Accounting Ratios

Accounting Ratios

Accounting ratios are used as an indication as to how a business is performing.  They should not be used in isolation, but as a comparison to the previous years' trading figures to show up any problems, or to compare to a similar company.

To complete a thorough examination of your company's effectiveness, however, you need to look at more than just easily attainable numbers like sales, profits, and total assets.  You must be able to read between the lines of your financial statements and make the seemingly inconsequential numbers accessible and comprehensible.

This massive data analysis could seem overwhelming.  Luckily, there are many well-tested ratios out there that make the task a bit less ominous.  Comparative ratio analysis helps you identify and quantify your company's strengths and weaknesses (S.W.O.T analysis), evaluate its financial position, and understand the risks you may be taking.

As with any other form of analysis, comparative ratio techniques aren't definitive and their results shouldn't be viewed as gospel.  Many off-the-balance-sheet factors can play a role in the success or failure of a company.  But, when used in conjunction with various other business evaluation processes, comparative ratios are invaluable.

This section contains descriptions and examples of the eight major types of ratios used in financial analysis:

1. Bankruptcy Ratios
2. Coverage Ratios
3. Income Ratios
4. Leverage Ratios
5. Liquidity Ratios
6. Long-Term Analysis Ratios
7. Profitability Ratios
8. Working Capital Ratios

Ratio Analysis - Purposes and Considerations

Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage.  Although ratios report mostly on past performances, they can be predictive too, and provide lead indications of potential problem areas.

Ratio analysis is primarily used to compare a company's financial figures over a period of time, a method sometimes called trend analysis.  Through trend analysis, you can identify trends, good and bad, and adjust your business practices accordingly.  You can also see how your ratios stack up against other businesses, both in and out of your industry.

There are several considerations you must be aware of when comparing ratios from one financial period to another or when comparing the financial ratios of two or more companies.

• If you are making a comparative analysis of a company's financial statements over a certain period of time, make an appropriate allowance for any changes in accounting policies that occurred during the same time span.
• When comparing your business with others in your industry, allow for any material differences in accounting policies between your company and industry norms.
• When comparing ratios from various fiscal periods or companies, inquire about the types of accounting policies used.  Different accounting methods can result in a wide variety of reported figures.
• Determine whether ratios were calculated before or after adjustments were made to the balance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments.  In many cases, these adjustments can significantly affect the ratios.
• Carefully examine any departures from industry norms.

Common-Size Statement

When performing a ratio analysis of financial statements, it is often helpful to adjust the figures to common-size numbers.  To do this, change each line item on a statement to a percentage of the total.  For example, on a balance sheet, each figure is shown as a percentage of total assets, and on an income statement, each item is expressed as a percentage of sales.

This technique is quite useful when you are comparing your business to other businesses or to averages from an entire industry, because differences in size are neutralized by reducing all figures to common-size ratios.  Industry statistics are frequently published in common-size form.

When comparing your company with industry figures, make sure that the financial data for each company reflect comparable price levels, and that it was developed using comparable accounting methods, classification procedures, and valuation bases.

Such comparisons should be limited to companies engaged in similar business activities.  When the financial policies of two companies differ, these differences should be recognized in the evaluation of comparative reports.  For example, one company leases its properties while the other purchases such items; one company finances its operations using long-term borrowing while the other relies primarily on funds supplied by stockholders and by earnings.  Financial statements for two companies under these circumstances are not wholly comparable.

Example Common-Size Income Statement