AGR is a horizontal analysis tool because you are going to use numbers from two different years and compare these numbers to determine how well supported your growth is currently.
Additionally, you are going to use one number from the Profit and Loss Statement and one from the Balance Sheet. This is because traditionally the profit from any year is not added to the Balance Sheet until the year (or period) is closed out.
The simplified equation is:
Profit / Equity from Last Year
Things may become confusing if you follow our rules on understanding ratios. For instance, which is the good guy and which is the bad guy? They both look like good guys.
The answer to this quandry comes from answering the second question first. We are looking at this battle scenario from the point of view of the Equity from Last Year so do we want the number to be higher–meaning that Equity loses to Profit because each dollar of Equity has to wipe out more dollars of Profit–or do we want the number to be lower–meaning that Equity wins because each dollar of equity has to wipe out fewer dollars of Profit?
Remember that this ratio is like a rubber band and the higher the number, the more the rubber band is being stretched. With this in mind, we can answer the questions we need to in order to understand the ratio.
The quick answer is that a lower AGR is better and Equity from Last Year is our champion. However, the important number is not the AGR itself, but instead the change in AGR from one period to the next. If the Sales Growth Ratio is increasing rapidly and our AGR is growing rapidly, our growth is not supported by equity.
The important thing to keep in mind is that as a company grows, the growth has to be funded somehow. If the company has an increasing profit, and the AGR is increasing more than the profit, this can be a sign that additional funding for the growth may be necessary to pursue from outside sources.
If the AGR remains steady or drops and the profit of the company is increasing, this means you have a solid capital foundation and…
Your business THRIVES on a solid FOUNDATION!!!