Concept of Ratio Analysis
Ratio is an expression of quantitative relationship between two figures or numbers.
- Ratio analysis is referred to as the study or analysis of the line items present in the financial statements of the company. It can be used to check various factors of a business such as profitability, liquidity, solvency and efficiency of the company or the business.
- Ratio analysis is mainly performed by external analysts as financial statements are the primary source of information for external analysts.
- Ratio analysis is a very important factor that will help in doing an analysis of the fundamentals of equity.
Modes of Expression
The quantitative relationship between two or more items of the financial statements connected to each other is called accounting ratio. The accounting ratios may be expressed in the following ways:
(a) In Proportion:
In this type of expression the amounts of two items are expressed in a common denominator. An example of this form of expression is the relationship between current assets and current liabilities as “2”: “1”.
(b) In Rate or Times or Coefficient:
In this type of expression, a quotient obtained by dividing one item by another is taken as Unit of expression. Example of this form of expression is cost of sales divided by average stock (say 8), thus 8 times is the ratio between cost of sales and stock.
(c) In Percentage:
In this type of expression, a quotient obtained by dividing one item by another is multiplied by one hundred to show the relationship in terms of percentage. For example- the relationship between net profit and sales may be expressed as say 25%.
Uses of Ratio Analysis
Ratio Analysis is an important technique of financial statement analysis. It is the way by which financial stability and health of a concern can be judged. The following are the main points to highlight the uses of ratio analysis.
(1) Forecasting:
Ratios reveal the trends in costs, sales, profits and other inter-related facts, which will be helpful in forecasting future events. It is useful in financial forecasting and planning.
(2) Inter Firm Comparisons:
The technique of inter-firm comparisons can be carried out successfully only with the help of ratio analysis. Otherwise no firm may come forward to disclose full information. Inter-firm comparisons help the management to compare its performance with an external ‘benchmark’ or standard.
(3) Facilitates Communication:
Ratios facilitate the communication function of management as ratios convey the information relating to the present and future; quickly, forcefully and clearly.
(4) Measuring Efficiency:
Ratios help to know operational efficiency by comparison of present ratios with those of the past working and also with those of other firms in the industry.
(5) Facilitating Investment Decisions:
Ratios are helpful in computing return on investment. This helps the management in exercising effective decisions regarding profitable avenues of investment.
(6) Useful in Measuring Financial Solvency:
The financial statements disclose the assets and liabilities in a format. But they do not convey relationship of various assets and liabilities with each other, whereas ratios indicate the liquidity position of the company and the proportion of borrowed funds to total resources which reveal the short term and long term solvency position of a firm.
Importance of Ratio Analysis
The main points of importance are as follows:
1. Test of solvency. Ratios can illuminate the solvency of a firm. For example, when the ratio of current assets to current liabilities is increasing, this indicates sufficient working capital. Thus, creditors can be paid easily.
2. Helpful in decision-making. The main aim of financial statements is to inform users about the financial position of the company, as well as to serve as a decision-making aid for managerial personnel.
3. Useful in discovering profitability. Ratios are also useful when comparing the profitability of different companies. Present and past ratios can be compared, for example, to discover trends in the historical and future performance of companies.
4. Useful for operating efficiency. From a management perspective, ratios enable managers to measure the efficiency of assets. When sales and their contribution to net profit increase every year, this is a test of higher efficiency.
5. Business trends. Ratio analysis can expose trends that managers may use to take corrective actions.
Limitations of Ratio Analysis
Ratio Analysis is an important tool to reveal the financial condition of a business .However , it has some limits which are as follows:
- Ratio analysis illustrates the associations between prior data while users are more concerned about current and future data.
- Financial accounting data is influenced by views and hypotheses. Accounting criteria provide different accounting methods, which reduces comparability and thus ratio analysis is less helpful in such circumstances.
- Ratio Analysis information is historic – it is not current.
- Ratio Analysis does not measure the human element of a firm.
