What is Ratio Analysis and Why is it Important?
Ratio analysis involves the method of calculating and interpreting financial ratios in order to assess the strengths and weaknesses underlying the performance of an enterprise. Ratios are expressed either as percentage, proportion or fraction. The basic rationale behind ratio analysis is that one cannot simply compare the balance sheet or income statement numbers across two companies.
As an instance, Company A’s net profit is ₹500 crores and that of Company B is ₹800 crores. Based on this statement, one cannot comment that Company B is better than Company A. It might be the case that Company B is selling goods worth more than ₹10,000 crore to earn ₹800 crores while on the other hand, Company A is just selling goods worth ₹5,000 crore to earn around ₹500 crores. As it can be seen that Company A has a Net Profit Margin (NPM) of 10% (₹500/₹5,000) whereas Company B’s NPM stands at 8% (₹800/₹10,000)
Thus, we bank on ratios to compare the income statement and balance sheet numbers across companies & industries. Similarly, it becomes difficult to track the year-on-year (YoY) performance in absence of financial ratios. Thus, ratio analysis helps to do both inter firm and intra firm comparison.
There are two main types of ratio analysis:
- Cross-sectional Analysis: In cross sectional analysis we compare the financial ratios of the underlying firm against its competitors and also against the industry average at a single point of time rather than over a period of time.
- Time Series Analysis: In this type of analysis we compare the ratios over a period of time and observe the variations.
One of the most important facets of ratio analysis lies in the selection of an appropriate comparable. The two companies whose ratios are compared should be of similar size/ business model.
It is never justified to compare the ratios of Reliance Jio with that of MTNL. Despite the fact that both are telecom operators, Reliance Jio is one of the largest telecom players in India and MTNL, on the other hand, is a small regional player. However, the ratios of Reliance Jio can be easily compared to the ratios of Bharti Airtel because of the similar size of their businesses.
Thus, the selection of the appropriate benchmark ratios is one of the keys to do successful ratio analysis.
Why Benchmark Ratios?
- Ratios by themselves do not provide answers to analysts' questions directly.
- When ratios are compared with benchmark ratios, they provide insights that help to ask the right questions.
- It may not be an exaggeration to say that the quality of ratio analysis depends largely on the analyst's ability to determine appropriate benchmark ratios.
- Selection of inappropriate benchmark ratios misleads the analysts.
For example, one cannot compare the ratios of ITC and HUL even though they both are in the FMCG business.
As a matter of fact, ITC derives more than 42% of its revenues and a startling 74% of its Net Profits from the Cigarette Division in FY21.
On the other hand, HUL is a pure-play FMCG company deriving over 75-80% revenue from its FMCG products. Since, the core business of both the similar looking companies is different thus one cannot compare the ratio of ITC with HUL.
Some major types of financial ratios that analyst uses are classified as:
We will learn each of these ratios & their usefulness in our upcoming units of this module.