Ratio Analysis

Ratio Analysis turns things into a standard scale to allow a comparison to be made either with last year’s figures, a competitors or industry averages.

You usually need to : -

• Calculate the ratio showing the formula and workings
• Explain the ratio
• Compare the Ratio with last years, competitors, industry averages
•  Assess what the ratios implications may be

When comparing use the words improved or declined or similar.  Do not use higher or lower as this does not show if something is good or bad for the firm!!! 

You must compare similar businesses – you cannot compare apples with pears!

Benefits of ratio analysis

·         Allows a business to measure its performance and evaluate whether any changes need to be made by comparing with other figures.

·         Enables them to check if  the changes it has already made were successful.

·         Measures different areas of the business such as profitability and liquidity.

Limitations of ratio analysis

•          Based on past performance – may not reflect current / future performance.

•          May give contrasting information – e.g. Liquid or Gross Profit ratio getting better but Net Current Asset or Net Profit ratios are getting worse.

•          Does not consider external factors such as competitors entering the market.

•          Can suggest more than one thing e.g. low liquidity ratios could be perceived as causing cash flow problems or being very efficient.