Techniques Used in Ratio Analysis

Ratio, as the name suggests, is nothing more than one number divided by the other. However, they become useful when they are put in some sort of context. This means that when an analysts looks at the number resulting out of a ratio calculation he/she must have a reasonable basis to compare it with. Only when the analyst looks at the number and compares it what the ideal state of affairs should be like, do the numbers become powerful tool of management and financial analysis.

Dividing numbers and obtaining ratios is therefore not the main skill. In fact this part can be automated and done by the computer. Companies wouldn’t want to pay analysts for doing simple division, would they?. The real skill lies in being able to interpret these numbers. Here are some common techniques used in the interpretation of these numbers.

Horizontal Analysis

Horizontal analysis is an industry jargon for comparison of the same ratio over time. Once a ratio is calculated, it is compared with what the value was in the previous quarter, the previous years, or many years in case the analyst is trying to make a trend. This provides more information of two grounds. They are:

  • Horizontal analysis clarifies whether the company has a stable track record or is the value of the ratio influenced by one time special circumstances.

  • Horizontal analysis helps to unveil trends which help analysts unveil trends in the performance of the business. This helps them make more accurate future projections and value the share correctly.

Cross-Sectional Analysis

Cross sectional ratio analysis is the industry jargon used to denote comparison of ratios with other companies. The other companies may or may not belong to the same industry. Cross sectional analysis helps an analyst understand how well a company is performing relative to its peers. In a way this removes the effect of business cycles. There are many variations of cross sectional analysis. They are as follows:

  • Industry Average: The most popular method is to take the industry average and compare it with the ratios of the firm. This provides a measure of how the company is performing in comparison to an average firm.

  • Industry Leader: Many companies and analysts are not satisfied with being average. They want to be the industry leader and therefore benchmark against them.

  • Best Practice: In case, the company is the industrial leader, then it usually crosses the industry border and seeks inspiration from anyone anywhere in the world. They benchmark with the best practices across the globe.

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