Accounting ratios are used by internal and external audiences to measure company performance and prospects for future success or failure. Managers, lenders, suppliers and investors all use accounting ratios to help make critical decisions related to a firm. As important as accounting ratios are, these measures should be the first step rather than the final word in determining company performance.
Managers Use Accounting Ratios to Benchmark Progress
Managers use accounting ratios to measure company performance in an objective way. Accounting ratios such as inventory turnover, sales to assets or days payable can pinpoint performance of departments within a company. Management can benchmark performance from accounting period to accounting period or year over year to understand where a company is doing well or poorly. Accounting ratios also provide a way for a company's managers to set goals.
Lenders and Suppliers Scrutinize Accounting Ratios
External audiences such as lenders and suppliers are influenced by accounting ratios. These external users of accounting information examine a firm's books to reduce business risk. Lenders want to know the companies receiving loans have the cash flow capacity to pay back loans. Suppliers want to know that a potential customer is financially strong enough to do business with. Often lenders and suppliers have minimum accounting ratio performance thresholds.
Investors Make Decisions Based on Accounting Ratios
Investors should pay close attention to accounting ratios because of the impact on share price. For example, the price-to-earnings accounting ratio is widely used to benchmark stock prices. If a firm has a high price-to-earnings ratio compared to a group of peer companies, investors may consider the stock risky. Investors also look at accounting balance sheet ratios such as share price to book value and compare that to industry peers.
Accounting Ratios Should Be a First Step in Analysis
Ratios should be considered red flags, not the final determining factor for decision making. Managers, lenders, suppliers and investors should continue to analyze the drivers behind the accounting ratios. Understanding drivers provides critical context to a company's performance. Accounting ratios taken out of context can paint an inaccurate picture of a firm.