Ratio Analysis is a very self explanatory subject, as it is really just analyzing situations using different kinds of ratios. Ratios are very handy when assessing risk, liquidity, and profitability, because they can be used to accentuate competitive advantages and warn for potential trouble.
However, to perform ratio analysis with the ratios, we have to compare them to what we call benchmarks. There is no absolute benchmark in ratio analysis, as in saying if the profitability of the company is 32% or more it is great and if not, the company’s in trouble. However, there are two types of benchmarking that can be done, and they are time-series analysis and cross-sectional analysis. Time-series analysis is comparing one company’s ratios at different points in time, and cross-sectional analysis is comparing different companies in the same industry.
Ratios can also be misused at times. A common mistake one makes is not realizing that ratios have different definitions for different firms and organizations that use them. This leads to incorrect comparisons, because the same definition of a ratio needs to be used for the ratios to be compared correctly.
Sometimes the inappropriate benchmark is selected for comparison, and this is important because major changes in a firm will at times distort the results of a time-series analysis, different strategies and capital structures of companies can distort the results of a cross-sectional analysis, and different accounting methods make comparing a very difficult job.
Also, some ratios can be intentionally changed and manipulated by managerial action. This always needs to be kept in mind, since at times some people focus on just one ratio that has a chance of having been manipulated. Next week, I’ll get more in depth into some of the types of ratios that are used by companies to assess productivity.
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