At the end of each financial year, every company produces the following accounts: Essentially, these statements present—in a summarized form—all the information recorded in the company's accounting books. The results disclosed by these statements are of obvious importance to several stakeholders, including shareholders, directors, accountants, creditors, stock exchanges, and—of course—the government. One of the prime uses of financial statements, from the point of view of almost all users, is to compare one company's operational results and financial strength with those of others. In fact, there is no better way to evaluate a company's performance or position than to compare it with others. Pre-set targets or the previous year's performance or norms may also be used. The comparison is usually made between the performance of: An overview of each of these areas is given below. Figures contained in financial statements are absolute figures. While these figures do serve the basic purpose of conveying the results achieved by the company in a given period, they are generally inadequate in themselves for the purpose of making a meaningful comparison. Thus, the fact that Company A may make a net profit of $25 million and Company B of $40 million can lead to an impression that the latter company is more profitable. However, with the information about Company A's equity capital of $200 million and Company B's $400 million, and expressing net profit as a percentage of equity capital, we can determine—more accurately—the efficiency of the company's use of its funds. The net profit percentage comes to 12.5% for Company A and 10% for Company B. The conclusion is now both clearer and more appropriate. What a ratio essentially does is to provide a common base. In the example above, the two figures of net profit are not comparable initially. However, when we take the two figures showing return on equity, we get one common factor: the equity in both cases is taken as 100. The net profits of the two companies as a percentage of their respective equity figures thereby become comparable. This is the principal function of a ratio: namely, to provide a common base in two or more sets of figures so that they become comparable.
Same Unit Over Different Periods
Different But Related Units
Different Industries
Need of Comparing Financial Performance FAQs
Basically, this is the only meaningful way in which a company’s results can be evaluated. The ratios calculated for each of these comparisons constitute the measures most frequently used in making such evaluations.
One pitfall of comparing financial performance is that companies can present their numbers in different ways. For example, one company might use accrual accounting while another uses cash accounting. This can make it difficult to compare the two companies' financial statements. Additionally, companies may use different methods for calculating certain ratios, which can also lead to apples-to-oranges comparisons. Finally, it is important to remember that past performance is not necessarily indicative of future results.
Different sources of information should be used for different comparisons. For example, historical figures for a company’s performance must be obtained from the Financial Statements and other accounting data, while forecasts or budget figures can come from management discussion or analysis in annual reports, management discussion in interviews with analysts following the stock market, etc.
There is no one definitive way to do this, but there are a few methods that are commonly used. One approach is to look at ratios such as return on equity (ROE) or earnings per share (EPS). Another method is to examine the company's income statement and balance sheet to see how they have changed over time.
When comparing financial performance, it is important to look at factors such as revenue growth, profitability, and debt levels. You should also consider the industry in which the companies operate and how they compare to their competitors.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
