Notes

Ratio analysis is a process used to analyze an organization's financial statements to assess its financial status. Learn about the standards for comparison in financial statement analysis. Review the definition of ratio analysis, and explore the different comparisons used to understand the baseline, including prior period, competitor, and industry average.
What Is Ratio Analysis?
Jon has been an employee at Scary Bears Manufacturing Company for over 5 years. Recently, Jon's boss retired, and the company hired a new manager, Ross. Ross asks Jon to meet with him tomorrow to discuss new projects and goals for the department.

Ross tells Jon, he would like for him to complete a ratio analysis of Scary Bears. Ross explains that ratio analysis is the process of combining two or more line items by a mathematical operation and analyzing the results.

The following week, Jon gives Ross a 10-page glossy report of numbers. Ross ask Jon, 'Where's the written analysis?' Jon replied, 'What analysis? I calculated the numbers like you said.' Ross replies, 'Jon, ratio analysis is more than calculating numbers. You must follow the standards for comparing ratios.' The standards for comparing ratios are comparing the data to a prior period, competitor, industry average or baseline.

For the rest of this lesson, we'll explore the four standards for comparing ratios, show an example of each and discuss where to find the comparing data.

Comparison to Prior Period
Ratio analysis is a two-step process. The first step is to calculate the ratio, and the second step is to analyze the results. Let's take a debt ratio, for example. Debts are liabilities or obligations a business owes. A liability for Scary Bears would be a semi-truck loan. Assets are items a business owns. An example would be a building. Both liabilities and assets are found on the balance sheet. The formula for the debt ratio is total liabilities/total assets.

If total assets are $15,000 and total liabilities are $7,000, they have a debt ratio of 46% ($7,000 / $15,000). This is the only information Jon had in his report. How do we know if 46% is negative or positive? If he would have compared the 46% to a prior period, then he would have been able to make an informed analysis.

Let's say Jon reviews a prior year's financial statements and calculates the debt ratio of 56%; he could then say that the debt ratio has decreased by 10% when comparing it to the current period. The decrease in the ratio means they have paid off some of their obligations or increased their asset base without incurring more debt. We could then dig further to find out the specifics. Now let's talk about comparing a ratio to a competitor.

Comparison to Competitor
Scary Bears has reduced their debt ratio and, internally, that's a win-win for them, but how do they match up against their competitors? Comparing their debt ratio to a competitor's debt ratio will provide some additional insight. Competitor's financial ratios will be available on their website if they are publicly traded or you may find their information on some of the more popular search engines in the financial section.

Let's say Scary Bears' competitor has a current period debt ratio of 23%. Remember Scary Bears' current period debt ratio is 46%. Scary Bears' debt ratio is 23% higher than their competitor, meaning Scary Bears owns less of their assets than their competitor. This could be a positive or negative, it really depends on Scary Bears' strategic goals. However, with all else being equal, it's considered negative. Now, how does Scary Bears compare to the industry average?

Comparison to Industry Average
Scary Bears' comparison to the industry average provides information about their relative position within the industry. You can find industry averages from financial rating organizations. If the industry average debt ratio is 22%, Scary Bears has a solid understanding that they are too far in debt, almost double than their competitor and the industry. Now let's review the baseline.

Understanding the Baseline
There are some ratios that you must compare to a prior period, competitor or industry average to gain an understanding of the company's relative position. The debt ratio is one of them. However, there are other ratios that have a baseline, a minimum data point that provide insight as to a company's financial health.

The current ratio is an example of a ratio measured by a baseline. Its baseline is 1. The current ratio explains how well a company can pay their current liabilities with their current assets. Current in this instance means short term, less than a year. It's calculated by taking current assets/current liabilities.

For example, if Scary Bears has current assets of $7,500 and current liabilities of $5,000, their current ratio equals 1.5. Since Scary Bears' current ratio is greater than 1, they have a solid capability of paying their current liabilities with their current assets.

Lesson Summary
In this lesson, we reviewed the standards for comparing ratios are comparing the data to a prior period, competitor, industry average or baseline.

Prior period simply means reviewing a prior year's ratio to compare it to the current year. In the example above, Scary Bears' current year debt ratio was 46% and the prior period was 56%. Scary Bears reduced their ratio by 10%, which is a good indicator.

However, when compared to a competitor's debt ratio, they found out they owned a lot less assets than their competitor. Competitor information can be found on popular search engines in the financial section if the company is publicly traded.

Then we went a step further to compare Scary Bears' debt ratio to an industry average. Industry-average ratios can be found from financial rating organizations. This comparison still showed Scary Bears was in quite a bit more debt than the competitors in the industry.

Lastly, a little light at the end of the tunnel for Scary Bears when we used a baseline comparison to analyze their current ratio. The baseline for the current ratio is 1, Scary Bears' current ratio was 1.5 which showed their ability to pay their current liabilities with their current assets.

Key Words & Their Meanings
ratiostandards
Terminology Definitions
Ratio analysis the process of combining two or more line items by a mathematical operation and analyzing the results
Standards for comparing ratios comparing the data to a prior period, competitor, industry average or baseline
Debts liabilities or obligations of a business
Assets items that a business owns
Debt ratio formula includes total liabilities/total assets
Current ratio an example of a ratio measured by a baseline
Learning Outcomes
As this video lesson ends, see if you're prepared to:

Provide the meaning of ratio analysis
Note the purpose of the standards for comparing ratios
Remember the two steps of ratio analysis
Explain how to figure out the math of the ratio and analyze the results