Businessmen use financial ratios to gauge the performance of their businesses. They utilise them to evaluate profitability, liquidity, efficiency and debt leverage. While financial ratios can help to identify trends, industry standards for financial ratios help to rate a company's performance in relation to other businesses in the same industry.
Financial ratios quantify the performance of various areas of a business and form the basis for the analysis of financial statements. These ratios can be expressed as percentages or as absolute numbers.
Financial ratios are calculated with data normally available on a company's income statement and balance sheet. Examples of commonly used ratios are percentage of profitability, current ratio, inventory turnover, long-term debt to equity ratio and the return on equity.
A ratio by itself does not have much significance. The use of ratios comes from an analysis over a period of time to detect positive or negative trends. This allows business managers to identify the strengths of their companies and to spot potential weak areas that need improvement.
The ratios of an individual company can then be compared to industry standard ratios to see how the company ranks within its industry. Managers use these comparisons to further identify underperforming areas compared to similar companies and to develop strategies for improvement.
Lenders and analysts use industry standards of financial ratios when they are evaluating the performance and financial health of a company. For example, if a company reports an annual inventory turnover of three times, an analyst might not know whether this is good or bad until he makes a comparison to the industry standard.
A lender wants to know how much debt a company can safely manage. A reference to the industry standard for the debt-to-equity ratio will give him this information.
Bankers like to use the "Robert Morris Annual Statement Studies" published by Robert Morris Associates. This survey provides financial ratios and income statement and balance sheet data from thousands of commercial borrowers that is classified into several income brackets for several hundred industries.
Prentice Hall puts out its "Almanac of Business and Industrial Financial Ratios." This information comes from the Internal Revenue Service and covers all major financial ratios for a few hundred industries.
Dun & Bradstreet has an annual publication called "Industry Norms and Key Business Ratios." It provides coverage for several hundred industries, common financial ratios presented as medians and upper and lower quartiles.