Ratio Analysis - Introduction

Ratio Analysis – Introduction

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20, Aug 2014

Introduction

The term ‘ratio analysis’refers to the analysis of the financial statements in conjunction with the interpretations of financial results of a particular period of operations, derived with the help of ‘ratio’. Ratio analysis is used to determine the financial soundness of a business concern.

In this blog post, we will introduce ratio analysis, what it is used for, what are the advantages and disadvantages of it and its limitations.

Meaning and Definition of Ratio Analysis

Ratio analysis is a conceptual technique which dates back to the inception of accounting, as a concept. Financial analysis as a scientific tool is used to carry out the calculations in the area of accounting. In order to appraise the valid and existent worth of an enterprise, the financial tool comes handy, regularly. Besides, it also allows the firms to observe the performance spanning across a a long period of time along with the impediments and shortcomings. Financial analysis is an essential the mechanism for a clear interpretation of financial statements. It aids the process of discovering, the existence of any cross-sectional and time series linkages between various ratios.

Formerly, Security qualified as a major requisite for banks and financial institutions, to consider and grant loans and advances. However, there’™s been a complete paradigm shift in the structure. Currently, lending is based on the evaluation of the actual need of the firms. Financial viability of a the proposal, as a base to grant loans, is now been given precedence over security. Further, an element of risk is imperative in every business decision. Credits, run a higher risk, as a part of any decision making in business and so, Ratio analysis and other quantitative techniques mitigate the risk to some the extent by providing a fair and rational assessment of risks.

Ratio analysis broadly explains the process of computing, acts as a vital tool in determination and presentation of the relationship of related items and groups of items of the financial statements. The financial position of a unit is concretely and clearly encapsulated by the means of ratio analysis. The significance of Ratio Analysis for a holistic Financial Analysis remains unflinchingly supreme.

Ratio can be used in the form of a percentage, Quotient, and Rates. In other words, it can be expressed as a to b; a: b (a is to b) or as a simple fraction, integer and decimal. A ratio is calculated by dividing one item or figure by another item or figure.

Analysis of Ratio

Analysis using ratios can be done in following ways.

Analysis of an individual (or) Single Ratio
Analysis of referring to a Group of Ratio
Analysis of ratios by Trend
Analysis by inter-firm comparison

Advantages of Ratio Analysis

In order to establish the relationship between two accounting figures, application of Ratio Analysis is necessary. Application of the same provides significant information to the management or users who can analyze the business situation? It also facilitates meaningful and productive monitoring of the annual performance of the firm. Illustrated below are the advantages of ratio analysis:

It facilitates the accounting information to be summarized and simplified in a concise and concrete form which is comprehensible to the user.
It depicts the inter-relationship between the facts and figures of various segments of business which are instrumental in taking important financial decisions.
Ratio analysis clears all the impediments and inefficiencies related to performance of the firm/individual.
It equips the management with the requisite information enables them to take prompt business -decisions.
It helps the management in effectively discharging its functions/operations such as planning, organizing, controlling, directing and forecasting.
Ratio analysis provides a detailed account of profitable and unprofitable activities. Thus, the management is able to concentrate on unprofitable activities and consider the necessary steps to overcome the existential shortcomings.
Ratio analysis is used as a benchmark for effective control of performance of business activities.
Ratios are an effectual means of communication and informing about financial soundness made by the business concern to the proprietors, investors, creditors and other parties.
Ratio analysis is an effective tool which is used for measuring the operating results of the enterprises.
It facilitates control over the operation as well as resources of the business.
Ratio analysis provides all assistance to the management to discharge responsibilities.
Ratio analysis aids in accurate determination of the performance of liquidity, profitability and solvency position of the business concern.

Limitations of Ratio Analysis

Various environmental conditions such as regulation, market structures etc. vary for different companies, operating in different industries. Significance of such factors is extremely high. This variation may lead to a difference or an element of a discrepancy, while comparing the two companies from diverse industries.
Financial accounting information is impacted and often subject to change, by estimates and assumptions. Accounting standards allow scope for incorporating different accounting policies, which impairs comparability and hence functionality of ratio analysis is less in such situations.
Ratio analysis explicates association between past information while current and future information is of more relevance and application to the users.

In our next article we will discuss classification of ratios and look at different ratios in detail.

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