Financial Ratio Analysis - What do we want ratio analysis to tell us?

What do we want ratio analysis to tell us?

The key question in ratio analysis isn't only to get the right answer: for example, to be able to say that a business's profit is 10% of turnover. We have to start working on ratio analysis with the following question in our heads:

What are we trying to find out?

Isn't this just blether, won't the exam just ask me to tell them that profit is 10% of turnover? Well, yes, but then they want to know that you are a good student who understands what it means to say that profit is 10% of turnover.

We can use ratio analysis to try to tell us whether the business

  1. is profitable
  2. has enough money to pay its bills
  3. could be paying its employees higher wages
  4. is paying its share of tax
  5. is using its assets efficiently
  6. has a gearing problem
  7. is a candidate for being bought by another company or investor

and more, once we have decided what we want to know then we can decide which ratios we need to use to answer the question or solve the problem facing us.

There are ratios that will help us with question 1, but that wouldn't help us with question 2; and ratios that are good for question 5 but not for question 4 - we'll see!

Let's look at the ratios we can use to answer these questions.

The Ratios

We can simply make a list of the ratios we can use here but it's much better to put them into different categories. If we look at the questions in the previous section, we can see that we talked about profits, having enough cash, efficiently using assets - we can put our ratios into categories that are designed exactly to help us to answer these questions. The categories we want to use, section by section, are:

  1. Profitability: has the business made a good profit compared to its turnover?
  2. Return Ratios: compared to its assets and capital employed, has the business made a good profit?
  3. Liquidity: does the business have enough money to pay its bills?
  4. Asset Usage or Activity: how has the business used its fixed and current assets?
  5. Gearing: does the company have a lot of debt or is it financed mainly by shares?
  6. Investor or Shareholder

Not everyone needs to use all of the ratios we can put in these categories so the table that we present at the start of each section is in two columns: basic and additional.

The basic ratios are those that everyone should use in these categories whenever we are asked a question about them. We can use the additional ratios when we have to analyse a business in more detail or when we want to show someone that we have really thought carefully about a problem.

Users of Accounting Information

Now we know the kinds of questions we need to ask and we know the ratios available to us, we need to know who might ask all of these questions! This is an important issue because the person asking the question will normally need to know something particular.

Of course, anyone can read and ask questions about the accounts of a business; but in the same way that we can put the ratios into groups, we should put readers and users of accounts into convenient groups, too: let's look at that now.

The list of categories of readers and users of accounts includes the following people and groups of people:

  • Investors
  • Lenders
  • Managers of the organisation
  • Employees
  • Suppliers and other trade creditors
  • Customers
  • Governments and their agencies
  • Public
  • Financial analysts
  • Environmental groups
  • Researchers: both academic and professional

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