Financial Ratio Analysis: Definition, Importance and Limitations

After reading this article you will learn about Financial Ratio Analysis:- 1. Introduction to Financial Ratio Analysis 2. Definition of Financial Ratio Analysis 3. Importance 4. Limitations 5. Interested Parties.

Contents:

  1. Introduction to Financial Ratio Analysis
  2. Definition of Financial Ratio Analysis
  3. Importance of Financial Ratio Analysis
  4. Limitations of Financial Ratio Analysis
  5. Interested Parties of Financial Ratio Analysis



1. Introduction to
Financial Ratio Analysis:

The Financial Statements in their conventional forms have two parts; viz.:

(i) The Revenue Statement or Profit and Loss Account;

(ii) The Balance Sheet.

The purpose of Revenue Statement and the Balance Sheet are, first, to show the result of the operation for the period under review and secondly, the assets and liabilities of the enterprise as at the relevant date. But it is difficult to deduce any inference from the mass of figures included in the conventional annual Financial Statement indicated above.

For dissimulating better information to the users of Financial Statements, now a days, these are often supplemented by statements, such as, Funds Flow Statement, Cash Flow Statement and various other graphical repre­sentations.

This, no doubt, is an improvement. Nevertheless, in order to gauge accurately, the financial health of an enterprise, it becomes necessary to undertake further analysis and regrouping of the figures contained in the conventional Financial Statements, viz, the Revenue Statements and the Balance Sheet.

Analysis may be in two directions:

(i) Analysis of Financial Statements over a number of years – in such a case trend is important;

(ii) Analysis of position of an enterprise at a particular date – here, the detailed position as disclosed by one set of Financial Statements is sought to be examined.

Needless to mention, accounting ratios can be of significant help in this task of Financial Statements analysis. This has also been corroborated by Parkinson.



2. Definition of Financial Ratio Analysis:

Ratio is a fraction whose numerator is the antecedent and denominator the consequent. It is simply an expression of one number in terms of another. It may also be defined as the relationship or proportion that one amount bears to another, the first number being the numerator and the later denominator.

Another explanation of the ratio may be the relation of the later to the earlier amount and computed by dividing the amount for the later date or period by the amount of the earlier date or period.

Ratio may be expressed in different forms, such as:

(i) Pure ratio: e.g., a ratio between Debt and Equity, say, 1:1;

(ii) Ratio which refers to ratios ascertained with reference to time period, e.g., Working Capital Turnover Ratio 3 times a year;

(iii) Percentage: e.g.. Net Profit is 20% on sales.



3. Importance of Ratio Analysis:

The inter-relationship that exists among the different items appeared in the Financial Statement, are revealed by accounting ratios. Thus, they are equally useful to the internal management, prospective inventors, creditors and outsiders etc.

Be­sides, ratios are the best tool for measuring liquidity, solvency, profitability and management efficiency of a firm. That is why, the role of accounting ratios are very much significant to increase the efficiency of the management, to reduce the expen­diture and to increase the rate of profit etc.

The importance of ratio analysis is discussed hereunder:

(a) It helps to analyse the probable casual relation among different items after analysing and scrutinizing the past result.

(b) The ratios that are derived after analysing and scrutinizing the past result, helps the management to prepare budgets, to formulate policy, and to prepare the future plan of action and thus helps as a guide to harmonize among different items for preparing budgets.

(c) It helps to take time dimension into an account by trend analysis, i.e., whether the firm is improving or deteriorating over a number of years, that can easily be studied by the trend analysis. So, comparison can be made without difficulty by the analyst and to see whether the said ratio is high or low in comparison with the Standard or Normal ratio.

(d) It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called surveyor of efficiency.

(e) It helps to make an inter-firm comparison either between the different departments of a firm or between two firms employed in the identical types of business or between the same firm of two different dates. Thus, the comparative analysis can be possible between the industry average ratio and the ratio of each business unit.

(f) Short-term liquidity position, i.e., whether the firm is able to maintain its short-term maturing obligations or not, that can be easily known by applying liquidity ratios. At the same time, long-term solvency position can also be measured by the application of leverage or profitability ratios. Thus, the ratio helps an invaluable aid to the users of Financial Statements.

Superiority of Ratios over Absolute Figures:

It is a well-known fact that one cannot arrive at a definite conclusion about the financial health of an enterprise simply by studying and scanning of the absolute figures contained in the conventional form of Financial Statements viz. Revenue Statement and the Balance Sheet, The same is possible only when the absolute figures are analysed further in terms of ratios that one can assess properly.

That is why, ratio analysis has taken an important role in the field of Managerial Accounting. To illustrate why and how the ratios can be more meaningful and significant than the absolute figures (contained in the Financial Statement), the following example will make it clear.

Statement 1:

It will be observed from the above statement that although in both the years, the absolute difference between current assets and current liabilities, i.e. working capital (Net) of X. Co. Ltd. is equal, Rs. 50,000, its current ratio i.e., relation between current assets and current liabilities, is different. Current ratio had been 133: 1 in the year 1984 as against 2: 1 in the year 1983.

Thus despite an identical amount of working capital (Net) in both the years, its short-term financial position, so far as it can be read from the current ratio, had been much better in 1983 than in 1984.

This is because, in the year 1983, two rupees of current assets were available against each rupee of current liability, whereas in the year 1984, only one rupee and thirty three paise of current assets were available against one rupee of current liability.

Thus, it becomes obvious that ratio communicates better information about the financial strength of a firm than it can be conveyed by the absolute figures. The aforesaid example also indicates how ratio analysis can serve as a better tool for measurement of the financial health of an enterprise than is possible by the analysis of absolute figures.



4. Limitations of Financial Ratio
Analysis:

The ratio analysis is not even free from snags.

There are certain limitations which are discussed below:

(a) Comparison between two variables prove worth provided their basis of val­uation is identical. But in reality, it is not possible, such as, methods of valuation of stock-in-trade or charging different methods of depreciation on fixed assets etc. That is, if different methods are followed by different firms for their valuation, in that case, comparison will practically be of no use.

(b) Ratio depends on figures appeared on the Financial Statements. But in most cases, the figures are window dressed. As a result, the correct picture cannot be drawn up by the ratio analysis, although certain structural defects can be detected.

(c) Ratio analysis becomes more meaningful and significant if trend analysis (i.e. the analysis over a number of years) is possible instead of analysing the result of a particular year. But is practice, it is not always possible

(d) Ratios are computed on the basis of past result. It does not help properly to predict future, to prepare budgets and estimates since the business policies are constantly changing.

(e) It is very difficult to ascertain the Normal or Standard ratio in order to make proper comparison. Because, it differs from firm to firm, industry to industry and even between different seasons of the same industry. Besides, it may be happened that in one firm, a current ratio of 1 : 1 is found to be quite satisfactory, whereas in another firm 25: 1 may even be unsatisfactory



5. Interested Parties in Financial Ratio Analysis:

People in various walks of life are at present interested in ratio analysis though in different ways and fashion and each, however, from his own angle. Shareholders are interested to know the rates of return on capital employed the long-term solvency of the firm and also on the rates of dividend among others.

The same they can ascertain with the help of Gross Profit Ratio, Net Profit Ratio, Dividend Per Share, Earning Per Share etc.

Creditors’ interest lie in the ultimate solvency and liquidity position of a firm and in the interest cover. These they can read from the analysis of Current ratio. Liquid ratio, Debt-Equity ratio etc. Government is interested in profit earning capacity and on the effective utilisation of firm’s capacity.

Therefore, Gross Profit Ratio, Ratio of Net profit to Capital Employed, Net Profit to Sales, production capacity utilisation etc. are of much relevance to a Government.

Management is interested about profitability and efficiency in Financial Manage­ment. Therefore, to it, the Ratio between Turnover to Capital Employed, Turnover to Fixed Assets, Turnover to Current Assets, Stock-Turnover Ratio, Debtors’ Turnover Ratio, Creditors’ Turnover Ratio etc. are of significance to the management.

The ratios of social investigators will depend on area of his investigation. If the investigators’ interest lie in the analysis of turned of financing obtaining in a corporate enterprise over a period of time, the Ratio between Debt and Equity, Long-term and Short-term debts and total assets among others, will be relevant ratios for the investigation.

On the other hand, if their interest lays in the analysis of Profit trend the ratio that will interest to them are: Gross Profit on Sales, Net Profit on Sales, Net Profit to Capital Employed etc.

Use and Applications of different ratios :



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