What is Ratio Analysis? Definition, Limitations, Classification

Introduction to Ratio Analysis

A basic limitation of the traditional financial statement comprising the balance sheet and the profit and loss account, provides a summarised view of the financial position and operations of a firm. Different parties are interested in the financial statement for different purposes and look at them from different angles.

For example. the debentureholders analyse the statements in order to ascertain the ability to pay interest and maturity amount. The prospective shareholders would like to know whether the business is profitable and is progressing on sound lines. The management is interested in the operational efficiency as well- as financial position of the business.

Hence, the main objective of financial analysis is to make detail study about the cause and effect of the profitability and financial condition of the firm.

Hence, ratio analysis is a tool to predict operational as-well-as financial efficiency of business through analysis & intrepretation of financial data.

So analysis of financial statement is a process of selection, relation and evaluation. The first task of the financial analyst is to select the information relevant to the decision under consideration.

The second step is to arrange the information in a way to highlight significant relationships. The final step is interpretation and drawing of inferences and conclusions.

The present chapter involves an in-depth analysis of financial statements and its use for decision making by various parties interested in them.

Ratio Analysis Definition

The term “Ratio” simply means one number expressed in terms of another. It describes in mathematical terms the quantitative relationship that exists between two numbers.

The term “Accounting Ratio” is used to describe significant relationship between figures shown on a Balance Sheet, in a Profit and Loss Account.

Ratio analysis refers to the analysis and interpretation of financial statements through ratios.

Ratios are customarily presented either in the form of a coefficient or a percentage or as a proportion. Absolute figures may be misleading unless compared, one with another. Ratios provie the means of showing the relationship that exists between figures. However, the numerical relationships of the kind expressed by ratio analysis are not an end in themselves but are a means for understanding the financial position of a business. Ratios, by themselves, are meaningless, simple ratrios compiled from a single years’ financial statements of an enterprise may not serve the real purpose.

Different Approaches of Interpretation

Generally, there are four different approaches are available for interpreting ratios.

  • Interpretation of Individual Ratios: A single ratio fails to reveal the true position. If it relates to preceeding years or compared with same type of other business or studied with reference to some standards, may be useful. Hence this approach is to be combined with others.

  • Interpretation by Referring to a Group of Ratios: The analysis could be made more meaningful by computing some of the additional related ratios. A Change in one ratio may have significance only when viewed in relation to other ratios.
  • Interpetation of Ratios by Trend: It involves a comparison of ratios of a firm overtime. The trend ratios indicate the directon of change over the years.

  • Interpretation by Inter-firm Comparsions: It involves comparison of the ratios of a firm with those of others in the same line of business or for the industry as a whole reflects its performance in relation to its competitors.
  • It is an invaluable aid to management for planning, forecasting, control and decision making.

  • Ratios enable the mass of accounting data to be summarized and simplified.

  • It facilitates better co-ordination and control of performance as-well-as control of costs.

  • It is a tool to assess important characteristics of business like liquidity, solvency, profitability etc.

  • It is an effective tool of analysis for intra-firm and inter-firm comparisons.

  • It enables a firm to take time dimension into account by using trend analysis of ratios.

  • It enables the easy under standibility for accounting figures, for those who do not know the language of accounting.

  • It is a effective means of communication to the owners and other parties interested therein.

Limitations of Ratio Analysis

Ratio analysis is a widely used tool of financial analysis yet it suffers from various limitations such as:

  1. There are no ideal standards for comparison.

  2. Ratios are calculated on the basis of financial statements, but financial statements himself suffer from a number of limitations. Hence ratio analysis may fail to serve its purpose.

  3. Impact of inflation reflects misleading results, because ratios are calculated on the basis of historical data. Hence inflationary conditions are ignored.

  4. Ratios are based on historical data and it is used for future prediction. Hence, forecast for future may be wrong.

  5. Ratio is just an aid and cannot replace thinking and personal judgement employed in the decision making process.

  6. There are no standard formulae for working out ratios and it makes comparison very difficult.

  7. Ratios are tools of quantitative analysis only and normal qualitative factors that may generally influence conclusions derived are ignored while computing ratios.

  8. Ratio alone is not adequate. It will be useful when it is used in a group of ratios or compare with over a period of time.

Classification of Ratios

Ratios may be classified in a number of ways to suit any particular purpose. Different kinds of ratios are selected for different types of situation. In general, the following bases of classification are in vogue.

  1. Classification According to Accounting Statement: This classification is based on the nature of accounting statement such as Balance sheet ratios. Profit and loss Account Ratios, combined ratios etc.

  2. Classification According to Importance: It’s like primary ratios and secondary ratios. Some of the ratios are termed as primary and others are termed as subsidiary or supporting ratios.

  3. Classification According to Functions: ratios are grouped as liquidity, Activity, Profitability, long term solvency and Market analysis ratios.

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