Every so often, you get a physical checkup. You go to your doctor and he or she runs some tests and checks your vital signs. You do this to monitor and safeguard your health.
Ratio analysis is the business equivalent of a physical checkup. It involves the comparison of one account balance or group of balances with another. Ratio analysis clarifies relationships between different income statement and balance sheet accounts. The ratios are usually designed to provide insight into a company’s liquidity, leverage, efficiency, or profitability.
Not everyone who relies on financial statements is interested in the same ratios. Different groups are interested in different ratios. Short-term creditors want to know if the company will be able to pay its short-term obligations as they come due, so they’re primarily interested in the liquidity ratios.
Long-term creditors want to know if the company will be able to pay its long-term debt, and so they’re interested in the leverage ratios.
Managers and owners want to ensure that the company is well-managed in order to make money, so they’re mainly interested in the efficiency and profitability ratios.
There’s no “best level” for most of these ratios. Different people want to see different levels for the various ratios, depending on their relationship to the company. For any ratio, a good level for one company in one industry may not be good for another company in another industry, and a good level for a given company at one point in time may not be good for that same company at another time.
It may seem, for example, that if a little liquidity is good (as it is, from the perspective of the short-term lender), then a lot of liquidity must be better. But injecting liquidity could increase the asset base, so a company could reduce its return on investment (which is bad from the perspective of the owner).
Or if too much financial leverage is bad (as it is, in the view of the long-term lender), then no financial leverage at all must be the goal. But by avoiding all borrowing, a business may be missing profit opportunities and slowing its own growth (again, bad from the perspective of the owner).
It’s important to look not only at the absolute levels of the ratios, but at their consistency or variability over time to see if there are any significant trends in those levels (see related article). It’s also important to compare a company’s ratios with the ratios of other firms in the same or a similar industry.
Also, many ratios can be calculated in more than one way, and results vary depending on how the ratio was calculated. When making comparisons, be sure that the ratios were calculated in exactly the same way.
If you haven’t had a business “physical checkup” lately, contact your CPA.