RATIO ANALYSIS
The Ratio Analysis has emerged as the principal technique of the Analysis of Financial Statement.
A ratio is a relationship expressed in mathematical terms between two individual or groups of figures connected with each other in some logical manner. The Ratio analysis is based on the premise that a single accounting figure by itself may not communicate any meaningful information but when expressed as a relative to some other figure, it may definitely give some significant information.
The relationship between two or more accounting figures/groups is called a financial ratio. A financial ratio helps to summarize a large mass of financial data into a concise form and to make meaningful interpretations and conclusions about the performance and positions of a firm.
For example, a firm having Net Sales of Rs. 5,00,000 is making a gross profit of Rs. 1,00,000. It means that the ratio of the Gross Profit to net sales is 20% i.e. (Rs. 1,00,000 ÷ 5,00,000) × 100
Steps in Ratio Analysis:
The Ratio Analysis involves the following two steps:
- Calculation of ratios, which is purely a clerical work
- Comparing the ratio with some predetermined standard.
Forms of Ratios or the way of expressing ratio: Since the ratio is a relationship between two or more variables/ accounting figures, such relationship can be expressed in different ways as follows:
1. 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. 5,00,000 and the amount of gross profit are Rs. 1,00,000, then the gross profit may be described a 20% of sales.
2. As a pure ratio: For example, the equity share capital of the company is Rs. 20,00,000 and the preference share capital is Rs. 5,00,000, then the ratio equity share capital to preference share capital is 20,00,000: 5,00,000 or simply 4:1.
3. As a rate of times: In the above case, the equity share capital may also be described as 4 times of preference share capital.
Types of comparisons: Ratio Analysis can be done in three different ways:
1. Cross Section Analysis
2. Time series Analysis:
3. Combined Analysis
Prerequisites to Ratio Analysis: In order to use the Ratio Analysis as a device to make purposeful conclusions, there are certain pre-requisites which must be taken care of. It may be noted that this pre-requisite are not conditions for calculations but conditions for meaningful conclusions. The accounting figures are inactive in themselves and can be used for any ratio but meaningful and correct interpretation and conclusion can be arrived at only if the following points are taken into account:
1. The date of different financial statements from where data is taken must be same.
2. If possible, only audited financial statements should be considered. Otherwise, there must be sufficient evidence that the data is correct.
3. 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.
4. One ratio may not throw light on any area of performance of the firm. Therefore, a group of ratios must be preferred. This will also be conducive to counter checks.
5. Last but not the 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.
For example, if an analyst finds a ratio between a number of bad debts and the depreciation charge of a firm, then this ratio is meaningless, though some trend can be established on the basis of this ratio.
Significance of Ratio analysis
Ratio Analysis is an effective and suitable tool of financial analysis. Analysis of financial statement with the support of ratios would guide the management in management in important decision making, implementation, and control. Ratio analysis is an instrument for diagnosing the financial health of an enterprise. The usefulness of the ratio analysis is not only for the financial manager but also to various parties who are interested to know different purposes of financial information. In the real sense, ratio analysis is based on the accounting data contained in the financial statements.
Ratio Analysis offers the following advantages:
1. Simplifies financial statement:
2. Facilitates intra-firm comparison
3. Aid to inter-firm comparison
4. Facilitates decision making
5. Easy to calculate
6. Helps in taking corrective action
7. Helps in identifying trends:
