When it comes to judging you business against others in your industry, it can sometimes be difficult because of the differences between the two companies. Size, revenue, and inventory can all be large discrepancies when it comes to evaluating each firm. A way to make this type of comparison equal comes with the use of accounting ratios. Ratios can be used for a variety of business measurements and are extremely helpful because they can compare two companies as if they are the exact same size. This article will discuss how the use of ratios can be advantageous to a business, but will also discuss some of their limitations.
1. Comparability of multiple entities. Ratios are a great tool to look at how the inner workings of different companies are when looked at side by side. Ratios can show where the strong points of successful companies are, while also showing weak areas.
2. Financial statement analysis. Often times, looking at the financial statements, can be confusing and overwhelming. There are many different numbers to look at, and if you are really only trying to figure out one specific item, going through the entire statement can be a waste of time. This is where ratios help. They can tell a reviewer how much debt to equity the company has, current assets VS current liabilities, as well as how often inventory turns over every period. These are all a great help when comparing one company to another, regardless of size.
Although the two examples above show when ratios can be useful, they also suffer from some limitations that need to be noted.
1. Ratios are historic. The numbers the ratios provide are great when evaluating the past performance of the company, but they do not provide any insight to the future. Despite how well a company performed last quarter, there could be certain extenuating circumstances that will have an adverse effect when they take place, drastically affecting the company’s well being.
2. Potentially misleading. Because each business can utilize different accounting procedures, the comparable ratios might give a better picture than what is really on the books. Business might move specific items to a different area in order to make their ratios look better, which would be misleading to anyone who used them as a measurable tool.
Although ratios have both advantages and disadvantages, if used in the correct way they can be a great tool for any business looking to compare with another. Their simplicity and ease of use makes them a useful accounting instrument in any multiple commerce environments.