Ratio analysis should not be taken in isolation of other aspects of a business. What type of business is it? A company's debtor day indicator (how long on average it takes debtors to settle bills) may be 29 days. This seems fine but not for fast-food business. Ratios must be seen against
- norms/benchmarks for the industry
- performance over time (previous years)
- prospects for the future and
- expectations of significant stakeholders.
As a principle, accounting policies should be applied consistently. Changes must be highlighted and the impact of changes from an original policy disclosed. This applies when calculating and interpreting ratios. Trends in a company's performance cannot be determined if published accounting data is dressed up so as to produce more favourable outcomes. Yet benchmark comparisons against other companies in a sector may be difficult given the flexible scope offered by Statements of Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs).
As an example of such flexibility, under SSAP 13, Research and Development, companies may within certain limits decide to capitalise development expenditure, as an alternative to charging this expense to the P&L account. One firm may do this and by-pass the P&L account in certain years whereas another may not. This will affect performance ratios and make it difficult to conclude on how the company compares against its competitors.