Ratio analysis AO2, AO4
We have examined the purpose, layout and content of the balance sheet and profit and loss account.
We have said that these documents contain a story of the business but this story is sometimes difficult to reveal in detail.
We can do this through the use of financial ratios.
Single balance sheets and profit and loss accounts tell us very little. If we are told that sales this year were $20m and profit rose to $5m, this information has limited meaning expressed as it is in absolute terms. What we want is some way to provide a relative comparison, either between years (for progress or otherwise) or between similar companies in the same industry. For example comparing ratios of the local grocer's shop with multinational supermarkets will have little practical use.
What we are hoping to reveal are trends in performance or contrasts with similar organisations that may require further analysis.
To help us understand more about the firms we are studying, we will be examining two specific groups of ratios, namely:
- Profitability and Liquidity ratios (HL and SL) identify the ability of a firm to pay its current liabilities
- Efficiency ratios (HL Only) provide information on how effectively resource are used in the business
These ratios are of interest to different groups of people (stakeholders). Who might be Interested Parties?
In Business and Management examinations you will be provided with the formula for all of the ratios, so you do not need to memorise them. However, the skill is in interpreting the ratios, rather than calculating them