Question

Once calculated all ratios should be compared to what?

Answer 1

Once the ratios for a company have been calculated, they can be compared with the ratios of firms/companies operating within the same industry or can also be compared with the industry average (as a whole). Such a comparison would help the analyst/company's accountant to understand the company's financial position in terms of liquidity, solvency, returns and growth prospects as against its competitiors. It will become easier to identify the areas where the company is performing as per expectations and where it is lacking in performance. Comparisons are frequently made by investors before they invest their money in a particular company. For Instance, let us assume that Company A is having a debt equity ratio of 4:1, while other companies within the same industry are maintaining a debt ratio of 2:1 and industry average is also around 2.5:1. By looking at these figures, it may be concluded that Company A is having a higher proportion of debt in its capital structure when compared to its competitors. This ratio when used along with other financial ratios may indicate that the company is heavily dependant on debt/external borrowings, which may indicate higher financial risk (because of fixed interest obligations) which in turn may deter investors from putting their money in Company A.

Similarly, let us assume that Company B is having a current ratio of 7:1, while its competitors are maintaining a current ratio of 3:1. While a high current ratio (when studied in isolation) may indicate that the company is highly liquid, its comparison with other companies, may help the company/analyst/investor to identify the actual cause behind such a high ratio. It could be possible that the company has a huge amount of money blocked in inventories. In such a case, it would be advisable to look at the quick ratio to gain a further understanding on the liquidity position. With this comparison, the company's accountant can identify the areas where the company needs to improve in order to bring its current ratio in line with other companies/industry average.