Most employees are familiar with ratio analysis. There are literally hundreds of ratios some of which are industry specific.

However, traditional ratio analysis

A. can actually be harmful

A traditional ratio is gross profit margin. One way to improve this ratio is to decrease cost of goods sold. One way to decrease cost of costs sold is to increase inventory so fixed costs are spread across more units. Increased inventory may lead to damage, obsolesce, moving it around, etc.

So financial ratios by themselves may create behavior that is  harmful. Financial ratios often have to be used in groups and or used with process and activity analysis to achieve the desired behavior.

B. is just a starting point

Lets look at a common financial ratio called the collection period. This ratio simply calculate on average how many days does it take to collect your receivables.  For example, a company may have terms of net 30 days. They may decide that if they collect their receivable on average in 45 days they are doing pretty good. However, if the ratio is much over 45 days, then they will investigate whey the receivables department is not doing a better job of collecting customer invoices.

This ratio may be helpful as a stating point, however, it does not address the root causes of the problem.  For example, collections may be slow due to:

• invoice pricing errors
• invoice quantity errors
• partial deliveries
• invoice wrong item errors
• returns
• errors in catalog or on website causing problems
• discount taken outside terms

So ratio analysis can only be successful if it is combined with root cause analysis to determine what is the real source of the problems.