Ratio Analysis: Introduction
Financial statements, apart from satisfying compliance and regulatory requirements, show an organisations financial performance, strength and financial position. These accounts are a record of the firm’s performance and, by themselves, have limited use since they give no indication of whether the results are favourable or unfavourable.
For example, they show the profit/loss figure but there is nothing to indicate whether that figure is satisfactory for the firm concerned.
The assets are listed in the position statement, but again, there is nothing to show that they are being used effectively – for example, is a bank balance of £10,000 a healthy sign and is an overdraft of £5,000 unhealthy?
Management needs to know whether or not:
- Performance is satisfactory.
- Performance is showing improvement on previous years.
- There are problem areas that should be investigated.
It may also be desirable to compare figures with those of competitors or with the average for the industry. A straightforward comparison of figures is usually unhelpful. A profit of £20,000 may be acceptable for one firm but entirely unacceptable for another: if it is related to the capital employed it becomes more meaningful. A return of £20,000 on capital of £100,000 (20%) is obviously better than a return of £20,000 on capital of £200,000 (10%).
Ratios and percentages are therefore normally used for the purpose of comparison. Parties who would be interested (stakeholders) in the firm’s ratios are:
- Owners/shareholders who want to see how profitable their investment is.
- Potential creditors such as suppliers and banks who would be interested to know if the firm is credit worthy.
- Staff who are interested in wage rates, bonuses and profit-sharing, which must be considered in the light of profitability.
- Companies interested in take-over bids who want to see profitability and efficient use of assets.
Ratio Analysis: Limitations
Some caution has to be exercised when calculating and evaluating ratios, for example the accounts that will be used will be past information and not necessarily indicative of the current situation, the accounts will be a mixture of fact and accounting judgements, comparisons must be made but they need to be truly comparable – artistic programmes may be fundamentally different, client groups may be different, different accounting judgements may have been made last year.
A ratio simply shows the relationship between two or more figures that you would expect to be linked in the final accounts and/or balance sheet of a business, e.g. sales and profit, sales and expenses, etc. Ratios are used by management to help to assess performance and to help to detect underlying trends. Prompt action can then be taken to improve poor performance and to eliminate trends that are unfavourable.
For a ratio to be of any value it must be compared with a standard to deduce whether it is good or bad. This standard may be one or more of the following:
- The same ratio for previous years;
- The same ratio for other firms of similar size in the same line of business;
- a predetermined or budgeted ratio (probably best).