At the end of each financial year every company produces a trading and profit and loss account (or income statement), an appropriation account (or statement of retained earnings) and a balance sheet. Essentially these statements present, in a summarized form, all the information recorded in the company’s accounting books. Results disclosed by these statements are of obvious importance to several people such as shareholders, directors, accountants, creditors, stock exchange and of course the government.
One of the prime uses of financial statements, from the point of view of almost all the users, is comparison of operational results and financial strength of a company with those of others. In fact, there is no better way of evaluating a company’s performance or position than to compare it with others, or with pre-set targets, or with previous year’s performance or norms. The comparison may be made between the performance of:
The same unit over different periods:
- e.g. comparing year 2016’s performance with year 2015’s performance, or
- 2016’s actual performance with 2016’s forecast or budgeted performance
Different but related units:
- e.g. performance of department A with department B, or
- Product A with Product B, or
- Company A with company B in the same business, or
- New York branch with Washington branch
- USA subsidiary with UK subsidiary, etc.
- Company A with average or normal performance or other companies in the same business.
- e.g. performance of an oil marketing company with a tools retailing chain, or
- Performance of a manufacturing company with a financial services company
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 the company A has made a net profit of $25 million and company B of $40 million can lead to an impression that the latter company is more profitable. But if we use the additional information about Company A’s equity capital of $200 million and company B’s equity of $400 million, and express net profit as a percentage of the equity capital we can determine, to a greater degree of accuracy, the efficiency with which each company has used its funds. It 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 taken above, the two figures of net profit are not comparable but when we take two figures showing return on equity, we get on 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 thus become comparable. This is the principle function of a ratio – namely to provide a common base in two or more sets of figures so that they become comparable.