Ratio Analysis

An investor or interested stakeholder, can use the financial statements to assess an organisation. But in most cases we would like to answer the question: Is organisation A better or not than B?.

In this case, we should rely on a method to analyse and compare financial statements. One of the tools devised to analyse and asses the financial situation of an organisation is the ratio analysis.

The definition of ratio (Oxford Dictionaries, 2019), states that is the quantitative relation between two amounts, showing the number of times one value contains or is contained within the other.

The definition of financial ratios is very similar to the mathematical description exposed above and consist in the comparison of two numbers derived directly or indirectly from the balance sheet or the income statement.

As the interpretation of the financial statements is essential for all kind of stakeholders of a company, ratio analysis is an essential tool not only for analysis but also for management.

The advantages of ratio analysis rely on the simplification of complex accounting statements, helping (1) the validation or disproval of financial investment in a corporation, (2) the identification of problem areas for better treatment of management and (3) the comparison with other firms or sectors and previous financial periods.

Some of the disadvantages of the ratio analysis are that they do not consider some short-term measures to mask possible financial problems in the statements, they ignore the challenge of comparing values regardless of inflation and exchange rate in case of multinational companies and the lack of a single well-documented standard for reporting make the task of comparing two statements challenging.

The most important objectives of ratio analysis are: (1) Measure of Profitability, (2) Evaluation of Operational Efficiency, (3) Study liquidity and solvency, (4) Overall financial strength for stakeholders, (5) Comparison

Measure of profitability

Profitability can be divided into ‘efficiency’ and ‘effectiveness’. Peter Drucker, as cited by (The Open University, 2015), stated that the first is about ‘doing things right’ and the second ‘doing the right things’. Some profitability ratios are, return on sales (ROS), assets utilisation ratio (AUR) and return on capital invested (ROCE).

Evaluation of operational efficiency

Operational efficiency of an organisation means that it chooses the correct pool of assets and uses them in a precise way to achieve the maximum return for the shareholders of the organisation. Some efficiency ratios of interest are creditor days, stock days and debtor days

Study of liquidity and solvency

The components that study if the activities of a corporation are properly funded are called liquidity and solvency, attending to short term and long term, respectively. Some liquidity ratios of interest are current ratio, quick ratio and working capital. In the other hand, some common solvency ratios are leverage and gearing.

Overall financial strength for stakeholders

Investor ratios provide a measurement for current or prospective stakeholders interested in an organisation. In this category we have the following ratios commonly: return on equity, playout ratio, interest cover and earnings per share

Comparison

Ratios can allow us to compare an organisation against another, for example, a direct competitor or to compare our organisation of interest with the average of other organisations in the same sector. Nonetheless, we should be careful, as many organisations that could be perceived as direct competitors might be operating in different sectors as well, and their consolidated statements will not reflect a good study comparison.

Another possible comparison allowed by ratios is against the time evolution of the organisation, comparing the trend of ratios over a long period of time.