What Is Comparative Ratio Analysis?
Comparative ratio analysis is a method companies use to assess financial performance. Though the ratios use accounting information, they can provide a deeper meaning to the company’s profitability, asset use, leverage, and other business activities. Benchmarking is typically the most common purpose for this type of analysis. For example, a company often tracks its financial leverage over several months or years to determine if it is more or less in current periods. Managers may also be subject to performance reviews based on financial ratios that explain their departments' efficiency with the company’s assets.
A company typically starts an analysis by separating ratios into groups, such as profitability, liquidity, financial leverage, and asset turnover. The ratios test different parts of the business based on related accounting data. Information provided from each group includes the ability to meet short-term debt obligations, use of assets to generate profits, use of debt in the business, and profit earned from a single product or multiple product lines. Accountants typically prepare the ratios as they are neutral parties in the analysis. From here, owners and executives take the data for comparative and review purposes.
Reports that detail a company’s comparative ratio analysis do not need to follow a specific format. Although the ratios carry the name financial ratios, they are often more of an internal accounting tool for specific stakeholders. Therefore, the report can have a format that best suits the needs of owners, executives, or managers. The only standard is the separation of ratios by type, as mentioned earlier. The order of importance or other ranking is purely decided by the needs or demands of the business.
Trend analysis is the first major use of a comparative ratio analysis. Accountants prepare data for several months and place them in order by month and year if necessary. Report users can then look at the increase or decrease in the different ratios and assess performance. For example, decreasing current and quick ratios can indicate a tougher time meeting short-term debt obligations. Weaker profitability ratios can also provide information as to why the current or quick ratios are losing ground.
Benchmarking compares one company’s performance to another business, which allows owners and executives to determine how well the company operates under the same economic conditions. When a company is significantly behind its competitors, there is typically a major issue at hand. Comparative ratio analysis tends to strip away any accounting policies that change or alter a company’s earnings, allowing for a one-tone review on financial performance.
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