TABLE OF CONTENTS Ratios were originally developed at the turn of the twentieth century from credit relationships businesses had with each other and with lenders. When the first comprehensive system of ratio analysis was introduced in 1919, it was totally from the creditor's viewpoint. Ratio analysis helps creditors evaluate a company's financial strengths and weakness, flagging any irregularities that may affect repayment of debt. For purposes of examining potential credit serviceability today, financial managers analyze internal operations in much the same way. But ratios don't tell the whole story; they offer clues, not direct answers. It is unreasonable to expect that the mechanical calculation of one ratio or a group of ratios will automatically yield critical information about a complex corporation. Bankers must interpret, compare, and look behind the numbers in order to form conclusions about a company's well-being.
Ratios serve as relative measures or interactions between numbers. They are used to (1) clarify the relationship between accounts or items appearing on financial reports (structural analysis), (2) match borrowers' performance against historical levels (time-series analysis), and (3) compare performance with benchmarks or industry averages (cross-sectional analysis). Ratios simplify absolute numbers down to a common scale. For example, a borrower may have expanded markets over the past few periods, so comparing gross profit, an absolute number, to historical levels will not be particularly useful. On the other hand, ratios eliminate the problem of trying to extract meaning through a vacuum of absolute numbers gross profit, debt level, or, for that matter, revenue.
