Ciaran Walsh - 25 need-to-know management ratios

A ratio is meaningless and potentially misleading on its own. To interpret a ratio properly it is essential to use an appropriate benchmark.

Suitable benchmarks can be from internal or external sources. Internally: historic data or another product, service, customer or geographical territory make the best benchmarks. Externally: competitor information (if obtainable), industry data, external analyst reports and government statistics can be useful.

Be careful when comparing to the industry norm. This will be an average and include some extreme top performers and extreme poor performers which may distort the average. It is better to compare against a pre-selection of known good performers which provide the best comparison against your business.

At the same time it is important to remember that no two businesses are the same even if they are direct competitors in the same industry. They could be financed differently and have different tax rates, for example.

There is a common desire for businesses to focus on one key ratio. In this book we talk about one of the most popular sole measures, return on equity (one ratio there is a danger of missing out the essential feedback provided by using a variety of ratios.

Whereas it is useful to have a primary ratio, using a portfolio of supporting secondary ratios provides a fuller picture of a business. Additionally, secondary ratios can help to read between the lines and make sure the whole organisation is performing optimally.

A useful analogy is a car dashboard where the speedometer is the primary focus (or key ratio). However, the fuel gauge, tachometer, odometer, oil temperature, oil pressure and engine warning lights provide other essential information which affects the performance of the car.

At the other end of the scale is the symptom of analysis paralysis where businesses monitor so many ratios that it is difficult to see the wood for the trees, let alone spot the primary measure.

Returning to the dashboard analogy, many non-pilots would find it challenging to navigate an instrument panel within the cockpit of a modern aircraft.

The financial statements on which many ratios are based are produced at a point in time. The balance sheet (covered in ) is a snapshot of the business on a particular day. The position may be different the day before or the day after.

Therefore, it is important to look at trends in ratios versus interpreting ratios at a single point in time.

Seasonality may impact certain businesses. For example a calendar retailer will have high inventory as they build up stocks towards the year-end and hopefully low inventory by the time it gets to February.

Ratios can be influenced by a one-off event. For example, sale of a large asset prior to a companys year-end may boost its bank balance temporarily.

Similarly, there may be a lag in results. A company may have raised debt to fund a sound and profitable investment which will not payback for a number of years.