Basis of Comparison
Ratios, as shown above, are relative figures reflecting the relationship between variables, They enable analysis to draw conclusions regarding financial operations. The use of ratios, as a tool of financial analysis, involves their comparison, for a simple ratio, like absolute figures, fails to reveal the true position. For example, if in the case of a firm, the return on capital employed is, 15 per cent in a particular year, what does it indicate? Only if the figure is related to the fact that in the preceding year the relevant return was 12 per cent or 18 per cent, it can be inferred whether the profitability of the firm has declined or improved. Alternatively, if we know that the return for the industry as a whole is 10 per cent or 20 per cent, the profitability of the firm in question can be evaluated. Comparison with related facts is, therefore, the basis of ratio analysis. Four types of comparisons are involved: (i) trend ratios, (ii) inter firm comparison (iii) comparison of items within a single year’s financial statement of a firm, and (iv) comparison with standards or plans.