Accrual Accounting

Vertical percentage analysis helps you analyze relationships between items on your income statement. But how do you compare your financial results with those of other companies in your industry or with the industry overall? And what about your balance sheet? Are there relationships on this statement that also warrant investigation? Should you further examine any relationships between items on your income statement and items on your balance sheet? These issues can be explored by using ratio analysis, a technique for evaluating a company's financial performance.

First, remember that a ratio is just one number divided by another, with the result expressing the relationship between the two numbers. Let's say, for example, that you want to know the relationship between the cost of going to a movie and the cost of renting a DVD movie. You could make the following calculation:

$\frac{\text{Cost of going to a movie}}{\text{Cost of renting a DVD}}  =  \dfrac{$8}{$4}  =2 (or 2 to 1)$

Going to a movie costs two times as much as renting a DVD.

Ratio analysis is also used to assess a company's performance over time and to compare one company to similar companies or to the overall industry in which it operates. You don't learn much from just one ratio, or even a number of ratios covering the same period. Rather, the value in ratio analysis lies in looking at the trend of ratios over time and in comparing the ratios for several time periods with those of competitors and the industry as a whole. There are a number of different ways to categorize financial ratios. Here's just one set of categories:

• Profit margin ratios tell you how much of each sales dollar is left after certain costs are covered.
• Management efficiency ratios tell you how efficiently your assets are being managed.
• Management effectiveness ratios tell you how effective management is at running the business and measure overall company performance.
• Financial condition ratios help you assess a firm's financial strength.
  

Using each of these categories, we can find dozens of different ratios, but we'll focus on a few examples.