In this article we will discuss about:- 1. Introduction to Ratio Analysis 2. Modes of Expression of Ratios 3. Steps in Ratio Analysis 4. Classification 5. Rearrangement of Financial Statements 6. Advantages 7. Limitations.
Ratio Analysis: Mode, Types, Examples, Steps, Financial Statements, Advantages and Limitations
Introduction to Ratio Analysis:
Analysis and interpretation of financial statements with the help of ‘ratios’ is ‘termed as ‘ratio analysis’. Ratio analysis involves the process of computing, determining and presenting the relationship of items or groups of items of financial statements.
Ratio analysis was pioneered by Alexander Wall who presented a system of ratio analysis in the year 1909. Alexander’s contention was that interpretation of financial statements can be made easier by establishing quantitative relationships between various items of financial statements.
A ratio is a mathematical relationship between two items expressed in a quantitative form.
Ratios can be defined as “Relationships expressed in quantitative terms, between figures which have caused and effect relationships or which are connected with each other in some manner or the other”.
An accounting ratio can be defined as quantitative relationship between two or more items of the financial statements connected with each other. Arithmetically ratio is a comparison of the numerator with the denominator.
The essence of ratio is putting together of two figures to study their relationship. The study is in the form of analysis, interpretation and expression of all the ramifications of the relationship.
Ratio analysis is an age old technique of financial analysis. The information provided by the financial statements in absolute form is historical and static, conveying very little meaning to the users. Accounting ratios are designed to show how one number is related to another and the meaning of such relationships. A ratio is worked out by dividing one number by another number. Accounting ratios measure and indicate efficiency of an enterprise in all aspects.
Modes of Expression of Ratios:
Ratios may be expressed in any one or more of the following ways:
(a) In Proportion:
In this type of expression the amounts of two items are expressed in a common denominator. An example of this form of expression is the relationship between current assets and current liabilities as “2”: “1”.
(b) In Rate or Times or Coefficient:
In this type of expression, a quotient obtained by dividing one item by another is taken as Unit of expression. Example of this form of expression is cost of sales divided by average stock (say 8), thus 8 times is the ratio between cost of sales and stock.
(c) In Percentage:
In this type of expression, a quotient obtained by dividing one item by another is multiplied by one hundred to show the relationship in terms of percentage. For example- the relationship between net profit and sales may be expressed as say 25%.
Ratios can be expressed as-
(b) Rate or times
Each way of expression may have a distinct advantage over the others. The analyst will choose a particular mode or a combination suitable for a specific purpose.
Steps in Ratio Analysis:
(1) Selection of Relevant Information:
The first step in ratio analysis is to select relevant information from financial statements and calculate appropriate ratios required for decision under consideration.
(2) Comparison of Calculated Ratios:
In order to assess the relative meaning, the ratios calculated are compared with the past ratios and industry ratios.
(3) Interpretation and Reporting:
The third step in ratio analysis is to interpret the significance of various ratios, draw inferences and to write a report. The report may recommend specific action in the matter of the decision situation or may present alternatives with comparative merits or it may just state the facts and interpretation.
Classification of Ratios:
Ratios are classified in several ways. Different approaches are used for classifying ratios. There is no uniformity in classification by different experts. They have adopted different stand points for classifying ratios into various groups.
Some of the classifications are discussed below:
(a) Classification of Ratios by Statements:
Under this method, ratios are classified on the basis of statements from which the information is obtained for calculating the ratios. The only statements which provide information are i.e., balance sheet and profit and loss account.
The following are included in this classification:
(b) Classification by Users:
Under this classification ratios are grouped on the basis of the parties who are interested in making use of the ratios.
The following is the classification on this basis:
(c) Classification by Relative Importance:
This classification is being adopted by the British Institute of Management, where there are three types of ratios:
1. Primary Ratios:
They are also known as explanatory ratios which include:
(a) Return on capital employed
(b) Assets turnover, and
(c) Profit ratios.
2. Secondary Performance Ratios:
(a) Working capital turnover.
(b) Stock to current assets.
(c) Current assets to fixed assets.
(d) Stocks to fixed assets, and
(e) Fixed assets to total assets.
3. Secondary Credit Ratios:
(a) Creditors turnover
(b) Debtors turnover
(c) Liquid ratio
(d) Current ratio, and
(e) Average collection period.
4. Growth Ratios:
(a) Growth rate in sales.
(b) Growth rate in net assets.
The above list is not exhaustive; other relevant ratios can be added to each category.
(d) Classification of Ratios by Purpose/Function:
The basis for classification under this head is the purpose for which the ratios are calculated. Generally ratios are used for the purpose of assessing profitability, activity or operating efficiency and financial position of a concern. Based on the purpose the ratios are classified as profitability ratios, turnover ratios and financial ratios or solvency ratios.
For the purpose of analysing the balance sheet and the profit and loss account to compute ratios, it is useful to rearrange and redraft them. In the process of rearrangement, several useful items of information emerge which facilitate the calculation of different ratios.
The following are the rearranged trading and profit and loss account and balance sheet with imaginary figures:
The following is the Rearranged Balance Sheet for Ratio Analysis, with imaginary figures:
The Rearranged Balance Sheet is also called ‘Statement of Funds’ or ‘Position Statement’.
Advantages of Ratio Analysis:
The information shown in financial statements does not signify anything individually because the facts shown are inter-related. Hence it is necessary to establish relationships between various items to reveal significant details and throw light on all notable financial and operational aspects. Ratio analysis caters to the needs of various parties interested in financial statements. The basic objective of ratio analysis is to help management in interpretation of financial statements to enable it to perform the managerial functions efficiently.
The following are the advantages of ratio analysis:
Ratios reveal the trends in costs, sales, profits and other inter-related facts, which will be helpful in forecasting future events.
(2) Managerial Control:
Ratios can be used as ‘instrument of control’ regarding sales, costs and profit.
(3) Facilitates Communication:
Ratios facilitate the communication function of management as ratios convey the information relating to the present and future; quickly, forcefully and clearly.
(4) Measuring Efficiency:
Ratios help to know operational efficiency by comparison of present ratios with those of the past working and also with those of other firms in the industry.
(5) Facilitating Investment Decisions:
Ratios are helpful in computing return on investment. This helps the management in exercising effective decisions regarding profitable avenues of investment.
(6) Useful in Measuring Financial Solvency:
The financial statements disclose the assets and liabilities in a format. But they do not convey relationship of various assets and liabilities with each other, whereas ratios indicate the liquidity position of the company and the proportion of borrowed funds to total resources which reveal the short term and long term solvency position of a firm.
(7) Inter Firm Comparisons:
The technique of inter-firm comparisons can be carried out successfully only with the help of ratio analysis. Otherwise no firm may come forward to disclose full information. Inter-firm comparisons help the management to compare its performance with an external ‘benchmark’ or standard.
Limitations of Ratio Analysis:
Ratios are precious tools in the hands of management but the utility lies in the proper utilisation of ratios. Mishandling or misuse of ratios and using them without proper context may lead the management to a wrong direction. The financial analyst should be well versed in computing ratios and proper utilization of ratios. Like all techniques of control, ratio analysis also suffers from several ‘ifs and buts’ and for proper computation and utilization of ratios the analyst should be aware of the limitations of ratio analysis.
The following are the limiting factors which minimise or reduce the value of ratio analysis:
(1) Practical Knowledge:
The analyst should have thorough knowledge and experience about the firm and industry.
(2) Ratios are Means:
Ratios are not an end in themselves but they are means to achieve a particular purpose or end.
Ratios are inter-related and therefore a single ratio cannot convey any meaning. It has to be interpreted with reference to other related ratios to draw meaningful conclusions.
(4) Non Availability of Standards or Norms:
Ratios will be meaningful if they can be compared with standards or norms. Except for a few financial ratios, other ratios lack standards which are universally recognised.
(5) Accuracy of Financial Information:
The accuracy of a ratio depends on the accuracy of information derived from financial statements. If the statements are-inaccurate, same will be the result with ratios.
(6) Consistency in Preparation of Financial Statements:
Inter-firm comparisons with the help of ratio analysis will be useful only if the firms use uniform accounting procedures consistently. Otherwise the comparison may be useless.
(7) Detachment from Financial Statements:
Ratios are not substitutes to financial statements. They can be meaningful only if they are read along with information with which they are prepared. If the information is detached, ratios themselves cannot convey much useful message.
(8) Time Lag:
Ratio analysis will be fruitful only if the conclusions are conveyed quickly to the management. If there is a delay, the utility of the data is diminished and the purpose itself may be defeated.
(9) Change in Price Level:
Ratio analysis becomes redundant during periods of heavy price fluctuations.