4 What is ratio analysis?
Ratio analysis is an evaluation of the relationship between various figures within a set of financial statements. This can be done by calculating ratios using two or more figures from the financial statements.
For example, gross profit margin expresses the relationship between gross profit and sales revenue of a company.
If a company’s gross profit was £50,000 and the value of the total revenue earned was £100,000, its gross profit margin will be calculated as follows:
This means that for every £1 of sales, the company earns £0.5, which is then used to cover company’s other operating and financing costs.
The figures for ratio analysis should be chosen in such a manner that they generate a meaningful analysis.
Ratio analysis is carried out on the basis of the assumption that:
- accounts under review are prepared using the same accounting policies
- the company was involved in the same economic activity during the period of analysis.
Ratio analysis can be used in several different ways to provide useful insights. For example, the ratios for one accounting period can be compared with:
- the ratios from preceding period(s)
- the ratios of other segments within the company
- the ratios of competitors or other companies within the same industry
- industry benchmarks.
Comparison: The key to ratio analysis
If a company in India, Sugith Telecom, earns a revenue of INR 2,000m in 2023 whilst the total market for that product is INR 30,000m, then the ratio of sales to the total home market (that is, the company’s market share) is 2,000:30,000 (or 1:15 or 6.67%). (Note: INR is the currency code for the Indian Rupee.) If in 2024, the total market for the product expands to INR 35,000m, and the company’s revenue also increases to INR 2,360m, then the ratio of sales to the total home market will become 2,360:35,000 or 6.74%. This comparison reveals that the company has succeeded in capturing a larger market share and customers in that product market increasingly prefer the company’s products over those of its competitors. Let us further assume that the biggest market player in the telecom sector has a ratio of sales to the total home market of 6.83%. This comparison may indicate that Sugith Telecom is performing fairly well by being a very close competitor to the biggest market player.
Caution
It is important to be conscious of the differences in international accounting policies and standards when comparing the financial ratios of companies from different regions.
Furthermore, you should bear in mind that a ratio does not provide information about any trends of its individual components. It only measures the relationship between variables. For example, the ratio of sales to the total home market calculated in the above example ‘Comparison: The key to ratio analysis’ does not give any information about the extent of change in revenue alone.