Ratios allow investor or analyst to asses and analyse the financial health of a company, its strength and weakness, in terms of such measures as liquidity, performance, profitability, leverage, growth and valuation, on an absolute basis and by comparison with other companies in its industry or industry standard.
The power of ratios comes from comparing them to relative ratios representing:
- the general economy,
- the firm’s industry,
- firm’s major competitors,
- Firm’s own past performance records.
There are two common type of analysis done using ratio:
- Trend Analysis
- Cross-sectional Analysis
Trend analysis is done by comparing the company’s ratio over its historical time period and it identifies trend that might indicate financial performance deterioration or improvement.
A common size statement normalize balance sheet and income statement and allows the investor to make easier comparison of different sized companies.
A common size balance sheet express all balance sheet account as % of total assets.
However if we analyse the trend of movement in the balance sheet, non-current assets which are investments in financial assets have increased previous year and tangible asset such as property, plant and equipment has been reduced with respect to time and average. Although there has been a rise in inventories and receivable this year, they are at level to their historic averages.
The trend in liabilities is turning down and Britannia industries is seeing a strong rise in trend of reserves and surplus. Both situation are signalling efficiency of resource management by the company.
A common size income statement expresses all income statement accounts as % of Sales.
Although the trend in expense has been rising year on year but with respect to sales the expenses are in a declining trend signifying that the company’s management is keeping cost under check and managing its inventories and other cost effectively.
The benefit of using common size statement is that raw numbers usually hide relevant information that percentages frequently unveil. Common size income statement are especially useful in studying trends in costs and profit margins.