We have developed a set of rules regarding financial analysis that we apply in writing business plans. We share them with you in this article in the hope that you will find these rules worthy of adopting in your efforts to write business plans as well.

Rule 1: Financial analysis techniques are tools to uncover facts, not define them.

People use a number of financial analysis techniques, such as ratio analysis, bankruptcy analysis, sensitivity analysis, etc. The purpose of these exercises is not to arrive at some final result that looks good. Rather, the analyses are performed in order to find how the business can be improved. Never be lulled into thinking everything is good. Things can change on a dime. Look for areas than can be improved in order to give you a cushion in case things go bad.

I had someone ask me once if a current ratio of 2.0 was good for his business. Well, it depends. Granted, a ratio value of 2.0 means that the value of current assets is large enough to pay off current liabilities twice should the company need to be liquidated. However, what if the vast majority of the current assets was made up of inventory that, in a liquidation emergency, could only be sold for five cents on the dollar? Also, in this particular case, the current ratio for most companies in the industry was well over 5. This meant that the current ratio for his business was much lower than the average in the industry--a definite cause for concern.

As shown in the discussion above, results can be misleading if the values going into the analysis are not understood and other related variables are not considered.

See Rules 2 and 3.

It is relatively easy to be fooled if you only look at one ratio, for example. In the discussion with my friend above, I found out that while his current ratio was 2.0 his quick ratio (similar to the current ratio but without the inventory) was 0.2. This value was clearly not acceptable as it meant that a huge part of the value of his current assets was tied up in inventory. When he saw that, he made definite steps to improve his management of his inventory.

What value would the ratios analyzed in my example above be to the business owner if he did not understand what the ratios meant? That's right, nothing. Financial analysis is an indispensable tool but only if you understand how to interpret the results and know the right questions to ask.