4.1 Benefits of ratio analysis
Ratio analysis provides several benefits to analysts as explained in figure 8.
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Figure 8 Comparing performance
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Although ratio analysis is a useful tool for financial analysis, it can be of benefit only if it is used effectively. There are a number of factors that must be considered when performing ratio analysis. Video 1 explains these factors in detail.
Please note: this video references Units 5 and 6, as it is an excerpt from an OU qualification [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] .
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Transcript: Video 1 A few points to consider
FATIMA YUSUF
In this video, we are going to discuss a few points that should be considered whilst carrying out the analysis of financial data. Ratio analysis can be performed effectively only if the analyst understands financial data and uses various techniques for analysis of data effectively. The analyst must understand the basic requirements in relation to the preparation of financial statements and should be aware about the format and composition of various financial statements.
You learnt how to prepare various financial statements in Units 5 and 6 of this module. An understanding of the content and structure of these financial statements makes it easier for an analyst to extract relevant financial information from these statements efficiently and without errors. Notes to financial statements provide pertinent information. It is important to be able to make use of the notes to financial statements as and when needed.
The usefulness of ratio analysis can be enhanced by comparing ratios for one year with the ratios from previous years, ratios of other comparable businesses or competitors within industry, or with the standards provided by expert organisations such as banks. For example, Jabulani Carpets Limited’s gross profit margin is 50%. This information does not enable an assessment of how the business performed in comparison to other businesses in the same industry or how it performed in previous years.
A careful evaluation of the makeup of each figure within financial statements should be carried out. If a figure in financial statements is an aggregate of other line items, then one must carefully consider that the figure it is to be compared with is an aggregate of the same line items. For example, if you are analysing finance costs, you must carefully consider which line items have been aggregated to calculate finance costs whilst comparing them across different companies.
It is also important to consider if valuation bases used for calculating these ratios are comparable. For example, company A is reporting its assets at fair value whilst company B is reporting its assets at cost. The analyst must take these factors into account whilst comparing the financial position of these companies. The relationship between various ratios also communicates important information, as interpretation of only one ratio might present one picture of the business performance whilst other ratios might provide other useful insights into the business affairs.
For example, the debt ratio of a company indicates high levels of debt, and an investor feels anxious about its ability to finance that debt. However, the company earned a very good profit and does not have any liquidity problems and has an ability to finance its debt. Furthermore, although it might be easily possible as well as valuable to compare certain ratios across industries, however, such a comparison might not prove beneficial when calculating other ratios.
For example, you can compare return on equity for companies from different industries. And this information will be particularly useful for investors. However, inventory turnover of a supermarket such as Tesco might be very different from a company manufacturing luxury cars, as the level of inventory turnover in a retail business has to be very high considering the perishable nature of many of their products compared to the manufacturing industry.
In addition to the aspects discussed so far, one must also carefully consider the context of the business organisation for gaining a holistic understanding of its financial statements. The information about the industry, company operations, location, assets owned, relationship with various stakeholder groups, competitors, governance and ownership structure, nature of the business organisation and bargaining power with stakeholders are all important factors that contribute to a fuller understanding of a company’s performance and position.
Video 1 A few points to consider
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