When it comes to understanding a company’s financial health and the gaps, analysing the quantitative numbers in the financial statements is one of or perhaps the most important aspect of the process. However, the sheer amount of numbers within the financial statements can often be overwhelming for many. Analysis might as a result end up disorganised and nonsensical. This is where ratios can come in to assist and structure the analysis process.
What are ratios and why should it be used?
While ratios maybe somewhat unfamiliar to many, financial ratio analysis is neither too technical nor complicated. Ratios are simply the comparison of the relative size and relationship between two numbers. In fact, ratios are commonly analysed in the business world. For example, profit margin is a ratio of profit before tax to revenue that measures how much profit before tax is made for every dollar of revenue generated.
One aspect that ratios can really facilitate is the understanding of the relative changes between two numbers. While it is easy to understand when the two numbers move in the opposite directions (i.e. one increases and the other decreases), it is not so in the case whereby both numbers move in the same direction. Take for example, a company that has assets of $80 in 20X1 and $100 in 20X1; liabilities of $40 in 20X1 and $50 in 20X2. By purely comparing the increases, the increment in assets of $20 is more significant than the increment in liabilities of $10. This should mean that the company has better ability to meet the financial obligations when they fall due and financially healthier as a result. However, the utilisation of ratios as a means of comparison would reveal that the proportion of liabilities to assets remained at 50% and did not vary in both years. Therefore, ratios can paint a completely different picture and allow for a more accurate understanding of the company’s financial health than just a simple comparison of numbers or of their increment.
Though it is easy to compute since it is the division of two numbers, picking the appropriate numbers to compare is of utmost importance to ensure that the ratio makes sense. The general principle to the selection of the numbers is to ensure that the two numbers have direct causation between the two. For example, comparing marketing cost and utilities may not be that relevant as increasing marketing activities, and hence its cost, would not directly increase utilities. While comparing profit after tax to equity is more useful to understand how much profit the company is able to generate per dollar of equity invested. If this sounds overly complex, one can cut through the clutter and utilise some more commonly used ratios that would be sufficient to analyse the company’s financial health.
Lastly, ratios provides little information of the company’s performance unless it is compared with something else. What does it mean when liabilities to assets ratio is 50%, besides knowing that the company’s assets is half funded by liabilities? Therefore, there is a need to benchmark the ratios to that of fellow industrial peers in order to understand how well the company is ran in comparison to fellow competitors.