Importance of Ratio Analysis
If we were look at a balance sheet or profit and loss account, how would you decide whether the company was doing well or badly? Or whether it was financially strong or financially vulnerable? And what would be you looking at in the figures to help you to make your judgment?
Ration analysis involves comparing one figure against another to produce a ratio, and assessing whether the ratio indicates a weakness or strength in the company’s affairs.
The Broad Categories of Ratios
Broadly speaking, basic ratios can be grouped into five categories:
- Profitability and return
- Long-term solvency and stability
- Short-term solvency and liquidity
- Efficiency (turnover rations)
- Shareholders’ investment ratios
Within each heading we will identify a number of standard measures or ratios that are normally calculated and generally accepted as meaningful indicators. Each individual business must be considered separately, and a ration that is meaningful for a manufacturing company may be completely meaningless for a financial institution. Try not to be too mechanical when working out ratios and constantly thinks about what you are trying to achieve.
They key to obtaining meaningful information from ratio analysis is comparison. This may involve comparing ratios over time within the same business to establish whether things are improving or declining, and comparing ratios between similar business to see whether the company you are analyzing is better or worse than average within its specific business sector.
It must be stressed that ratio analysis on its own is not sufficient for interpreting company accounts, and that there are other items of information which should be looked at, for example:
- Comments in the chairmen’s report and director’s report
- The age and nature of the company’s assets
- Current and future developments in the company’s markets, at home and overseas;
- Any other noticeable feature of the report and accounts, such as post balance sheet events, contingent liabilities, a qualified auditors report, the company’s taxation position, and so on
In case, consider also who you are advising, a creditor will not be interested in shareholder’s investment ratios.