Financial ratios are an effective way to measure the financial health of a business and compare performance of different organisations. Even whereas a significant difference in the scale of businesses exists, ratios, which relate financial resources one to another, eliminates the issue of a straight and often misleading comparison. Eliminating differences on the scale of business is also helpful in case users need to compare the perfomance of an organisation overtime. Clearly, although ratios are relatively easy to calculate and are able to highlight weaknesses and strengths of a company, they represent only the starting point for further analysis.
The number and type of ratios that we can calculate vary according to users’ type and needs. Though a potentially infinite set of ratios can be calculate, a list of important ratios useful for decision-making purposes can be drawn. In particular, ratios can be grouped into four main categories:
– Profitability: they express the profit made in relation with other financial aspect of the business
– Efficiency: here the accent is on the resources used by the business activity
– Liquidity: a positive cash flow is vital for any business in order to survive and continue its operations. Liquidity ratios usually measure liquid resources in relation to the amounts due for payments in both short and long term
– Financial Gearing: relationship between equity and debt of the business. This kind of ratios measure the incidence of borrowings on the business
– Investment: assessing the returns and performance of shares and this is particular important for existing and potential shareholders
Analysis of ratios and financial performance in general must always consider who the users will be and why they need this information. Furthermore, ratios are relevant in comparison: without having targets or benchmark would be impossible to measure the performance of a business. The type of comparison possible are mainly the following:
– Past periods: evaluation of improvement or deterioration of the business activity over time. Comparing present ratios old ones helps to identify trends and highlights weaknesses/strengths to address. When using this methods, considerations on the trading conditions both present and past should be clearly outlined. Inflation is another factor which may hinder the relevance of the comparison
– Similar business: comparing organisation’s performance to performance of similar business in the same industry is one of the most relevant type of ratios comparison. Comparison should be made considering similar period of business activity. In this case, different accounting policies or an insufficient breakdown of activites are the most common limitations to this type of comparison
– Planned performance: comparison of ratios to target performance set out by management before the period of time under analysis. Targets must be based on realistic assumptions if we want them to be useful for comparison purposes.
It is worth remembering that the reliability of financial ratio is unavoidably dependent on the reliability of the financial statements from which they derive. Other elements of attention are, the influence of inflation, the snapshot nature of the statement of balance position and the difficulty to find relevant benchmarks for comparison