What is ratio analysis and why is it being used?

Ratio analysis is a numerical technique of re-expressing financial statements. It aids decision making by summarising and interpreting financial statements more easily. There are different sets of ratios, each indicating a company’s performance in a certain area – profitability, efficiency, liquidity, solvency and investment. Investors would use these ratios to decide whether it is worth investing in the company’s equity, or whether the company would be able to repay its debt if investors were to lend. The reason why rations are so commonly used is because they act as summary statistics for the company as financial statements can be too complex. Moreover, ratios make it possible to more accurately compare companies as ratios control the size differences between companies. They can also be used in statistical analyses aiming to predict future economic events. Ratios are also very use to calculate but the problem comes when interpreting them. Usually, the best way to know whether a ratio is indicating good or bad performance is by comparing it to industry benchmarks or to competitors’ ratios. However, even though ratios can be used for predictions, they are in no way means of exhaustive analysis of company performance or prediction for future performance. This is because ratios are based on financial statements which are backwards-looking, i.e. they represent past events. Moreover, ratios simply show what area is a weakness and what area is a strength but they do not provide reasons/causes for these strengths/weaknesses. Specifically, balance sheet ratios such as liquidity ratios are only snapshots at a particular time (the period end) and hence such ratios do not represent the company’s liquidity performance over the whole year. Lastly, rations should be used for comparison of companies that use the same accounting standards. A very good example is Daimler Benz. In 1993, the company reported 615 million deutsche marks under German GAAP, but the results for the same year under US GAAP was a loss of 1,839 million deutsche marks.