This article will introduce you to the ratio analysis which is a simple but very important technique to analyse the financial statements. It’s so simple to teach and understand that it is taught at the start of any accounting qualification. For example, it is taught at year one on an undergraduate accounting qualification. In fact, there is always a module at year 2 and year 3 too where ratios are part of the syllabus. Ratio analysis can also be so advanced that it is taught at the final level exams of a Chartered Accountancy qualification which is considered to be the highest qualification in accountancy.
This shows the significance of the ratio analysis, a technique which can be used to explain and understand the very basic accounting concepts as well as advanced level of financial analysis. This is the reason ratio analysis is a very common topic for coursework where students are taught the basics of the financial analysis and then required to extend their understanding by carrying out the research to analyse the financial position and performance of a business to a higher level.
The simplicity of ratio analysis can help students who are new to accounting & finance to explore and understand the financial statements.
There is so much information in the financial statements that if you do not have experience and/or a purpose to look at those, you would not know what you need to look at. Ratio analysis gives that purpose because to solve different ratios, one need to locate and extracts different figures from the financial statements and during that process, students get to explore the financial statements too. One of the main skills of a financial analysts is to extract the relevant information and then ignore the other information. There’s a lot of information in financial statements, some of which is not relevant to the ratio analysis. Ratio analysis can direct us to look only for the relevant figures and ignore the rest. As a teacher, I use ratio analysis to familiarize my students to the financial statement by combining introduction to financial statements with the topic of ratio analyses.
Ratio analysis is used widely in the business world. Investors use ratios to assess the financial performance of the company. Management uses ratios as key performance indicators (KPI) to assess the performance of individual departments, divisions and the whole company.
What is “ratio?”
A ratio is an equation or a formula which can be a simple as well as a complicated one. Ratio, in simple words, is the weighting of one thing in comparison to the other. It could be mixing of salt in the flour, “the ratio of salt to the flour.” A recipe to make a cake will tell the ratio of different ingredients.
In financial statement terms, ratio is the weighting of one number from the financial statements in relation to the other figure. Ratio analysis compares one figure in the financial statements to another and calculates the simplified relative weighting of those numbers which is meaningful to the reader.
A ratio can pick figures from different financial statements i.e. a ratio can take a figure from income statement and another one from the balance sheet or a ratio could take both figures from the income statement or from the balance sheet, compare them and give simplified ratios which can be helpful to analyse the financial statements in more detail.
For example, A well-known ratio “Asset Turnover” ratio compares total assets figure from the balance sheet with the total revenue figure in the income statement. This gives us the weighting of sales in comparison to the business assets. A higher result shows a better use of assets to generate sales. This ratio can help to compare the performance of two different businesses even if they are of different sizes or if they operate in different countries or currencies. It can also help to compare the figure from the previous years.
An example from the real world always helps.
Burberry’s sales were £2343.9m and total assets £3502.2m in the financial year ending in 2021 (FY2021) so the ratio is 2343.9:3502.2.
Ted Baker is another business in the same industry with the sales of £351.98m and total asset of £399.26m in the FY2021 so the ratio is 351.98:399.26. From this data it can be deduced easily that Ted Baker is a smaller company then Burberry but their performance can not be judged and compared clearly.
Ratio analysis simplifies these ratios to
- Burberry 0.67:1 – 2343.9 divided by 3502.2
- Ted Baker 0.88:1 – 351.98 divided by 399.26
By looking at the above simplified ratios, we can instantly assess that
- Burberry is making sales of £67 from every £100 worth of its assets while
- Ted Baker is generating £88 worth of sales from every £100 worth of its assets which means
- Ted Baker’s performance in this area is better then Burberry.
Ratio analyses looks at five different areas of financial performance of a business.
So that’s another 5
- five elements of financial statements,
- five parts of financial statements and
- five areas which ratio analysis looks into
These five areas are
Profitability
Profitability ratios help us to assess the profitability of a business. Profit is the excess of income over expenses (or a loss if income is less than expenses). Making profit is one of the main objectives of any commercial organization. This figure can be found in income statement in its various forms as I have discussed in my article “understanding Profit or Loss Statement.” These ratios help us to understand if the business is making enough profit or not. After calculating profitability ratios, you should be able to comment on the performance of a company in the profitability area. From management’s point of view, you should be able to suggest how to increase the profitability of a company.
Liquidity
Liquidity is another measure of a company’s performance and these ratios help us to understand if the business has enough cash to pay its liabilities when they fall due.
Liquidity means the cash within the business. Profit and cash are two different concepts. Liquidity is important as sometimes very profitable businesses can go bankrupt because they don’t have cash. How is that possible?
Please read my article on “Understanding Statement of Cash Flow.”
Efficiency
The third area of financial performance which ratio analysis looks into is efficiency ratios. This is directly relevant to management as the purpose of the efficiency ratios is to assess how efficiently the management of the business is running the different departments or functions of the business.
Investment ratios
Investment ratios are the ratios which are used by the investors to assess the performance of the company to decide if an investment in the shares of the company would be profitable or not. Many of the figures used in these ratios are fetched from the stock markets and are real time figures unlike ratios in the other performance areas which use historical data.
Gearing/ solvency ratios
These ratios assess how risky is the business which means risk of bankruptcy and going out of business. Large companies rely on two sources of finance to run and expand their business, equity and debt. Equity is the shareholders money and debt is lenders money. As the proportion of debt increases in the financing mix of a company, the risk increases as debt finance requires regular payments of interest and inability to pay it on time can lead to insolvency of the business.
In the next article, we will look at the features of a comprehensive ratio analysis. By including these features in your analysis, you can ensure that you have done a thorough analysis which will fetch you high marks in your coursework.
This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.