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Authors: Colin Barrow
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Some problems in using ratios
Finding the information to calculate business ratios is often not the major problem. Being sure of what the ratios are really telling you almost always is. The most common problems lie in the four following areas.
Which way is right?
There is natural feeling with financial ratios to think that high figures are good ones, and an upward trend represents the right direction. This theory is, to some extent, encouraged by the personal feeling of wealth that having a lot of cash engenders.
Unfortunately, there is no general rule on which way is right for financial ratios. In some cases a high figure is good, in others a low figure is best. Indeed, there are even circumstances in which ratios of the same value are not as good as each other. Look at the two working capital statements in Table 1.12 .
TABLE 1.12 Â Â Difficult comparisons
1
2
Current assets
$/£/â¬
$/£/â¬
$/£/â¬
$/£/â¬
Stock
10,000
22,990
Debtors
13,000
100
Cash
100
23,100
10
23,100
Less current liabilities
Overdraft
5,000
90
Creditors
1,690
6,690
6,600
6,690
Working capital
16,410
16,410
Current ratio
3.4 : 1
3.4 : 1
The amount of working capital in each example is the same, $/£/â¬16,410, as are the current assets and current liabilities, at $/£/â¬23,100 and $/£/â¬6,690 respectively. It follows that any ratio using these factors would also be the same. For example, the current ratios in these two examples are both identical, 3.4 : 1, but in the first case there is a reasonable chance that some cash will come in from debtors, certainly enough to meet the modest creditor position. In the second example there is no possibility of useful amounts of cash coming in from trading, with debtors at only $/£/â¬100, while creditors at the relatively substantial figure of $/£/â¬6,600 will pose a real threat to financial stability.
So in this case the current ratios are identical, but the situations being compared are not. In fact, as a general rule, a higher working capital ratiois regarded as a move in the wrong direction. The more money a business has tied up in working capital, the more difficult it is to make a satisfactory return on capital employed, simply because the larger the denominator the lower the return on capital employed.
In some cases the right direction is more obvious. A high return on capital employed is usually better than a low one, but even this situation can be a danger signal, warning that higher risks are being taken. And not all high profit ratios are good: sometimes a higher profit margin can lead to reduced sales volume and so lead to a lower ROCE (return on capital employed).
In general, business performance as measured by ratios is best thought of as lying within a range, liquidity (current ratio), for example, staying between 1.2 : 1 and 1.8 : 1. A change in either direction represents a cause for concern.
Accounting for inflation
Financial ratios all use pounds as the basis for comparison: historical pounds at that. That would not be so bad if all these pounds were from the same date in the past, but that is not so. Comparing one year with one from three or four years ago may not be very meaningful unless we account for the change in value of the pound.
One way of overcoming this problem is to adjust for inflation, perhaps using an index, such as that for consumer prices. Such indices usually take 100 as their base at some time in the past, for example 2000. Then an index value for each subsequent year is produced showing the relative movement in the item being indexed.
Apples and pears
There are particular problems in trying to compare one businessâs ratios with
Some problems in using ratios
Finding the information to calculate business ratios is often not the major problem. Being sure of what the ratios are really telling you almost always is. The most common problems lie in the four following areas.
Which way is right?
There is natural feeling with financial ratios to think that high figures are good ones, and an upward trend represents the right direction. This theory is, to some extent, encouraged by the personal feeling of wealth that having a lot of cash engenders.
Unfortunately, there is no general rule on which way is right for financial ratios. In some cases a high figure is good, in others a low figure is best. Indeed, there are even circumstances in which ratios of the same value are not as good as each other. Look at the two working capital statements in Table 1.12 .
TABLE 1.12 Â Â Difficult comparisons
1
2
Current assets
$/£/â¬
$/£/â¬
$/£/â¬
$/£/â¬
Stock
10,000
22,990
Debtors
13,000
100
Cash
100
23,100
10
23,100
Less current liabilities
Overdraft
5,000
90
Creditors
1,690
6,690
6,600
6,690
Working capital
16,410
16,410
Current ratio
3.4 : 1
3.4 : 1
The amount of working capital in each example is the same, $/£/â¬16,410, as are the current assets and current liabilities, at $/£/â¬23,100 and $/£/â¬6,690 respectively. It follows that any ratio using these factors would also be the same. For example, the current ratios in these two examples are both identical, 3.4 : 1, but in the first case there is a reasonable chance that some cash will come in from debtors, certainly enough to meet the modest creditor position. In the second example there is no possibility of useful amounts of cash coming in from trading, with debtors at only $/£/â¬100, while creditors at the relatively substantial figure of $/£/â¬6,600 will pose a real threat to financial stability.
So in this case the current ratios are identical, but the situations being compared are not. In fact, as a general rule, a higher working capital ratiois regarded as a move in the wrong direction. The more money a business has tied up in working capital, the more difficult it is to make a satisfactory return on capital employed, simply because the larger the denominator the lower the return on capital employed.
In some cases the right direction is more obvious. A high return on capital employed is usually better than a low one, but even this situation can be a danger signal, warning that higher risks are being taken. And not all high profit ratios are good: sometimes a higher profit margin can lead to reduced sales volume and so lead to a lower ROCE (return on capital employed).
In general, business performance as measured by ratios is best thought of as lying within a range, liquidity (current ratio), for example, staying between 1.2 : 1 and 1.8 : 1. A change in either direction represents a cause for concern.
Accounting for inflation
Financial ratios all use pounds as the basis for comparison: historical pounds at that. That would not be so bad if all these pounds were from the same date in the past, but that is not so. Comparing one year with one from three or four years ago may not be very meaningful unless we account for the change in value of the pound.
One way of overcoming this problem is to adjust for inflation, perhaps using an index, such as that for consumer prices. Such indices usually take 100 as their base at some time in the past, for example 2000. Then an index value for each subsequent year is produced showing the relative movement in the item being indexed.
Apples and pears
There are particular problems in trying to compare one businessâs ratios with
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