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 bit that this story is sometimes difficult to reveal. We need to find some way of bringing this information to life and to provide answers to stakeholders on a whole series of questions about the performance, efficiency and liquidity of the business. We can do this through the use of financial ratios. A ratio is simply a mathematical relationship between one figure and another. Financial ratios are relationships between quantities taken from the accounts.
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. Financial ratios offer a tool to do this, but are only of significant use when they are compared to other ratios. In practice, comparison will be between different years and between the firm and its competitors or industry averages (inter-firm comparisons). However, it is important that any comparison is between similar organisations. 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. Ratios should help decision-makers and provide the information to set future policy
To help us understand more about the firms we are studying, we will be examining specific groups of ratios, namely:
- Profitability ratios examine profit in relation to other figures
- Liquidity ratios identify the ability of a firm to pay its current liabilities
- Financial efficiency ratios provide information on how effectively resource are used in the business
- The gearing ratio shows the long-term liquidity position of the business
- Shareholders ratios measure the returns to shareholders
These ratios are of interest to different groups of people. 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
In the following sections we will also examine the limitations of ratio analysis