A ratio is one figure express in terms of another figure. It is a mathematical yardstick that measures the relationship of two figures, which are related to each other and mutually interdependent. Ratio is express by dividing one figure by the other related figure. Thus a ratio is an expression relating one number to another. It is simply the quotient of two numbers. It can be expressed as a fraction or as a decimal or as a pure ratio or in absolute figures as “so many times”. As accounting ratio is an expression relating two figures or accounts or two sets of account heads or group contain in the financial statements.
Ratio analysis is a widely-used tool of financial analysis. It can be used to compare the risk and return relationship of firms of different sizes. It is defined as the systematic use ratio to interpret the financial statement so that the strengths and weaknesses of a firm as well as historical performance and current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two the items/variable. This relationship can be expressed as (i) percentages, say, net profits are 25percent of sales (assuming net profits of Rs 25,000 and sales of Rs. 1, 00,000), (ii) fraction (net profit is one –fourth of sales) and (iii) proportion of numbers (the relationship between net profits and sales is 1:4).
these alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratios does not add any information not already inherent in the above figures of profit and sales. What the ratio does is that they reveal the relationship in a more meaningful way so as to enable equity investors; management and lenders make better investment and credit decisions.
The Review on Unfaithfulness In Student Relationship
This aged old question has been discussed from time to time and there are many differing views as to why people cheat. The general understanding of the word relationship is a significant connection or similarity between two or more things. It can also be used to describe an emotionally close friendship which usually involves sexual activity between male and female (Encarta dictionary). Do students ...
The rationale of ratio analysis lies in the fact that it makes related information comparable. A single figure by itself has no meaning but when expressed in terms of a related figure, it yields significant inferences. For instance, the figure of net profits of a firm amount to, say, Rs10lakhs [23] throws no light on its adequacy or otherwise. The figure of net profits has to be considered in relation to other variables. How does it stand in relation to sales? What does it represent by way of return on total assets used or total capital employed?
If, therefore, net profits are shown in terms of their relationship with items such as sales, assets, capital employed, equity capital and so on, meaningful conclusions can be drawn regarding their adequacy. To carry the above example further assuming the capital employed to be Rs 50lakh and Rs 100lakh, the net profits are 20 percent and 10 percent respectively. Ratio analysis, thus, as a quantitative tool, enables analysts to draw quantitative answers to questions such as: are the net profits adequate? Are the assets being used efficiently? Is the firm solvent? Can the firm meet its current obligations and so on?
Since a ratio is a mathematical relationship between two or more variables / accounting figures, such relationship can be expressed in different ways as follows – A. As a pure ratio: For example the equity share capital of a company is Rs. 20,00,000 & the preference share capital is Rs. 5,00,000, the ratio of equity share capital to preference share capital is 20,00,000: 5,00,000 or simply 4:1. B. As a rate of times: In the above case the equity share capital may also be described as 4 times that of preference share capital. Similarly, the cash sales of a firm are Rs. 12, 00,000 & credit sales are Rs. 30, 00,000. So the ratio of credit sales to cash sales can be described as 2. 5 [30, 00,000/12, 00,000] or simply by saying that the credit sales are 2. 5 times that of cash sales. C. As a percentage: In such a case, one item may be expressed as a percentage of some other item. For example, net sales of the firm are Rs. 50,00,000 & the amount of the gross profit is Rs. 10,00,000, then the gross profit may be described as 20% of sales [ 10,00,000/50,00,000] [24] Steps in Ratio Analysis The ratio analysis requires two steps as follows: 1. Calculation of ratio
The Essay on Executive Summary Report Firm Analysis
1. Executive Summary 2. Problem definition and company objectives - What are the company's goals and objectives? - What, exactly, is the problem? 3. Situational analysis - Competitive environment; market structure; firm capabilities; culture etc. 4. Strategy - How can the firm take advantage of capabilities and environment to achieve its goals and objectives? What are its strategic options, and ...
2. Comparing the ratio with some pre-determined standards: The standard ratio may be the past ratio of the same firm or industry? s average ratio or a projected ratio or the ratio of the most successful firm in the industry. In interpreting the ratio of a particular firm, the analyst cannot reach any fruitful conclusion unless the calculated ratio is compared with some predetermined standard. The importance of a correct standard is oblivious as the conclusion is going to be based on the standard itself. Types of Comparison The ratio can be compared in three different ways –
1. Cross section analysis: One of the way of comparing the ratio or ratios of the firm is to compare them with the ratio or ratios of some other selected firm in the same industry at the same point of time. So it involves the comparison of two or more firm? s financial ratio at the same point of time. The cross section analysis helps the analyst to find out as to how a particular firm has performed in relation to its competitors. The firms performance may be compared with the performance of the leader in the industry in order to uncover the major operational inefficiencies.
The cross section analysis is easy to be undertaken as most of the data required for this may be available in financial statement of the firm. 2. Time series analysis: The analysis is called Time series analysis when the performance of a firm is evaluated over a period of time. By comparing the present performance of a firm with the performance of the same firm over the last few years, an assessment can be made about the trend in progress of the firm, about the direction of progress of the firm. Time series analysis helps to the firm to assess whether the firm is approaching the long-term goals or not.
The Time series analysis looks for (1) important trends in financial performance (2) shift in trend over the years (3) significant deviation if any from the other set of data. [25] 3. Combined analysis: If the cross section & time analysis, both are combined together to study the behavior & pattern of ratio, then meaningful & comprehensive evaluation of the performance of the firm can definitely be made. A trend of ratio of a firm compared with the trend of the ratio of the standard firm can give good results.
The Business plan on Ratio and Financial Statement Analysis
This paper analyzes tools used in financial analysis such as ratios. Financial ratio analysis is a judicious way for different stakeholders to use for different goals. This paper demonstrates that financial ratio analysis is an important instrument to estimate resources and their used. It also demonstrates that despite the fact that financial ratio analysis is an excellent tool, it does have ...
For example, the ratio of operating expenses to net sales for firm may be higher than the industry average however, over the years it has been declining for the firm, whereas the industry average has not shown any significant changes. Pre-requisites to Ratio Analysis In order to use the ratio analysis as device to make purposeful conclusions, there are certain prerequisites, which must be taken care of. It may be noted that these prerequisites are not conditions for calculations for meaningful conclusions.
The accounting figures are inactive in them & can be used for any ratio but meaningful & correct interpretation & conclusion can be arrived at only if the following points are well considered. ? The dates of different financial statements from where data is taken must be same. ? If possible, only audited financial statements should be considered, otherwise there must be sufficient evidence that the data is correct. ? Accounting policies followed by different firms must be same in case of cross section analysis otherwise the results of the ratio analysis would be distorted. ?
One ratio may not throw light on any performance of the firm. Therefore, a group of ratios must be preferred. This will be conductive to counter checks. ? Last but not least, the analyst must find out that the two figures being used to calculate a ratio must be related to each other, otherwise there is no purpose of calculating a ratio. [26] 4. 2 Classification of ratio:Figure 4. 2. 1 CLASSIFICATION OF RATIOS Based on Financial Statement Based on Function Based on User 1. Balance Sheet Ratio 1. Liquidity ratio 1. Ratios for Short Term Creditors 2. Revenue Statement ratio 2. Leverage Ratio 2. Ratios for Share holders
3. Composite Ratio 3. Turnover Ratio 3. Ratios for Management 4. Profitability Ratio 4. Ratios for Long Term Creditors 5. Coverage Ratio BASED ON FINANCIAL STATEMENT Accounting ratios express the relationship between figures taken from financial statements. Figures may be taken from Balance Sheet , P& P A/C, or both. One-way of classification of ratios is based upon the sources from which are taken. 1. Balance sheet ratio: If the ratios are based on the figures of balance sheet, they are called Balance Sheet Ratios. E. g. ratio of current assets to current liabilities or ratio of debt to equity.
The Essay on Current and Non-Current Assets
Current assets are items on a balance sheet. According to Investorwords, current assets equal “…the sum of cash and cash equivalents, accounts receivable, inventory, marketable securities, prepaid expenses, and other assets that could be converted to cash in less than one year,” (2008). If a company goes bankrupt, current assets are easily liquidated. Additionally, current assets are a ...
While calculating these ratios, there is no need to refer to the Revenue statement. These ratios study the relationship between the assets & the liabilities, of the concern. These ratios help to judge the liquidity, solvency & capital structure of the concern. Balance sheet ratios are Current ratio, Liquid ratio, and Proprietary ratio, Capital gearing ratio, Debt equity ratio, and Stock working capital ratio. 2. Revenue ratio: Ratio based on the figures from the revenue statement is called revenue statement ratios. These ratios study the relationship between the profitability & the sales of the concern.
Revenue ratios are Gross profit ratio, Operating ratio, Expense ratio, Net profit ratio, Net operating profit ratio, Stock turnover ratio. [27] 3. Composite ratio: These ratios indicate the relationship between two items, of which one is found in the balance sheet & other in revenue statement. There are two types of composite ratiosa) Some composite ratios study the relationship between the profits & the investments of the concern. E. g. return on capital employed, return on proprietors fund, return on equity capital etc. b) Other composite ratios e. g. ebtors turnover ratios, creditors turnover ratios, dividend payout ratios, & debt service ratios BASED ON FUNCTION: Accounting ratios can also be classified according to their functions in to liquidity ratios, leverage ratios, activity ratios, profitability ratios & turnover ratios. 1. Liquidity ratios: It shows the relationship between the current assets & current liabilities of the concern e. g. liquid ratios & current ratios. 2. Leverage ratios: It shows the relationship between proprietors funds & debts used in financing the assets of the concern e. g. capital gearing ratios, debt equity ratios, & Proprietary ratios.
3. Activity ratios: It shows relationship between the sales & the assets. It is also known as Turnover ratios & productivity ratios e. g. stock turnover ratios, debtors? turnover ratios. 4. Profitability ratios: ? It shows the relationship between profits & sales e. g. operating ratios, gross profit ratios, operating net profit ratios, expenses ratios ? It shows the relationship between profit & investment e. g. return on investment, return on equity capital. [28] 5. Coverage ratios: It shows the relationship between the profit on the one hand & the claims of the outsiders to be paid out of such profit e.g. dividend payout ratios & debt service ratios. BASED ON USER: 1. Ratios for short-term creditors: Current ratios, liquid ratios, stock working capital ratios 2. Ratios for the shareholders: Return on proprietors fund, return on equity capital 3. Ratios for management: Return on capital employed, turnover ratios, operating ratios, expenses ratios 4. Ratios for long-term creditors: Debt equity ratios, return on capital employed, proprietor ratios. Figure: 4. 2. 2 [29] LIQUIDITY RATIO: Liquidity refers to the ability of a firm to meet its short-term (usually up to 1 year) obligations.
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Consumption (C), investment (I), government spending (G-T) and net export (X-I) are the major components of aggregate demand (Y). Economists have been particularly interested in the volatility of investment. Both Fig. 1 and 2 suggest that there is a general positive relationship between GDP and investment, more importantly, investment is much more volatile. E. g. in the 1990-91 recession, ...
The ratios, which indicate the liquidity of a company, are Current ratio, Quick/Acid-Test ratio, and Cash ratio. These ratios are discussed below Figure: 4. 2. 3 1. CURRENT RATIO: This ratio compares the current assets with the current liabilities. It is also known as „working capital ratio? or „solvency ratio?. It is expressed in the form of pure ratio. Formula: Current Assets current ratio = Current Liabilities The current assets of a firm represents those assets which can be, in the ordinary course of business, converted into cash within a short period time, normally not exceeding one year.
The current liabilities defined as liabilities which are short term maturing obligations to be met, as originally contemplated, within a year. [30] Current ratio (CR) is the ratio of total current assets (CA) to total current liabilities (CL).
Current assets include cash and bank balances; inventory of raw materials, semi-finished and finished goods; marketable securities; debtors (net of provision for bad and doubtful debts); bills receivable; and prepaid expenses. Current liabilities consist of trade creditors, bills payable, bank credit, and provision for taxation, dividends payable and outstanding expenses.
The Term Paper on Ratio Analysis Of Financal Statements
... can find the current ratio by dividing the total current assets by the total current liabilities. 1. Quick Ratio The Quick ... in comparison with the amount of capital invested by current and past shareholders into it. Attock ... second largest cash and carry operator in terms of turnover with group annual turnover in ... by the firm per share. It is used for valuation: a higher P/E ratio means that ...
This ratio measures the liquidity of the current assets and the ability of a company to meet its short-term debt obligation. CR measures the ability of the company to meet its CL, i. e. , CA gets converted into cash in the operating cycle of the firm and provides the funds needed to pay for CL. Higher the current ratio, greater the short-term solvency. This compares assets, which will become liquid within approximately twelve months with liabilities, which will be due for payment in the same period and is intended to indicate whether there are sufficient shortterm assets to meet the short- term liabilities.
Recommended current ratio is 2: 1. Any ratio below indicates that the entity may face liquidity problem but also Ratio over 2: 1 as above indicates over trading, that is the entity is under utilizing its current assets. 2. QUICK RATIO Quick ratio is also known as acid test ratio or liquid ratio. Quick ratio compares the quick assets with the quick liabilities. It is expressed in the form of pure ratio. The term quick assets refer to current assets, which can be converted into, cash immediately or at a short notice without diminution of value. Formula: Current Assets – Inventory Quick Ratio = Current Liabilities
Quick Ratio (QR) is the ratio between quick current assets (QA) and CL. QA refers to those current assets that can be converted into cash immediately without any value strength. QA includes cash and bank balances, short-term marketable securities, and sundry debtors. Inventory and prepaid expenses are excluded since these cannot be turned into cash as and when required. [31] QR indicates the extent to which a company can pay its current liabilities without relying on the sale of inventory. This is a fairly stringent measure of liquidity because it is based on those current assets, which are highly liquid.
Inventories are excluded from the numerator of this ratio because they are deemed the least liquid component of current assets. Generally, a quick ratio of 1:1 is considered good. One drawback of the quick ratio is that it ignores the timing of receipts and payments. [32] INVESTMENT / SHAREHOLDERS Figure: 4. 2. 4 1. EARNING PER SHARE Earnings per Share are calculated to find out overall profitability of the organization. Earnings per Share represent earning of the company whether or not dividends are declared. If there is only one class of shares, the earning per share are determined by dividing net profit by the number of equity shares.
EPS measures the profits available to the equity shareholders on each share held. Formula: NPAT Earnings per share = Number of equity share The higher EPS will attract more investors to acquire shares in the company as it indicates that the business is more profitable enough to pay the dividends in time. But remember not all profit earned is going to be distributed as dividends the company also retains some profits for the business 2. DIVIDEND PER SHARE DPS shows how much is paid as dividend to the shareholders on each share held. [33] Formula: Dividend Paid to Ordinary Shareholders
Dividend per Share = Number of Ordinary Shares 3. DIVIDEND PAYOUT RATIO Dividend Pay-out Ratio shows the relationship between the dividend paid to equity shareholders out of the profit available to the equity shareholders. Formula: Dividend per share Dividend payout ratio = X 100 Earnings per share D/P ratio shows the percentage share of net profits after taxes and after preference dividend has been paid to the preference equity holders. [34] GEARING Figure: 4. 2. 5 1. CAPITAL GEARING RATIO Gearing means the process of increasing the equity shareholders return through the use of debt.
Equity shareholders earn more when the rate of the return on total capital is more than the rate of interest on debts. This is also known as leverage or trading on equity. The Capital-gearing ratio shows the relationship between two types of capital viz: – equity capital & preference capital & long term borrowings. It is expressed as a pure ratio. Formula: Preference capital+ secured loan Capital gearing ratio = Equity capital & reserve & surplus Capital gearing ratio indicates the proportion of debt & equity in the financing of assets of a concern. [35] PROFITABILITY
These ratios help measure the profitability of a firm. A firm, which generates a substantial amount of profits per rupee of sales, can comfortably meet its operating expenses and provide more returns to its shareholders. The relationship between profit and sales is measured by profitability ratios. There are two types of profitability ratios: Gross Profit Margin and Net Profit Margin Figure: 4. 2. 6 FF . 1. GROSS profit ratio This ratio measures the relationship between gross profit and sales. It is defined as the excess of the net sales over cost of goods sold or excess of revenue over cost.
This ratio shows the profit that remains after the manufacturing costs have been met. It measures the efficiency of production as well as pricing. This ratio helps to judge how efficient the concern is I managing its production, purchase, selling & inventory, how good its control is over the direct cost, how productive the concern , how much amount is left to meet other expenses & earn net profit. Formula: Gross profit Gross profit ratio = x 100 Net sales [36] 2. NET PROFIT RATIO:Net Profit ratio indicates the relationship between the net profit & the sales it is usually expressed in the form of a percentage.
Formula: NPAT Net profit ratio = x 100 Net sales This ratio shows the net earnings (to be distributed to both equity and preference shareholders) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. Jointly considered, the gross and net profit margin ratios provide an understanding of the cost and profit structure of a firm. 3. RETURN ON CAPITAL EMPLOYED The profitability of the firm can also be analyzed from the point of view of the total funds employed in the firm.
The term fund employed or the capital employed refers to the total long-term source of funds. It means that the capital employed comprises of shareholder funds plus long-term debts. Alternatively it can also be defined as fixed assets plus net working capital. Capital employed refers to the long-term funds invested by the creditors and the owners of a firm. It is the sum of long-term liabilities and owner’s equity. ROCE indicates the efficiency with which the long-term funds of a firm are utilized. Formula: NPAT Return on capital employed = x100 Capital employed [37] FINANCIAL
These ratios determine how quickly certain current assets can be converted into cash. They are also called efficiency ratios or asset utilization ratios as they measure the efficiency of a firm in managing assets. These ratios are based on the relationship between the level of activity represented by sales or cost of goods sold and levels of investment in various assets. The important turnover ratios are debtors turnover ratio, average collection period, inventory/stock turnover ratio, fixed assets turnover ratio, and total assets turnover ratio. These are described below: Figure: 4. 2. 7 1. DEBTORS TURNOVER RATIO (DTO)
DTO is calculated by dividing the net credit sales by average debtors outstanding during the year. It measures the liquidity of a firm’s debts. Net credit sales are the gross credit sales minus returns, if any, from customers. Average debtors are the average of debtors at the beginning and at the end of the year. This ratio shows how rapidly debts are collected. The higher the DTO, the better it is for the organization. Formula: Credit Sales Debtors Turnover Ratio = Average Debtors [38] 2. INVENTORY OR STOCK TURNOVER RATIO (ITR) ITR refers to the number of times the inventory is sold and replaced during the accounting period.
Formula: COGS Stock Turnover Ratio = Average Stock ITR reflects the efficiency of inventory management. The higher the ratio, the more efficient is the management of inventories, and vice versa. However, a high inventory turnover may also result from a low level of inventory, which may lead to frequent stock outs and loss of sales and customer goodwill. For calculating ITR, the average of inventories at the beginning and the end of the year is taken. In general, averages may be used when a flow figure (in this case, cost of goods sold) is related to a stock figure (inventories).
3.
FIXED ASSETS TURNOVER (FAT) The FAT ratio measures the net sales per rupee of investment in fixed assets. Formula: Net Sales Fixed Assets Turnover = Net Fixed Assets This ratio measures the efficiency with which fixed assets are employed. A high ratio indicates a high degree of efficiency in asset utilization while a low ratio reflects an inefficient use of assets. However, this ratio should be used with caution because when the fixed assets of a firm are old and substantially depreciated, the fixed assets turnover ratio tends to be high (because the denominator of the ratio is very low).
4. STOCK WORKING CAPITAL RATIO: This ratio shows the relationship between the closing stock & the working capital. It helps to judge the quantum of inventories in relation to the working capital of the business. The purpose of this ratio is to show the extent to which working capital is [39] blocked in inventories. The ratio highlights the predominance of stocks in the current financial position of the company. It is expressed as a percentage. Formula: Closing Stock Stock Working capital ratio = Working Capital Stock working capital ratio is a liquidity ratio.
It indicates the composition & quality of the working capital. This ratio also helps to study the solvency of a concern. It is a qualitative test of solvency. It shows the extent of funds blocked in stock. If investment in stock is higher it means that the amount of liquid assets is lower. 5. DEBT EQUITY RATIO: This ratio compares the long-term debts with shareholders fund. The relationship between borrowed funds & owners capital is a popular measure of the long term financial solvency of a firm. This relationship is shown by debt equity ratio.
Alternatively, this ratio indicates the relative proportion of debt & equity in financing the assets of the firm. It is usually expressed as a pure ratio. Formula: Total Long-term Debt Debt-equity ratio = Total Shareholders Fund Debt equity ratio is also called as leverage ratio. Leverage means the process of the increasing the equity shareholders return through the use of debt. Leverage is also known as „gearing? or „trading on equity?. Debt equity ratio shows the margin of safety for longterm creditors & the balance between debt & equity. 6. CREDITORS TURNOVER RATIO:
It is same as debtor? s turnover ratio. It shows the speed at which payments are made to the supplier for purchase made from them. It is a relation between net credit purchase and average creditors [40] Formula: Net credit purchase Credit turnover ratio = Average creditors 365 days Average age of accounts payable = Credit turnover ratio Both the ratios indicate promptness in payment of creditor purchases. Higher creditors turnover ratio or a lower credit period enjoyed signifies that the creditors are being paid promptly. It enhances credit worthiness of the company.
A very low ratio indicates that the company is not taking full benefit of the credit period allowed by the creditors. 4. 3 Importance of ratio analysis As a tool of financial management, ratios are of crucial significance. The importance of ratio analysis lies in the fact that it presents facts on a comparative basis & enables the drawing of interference regarding the performance of a firm. Ratio analysis is relevant in assessing the performance of a firm in respect of the following aspects: 1] LIQUIDITY POSITION: With the help of Ratio analysis conclusion can be drawn regarding the liquidity position of a firm.
The liquidity position of a firm would be satisfactory if it is able to meet its current obligation when they become due. A firm can be said to have the ability to meet its short-term liabilities if it has sufficient liquid funds to pay the interest on its short maturing debt usually within a year as well as to repay the principal. This ability is reflected in the liquidity ratio of a firm. The liquidity ratios are particularly useful in credit analysis by bank & other suppliers of short term loans. 2] LONG TERM SOLVENCY: – [41] Ratio analysis is equally useful for assessing the long-term financial viability of a firm.
This respect of the financial position of a borrower is of concern to the long-term creditors, security analyst & the present & potential owners of a business. The long-term solvency is measured by the leverage/ capital structure & profitability ratio Ratio analysis s that focus on earning power & operating efficiency. Ratio analysis reveals the strength & weaknesses of a firm in this respect. The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or if it is heavily loaded with debt in which case its solvency is exposed to serious strain.
Similarly the various profitability ratios would reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved. 3] OPERATING EFFICIENCY: Yet another dimension of the useful of the ratio analysis, relevant from the viewpoint of management, is that it throws light on the degree of efficiency in management & utilization of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets- total as well as its components.
4] OVERALL PROFITABILITY: Unlike the outsides parties, which are interested in one aspect of the financial position of a firm, the management is constantly concerned about overall profitability of the enterprise. That is, they are concerned about the ability of the firm to meets its short term as well as long term obligations to its creditors, to ensure a reasonable return to its owners & secure optimum utilization of the assets of the firm. This is possible if an integrated view is taken & all the ratios are considered together. 5] INTER – FIRM COMPARISON:
Ratio analysis not only throws light on the financial position of firm but also serves as a stepping-stone to remedial measures. This is made possible due to inter firm comparison & comparison with the industry averages. A single figure of a particular ratio is meaningless unless [42] it is related to some standard or norm. One of the popular techniques is to compare the ratios of a firm with the industry average. It should be reasonably expected that the performance of a firm should be in broad conformity with that of the industry to which it belongs. An inter firm comparison would demonstrate the firms position vice-versa its competitors.
If the results are at variance either with the industry average or with those of the competitors, the firm can seek to identify the probable reasons & in light, take remedial measures. 6] TREND ANALYSIS: Finally, ratio analysis enables a firm to take the time dimension into account. In other words, whether the financial position of a firm is improving or deteriorating over the years. This is made possible by the use of trend analysis. The significance of the trend analysis of ratio lies in the fact that the analysts can know the direction of movement, that is, whether the movement is favorable or unfavorable.
For example, the ratio may be low as compared to the norm but the trend may be upward. On the other hand, though the present level may be satisfactory but the trend may be a declining one. ADVANTAGES OF RATIO ANALYSIS Financial ratios are essentially concerned with the identification of significant accounting data relationships, which give the decision-maker insights into the financial performance of a company. The advantages of ratio analysis can be summarized as follows: ? Ratios facilitate conducting trend analysis, which is important for decision making and forecasting.
Ratio analysis helps in the assessment of the liquidity, operating efficiency, profitability and solvency of a firm. ? Ratio analysis provides a basis for both intra-firm as well as inter-firm comparisons. ? The comparison of actual ratios with base year ratios or standard ratios helps the management analyze the financial performance of the firm. LIMITATIONS OF RATIO ANALYSIS Ratio analysis has its limitations. These limitations are described below: [43] 1] Information problems ? Ratios require quantitative information for analysis but it is not decisive about analytical output.
The figures in a set of accounts are likely to be at least several months out of date, and so might not give a proper indication of the company? s current financial position. ? Where historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based on this information will not be very useful for decision-making. 2] Comparison of performance over time ? When comparing performance over time, there is need to consider the changes in price. The movement in performance should be in line with the changes in price
When comparing performance over time, there is need to consider the changes in technology. The movement in performance should be in line with the changes in technology. ? Changes in accounting policy may affect the comparison of results between different accounting years as misleading. 3] Inter-firm comparison ? Companies may have different capital structures and to make comparison of performance when one is all equity financed and another is a geared company it may not be a good analysis. ? Selective application of government incentives to various companies may also distort intercompany comparison.
comparing the performance of two enterprises may be misleading. ? Inter-firm comparison may not be useful unless the firms compared are of the same size and age, and employ similar production methods and accounting practices. ? Even within a company, comparisons can be distorted by changes in the price level. ? Ratios provide only quantitative information, not qualitative information. [44] ? Ratios are calculated on the basis of past financial statements. They do not indicate future trends and they do not consider economic conditions. ROLE OF RATIO ANALYSIS:
It is true that the technique of ratio analysis is not a creative technique in the sense that it uses the same figure & information, which is already appearing in the financial statement. At the same time, it is true that what can be achieved by the technique of ratio analysis cannot be achieved by the mere preparation of financial statement. Ratio analysis helps to appraise the firm in terms of their profitability & efficiency of performance, either individually or in relation to those of other firms in the same industry. The process of this appraisal is not complete until the ratio so computed can be compared with something, as the ratio al
