Understanding the meaning and benefits of ratio analysis

A ratio is calculated by dividing one item by another. In our case, we are looking at financial statements, so the items will come from there, such as profit divided by turnover. However, you do not pick items from the financial statements at random and divide them. You select items whose ratio is meaningful and provides information that will aid decision making. In the example of profit divided by turnover, this ratio, otherwise called profit margin, tells you how much profit is generated for every Naira of turnover.

Ratios are usually expressed as percentages but also as times or days, so a profit margin of 20% means that after all relevant deductions, the company retains 20% of turnover as profit. In other words, the profit for the period is 20% of turnover.

The ratios on their own when calculated for one period are useful in directing the attention of management and section heads to areas of concern. However, management...