I messed up while choosing a ratio for my analysis and how you can avoid it
If you are new to finance and looking for ways to learn more about it, then ratio analysis will be your best friend. Ratios help us understand how well a business has done over time and its future potential. This post will explain the different problems with ratio analysis and provide tips on how to proceed.
The problem with ratios Analysis
A ratio is a statistical calculation that expresses the relationship between two variables. For example, if you have a certain amount of money in your bank account and spend $10 on groceries, your spending has increased from 15% to 30%. This means that your total expenditure was 20% more than what it had been before.
Ratios can compare different companies or times. They can also get used when comparing companies/times against each other, so we know how they "rank" against each other.
Ratio Analysis Only Provides Numbers, Not Causation Factors. You can compute all the ratios you discover. You're playing a pointless game until you try to figure out what the numbers mean. Ratios are worthless unless they get compared to trends or industry statistics.
How to proceed with ratio analysis?
The next step is to select the ratios for your business.
- Relevant ratios: This means that you should use ratios that are relevant to your business, industry, country, and sector. For example, suppose you are in the food industry and want to compare two different types of chicken wings (breast vs. drumstick). In that case, it makes sense that breast meat would be a better choice than drumstick because breast meat has more fat content, which will lead to a tastier product overall.
- Non-Relevant Ratios: If there is no relationship between two numbers (such as cost per unit produced), then they don't belong together on any form or chart, so don't include them!
Importance of industry and company-specific ratios
While industry and company-specific ratios help you understand a company, they can be misleading if you don't take the right approach.
If you are comparing two companies within the same industry, then both should have similar numbers on their ratio charts. If one has a higher number than another, it could be more profitable or less risky for investors to invest in that company.
Ratios are an essential finance tool
If you're looking for a way to compare companies within the same industry, use a ratio such as return on equity (ROE). This is helpful because it shows how much profit each company generates per dollar shareholders invest.
If you're comparing companies across industries, consider using debt/equity ratios or earnings before interest and taxes (EBIT). These two ratios show how much money each company makes after paying its debts and expenses like rent, salaries, and advertising costs—and can give you an idea of whether or not these firms are profitable enough to invest in further growth.
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