Question

During financial analysis, an analyst must compare the computed ratios to industry norms. Explain why industry ratios are important in financial analysis.

Answer 1

One of the main advantages of financial ratio analysis is that it helps to compare the financial statements of two or more companies or to industry-wide average ratios.

Comparing firm's ratios to that of industry ratios are helpful as follows:

• Different industry have different average ratios pertaining to their business models. For example, financial firms/banks will have more cash in hand and less inventory, and less capital tied up in fixed capital as compared to an auto parts manufacturing industry. As such, the average inventory turnover ratio, coverage ratios would differ from industry to industry. And hence we should compare the firm's ratios to that of its industry and then make decisions.

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