Introduction

After two year running the business, the company’s Income Statement is as follow:

Is it great? The company is able to increase the sales from 15,000 to 25,000 and the net profit increase from 4,500 to 5,000. The company should be proud of it, that’s the logical conclusion.

But, is it true that the company is that great? Look at the information below which is compiled from the above data:

Note:
The sales figure is consider as 100% than each value is compared to the sales. For example:
                                                            10,000
Cost of Goods Sold of Year 19X1 = ----------- X 100% = 67%
                                                            15,000

Now, back to the case. It is true that in absolute term, there’s an increase in sales and net profit, but the performance of 19X2 is actually not better than 19X1. The company did work harder in 19X2 (to increase the sales), but they got less result. The profit margin falls from 30% to 20% of sales. If the company able to maintain their profit margin at 30% (as year 19x1), the profit of 19X2 should be 7,500 (25,000 X 30%), but the company didn't obtain that number because the Cost of Goods Sold and Operating Expenses are increasing faster than the increase of sales

Again, in absolute term, there’s no doubt that the company is succeeded to increase the sales and net profit figure, but if we analyse it more detail by using ratio, it shows that the company’s performance in year 19X2 is not better than 19X1.

That’s the simple example of ratio analysis and how the ratio is used. By comparing the absolute number, we will be able to analyse the financial performance more detail and "see the picture" clearer. Ratio analysis may assist us to identify the strengths and the weaknesses of the company.