Companies use comparative ratio analysis to check their financial performance.
Comparative ratio analysis is a method that companies use to assess financial performance. While ratios use accounting information, they can provide deeper meaning to a company’s profitability, asset usage, 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 whether it is more or less in current periods. Managers may also be subject to performance appraisals based on financial ratios that explain their departments’ efficiency with company assets.
Benchmarking for a company is often done by accountants to keep the process impartial.
A company typically starts an analysis by separating ratios into groups such as profitability, liquidity, financial leverage, and asset turnover. Ratios test different parts of the business based on related accounting data. The information provided by 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 made from a single product or multiple product lines. Accountants often prepare the indices as they are neutral parties in the analysis. From here, owners and executives obtain the data for comparative and review purposes.
Reports detailing the benchmarking of a company’s index do not need to follow a specific format. Although 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 the owners, executives or managers. The only default is the separation of proportions by type, as mentioned earlier. The order of importance or other ranking is decided purely by the needs or demands of the business.
Trend analysis is the first important use of a comparative ratio analysis. Accountants prepare data for several months and sort it by month and year if necessary. Report users can then observe the increase or decrease in different ratios and evaluate performance. For example, declining current and rapid ratios may indicate a more difficult period to meet short-term debt obligations. Weaker profitability ratios can also provide insight into why current or fast ratios are losing ground.
Benchmarking compares the performance of one company with that of another business, which allows owners and executives to determine how the company operates under the same economic conditions. When a company is significantly behind its competitors, there is usually a big problem at hand. Comparative ratio analysis tends to eliminate any accounting policies that change or alter a company’s earnings, allowing for a review of a tone on financial performance.