INTRODUCTION TO RATIO ANALYSIS

A general technique for analyzing a business's performance or its potential performance is known as Ratios Analysis. Ratio Analysis involves calculating ratios for a business or proposed business and comparing them to ratios of other businesses within the same industry.

Ratios involve dividing numbers from a business' Balance Sheet and Income Statement to create percentages and decimals. When existing businesses apply for a loan, for example, bankers will look at the company's ratios and compare them to ratios of other businesses within the same industry. This will determine how "stable" the company is compared to other businesses within the same industry. Moreover, ratio analysis will assist investors in determining three things about an existing business:

In addition, bankers and educated investors will compare ratios of non-existing businesses (aspiring entrepreneurs planning on establishing a business) to businesses already existing within the industry to determine if the proposed business will be competitive . Moreover, ratio analysis will show investors three things regarding the performance of a potential business venture;

1. How the aspiring entrepreneur anticipates his or her business will perform in their third year of operations;

2. How the aspiring entrepreneur anticipates his or her business will be performing in the first two years of operations; and

3. How the aspiring entrepreneur's business will compare to other businesses already operating within the industry.

Both existing business owners and potential business owners should calculate their own ratios. This will help to determine how well they are performing or plan to perform internally and externally. In addition, ratios are generally required in a business plan and will be closely scrutinized by bankers and other educated investors.

This section has been organized into three parts, namely;

To help us in our discussions, we will use a fictitious company called "The Widget Manufacturing Company". In Part 1, you will learn how to calculate ratios for The Widget Manufacturing Company for 200Y. Part 2 involves calculating the company's 200X ratios and comparing them to the company's 200Y ratios. This will assist in determining whether or not the company is improving its performance. In Part 3, we will compare the company's 200Y ratios to the ratios of an average business within the industry. Moreover, Part 3 will determine how well the company is performing in relation to other businesses within the same industry.

Please Note: Do not attempt to memorize the ratio formulas, rather focus your attention on what each ratio means. This will enable you to intelligently draw conclusions for the Widget Manufacturing Company as well as for your own business or proposed business venture.

Lets now begin our ratio analysis discussion, starting with PART 1 "Calculating Ratios". Good Luck and have fun.