Financial & Accounting ratios Analysis
Information conveyed through financial statements is used by the stakeholders to make various decisions. These decisions are taken after evaluating the status and the performance of the reporting entity. To make informed and better decisions, the information contained in financial statements is compared against various benchmarks e.g. the performance of the business with the previous years and with the similar business in the industry.
For illustration, let’s assume the four firms with the following sales and gross profit information during the last accounting period;
| Sales | Gross Profit | |
| Amounts in | $ | $ |
| Business 1 | 848,000 | 150,000 |
| Business 2 | 1,252,000 | 440,000 |
| Business 3 | 1,927,500 | 450,000 |
| Business 4 | 1,468,400 | 750,000 |
The above table shows Business 3 earnings during the period exceeded all the other businesses, whereas Business 4 earned the most profit amongst all. So apparently it can be argued that Businesses 3 and 4 outperformed all four firms.
However, if we calculate the Gross profit margin, it is revealed that Business 2 made most of the profit from the given sales and earned a margin of 35.14%, indicating the better cost controls over the business operations as compared to the other three businesses.
From the above example, we can learn that merely looking at the financial information may not lead to a fruitful conclusion until this information is not compared by gauging the results through performing ratio analysis.
All the financial information of a business provides plenty of information through Financial Statements, however, to make beneficial economic decisions, the results and status provided need to be contextualized and compared to the other information in the financial statement, previous years’ results, and with the similar business within the industry.
Ratio analysis helps to study the financial performance and status conveyed through the financial statements. It also assists to understand how well a company performed under the circumstances surrounding the organization. These in-depth analyses will pinpoint the areas that need further examination before drawing a decisive conclusion and making better economic decisions.
How to use Ratios
The first and most crucial principle of using ratios is that, a comparison shall be made with businesses of similar nature and an apple-to-apple comparison shall be made. For example, the performance of a medicine seller shall not be compared to the performance of a shoe manufacturer. Further, before starting a comparison it shall be ensured that financial statements by all the concerned businesses have been prepared by following the same Accounting Principles. The sales of a company that records its revenues when cash is received shall not be compared to the company which records/realize its revenues upon issuance of the sales invoice.
Let’s compare the information on Inventory turnover from two toy sellers during the last accounting periods.
| Company A | Company B | |
| Cost of SaleAverage Stock | 500,0005,000=10 | 500,000 100,000=5 |
From the above information, both the companies had the same Cost of Sales whereas it appears that the Business A had sold its inventories more quickly and avoided the stock from piling up as compared to the Business B. Let’s imagine that Company B had a financial year-end of 30 November, just before Christmas, so toy stocks would be extremely high; that Business B had a year-end of 31 December soon after the Christmas sales, its stock had dropped to the year’s lowest level; and that at 30 November both this year and last year Company B also had stock valued at $50,000. Can you see how the difference in the timing of the year-end can affect this ratio significantly?
From the examples in the above paragraphs, it can be seen that the Financial analysis of a company based on a comparison of ratios requires careful handling to reach conclusions and make beneficial decisions.
Categories of Accounting ratios
The ratio can be divided into the following classes based on the nature of the results and their uses for stakeholders.
1. Profitability Ratios- Provide insight into how effectively the resource and costs were managed during the given period.
2. Liquidity Ratios- Indicate the status of a business regarding fulfillment of liabilities and obligations, if fall due.
3. Efficiency Ratio- Convey how effectively a business is realizing the investment in working capital into cash.
4. Shareholder Ratios- Tell how a good company provides a return to shareholders as compared to its share price in the stock market.
Gearing- Highlight the finance mix of long-term capital invested in common.
In the coming sections, we will go through each type of ratio to see how it helps the users to make beneficial economic decisions.
Uses of Accounting Ratios
Every stakeholder before making financial decisions regarding the business needs accounting ratios up to some extent. However, various stakeholders need different types of information for distinct analyses for making decisions per their requirements and goals.
For example, lenders of the company will be more concerned if a company is making enough profits to pay back the debt provided by them. Customers of a business may want to see if the company has enough financial resources to fulfill timely orders on time. Similarly, employees of a business will look for profit margins to ascertain the growth potential of a business and the security of their jobs.
Therefore there is no final and decisive list by importance stating which ratios are more important and shall be preferred over the others.
| Ratio category | Examples of interested groups |
| Profitability | Shareholders, management, employees, creditors, competitors, potential investors |
| Liquidity | Shareholders, suppliers, creditors, competitors |
| Efficiency | Shareholders, potential purchasers, competitors |
| Shareholder | Shareholders, potential investors |
| Capital structure | Shareholders, lenders, creditors, potential investors |
