What is the Nature of Ratio Analysis? Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing and interpreting various ratios for helping in making certain decisions. However, ratio analysis is not an end in itself. It is only a means of better understanding of financial strengths and weaknesses of a firm. So, what we discussing is – Mode, Classification, Uses, Steps of Ratio Analysis.
The Concept of Accounting explains Ratio Analysis in the points of Mode, Classification, Uses, Steps.
In this article discussing Ratio Analysis: First Mode of Ratio Analysis, then the second Classification of Ratios, the third Uses of Ratio Analysis and finally Steps of Ratio Analysis. How to Calculation of Ratio Analysis? Calculation of mere ratios does not serve any purpose unless several appropriate ratios are analyzed and interpreted.
There are a number of ratios which can be calculated from the information given in the financial statements, but the analyst has to select the appropriate data and calculate only a few appropriate ratios from the same keeping in mind the objective of the analysis. The ratios may be used as a symptom like blood pressure, the pulse rate or the body temperature and their interpretation depend upon the caliber and competence of the analyst.
Modes of Expression of Ratios:
Ratios may be expressed in any one or more of the following ways; Ratios can be expressed as:
- Rate or times, and.
Each way of expression may have a distinct advantage over the others. The analyst will choose a particular mode or a combination suitable for a specific purpose.
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”.
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 the cost of sales divided by average stock (say 8), thus 8 times is the ratio between the cost of sales and stock.
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%.
The Classification of Ratios:
Ratios are classified in several ways. Different approaches are used for classifying ratios. There is no uniformity in classification by different experts. They have adopted different standpoints for classifying ratios into various groups.
Some of the classifications are discussed below:
Ratios by Statements:
Under this method, ratios are classified on the basis of statements from which the information is obtained for calculating the ratios. The only statements which provide information are i.e., balance sheet and profit and loss account.
Under this classification, ratios are grouped on the basis of the parties who are interested in making use of the ratios.
The following is the classification on this basis:
- Creditors, and.
This classification is being adopted by the British Institute of Management, where there are three types of ratios:
They are also known as explanatory ratios which include:
- Return on capital employed.
- Assets turnover, and.
- Profit ratios.
Secondary Performance Ratios:
- Working capital turnover.
- Stock to current assets.
- Current assets to fixed assets.
- Stocks to fixed assets, and.
- Fixed assets to total assets.
Secondary Credit Ratios:
- Creditors turnover.
- Debtors turnover.
- Liquid ratio.
- Current ratio, and.
- Average collection period.
- The growth rate in sales.
- The growth rate in net assets.
The above list is not exhaustive; other relevant ratios can be added to each category.
Ratios by Purpose/Function:
The basis for classification under this head is the purpose for which the ratios are calculated. Generally, ratios are used for the purpose of assessing profitability, activity or operating efficiency and financial position of concern. Based on the purpose the ratios are classified as profitability ratios, turnover ratios and financial ratios or solvency ratios.
Uses of Ratio Analysis:
The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyze and interpret the financial health of the enterprise. 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 help of ratios that the financial statements can be analyzed more clearly and decisions made from such analysis. The use of ratios is not confined to financial managers only.
There are different parties interested in the ratio analysis for knowing the financial position of a firm for different purposes. The supplier of goods on credit, banks, financial institutions, investors, shareholders, and management all make use of ratio analysis as a tool in evaluating the financial position and performance of a firm for granting credit, providing loans or making investments in the firm.
With the use of ratio analysis, one can measure the financial condition of a firm and can point out whether the condition is strong, good, questionable or poor. The conclusions can also be drawn as to whether the performance of the firm is improving or deteriorating.
Thus, ratios have wide applications and are of immense use today:
1. Managerial Uses of Ratio Analysis:
The following managerial uses below are:
Helps in decision-making:
Financial statements are prepared primarily for decision-making. But the information provided in financial statements is not an end in itself and no meaningful conclusion can be drawn from these statements alone. Ratio analysis helps in making decisions from the information provided in these financial statements.
Helps in financial forecasting and planning:
Ratio Analysis is of much help in financial forecasting and planning. Planning is looking ahead and the ratios calculated for a number of years work as a guide for the future. Meaningful conclusions can be drawn for the future from these ratios. Thus, ratio analysis helps in forecasting and planning.
Helps in communicating:
The financial strength and weakness of a firm are communicated in a more easy and understandable manner by the use of ratios. The information contained in the financial statements is conveyed in a meaningful manner to the one for whom it is meant. Thus, ratios help in communication and enhance the value of the financial statements.
Helps in coordination:
Ratios even help in coordination which is of utmost importance in effective business management. Better communication of efficiency and weakness of enterprise results in better coordination in the enterprise.
Helps in Control:
Ratio analysis even helps in making effective control of the business. Standard ratios can be based upon proforma financial statements and variances or deviations, if any, can be found by comparing the actual with the standards so as to take corrective action at the right time. The weaknesses or otherwise, if any, come to the knowledge of the management which helps in effective control of the business.
These are so many other uses of the ratio analysis. It is an essential part of the budgetary control and standard costing. Ratios are of immense importance in the analysis and interpretation of financial statements as they bring the strength or weakness of a firm.
An investor in the company will like to assess the financial position of the concern where he is going to invest. His first interest will be the security of his investment and then a return in the form of dividend or interest.
For the first purpose, he will try to asses the value of fixed assets and the loans raised against them. The investor will feel satisfied only if the concern has a sufficient amount of assets. Long-term solvency ratios will help him in assessing the financial position of the concern.
Profitability ratios, on the other hand, will be useful to determine profitability position. Ratio analysis will be useful to the investor in making up his mind whether the present financial position of the concern warrants further investment or not.
3. Utility to Creditors:
The creditors or suppliers extend short-term credit to the concern. They are interested to know whether the financial position of the concern warrants their payments at a specified time or not. The concern pays the short-term creditor, out of its current assets.
If the current assets are quite sufficient to meet current liabilities then the creditor will not hesitate in extending credit facilities. Current and acid-test ratios will give an idea about the current financial position of the concern.
4. Utility to Employees:
The employees are also interested in the financial position of the concern especially profitability. Their wage increases the number of fringe benefits is related to the volume of profits earned by the concern.
The employees make use of information available in financial statements. Various profitability ratios relating to gross profit, operating profit, net profit, etc. enable employees to put forward their viewpoint for the increase of wages and other benefits.
5. Utility to Government:
Government is interested to know the overall strength of the industry. Various financial statements published by industrial units are used to calculate ratios for determining short-term, long-term and overall financial position of the concerns. Profitability indexes can also be prepared with the help of ratios.
The government may base its future policies on the basis of industrial information available from various units. The ratios may be used as indicators of the overall financial strength of public as well as private sector, in the absence of the reliable economic information, governmental plans and policies may not prove successful.
6. Tax Audit Requirements:
Section 44 AB was inserted in the Income Tax Act by the Finance Act, 1984. Under this section, every assessee engaged in any business and having the turnover or gross receipts exceeding Rs. 40 lakh is required to get the accounts audited by a chartered accountant and submit the tax audit report before the due date for filing the return of income under Section 139 (1). In the case of a professional, a similar report is required if the gross receipts exceed Rs 10 lakh.
Clause 32 of the Income Tax Act requires that the following accounting ratios should be given:
- Gross Profit/Turnover.
- Net Profit/Turnover.
- Stock-in-trade/Turnover, and.
- Material Consumed/Finished Goods Produced.
Further, it is advisable to compare the accounting ratios for the year under consideration with the accounting ratios for the earlier two years so that the auditor can make necessary inquiries if there is any major variation in the accounting ratios.
The Steps in Ratio Analysis:
The following Steps in Ratio Analysis below are:
Selection of Relevant Information:
The first step in ratio analysis is to select relevant information from financial statements and calculate appropriate ratios required for decision under consideration.
Comparison of Calculated Ratios:
In order to assess the relative meaning, the ratios calculated are compared with the past ratios and industry ratios.
Interpretation and Reporting:
The third step in ratio analysis is to interpret the significance of various ratios, draw inferences and to write a report. The report may recommend specific action in the matter of the decision situation or may present alternatives with comparative merits or it may just state the facts and interpretation.