Why are ratios important?

For business analysis, ratios are far more useful than just looking at the absolute numbers.

A ratio is where you express something, either as a percentage or as one number against another, like horse racing odds.  A horse with odds of 2-1 is likely to be a better bet than a 100-1 outsider.

We use ratios to assess a business’s performance. For, example if business “A” makes £50,000 profit a year and business “B” only makes £10,000, which is the best business?

You would probably think business “A” but it depends.

We can’t truly know the business performance unless we know what capital or assets are used. It could be that business “A” has £2m of assets and business “B” only has £200,000 of assets. This would make business “B” twice as good and business “A”, even though it makes less profit.

The Return On Investment for business “A” is £50,000 divided by £2 million x 100 = 2.5%. The return on business “B” is £10,000 divided by £200,000 x 100 = 5%.

Where would you prefer to have your money, in a bank paying 2.5% interest or 5%?

Ratios are so important because we can compare, not just against our own businesses year-to-year, but we can compare against other businesses.  For example, if you ran a small mini supermarket, then just with the absolute numbers you would not get any reasonable comparisons if you compared your results with those of Sainsbury’s.

Sainsbury’s is going to generate much more profit in real terms and it’s going to have more cash in the bank, because they’re bigger.  But, if you look at the ratios, and you look at the gross profit, sales per square foot or the Return on Investment, it doesn’t matter how big or small a business is, you can make some meaningful comparisons.

We can then see how well we are performing against the competition and see if we can learn anything.