What ratios are for

A ratio shows the relationship between two accounting figures. It can be written as a fraction, a proportion (2:1), a percentage or a number of times. The two figures must be related: purchases ÷ furniture gives a number, but it means nothing.

Why use ratios? They:

• simplify a mass of figures into a few numbers;
• show trends over the years;
• point to problem areas that need attention, and areas to improve;
• give a deeper view of profitability, liquidity, solvency and efficiency;
• let you compare: with the firm's own past, with other firms (cross-sectional), and with industry standards;
• help with SWOT analysis and with projections.

Their limits. Some come from the data they use:

• the statements contain accounting judgements;
• price changes are ignored;
• qualitative factors (management, staff, reputation) are ignored;
• different firms may follow different accounting practices;
• they are built on history, which may not predict the future.

Others come from ratios themselves: a ratio is a means, not an end. It points to a problem but does not solve it. There are no standard definitions or ideal levels that fit every firm.