Accounting ratios are a powerful tool when evaluating a business unit's performance. The most important uses and advantages of accounting ratios are discussed in this article. A key advantage of ratios is that they provide a basis for comparison. It is impossible to compare two absolute figures (from different companies or sources) and to draw a meaningful conclusion. But two similar ratios can be compared and a meaningful conclusion can be drawn. For example, it would be unproductive to compare the net profit of a company with that of another company without considering factors like equity and sales. However, by comparing a company's net profit as a percentage of equity (ROE) with the ROE of another company, a meaningful comparison can be made. Similarly, we can compare net profit as a percentage of sales between two companies and use it to evaluate their respective pricing policies and operational efficiency. The reason why accounting ratios like ROE work as a good basis for comparing two or more entities is that, in both cases, there is one element common (i.e., an equity unit of 100 in the first case and a sales unit of 100 in the latter case). Ratios can be used as a tool for measuring an entity's financial performance. For example, if a business achieves a higher sales volume than the previous year (or than the budgeted level), along with higher net profit, one may tend to ignore certain aspects of the performance. It would be more prudent to calculate, for example, net profit as a percentage of sales in order to see if that also improved (or at least sustained the previous year's or budgeted level). If not, this would mean that increased sales have not brought in the due increase in profits. Let's consider another example. If a company's budgeted sales were $2,000,000 and the budgeted net profit is $200,000, this means that the budgeted net profit margin is 10%. Now let's assume that the actual sales achieved were $2,500,000 and the actual net profit was $220,000. This means that both the sales and net profit were greater than the budgeted levels. This may in itself be an adequate source of satisfaction for certain managers. However, an experienced manager will go a little beyond the absolute figures of sales and net profit. In particular, an experienced manager would calculate the actual net profit margin (8.8% in this case) and compare it to the budgeted net profit margin (which was 10%). Now it's clear that the management team, had they been vigilant and successful in sustaining the net profit margin, could have achieved a net profit of $250,000 (i.e., 10% of actual sales). Accounting ratios provide a means of controlling operational performance. By declaring certain ratios as benchmarks, management can control employee performance. For example, sales staff could be granted the authority to negotiate special deals and discounts for their clients, provided the gross profit margin on their total sales does not fall below a stated percentage. In this way, the operational staff exercises adequate flexibility in its dealings, while the profitability of the business remains unimpaired. Benchmarks are used to control the use of resources tied up in total stock carried, debtors, and others. When benchmarks are set and operational personnel report regularly (e.g., every month) on the level of stock (e.g., regarding the rate of stock turnover or average stock retention period), the efficiency of stock management can be clearly seen. Similarly, benchmarks provide a tool for controlling credit. If a benchmark of (for example) two months credit allowed is set, no further credit should be allowed to a customer with longer than two months of outstanding bills. Accounting ratios calculated over several periods provide an excellent way to notice and analyze trends. For example, if the gross profit margin falls from 45% in 1997 to 44% in 1998, 40% in 1999, and 38% in 2000, a pattern (or trend) can be observed. If the trend or pattern is common in the industry or countrywide, a useful lesson may be learned. The lessons learned from analyzing trends should be kept in mind when drawing up a pricing policy. Accounting ratios are useful when drawing up plans for the future. This is because many ratios express the relationships between different figures in an income statement or balance sheet. If only the major figures are forecasted or planned, other figures can be arrived at by applying the prevailing ratios to the key figures. Thus, a total plan can be drawn up by forecasting only the key figures and setting the key ratios.1. Basis for Comparing Two or More Entities
2. Measurement of Financial Performance
3. Tool for Controlling Operational Performance
4. Use of Ratios as Benchmarks
5. Analysis of Trends
6. Helpful in Future Planning
Uses and Advantages of Accounting Ratios FAQs
So a ratio is any relationship between two figures. If a car can travel 100 miles per gallon, the ratio of distance to fuel used is 100:1. The word "ratio" comes from latin and originally meant a proportional comparison, hence the use of fractions in this context.
"Index" means more or less the same thing as "ratio." It's another term for comparison of two (or more) numbers. The word "index" is associated with various statistical measures, like the consumer price index, where it indicates that all figures are measured against one base figure (for example, for the consumer price index, 100 represents the average level of prices in a given year).
There is no such thing as an "ideal" ratio. If you mean a ratio that indicates excellent performance or some desirable attribute, there might be one but it would depend on the circumstances.
Businesses use ratios in various ways, including benchmarking against similar businesses, allocating resources where different departments are using them to competing advantage or checking that targets are being met. Business ratios can be very specific or broad ranging depending on the purpose they're serving.
The gross profit margin is one common business ratio. This looks at the relationship between revenue and costs, essentially showing the amount left over after direct costs are deducted. It's important because it shows how much a company has to pay its overheads from that month or year. If the gross profit margin falls consistently then it suggests that overheads are becoming too much of the business' income, for example.
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.
