Using ratio analysis – an introduction

Over the coming weeks, I’ll be writing a number of posts on using ratios to analyse financial statements. First though, let me give an outline of what ratio analysis is about.

If you want to compare the financial statements on a business from one year to another, or, compare two businesses you cannot use direct comparisons of figures. Here’s a simple example:

Company A has a profit in 2010 of €1m according to its income statement. Company B has a profit of €5m. Which company is the most profitable?

You’re probably thinking Company B, as its profit is five times that of Company A. However, this comparison is mis-leading.  Now let’s assume Company A has capital of €2m, but Company B has capital of €25m. Now we can do a quick calculation as follows::

Return on investment Company A €1m/€2m = 50%

Return in investment Company B €5m/€25m – 20%.

Looking at the figures this way, we can see that Company A actually manages to make 2.5 times the return of Company B. This simple shows one problem of compare raw numbers, that is scale. However if we use financial ratios, which express figures in relative terms, we are able to make more direct comparisons between businesses. Over the next few weeks, I ‘ll be writing a number of posts detailing some individual ratios, so keep an eye out.  By the way, if you already know how to do ratios and/or want your accounts analysed, here’s a great website where you can plug in your data for a free analysis.