Comparing Capital Expenditures

The information contained in the four basic financial statements is of major significance to various interested parties who regularly need to have relative measures of the company’s operating efficiency. Through the use of ratios, companies can be measured on an equal playing field. No matter what the size or volume, ratios allow comparisons to be made across boundaries. Ratio analysis is nothing more than calculating and interpreting financial ratios to analyze and monitor the firm’s performance. The basic inputs to ratio analysis are the firm’s income statement and balance sheet.

Who uses the information? Ratio analysis of a firm’s financial statements is of interest to shareholders, creditors, and the firm’s own management. Both present and prospective shareholders are interested in the firm’s current and future level of risk and return, which directly affect share price. The firm’s creditors are interested primarily in the short-term liquidity of the company and its ability to make interest and principal payments. A secondary concern of creditors is the firm’s profitability; they need assurance that the company is healthy. Management is mostly concerned with all aspects of the firm’s financial situation, and it attempts to produce financial ratios that will be considered favorable by both owners and creditors. Further, management can use ratios to monitor the firm’s performance from period to period.

Types of Ratio Comparisons

Keep in mind that ratio analysis is not merely the calculation of a given ratio. More important is the interpretation of the ratio value. A meaningful basis for comparison is needed to answer such questions as “is it too high or too low?” and “Is it good or bad?” There are two types of ratio comparisons.