UNIT V: RATIO ANALYSIS

Concept and Meaning of Financial Statement Analysis The figure of the company’s financial statements particularly the profit and loss account and

the balance sheet do not communicate to the user much unless they are properly analyzed

and interpreted. The company's profit and loss occurred during a particular period. It does

not, however, reveal whether the company's revenues and expenses have increased over the

years or its net profit has been satisfactory as compared to past years or other companies of

the similar nature. Similarly, the company's balance sheet also does not reveal more than

what is the position of its assets, liabilities and shareholder's equity at a certain point of time.

Therefore, it is essential to analyze the figures of financial statements so that important

financial information can be obtained thereof.

Metcalf & Titard Analyzing financial statement is a process of evaluating the relationship

between component parts of a financial statement to obtain a better understanding of a firm's

position and performance.

Myers Financial statement analysis is largely a study of relationship among the various

financial factors in a business as disclosed by a single set of factors as shown in a series of

statements."

The analysis of financial figures contained in the company's profit and loss account and

balance sheet by employing appropriate technique is known as financial statement analysis.

Formally, financial statement analysis is defined as the process of analyzing and interpreting

the financial figures contained in the statements by developing some relationships among the

figures in such a manner that meaningful information can be obtained about the liquidity,

efficiency, profitability and leverage position of the company. Thus, the analysis of financial

statements is concerned with arranging, classifying and grouping of financial data in a

purposeful manner whereby a user can easily understand about the survival, stability,

profitability and growth prospect of the company. The analysis of financial statements

includes the following activities:

■ Arranging and classifying financial data in a purposeful manner.

■ Judging the inter relationship of financial figures in a meaningful manner.

■ Obtaining information in a conclusive manner for the purpose of decision-making.

Objectives of Financial Statements Analysis The objective of analysis of financial statements is to provide readymade financial

information to the management, creditors, lenders, shareholders; customers etc. and support

them to take decision to prepare future action plan. The following are the common objective

of financial statement analysis:

1. To judge liquidity: Analysis of financial statement helps to judge the short term solvency

position of the company. It can be determined by comparing the amount of current assets and

current liabilities. Trade creditors are more interested in assessing liquidity position of the

company as they have to recover short term debts from the company.

2. To assess solvency: Financial statements analysis supports to assess long term solvency

position of the company. It can be determined by comparing the amount of long term debts

with shareholders fund and long terms assets. Debenture holders and lenders are more

interested in assessing long term solvency position of the organization as they have to

recover their principal amount and interest from the company.

3. To judge profitability: Financial statement analysis judges the profitability position of the

company, the amount of gross profit and net profit is compared with sales, assets,

shareholder fund and other heads and accounts. It helps to know the weighted of net profit

margin, return on investment, return on assets etc. All the investors have more interest in this

context as they get return on their investment.

4. To judge operational efficiency: The objective of financial statement analysis is to assess

the operational efficiency of the company. The comparison of actual revenues and expenses

for a period with the standard determined helps to judge the operational strength and

weakness of the company. This supports to the management to minimize weaknesses and to

capitalize strength for better performance in future course of action.

5. To help for planning and budgeting: Planning and budgeting should be prepared on the

basis of past financial information and estimation about probable change in environment.

Financial statement analysis helps for planning and budgeting for future performance as it

provides readymade financial information to the management.

6. To compare inter-company performance: A comparative study of financial statements of

different companies in different way helps to know their probable strengths and weaknesses.

A financial statement analysis supports to make study of different ratios of the companies on

the basis requirement. The inter-company comparison of financial statements helps to

remove weakness in future performance

Meaning of Ratio Analysis:

Ratio is the expression of mathematical relation between two inter-dependent components. It

is used as an indicator to know about the relation among different related figures. Any figure

or number given does not provide meaning until and unless a relation is not maintained with

other related figures. Therefore, to test the relationship between related components, ratio is

used. The determination of ratios of different components of financial statements is the basis

of ratio analysis.

According to R.N. Anthony "A ratio is simply one number expressed in terms of another. It is found by dividing one number by the other."

Kohler states that "a ratio is the relationship of one amount to another expressed as the ratio or as a simple fraction, integer, decimal fraction or percentage."

Ratio analysis is one of the techniques of financial statements analysis. It is the process of

determining and interpreting mathematical relationship between different figures in financial

statements. It helps to measure the financial strength and weakness of an entity and also

facilitates to compare the operating results and financial positions of two or more entities. It

helps to ascertain the liquidity, solvency, turnover, and profitability position of the entities

for any fiscal year. It is supportive to the stakeholders like management, investors,

employees, creditors, lenders, and customers etc. for taking decision.

Importance /Significance/Advantage/Objectives of Ratio Analysis

Ratio analysis is one of the important techniques of financial statements analysis. It is the

means of measuring operating strength and weakness, and over financial position of an

entity. It is advantageous for all the stakeholders like management, investors, creditor,

customers, and lender etc. for taking important decisions. The following are the important of

ratio analysis:

1. Helps to know liquidity and solvency: Ratio analysis helps to know the short term

solvency position of the company. It can be determined by comparing the amount of

current assets and current liabilities. Trade creditors are more interested in assessing

liquidity position of the organization.

2. Helps to know turnover and profitability: Ratio analysis helps to know the volume of

sales by comparing its relationship with other components of accounts like stock,

debtors, assets, shareholders fund etc. It also helps to know the profitability position of

the company. The amount of gross profit and net profit is compared with sales, assets,

shareholder fund and other heads and accounts.

3. Helps in evaluation of performance: Ratio analysis helps to assess the operational

efficiency of the company. The comparison of actual revenues and expenses for a period

with the standard determined helps to judge the operational strength and weakness of

the company. This supports to the management to minimize weaknesses and to

capitalize strength for better performance in future course of action.

4. Helps to planning and budgeting: Ratio analysis helps for planning and budgeting of

the company for future performance. Planning should be prepared on the basis of past

financial information and estimation about probable change in environment. Ratio

analysis provides readymade financial information to the management for planning and

budgeting.

Limitations of Ratio Analysis

Ratio analysis is supportive to know about liquidity, solvency, turnover, and profitability

position an entity. It is helpful to prepare plans and policies for future course of action.

However, it also involves some limitations, they are as follows:

1. Ignores qualitative aspects: Ratio analysis does not consider and evaluate the

qualitative aspects of the company like team work, dedicated employees, effective

management, good relation between management and employees etc. of a company. It

provides only monetary information like profit and loss, solvency position, liquidity

position etc. For qualitative aspect managers need to consider their experience, skill and

other information.

2. May mislead to the user: In some cases ratio analysis may mislead to the user,

especially, when information given in financial statements are incorrect. The analysis of

wrong information may lead to wrong decision to the user. Ultimately, it provides

impact on future performance of the company.

3. Not reveal the current worth: Financial statements involve information of past

performance of the company. Therefore, analysis of historical financial statements

provides readymade information of past performance. It does not provide reveal the

position of current performance.

4. Based on personal judgment: Ratio analysis provides only the information liquidity,

solvency, turnover and profitability position of past performance. It also provides the

trend of business affairs. But, it does not provide readymade information to the

managers to take right decision. Managers need to use their personal judgment on the

basis of skill and experience for taking any decision.

TypesofAccountingRatios:

Ratios may be classified into different types on different ways on the basis of convenience

and requirement of the users. For financial statement analysis ratios may be broadly divided

into four as: liquidity ratio, solvency ratio, turnover ratio and profitability ratio, a detail of all

the ratios are given in the following figure: