Several aspects of ratio analysis are important to understand. First, the computed ratio is not “the answer.” The ratio is an indicatorof some aspect of a company’s performance, telling what happened but not why it happened.
Net profit margin is calculated by dividing net income by revenue:
A second important aspect of ratio analysis is that differences in accounting policies (across companies and across time) can distort ratios, and a meaningful comparison, therefore, may involve adjustments to the financial data.
Third, not all ratios are necessarily relevant to a particular analysis. The ability to select a relevant ratio or ratios to answer the research question is an analytical skill.
Finally, as with financial analysis in general, ratio analysis does not stop with computation; interpretation of the result is essential.
In practice, differences in ratios across time and across companies can be subtle, and interpretation is situation specific.
The Universe of Ratios
The Operating income/Average total assets ratio is one of many versions of the return on assets (ROA).
Return on equity (ROE) is defined as net income divided by average shareholders’ equity, can be decomposed into other ratios, some of which only use balance sheet data.
Value, Purposes, and Limitations of Ratio Analysis
Financial ratios provide insights into the following:
- economic relationships within a company that help analysts project earnings and free cash flow;
- a company’s financial flexibility, or ability to obtain the cash required to grow and meet its obligations, even if unexpected circumstances develop;
- management’s ability;
- changes in the company or industry over time; and
- comparability with peer companies or the relevant industry(ies).
Ratio analysis also has limitations. Factors to consider include the following:
- The heterogeneity or homogeneity of a company’s operating activities.
- The need to determine whether the results of the ratio analysis are consistent.
- The need to use judgment.
- The use of alternative accounting methods.
Some important accounting considerations include the following:
- FIFO (first in, first out), LIFO (last in, first out), or average cost inventory valuation methods (International Financial Reporting Standards [IFRS] does not allow LIFO);
- Cost or equity methods of accounting for unconsolidated affiliates;
- Straight-line or accelerated methods of depreciation; and
- Operating or finance lease treatment for lessors (under US GAAP, the type of lease affects classifications of expenses; under IFRS, operating lease treatment for lessors is not applicable).
Sources of Ratios
