Ratio Analysis helps to compare business performance in two ways – using historical comparisons of the same company, and using current comparisons between different companies in the same industry.
It is quite easy to compare business performance using one year’s figures with the previous year(s). Similar comparisons can be made between different companies too.
Changes in sales revenue, costs and profits can be identified within Profit and Loss Account (P&L Account), as well as differences from one year to the next in assets, liabilities and shareholders’ equity within Balance Sheet.
A. Compare business performance using historical comparisons – TRENDS
Ratios can be used to assess whether financial performance of a given business is good or not. And, whether the performance of that business improved or deteriorated.
To do so, financial information for the current year is compared with historical figures from the past year(s). Historical comparisons involve comparing the same ratio in two different time periods for the same business. Such comparisons show TRENDS, thereby help managers to assess the financial performance of a business over a period of time.
For example, one business might have different amounts of profits and different amounts of sales revenue in different years. Ratio Analysis can therefore show the relative financial performance of that business.
Example 1: Comparing historical performance of one company.
Let’s take a look at the following accounting data in 2020 and 2021 for one company: Company A.
2020 2021
Sales Revenue $500 $1,000
Net Profit Before Interest and TAX (EBIT) $100 $200
How much can we tell about the performance of this company over the last two years by looking at these results?
Simply from the results of Sales Revenue and Net Profit Before Interest and TAX, we can try to conclude that Company A performed much better in 2021 than in 2020. It is because Company A generated much higher Sales Revenue of USD$1,000 in 2021 than in 2020 which was only USD$500. Also, Net Profit Before Interest and TAX earned by Company A in 2021 was two times higher than Net Profit Before Interest and TAX earned by Company A in 2020. The year 2021 should be a fantastic year for Company A, shouldn’t it?
However, we cannot give a definite answer whether Company A performed better in 2020 or in 2021, without having the accountants to make assessments by relating two accounting results to each other in the form of a ratio.
Consequently, if we look at the ratio of Net Profit Before Interest and TAX to Sales Revenue for both years, it turns out that Company A had exactly the same profitability in 2020 and in 2021. Company A’s profitability ratio in 2020 was USD$100:USD$500, or 0.2, or 20% while in 2021 Company A’s profitability ratio was USD$200:USD$1,000, or 0.2, or 20%.
Company A is exactly the same profitable in both years. The management team at Company A was equally effective at converting sales revenue into net profit. The strategies adopted by Company A were equally successful in both years, and Company A could have made a good investment for shareholders in both years. So, in terms of profitability, the performance of Company A did not change.
B. Compare business performance using inter-business comparisons – RANKS
Alternatively, the same ratios can be compared with those of competitors. Inter-firm comparisons usually involve comparing the ratios of businesses in the same industry. This way will help managers to judge whether the business has improved or worsened against its rivals.
To do so, financial information for the current year of one company is compared with financial information for the current year of another company. Inter-business comparisons involve comparing the same ratio in the same time period for two or many different businesses. Such comparisons show RANKS, thereby helping managers to assess the financial performance of a business against similar firms.
For example, two businesses might have the same amount of profit although their sales revenue may be quite different. Ratio Analysis can therefore show the relative financial performance of a business.
Example 2: Comparing current performance of two companies.
Let’s take a look at the following accounting data in 2021 for two companies: Company A and Company B. These two firms are direct competitors in the same industry.
Company A Company B
Sales Revenue $1,000 $5,000
Net Profit Before Interest and TAX (EBIT) $200 $400
How much can we tell about the performance of this company over the last two years by looking at these results?
Simply from the results of Sales Revenue and Net Profit Before Interest and TAX, we can try to conclude that Company B performed much better than company A. It is because Company B generated much higher Sales Revenue of USD$5,000 than Sales Revenue generated by Company A which was only USD$1,000. Also, Net Profit Before Interest and TAX earned by Company B was two times higher than Net Profit Before Interest and TAX earned by Company A. This all should be a fantastic news for Company B, shouldn’t it?
However, we cannot give a definite answer which company performed better, without having the accountants to make assessments by relating two accounting results to each other in the form of a ratio.
Consequently, if we look at the ratio of Net Profit Before Interest and TAX to Sales Revenue for both companies, it turns out that it is Company A that has better profitability. Company A’s profitability ratio is USD$200:USD$1,000, or 0.2, or 20% while Company B’s profitability is only USD$400:USD$5,000, or 0.08, or 8%.
Company A is way more profitable than Company B. The management team at Company A was more effective at converting sales revenue into net profit. The strategies adopted by Company A were much more successful than those of Company B, and it is Company A which can make a good investment for shareholders.
While shareholders in Company B may expect to receive a higher dividend now than shareholders in Company A due to the fact that Company B has higher Net Profit Before Interest and TAX in terms of monetary value, it is actually Company A that is more profitable in terms of generating profit from its sales. Hence, they may decide to invest in a more profitable Company A. So, in terms of profitability, the performance of Company A was better.
Just imagine earning 20% of Net Profit Before Interest and TAX when Sales Revenue becomes USD$1,000,000 as Company A grows. It would be USD$200,000.
Additionally, if we want to find out which of these two companies has been becoming more profitable over the years, we should look at historical data in 2020, 2019, 2018, etc.
In reality, businesses use both historical comparisons and inter-firm comparisons at the same time when analyzing their financial ratios.
However, the simple interpretation of accounting data from Final Accounts for only one year may prove not to be highly valuable. It is because a simple comparison of the change in sales revenue, costs, profits, assets, liabilities and equity of a business, from one year to the next, can provide stakeholders with misleading information.
Ideally, we must compare financial information for many years and interpret financial data with care to effectively judge the overall business performance.
