| Ratios are highly essential profit tools in | | | | position vis-à-vis the industry. It will help in |
| financial analysis that help financial analysts | | | | analyzing the firm’s strengths and |
| implement plans that improve profitability, liquidity, | | | | weaknesses and take corrective action. Trend |
| financial structure, reordering, leverage, and | | | | Analysis of ratios over a period of years will |
| interest coverage. Although ratios report mostly | | | | indicate the direction of the firm’s financial |
| on past performances, they can be predictive | | | | policies. |
| too, and provide lead indications of potential | | | | Budgeting: Ratios are not mere post-modern of |
| problem areas. | | | | operations. They help in depicting future financial |
| Ratio analysis is primarily used to compare a | | | | positions. Ratios have predictor value and are |
| company's financial figures over a period of time, | | | | helpful in planning and forecasting the business |
| a method sometimes called trend analysis. | | | | activities of a firm for future periods, e.g. |
| Through trend analysis, you can identify trends, | | | | estimation of working capital requirements. |
| good and bad, and adjust your business practices | | | | Ratios are useful tools for financial analysis. |
| accordingly. You can also see how your ratios | | | | However the following limitations do exist. |
| stack up against other businesses, both in and out | | | | (a) Window Dressing: Ratios depict the |
| of your industry. | | | | picture of performance at a particular point of |
| There are several considerations you must be | | | | time. Sometimes, a business can make year-end |
| aware of when comparing ratios from one | | | | adjustments in order to result in favorable ratios |
| financial period to another or when comparing the | | | | (e.g. current ratio, operating profit ratio, |
| financial ratios of two or more companies. | | | | debt-equity ratio etc.) |
| - If you are making a comparative analysis of a | | | | (b) Impact of Inflation: Financial |
| company's financial statements over a certain | | | | Statements are affected by inflation. Ratios may |
| period of time, make an appropriate allowance for | | | | not depict the correct picture. For example, fixed |
| any changes in accounting policies that occurred | | | | assets are accounted at historical cost while |
| during the same time span. | | | | profits are measured in current rupee terms. In |
| - When comparing your business with others in | | | | inflationary situations, the Return on Assets or |
| your industry, allow for any material differences in | | | | Return on Capital Employed may be very high |
| accounting policies between your company and | | | | due to less investment in fixed assets. Ratios |
| industry norms. | | | | may not indicate the true position in such |
| - When comparing ratios from various fiscal | | | | situations. |
| periods or companies, inquire about the types of | | | | (c) Product Line diversification: Detailed |
| accounting policies used. Different accounting | | | | ratios for different divisions, products and market |
| methods can result in a wide variety of reported | | | | segments etc. may not be available to the users |
| figures. | | | | in order to make an informed judgment. For |
| - Determine whether ratios were calculated | | | | example, loss in one product may be set off by |
| before or after adjustments were made to the | | | | substantial profits in another product line. But, the |
| balance sheet or income statement, such as | | | | overall net profit ratio may be favorable. |
| non-recurring items and inventory or pro forma | | | | (d) Impact of Seasonal Factors: When |
| adjustments. In many cases, these adjustments | | | | the operations do not follow a uniform pattern |
| can significantly affect the ratios. | | | | during the financial period, ratios may not indicate |
| - Carefully examine any departures from industry | | | | the correct situation. For example, if the peak |
| norms. | | | | supply season of a business is between Februarys |
| Ratio Analysis is a useful tool in the following | | | | to June, it will hold substantial stocks on the |
| aspects: | | | | balance sheet date. This will lead to a very |
| Evaluation of Liquidity: The ability of | | | | favorable current ratio on that date. But the |
| a firm to meet its short term payment | | | | position for the rest of the year may be entirely |
| commitments is called liquidity. Current Ratio and | | | | different. |
| Quick Ratio help to assets the short-term | | | | (e) Differences in Accounting Policies: |
| solvency (liquidity) of the firm. | | | | Different firms follow different accounting policies, |
| Evaluation of Profitability: Profitability | | | | e.g. rate and methods of depreciation. |
| ratios i.e. Gross Profit Ratio, Operating Profit Ratio, | | | | Straight-jacket comparison of ratios may lead to |
| Net Profit Ratio are basic indicators of the | | | | misleading results. |
| profitability of the firm. In addition, various | | | | (f) Lack of Standards: Even though |
| profitability indicators like Return on Capital | | | | some norms can be set for ratios, there is no |
| Employed (ROCE), Earnings per share (EPS), | | | | uniformity as to what an “ideal” ratio is. |
| Return on Assets (ROA) etc. are used to assess | | | | Generally it is said that Current Ratio should be 2:1. |
| the financial performance. | | | | But if a firm supplies mainly to Government |
| Evaluation of Operating Efficiency: | | | | Departments where debt collection period is high, |
| Ratios throw light on the degree of efficiency in | | | | a Current Ratio of 4:1 or 5:1, may also be |
| the management and utilization of assets and | | | | considered normal. |
| resources. These are indicated by activity or | | | | (g) High or Low: A number by itself |
| performance or turnover ratios e.g. Stock | | | | cannot be “high” or “low”. Hence, |
| Turnover Ratio, Debtors Turnover Ratio. These | | | | a ratio by itself cannot become “good” or |
| indicate the ability of the firm to generate | | | | “bad”. The line of difference between |
| revenue (sales) per rupee of investment in its | | | | “good ratio” and “bad ratio” is |
| assets. | | | | very thin. |
| Evaluation of Financial Strength: | | | | (h) Interdependence: Financial Ratios |
| Long-term solvency strength is indicated by | | | | cannot be considered in isolation. Decision taken on |
| Capital Structure Ratios like Debt-Equity Ratio, | | | | the basis of one ratio may be incorrect when a |
| Gearing Ratio, Leverage Ratios etc. These ratios | | | | set of ratios are analyzed. |
| signify the effect of various sources of finance | | | | From the above discussion, it is felt that, the |
| e.g. debt, preference and equity. They also show | | | | ratio is a measuring device to judge the growth, |
| whether the firm is exposed to serious financial | | | | development and present condition of a concern. |
| strain or is justified in the use of debt funds. | | | | Further, it is found that, Each and every ratio |
| Inter-firm and Intra-firm comparison: | | | | indicates the financial position as well as it is also |
| Comparison of the firm’s ratios with the | | | | helpful for taking several management decisions |
| industry average will help evaluate the firm’s | | | | for the future period effectively and efficiently. |