatically for you.

Mark Collier:
Okay.

Dr. Eric Bonaparte:
I may even tell you a little bit of what they mean. So there are tons of resources out there. I would say, if you’re not a numbers person, don’t feel bad about trying this stuff. It’s not as difficult as it’s used to be.

Mark Collier:
Yes.

Dr. Eric Bonaparte:
And there’s a lot of strength in knowing how to manage by the numbers, using ratio analysis.

Mark Collier:
All right, Dr. Eric Bonaparte, the depth and breadth of your knowledge on this subject is second to none.

Dr. Eric Bonaparte:
Thank you.

Mark Collier:
And I appreciate you coming in and sharing with not only me, but the viewers out here on what ratio analysis is, why it’s important? And of course your bottom line, the numbers don’t lie.

Dr. Eric Bonaparte:
Numbers don’t lie. Thanks Mark, and thanks for your viewers allowing me to be here and sharing with them.

Mark Collier:
Very good.


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