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From the MerchantCircle Blog | Wednesday July 8. 2009

Financial Ratios: The Early Warning Indicator of Business Health
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For the past 30 years, Professor Bornstein has been a tenured Professor of Accounting and Taxation, and for the past 32 years a CPA and Consultant in public practice for Bornstein  &  Song, CPAs&Consultants.
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The current economic downturn requires a careful understanding of where the business is, where it has been, and where it is going. Cost cutting measures may be required for business survival. There are financial tools that can help.

Just as people monitor their health with blood tests, electrocardiograms, blood pressure readings, and other measurements that provide early warning indicators of illness, businesses must establish financial health measurement mechanisms that monitor their survival, profit, and growth. Such mechanisms can predict and head off small business failure.

Knowledge and understanding of accounting and its analytical tools and techniques, such as financial ratios, can help business owners diagnose, identify, and cure financial weaknesses. Financial ratios transform accounting data into useful data for business decision making, and they can reveal more than just the bottom line. These ratios may tell more about the true health of a company than actual sales and profit figures that appear in financial statements. 

Financial ratios can help determine which direction the business is going by measuring the following aspects of the business: (1) Liquidity ratios measure the ability to meet the cash flow needs as they arise; (2) Profitability ratios measure the overall performance and its efficiency in managing its assets, liabilities, and equity; (3) Activity ratios measure the liquidity of specific assets such as accounts receivable and inventory; (4) Leverage ratios measure the ability to meet its debt obligations and avoid bankruptcy. Businesses can compare their financial ratios to the averages in their industry. These comparisons can be vital to evaluating business performance. 

Various publications and internet websites provide industry financial ratios: Annual Statement Studies published by Risk Management Association (RMA) provides ratios for over 500 different industries, while Financial Studies of the Small Business published by Financial Research Associates specializes in small to mid-sized businesses. 

Financial ratios are extremely valuable analytical tools which can indicate areas of potential strength or weakness, however, their interpretation requires professional attention. The calculation and analysis of these ratios should be an integral part of the services provided by the business's accountant.


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Samuel D. Bornstein is a Professor of Accounting and Taxation, at Kean University School of Business, Union, NJ., and managing partner of Bornstein&Song, CPAs & Consultants in Oakhurst, NJ. Email: bornsteinsong@aol.com
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