Introduction to Ratios

The ratios we discuss and the ways that we calculate them are typical of the way companies or analysts may use ratios to analyze a business but they are not necessarily the correct way and other ratios and methods are not necessarily incorrect. The key things that you want to do when you use ratios are to try to use amounts that can give an insight into the business (such as EBIT per square foot, as we will hear mentioned by Geoff Ruddell from Morgan Stanley as a meaningful ratio in the retail industry) and to be consistent in the way that the ratios are calculated when comparing them between periods for a company or when comparing them for different companies.

In this course, when calculating ratios that include both balance sheet and income statement amounts, we generally use an average of beginning and ending balances for the balance sheet amount. Again, this is not the only way and it is not more correct than other ways; we do it because it relates the revenue or expense or income for the period with an average value of the balance sheet amounts for the period. It could be just as acceptable to use a four point average (quarterly balances) or a twelve point average (monthly balances) or just the ending balance (just the value with no average). You (or your company) can choose to do it in any of these ways; the decision should be based on the information you have available and the purpose of the ratio.

Also in this course, when calculating ratios that include two balance sheet amounts, we will generally use the balances at the end of the period. We are normally interested in these ratio relationships at a point in time so using some average balances tends to dull the point. However, different analysts or companies may be looking for different insights from the ratios and they may find it useful to use average balances for these ratios. Again, ratios can be used in different ways to show different things.

Max 200 words: Think about a company you are familiar with. If you were a manager at that company, what kind of ratios would you want to see? How do you think these ratios would help you in your decision-making?