Question

What role do ratios play in reaching and assessing its goal?

Answer 1

Ratios help us to measure the relative performance of different financial metrics that defines the firm’s financial condition. I will explain this with the help of a basic example. For example, suppose you go to the grocery store to buy a box of cereal. You see a 10 ounce box sells for $3.20 and a larger 15 ounce box sells for $4.50. Which would you buy? You can look at the price of each box and the amount contained in each box but it is difficult to tell which is the better deal because the more expensive box also contains more cereal. If we divide the price of each box, however, by the amount of cereal in the box we see that the small box cost $3.20/10 oz. = $0.32 per ounce and the large box cost $4.50/15 oz. = $0.30 per ounce. The large box of cereal costs you less for each ounce of cereal you purchase. This illustrates the power that ratios can have in helping analyze sets of data such as those we encounter in a firm’s financial statements.