Ratio analysis is the broad method by which financial data is converted into simple mathematic ratios for comparison. Since the data is widely available, calculating ratio analysis numbers can be accomplished by anyone with access to public financial statements. Calculations created from these formulas provide crucial information for decision-making.
Converting financial accounting data into ratios allows for comparisons of companies to be made in spite of size. Ratios provide information that raw data cannot. Very large companies can be compared reliably to smaller companies. Using ratio analysis, companies can be evaluated even across industries. Trends of growth, increased performance, and deterioration within the firm can be evaluated against itself, as well as across the industry.
While ratio analysis is valuable, there are limitations in application. All formulas are only as good at the input data. The ratios are calculated based on accounting data provided by the company, and while generally deemed reliable, accounting procedures may differ, or data may not be as reliable as another firmís data. Also, when comparing past rates, for example, inflation may skew interpretations. In addition, formulas or equations for ratio analysis must be comparable for a true comparison, and therefore based on an industry standard.
Calculation of Data
In order to calculate the ratio analysis for a financial institution, obtain the data from the financial statements. Typically, the balance sheet and income statement will provide the data that you require for calculations. Determine the industry standard for calculation by SIC code (Standard Industry Classification Code) if doing complex analysis, and make the calculations. For a small business, gross profit margin ratios (sales Ė cost of goods divided by cost of goods sold) may be a crucial piece of information when making decisions about growth. For example, a small company with $500,000 in sales, at a cost of $300,000 in cost of goods would have a 40% gross profit margin, or .40 on the dollar to cover costs.
Internal Usage for Ratio Analysis
Managers utilize ratio analysis to gauge the overall health of a company or business unit. These ratios can be calculated and reviewed, then measured again past years to determine if supply chains need to be reviewed or point to the need for lay-offs. Significant positive changes in ratios may determine growth opportunities, and lead to identifying trends. Companies also use the information to compare across the industry standard. In the example above, a 40% gross profit margin may be competitive in textiles, but in another industry, such as technology, where GPM can be 50-80%, a small company would require major cost-cutting measures to become or stay competitive.
Making Company-Level Comparisons Using Ratio Analysis
External usage of the ratio analysis data is widespread. While these ratios donít tell the whole story, sharp deviations from an industry standard, can forecast growth or decline. The calculations make it easy for larger companies to review smaller companies for buyout and merger opportunities. Financial analysts and individual investors utilize ratios to help determine the core health of a business, and make investment recommendations to individual investors partially based on this data. Entire industry sectors can also be easily assessed utilizing financial ratio data.
Ratio analysis has long been utilized to make educated internal and external decisions in business. Financial ratio data greatly influences decisions for growth, investment, and cost-cutting measures.