Ratio Analysis

Financial ratio analysis is a fascinating topic to study because it can teach us so much about accounts and businesses. When we use ratio analysis we can work out how profitable a business is, we can tell if it has enough money to pay its bills and we can even tell whether its shareholders should be happy!

Ratio analysis can also help us to check whether a business is doing better this year than it was last year; and it can tell us if our business is doing better or worse than other businesses doing and selling the same things.

In addition to ratio analysis being part of an accounting and business studies syllabus, it is a very useful thing to know anyway!

The overall layout of this section is as follows: We will begin by asking the question, What do we want ratio analysis to tell us? Then, what will we try to do with it? This is the most important question, funnily enough! The answer to that question then means we need to make a list of all of the ratios we might use: we will list them and give the formula for each of them.

Once we have discovered all of the ratios that we can use we need to know how to use them, who might use them and what for and how will it help them to answer the question we asked at the beginning?

At this stage we will have an overall picture of what ratio analysis is, who uses it and the ratios they need to be able to use it. All that's left to do then is to use the ratios; and we will do that step- by-step, one by one.

By the end of this section we will have used every ratio several times and we will be experts at using and understanding what they 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

What do the Users of Accounts Need to Know?

The users of accounts that we have listed will want to know the sorts of things we can see in the table below: this is not necessarily everything they will ever need to know, but it is a starting point for us to think about the different needs and questions of different users.

Investors	to help them determine whether they should buy shares in the business, hold on to the shares they already own or sell the shares they already own. They also want to assess the ability of the business to pay dividends.
Lenders	to determine whether their loans and interest will be paid when due
Managers	might need segmental and total information to see how they fit into the overall picture
Employees	information about the stability and profitability of their employers to assess the ability of the business to provide remuneration, retirement benefits and employment opportunities
Suppliers and other trade creditors	businesses supplying goods and materials to other businesses will read their accounts to see that they don't have problems: after all, any supplier wants to know if his customers are going to pay their bills!
Customers	the continuance of a business, especially when they have a long term involvement with, or are dependent on, the business
Governments and their agencies	the allocation of resources and, therefore, the activities of business. To regulate the activities of business, determine taxation policies and as the basis for national income and similar statistics
Local community	Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the business and the range of its activities as they affect their area
Financial analysts	they need to know, for example, the accounting concepts employed for inventories, depreciation, bad debts and so on
Environmental groups	many organisations now publish reports specifically aimed at informing us about how they are working to keep their environment clean.
Researchers	researchers' demands cover a very wide range of lines of enquiry ranging from detailed statistical analysis of the income statement and balance sheet data extending over many years to the qualitative analysis of the wording of the statements

Source:
http://www.bized.co.uk/