What is Ratio Analysis? An analysis of financial statements based on ratios is known as ratio analysis. A ratio is a mathematical relationship between two or more items taken from the financial statements. Ratio analysis is the process of computing, determining, and presenting the relationship of items. It also includes comparison and interpretation of ratios and using them as a basis for the future projections. Ratio analysis is helpful to management and outsiders to diagnose the financial health of a business concern. It helps in measuring the profitability, solvency, and activity of a firm. So, what we discussing is – Meaning, Definition, Nature, Steps, Limitations of Ratio Analysis.
The Concept of Financial Statement explains the Techniques of Ratio Analysis, and they are understood by Meaning, Definition, Nature, Steps, Limitations.
In this article we will discuss Ratio Analysis: Meaning of Ratio Analysis, second in Definition of Ratio Analysis, third simply learn Nature and Steps of Ratio Analysis and last studying Limitations of Ratio Analysis. So, Ratio analysis is the process of examining and comparing financial information by calculating meaningful financial statement figure percentages instead of comparing line items from each financial statement.
Meaning of Ratio Analysis:
The company’s financial information is contained in Balance Sheet and Profit and Loss Account. The figures contained in these statements are absolute and sometimes unconnected with one another. An absolute figure does not convey much meaning. However, it is only in the light of other information that the significance of a figure is realized. For instance, Mr. X weighs 50Kg. Is he fat? We cannot give an answer unless we know his age and height. Similarly, a company’s profitability cannot be known unless together with the amount of profit, the capital employed is also seen.
The relationship between these two figures expressed mathematically is called a RATIO. The ratio refers to the numerical or quantitative relationship between two variables or items. A ratio is calculated by dividing one item of the relationship with the other. The ratio analysis is one of the most useful and common methods of analyzing financial statements. As compared to other tools of financial analysis, the ratio analysis provides very useful conclusions about various aspects of the working of an enterprise. The need for ratio arises due to the fact that absolute figures are often misleading.
Absolute figures are certainly valuable but their value increases manifold if they are studied with another through ratio analysis. Ratios enable the mass of data to be summarised and simplified. Ratio analysis is an instrument for the diagnosis of the financial health of an enterprise. Ratios, in fact, are full of meaning and communicate the relative importance of the various items ‘appearing in the Balance Sheet and Profit and Loss Account.
Definition of Ratio Analysis:
Ratio Analysis is a powerful tool for financial analysis. A ratio is defined as,
“The indicated quotient of two mathematical expressions and as the relationship between two or mm thing?” — Webster’s New Collegiate Dictionary.
“The ratio analysis is an aid to management in taking credit decisions, but as a mechanical substitute for thinking and judgment, it is worse than useless.” —Hunt, Williams & Donaldson.
Ratio Analysis may be defined as the systematic use of ratio to interpret the financial statements so that the strength and weaknesses of a firm, as well as its historical performance and current financial condition, can be determined. The term ‘ratio’ refers to the numerical or quantitative relationship between two items or variables. In financial analysis, a ratio is used as an index or yardstick for evaluating the financial position and performance of a firm.
As a matter of fact, an accounting figure conveys meaning when it is related to some other relevant information. Therefore, ratios help to summaries the large quantities of financial data and to make a qualitative judgment about the firm’s financial performance and financial position. The accounting ratios serve any purposes, they can assist management in its basic functions like forecasting, planning, coordination, control, and communication. If they are used properly they can improve efficiency and therefore, profits.
Nature and Steps of Ratio Analysis:
The following Nature of Ratio Analysis below are:
Ratio analysis is a powerful tool for financial analysis. A ratio is defined as “the indicated quotient of two mathematical expressions” and as “the relationship between two or more things”. In financial analysis, a ratio is used as an index or yardstick for evaluating the financial position and performance of a firm. Analysis of financial statements is a process of evaluating the relationship between component parts of financial statements to obtain a better understanding of the firm’s position and performance.
Financial analysis is used as a device to analyze and interpret the financial health of the enterprise. The absolute accounting figures reported in the financial statements do not provide a meaningful understanding of the performance and financial performance of a firm. An accounting figure conveys meaning when t is related to some other relevant information.
Just like a doctor examines his patient by recording his body temperature, blood pressure etc., before making his conclusion regarding the illness and before giving his treatment, a financial analyst analyses the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise. A ratio is known as a symptom like blood pressure, the pulse rate or the temperature of an individual. It is with the help of ratios that the financial statements can be analyzed more clearly and decisions are drawn from such an analysis. The point to note is that a ratio indicates a quantitative relationship, which can be, in turn, used to make a qualitative judgment. Such is the nature of all financial ratios.
The following Steps in Ratio Analysis below are:
The first task of the financial analyst is to select the information relevant to the decision under consideration from the statements and calculates appropriate ratios. The second step is to compare the calculated ratios with the ratios of the same firm relating to past/with the industry ratios. This step facilitates in assessing success or failure of the firm. The third step involves interpretation, drawing of inferences and report-writing. Conclusions are drawn after comparison in the shape of the report or recommended the course of action.
Limitations of Ratio Analysis:
The following Limitations of Ratio Analysis below are:
- Incorrect Accounting Data.
- Probable Happenings in Future.
- Variation in Accounting Methods.
- Price Level Changes.
- Only One Method of Analysis.
- No Common Standards.
- Different Meanings Assigned.
- Ignores Qualitative Factors, and.
- Insignificant and Unrelated Figures.
Incorrect Accounting Data:
False Results if Based on Incorrect Accounting Data. Accounting ratios can be correct only if the data (on which they are based) are correct. Sometimes, the information given in the financial statements is affected by window dressing, i.e., showing position better than what actually is.
For example, if inventory values are inflated or depreciation is not charged on fixed assets, not only will one have an optimistic view of the profitability of the concern but also of its financial position. So the analyst must always be on the look-out for signs of window dressing if any.
Probable Happenings in Future:
No Idea of Probable Happenings in Future. Ratios are an attempt to make an analysis of the past financial statements; so they are historical documents. Nowadays keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future.
Variation in Accounting Methods:
The two firms’ results are comparable with the help of accounting ratios only if they follow the same accounting methods or bases. The comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock.
Similarly, if the two firms are following two different standards and methods, an analysis by reference to the ratios would be misleading. Moreover, utilization of inbuilt facilities, availability of facilities and scale of operation would affect financial statements of different firms. Comparison of financial statements of such firms by means of ratios is bound to be misleading.
Price Level Changes:
Changes in price levels make the comparison for various years difficult. For example, the ratio of sales to total assets in 1996 would be much higher than in 1982 due to rising prices, fixed assets being shown at cost and not at market price.
Only One Method of Analysis:
Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. So, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis.
No Common Standards:
It is very difficult to lay down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different. For example, a business with the current ratio of more than 2:1 might not be in a position to pay current liabilities in time because of an unfavorable distribution of current assets in relation to liquidity. On the other hand, another business with a current ratio of even less than 2:1 might not be experiencing any difficulty in making the payment of current liabilities in time because of its favorable distribution of current assets in relation to liquidity.
Different Meanings Assigned:
Different firms, in order to calculate the ratio, may assign different meanings. Different Meanings Assigned to the Same Term. For example, profit for the purpose of calculating a ratio may be taken as profit before charging interest and tax or profit before tax but after interest or profit after tax and interest. This may affect the calculation of ratio in different firms and such ratio when used for comparison may lead to wrong conclusions.
Ignores Qualitative Factors:
Accounting ratios are tools of quantitative analysis only. But sometimes qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted.
For example, though credit may be granted to a customer on the basis of information regarding his financial position, yet the grant of credit ultimately depends on debtor’s character, honesty, past record and his managerial ability.
No use if Ratios are worked out for Insignificant and Unrelated Figures. Accounting ratios may be worked for any two insignificant and unrelated figures as the ratio of sales and investment in government securities. Such ratios may be misleading. Ratios should be calculated on the basis of cause and effect relationship. One should be clear as to what cause is and what effect is before calculating a ratio between two figures.