The investors and other external interest groups of a company usually only have access to the financial statements of the company. However, financial details alone are of limited use when trying to assess a company. Ratios are a valuable tool for such interest groups, giving them the opportunity to assess companies in a standardized manner using widely accepted parameters.
It is usually a very subjective process to try and compare companies of different sizes, geographical locations, fiscal jurisdictions, and nature. Ratio analysis provides a level playing field by laying emphasis on performance rather than absolute size of turnover or profit. Efficiency, profitability, and liquidity are more or less independent of the absolute size of the individual parameters involved, such as turnover, assets, profit, and liabilities.
Ratio analysis allows the comparison of diverse companies, and also allows analysts to set benchmarks for the different ratios so that up-and-coming companies can assess their performance against these benchmarks and identify areas where they need to improve, as well as those areas where they are doing well.
Management can use ratio analysis to monitor the performance of department heads. They could use it to set targets and thresholds for rewards or bonuses. If ratios are calculated over several periods, they may reveal a trend that could highlight impending difficulties that can then be addressed before they crystallize.
We will now look at some examples of different kinds of trend analysis.
An increase in the gross profit percentage is not necessarily a good thing. You would have to consider the following:
- Ensure that the increase is not a result of some error, such as the overstatement of turnover or the understatement of the cost of sales.
- Find out whether this is a result of a change in company policy.
- Observe what effect this has had on the volume of sales. The increased gross profit percentage may have resulted in the loss of market share.
If this loss in market share continues unchecked, it could affect the company's ability to continue in business. Management could decide to reduce the markup on their products in order to attract customers back to their products and eventually restore their market share. A decrease in gross profit percentage is not necessarily a bad thing. You would have to consider the following:
- Ensure that the decrease is not a result of some error, such as the understatement of turnover or the overstatement of the cost of sales.
- Find out whether this is a result of a change in company policy.
- Observe what effect this has had on the volume of sales. The decreased gross profit percentage may have resulted in an increase of the market share, which will translate to increased profit.
Another example of interpreting ratios concerns liquidity ratios. A high current ratio indicates a healthy company with respect to liquidity; however, the quick ratio will reveal how much this liquidity depends on inventory. If the quick ratio drops drastically, with the exclusion of inventory from the equation, then management will need to look at ways of reducing the dependence on inventory to reflect liquidity.
One way of doing this is to reduce the amount of cash tied up in the inventory. As long as it does not affect the ability to satisfy customers' demands, management may consider holding less inventory. Another way to improve liquidity is to try and boost turnover, which will filter through to debtors and/or cash. Even if creditors also increase the company's markup, this will ensure that there is a net improvement in liquidity.
The acid test, which compares just the cash with the current liabilities, is a worst-case scenario ratio. It would only become relevant if a large creditor suddenly made an enforceable demand on what the company owes them.
Some ways to guard against this are as follows:
- Avoid depending on just one supplier. Where possible, spread your exposure over a number of suppliers so that if one supplier begins to apply pressure for quick settlement of outstanding balances, the company can quickly shift focus onto the other suppliers.
- Be prudent in selecting suppliers. A supplier that has a history of suddenly making demands on their balances should be avoided.
- Management should adopt a know-your-supplier policy. The health of all suppliers should be monitored so that at the first sign that a supplier is experiencing problems and may have to demand the quick settlement of their balances, the company can take appropriate action to reduce the dependence on that supplier.
- Management should ensure that inventory and debtors are being efficiently converted into cash.