With financial statements in hand, the time has come to put together a performance analysis of the division. In order to understand the financial performance of the division, it is necessary to compare it relative to the performance of other businesses in the same industry. Financial ratios are the relative values that weigh the performance of the business. For convenience, financial ratios are divided into five groups: liquidity, activity, debt, profitability, and market. These categories can be generalized further as liquidity, activity, and debt provide risk measurement, while profitability measures return. Market ratios have the benefit of measuring both risk and return (Gitman, 2009).
With all of the financial ratios available, a good idea is to choose one ratio from each of the major categories: risk, return, and risk and return. The most commonly used risk measurement is the current ratio. It measures the business’ liquidity by dividing current assets by current liabilities. This number describes how easily a business can cover it short-term liabilities. The most comprehensive return ratio is net profit margin. Unlike other return ratios it takes into account all expenses including interest and taxes. It is represented by a percentage and calculated by dividing final earnings by sales. The final ratio to consider relies on the stock market and is not as useful for measuring the performance of a single division. The price/earnings ratio reflects how the stock market views the prospects of the company. It is calculated by dividing the share price by the earnings per share. The higher the ratio the better (Atkinson, Kaplan, Matsumura, & Young, 2007).
Unfortunately, financial ratios by themselves provide little insight into the performance of the company. To be truly beneficial, the ratios must be compared to something. One method is to compare the business’ ratios with those of other firms in the same industry. This method is called cross-sectional analysis and gives the business an idea of how well it is performing relative to its competitors. Another method of comparison is to compare the same numbers from previous periods to determine if performance is improving or falling behind. This method, known as a time-series analysis, is useful for determining trends within the business over time. The final method of comparison is called a combined analysis and compares both industry measurements and evaluation over time (Gitman, 2009).
Atkinson, A. A., Kaplan, R. S., Matsumura, E. M., & Young, S. M. (2007). Management accounting (5th ed.). Upper Saddle River, NJ: Pearson.
Gitman, L. J. (2009). Principles of managerial finance (12th ed.). Boston: Pearson.