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Ratio Analysis: A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage and a number of times.
When the number is calculated by referring to two accounting numbers derived from the financial statements, it is termed as accounting ratio.
Ratio analysis is indispensable part of interpretation of results revealed by the financial statements. It provides users with crucial financial information and points out the areas which require investigation.
Ratio analysis is a technique which involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter.
Objectives of Ratio Analysis
It requires a fine understanding of the way and the rules used for preparing financial statements. Once done effectively, it provides a lot of information which helps the analyst:
1. To know the areas of the business which need more attention;
2. To know about the potential areas which can be improved with the effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;
4. To provide information for making cross-sectional analysis by comparing the performance with the best industry standards;
5. To provide information derived from financial statements useful for making projections and estimates for the future.
Advantages of Ratio Analysis
1. Helps to understand efficacy of decisions:
The ratio analysis helps you to understand whether the business firm has taken the right kind of operating, investing and financing decisions. It indicates how far they have helped in improving the performance.
2. Simplify complex figures and establish relationships:
Ratios help in simplifying the complex accounting figures and bring out their relationships. They help summarize the financial information effectively and assess the managerial efficiency, firm’s credit worthiness, earning capacity, etc.
3. Helpful in comparative analysis:
The ratios are not be calculated for one year only. When many year figures are kept side by side, they help a great deal in exploring the trends visible in the business. The knowledge of trend helps in making projections about the business which is a very useful feature.
4. Identification of problem areas:
Ratios help business in identifying the problem areas as well as the bright areas of the business. Problem areas would need more attention and bright areas will need polishing to have still better results.
5. Enables SWOT analysis:
Ratios help a great deal in explaining the changes occurring in the business. The information of change helps the management a great deal in understanding the current threats and opportunities and allows business to do its own SWOT (Strength- Weakness-Opportunity-Threat) analysis.
6. Various comparisons:
Ratios help comparisons with certain bench marks to assess as to whether firm’s performance is better or otherwise.
For this purpose, the profitability, liquidity, solvency, etc., of a business, may be compared (i) over a number of accounting periods with itself (Intra-firm Comparison /Time Series Analysis),
(ii) with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis) and
(iii) with standards set for that firm/industry (comparison with standard (or industry expectations).
Limitations of Ratio Analysis
1. Means and not the End:
Ratios are means to an end rather than the end by itself.
2. Lack of ability to resolve problems:
Their role is essentially indicative and of whistle blowing and not providing a solution to the problem.
3. Lack of standardized definitions:
There is a lack of standardized definitions of various concepts used in ratio analysis. For example, there is no standard definition of liquid liabilities. Normally, it includes all current liabilities, but sometimes it refers to current liabilities less bank overdraft.
4. Lack of universally accepted standard levels:
There is no universal yardstick which specifies the level of ideal ratios. There is no standard list of the levels universally acceptable, and, in India, the industry averages are also not available.
5. Ratios based on unrelated figures:
A ratio calculated for unrelated figures would essentially be a meaningless exercise. For example, creditors of ₹ 1,00,000 and furniture of ₹ 1,00,000 represent a ratio of 1:1. But it has no relevance to assess efficiency or solvency.
Types of Ratios
There is a two way classification of ratios:
(1) Traditional Classification
The traditional classification has been on the basis of financial statements to which the determinants of ratios belong. On this basis the ratios are classified as follows:
1. ‘Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as statement of profit and loss ratio. For example, ratio of gross profit to revenue from operations is known as gross profit ratio. It is calculated using both figures from the statement of profit and loss.
2. Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios. For example, ratio of current assets to current liabilities known as current ratio. It is calculated using both figures from balance sheet.
3. Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another variable from the balance sheet, it is called composite ratio. For example, ratio of credit revenue from operations to trade receivables (known as trade receivables turnover ratio) is calculated using one figure from the statement of profit and loss (credit revenue from operations) and another figure (trade receivables) from the balance sheet.
(2) Functional Classification.
Functional classification based on the purpose for which a ratio is computed, is the most commonly used classification which is as follows:
1. Liquidity Ratios:
To meet its commitments, business needs liquid funds. The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to measure it are known as ‘Liquidity Ratios’. These are essentially short-term in nature.
2. Solvency Ratios:
Solvency of business is determined by its ability to meet its contractual obligations towards stakeholders, particularly towards external stakeholders, and the ratios calculated to measure solvency position are known as ‘Solvency Ratios’. These are essentially long-term in nature.
3. Activity (or Turnover) Ratios:
This refers to the ratios that are calculated for measuring the efficiency of operations of business based on effective utilization of resources. Hence, these are also known as ‘Efficiency Ratios’.
4. Profitability Ratios:
It refers to the analysis of profits in relation to revenue from operations or funds (or assets) employed in the business and the ratios calculated to meet this objective are known as ‘Profitability Ratios’.