Ratios
A great number of ratios might be appropriate for this purpose depending on the specific kind of financial performance which is being compared. Amongst those appropriate for such a purpose are
- Return on equity
- Asset turnover (by classes of asset type)
- Gross/net profit margins
- Inventory days
- Receivables days
- Interest cover
- Dividend cover
- Financial and operating gearing
- P/E ratio
The ratios selected is able to be justified on the grounds that they measure the key determinants of financial performance namely
(1) The company's profit performance gross as well as net profit margins and the returns it offers its investors (ROE & P/E ratio).
(2) Liquidity which will influence its ability to continue trading: inventory/receivables days and dividend and interest cover.
(3) Capital structure as well as level of business risk financial and operating gearing. A comparison which is to be used to assess the relative performance of a particular company should be based on data from companies in the same sector for the reason that other businesses in other sectors may have different operating technology, production systems and sources of finance.
Consequently the average rates of return the scale of operations and the risks of a business will vary from sector to sector. For example a retail bank may face very high fixed costs as it has a large branch network to support. On the contrary a franchised restaurant chain will have very low fixed costs because fixed assets are owned by the franchisees and not the main company. In such circumstances judgement on the relative levels of operating gearing in the two businesses would be impossible because of the variation in the cost structures. Likewise the risks of operating a shoe factory are fundamentally different from those of a chemical plant and so the financial ratios generated by each operation will differ widely.
At the same time it is valuable to compare ratios with firms of differing sizes in the one sector because market dynamics and profitability may well be linked to the scale of a company's operations. For instance in some product markets larger companies may report higher net profit margins as a result of being able to exploit scale economies in production or distribution or the benefits of vertical integration. With contrast in other markets specialisation and niche marketing may increase margins. Comparing ratios among companies of differing sizes facilitates some analysis of the factors which can add to profit.