Ratio Analysis: Steps and Nature | Accounting

In this article we will discuss about:- 1. Introduction to Ratio Analysis 2. Steps in Ratio Analysis 3. Nature.

Introduction to Ratio Analysis:

The company’s financial information is contained in Balance Sheet and Profit and Loss Account. The figures contained in these statements are absolute and sometimes unconnected with one another. An absolute figure does not convey much meaning. However, it is only in the light of other information that the significance of a figure is realised. For instance, Mr. X weighs 50Kg. Is he fat? We cannot give answer unless we know his age and height.

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Similarly a company’s profitability cannot be known unless together with the amount of profit, the capital employed is also seen. The relationship of these two figures expressed mathematically is called a RATIO. The ratio refers to the numerical or quantitative relationship between two variables or items. A ratio is calculated by dividing one item of the relationship with the other.

The ratio analysis is one of the most useful and common method of analysing financial statements. As compared to other tools of financial analysis, the ratio analysis provides very useful conclusions about various aspects of the working of an enterprise. The need for ratio arises due to the fact that absolute figures are often misleading.

Absolute figures are certainly valuable but their value increases manifold if they are studied with another through ratio analysis. Ratios enable the mass of data to be summarised and simplified. Ratio analysis is an instrument for diagnosis of the financial health of an enterprise. Ratios, in fact, are full of meaning and communicate the relative importance of the various items ‘appearing in the Balance Sheet and Profit and Loss Account.

Steps in Ratio Analysis:

The first task of the financial analyst is to select the information relevant to the decision under consideration from the statements and calculates appropriate ratios.

The second step is to compare the calculated ratios with the ratios of the same firm relating to past or with the industry ratios. This step facilitates in assessing success or failure of the firm.

The third step involves interpretation, drawing of inferences and report-writing. Conclusions are drawn after comparison in the shape of report or recommended course of action.

Nature of Ratio Analysis:

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Ratio analysis is a powerful tool of financial analysis. A ratio is defined as “the indicated quotient of two mathematical expressions” and as “the relationship between two or more things”. In financial analysis, a ratio is used as an index or yardstick for evaluating the financial position and performance of a firm.

Analysis of financial statements is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of the firm’s position and performance. Financial analysis is used as a device to analyse and interpret the financial health of enterprise.

The absolute accounting figures reported in the financial statements do not provide a meaningful understanding of the performance and financial performance of a firm. An accounting figure conveys meaning when t is related to some other relevant information.

Just like a doctor examines his patient by recording his body temperature, blood pressure etc., before making his conclusion regarding the illness and before giving his treatment, a financial analyst analyses the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise. A ratio is known as a symptom like blood pressure, the pulse rate or the temperature of an individual.

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It is with the help of ratios that the financial statements can be analysed more clearly and decisions are drawn from such analysis. The point to note is that a ratio indicates a quantitative relationship, which can be, in turn, used to make a qualitative judgement. Such is the nature of all financial ratios.

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