In ratio analysis we look to find out how effectively a company uses its assets,

Question

In ratio analysis we look to find out how effectively a company uses its assets, its equity and its debt to generate profits. In general a business that is more effective, should generate more profit per dollar of investment. However, given that different businesses require different concentrations of assets, and also have different opportunities for leverage, is it fair to compare the ratios of businesses in two different industries or should ratio analysis be restricted to comparing like businesses?

Explanation / Answer

The borrowing requirements of different industry is different. A Walmart like store having all cash sales, will have different financing requirement than a manufacturing unit of Car / Aircraft.

Walmart will need most in credit purchases, so it will be a current liability, there is less requirements of long term financing and the repayment is also on short terms.

In manufacturing industry, the loan requirements are for long term as the repayments cannot be made in short period. Their cash collections from sales will take time.

In view of the above, it is evident that different businesses require different concentrations of assets, and also have different opportunities for leverage. Hence it is unfair to compare the ratios of businesses in two different industries. Therefore ratio analysis be restricted to comparing like businesses.

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