The relative indicator (ratio) is the ratio of two or more indicators. The relative indicator (ratio) is obtained by comparing two or more absolute indicators and is much better than an absolute indicator.
Relative indicators (ratios) evaluate the object in question more objectively and comprehensively than the absolute indicators would. If two companies of the same industry, profile and size received 0.5 million dollars in profit, it cannot be inferred that both companies were equally profitable. Which company acts more profitably, can only be told when the profit indicator of both companies will be compared with sales, assets, capital and other indicators? The relative indicator (ratio) allows comparing the results between differences sizes enterprises.
Financial ratios are chosen according to the goal of the analysis. It is important to choose the indicators, which are logically and mathematically tied to each other. The numerator and denominator in formula of the indicator calculation must be properly assessed and measured, all from the same period. It is necessary to avoid pseudo-ratios. Let's say that we have two absolute indicators: production volume and number of workers. Based on these parameters, we calculate the third indicator - output per worker, which is output, divided by the number of workers. And if the number of workers is divided by the volume of production, we get a pseudo variable that does not meet the human logic.
Financial ratios, as well as many other relationships, are not significant if they are not compared to:
1. the indicators of the previous period in the same company;
2. certain parametric indicators;
3. the indicators of other companies in the same field;
4. the indicators of the majors competitors;
5. the aggregate economic indicators.
For the analysis of the relative indicators (ratios), it is very important to have reference values for assessing the level of indicators. The selection of such sizes, and the evaluation of financial ratio are both highly dependent on the attitudes of the person and his estimation of current situation. For example, from the creditor's point of view a high solvency ratio is treated positively, but in terms of working capital management perspective, it might seem that the company has too much free money in circulation.
It's very important to correctly assess the relative indicators (financial ratios). Usually one relative indicator tells us too little. Some of the financial ratios are closely related. They change depending on other financial ratios, because they are influenced by the same factors. Suppose that first company’s sales over the period increased by 10%, while second company's increased by 20%. From this we cannot yet tell that the second company had worked better. In this case, it is important to obtain information that would show us the share that each company holds in the market, because in fact it is easier to extend a small market share than a large one.
On the basis of financial statement we can be calculate over 100 significant ratios. However, there is no sense in calculating of the biggest possible number of ratios, it is important to calculate such indicators, which are useful in practice. On the other hand, if you want to evaluate a company's financial condition, results of operations and cash flows, you will need to use not only 2-3 financial ratios, while their whole system. The financial ratios, used to assess the company's activities, must be developed by the company's management team. It is important to develop a financial ratios’ system which will comply with the changing economic environment, will help make the right economic decisions.
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