To have a strong and successful business, you need to have a clear understanding of the financial impact that your most basic business decisions may have.

A second tool for management decisionmaking that has grown out of cost/volume/profit analysis is breakeven analysis.

One of the important, yet relatively simple, tools afforded by cost/volume/profit analysis is known as contribution margin analysis. Your company's contribution margin is simply the percentage of each sales dollar that remains after the variable costs are subtracted. When you know the contribution margin, you can make better decisions about whether to add or subtract a product line, about how to price your product or service, and about how to structure any sales commissions or bonuses.

The second major cause of distortions in the picture presented by financial statements and ratio analysis of the items in the statements is the different accounting procedures that may be used in arriving at the figures presented in the income statement and balance sheet.

Inflation has its biggest impact on the reported profits of businesses with sizable inventories. Consider the following example:

Your financial statements and ratio analysis may not always give a true picture of the condition of your business and how you stack up against other businesses. Various factors can distort the picture.

Interest coverage is also sometimes known as the "times interest earned ratio." It is very similar to the "times fixed charges earned" ratio but focuses more narrowly on the interest portion of your debt payments.

Coverage of fixed charges is also sometimes called "times fixed charges earned."

The final group of ratios are designed to help you measure the degree of financial risk that your business faces. "Financial risk," in this context, means the extent to which you have debt obligations that must be met, regardless of your cash flow. By looking at these ratios, you can assess your level of debt and decide whether this level is appropriate for your company. Commonly used solvency ratios are:

This ratio measures the percentage of a business's assets that are financed with debt, and can be calculated using the following formula:

The debt-to-equity ratio can be computed with the following formula, using figures from your balance sheet:

Your net profit margin shows you the bottom line: how much of each sales dollar is ultimately available for you, the owner, to draw out of the business or to receive as dividends. It's probably the figure you are most accustomed to looking at. This ratio takes into account all your expenses, including income taxes and interest.

The return on equity ratio can be calculated using the following formula:

Return on assets is the ratio of net income to total assets. It is basically a measure of how well your business is using its assets to produce more income. It can be viewed as a combination of two other ratios, net profit margin (ratio of net income to sales) and asset turnover (ratio of sales to total assets):

The operating profit percentage can be calculated using the following formula, with figures taken from your income statement:

You can use another set of ratios to assess the profitability of your business and changes in its profit performance. These ratios are probably the most important indicators of your business's financial success. Investors (including yourself, as business owner) will be interested in these ratios insofar as they demonstrate the performance and growth potential of the business:

Your gross profit margin can be calculated with the following formula, using figures taken from your income statement:

The ratio of total sales (on your income statement) to total assets (on your balance sheet) indicates how well you're using all your business assets (rather than just inventories or fixed assets) to generate revenue.

Accounts receivable represent sales for which payment has not yet been collected. If your business normally extends credit to its customers, the payment of accounts receivable is likely to be your single most important source of cash inflows.

Fixed asset turnover is the ratio of sales (on your income statement) to the value of your fixed assets (on your balance sheet). It indicates how well your business is using its fixed assets to generate sales.

The quick ratio, also known as the acid test, serves a function that is quite similar to that of the current ratio. The difference between the two is that the quick ratio subtracts inventory from current assets and compares the resulting figure (also called the quick current assets) to current liabilities.

As a business owner/manager, you're concerned with making the best use of your assets and being a low-cost producer in your industry. You can determine how efficiently your business uses its assets, and where there's room for improvement, by looking at the following ratios:

Inventory is the amount of merchandise, parts, supplies, or other goods your business keeps on hand to meet the demands of your customers. Depending on the nature of your business (i.e., retail, wholesale, service, manufacturing), the efficiency of your inventory management may have a significant impact on your cash flow and, ultimately, your business's success or failure.

The current ratio is a way of looking at your working capital and measuring your short-term solvency. The ratio is in the format x:y, where x is the amount of all current assets and y is the amount of all current liabilities.

In order to assess how your business is doing, you'll need more than single numbers extracted from the financial statements. Each number has to be viewed in the context of the whole picture.