Meaning of Ratio Analysis

In the interest of good health, medical authorities (i.e. Doctors) advise every individual to have a periodical examination of his body. In the interest of a sound financial policy, every company should also analyse its accounts periodically. The financial statements are voluminous, cumbersome and detailed to the point where they are almost useless to top management. The analysis and interpretation of the financial statements results in the presentation of information that will aid in decision making by business managers, investors and creditors as well as other groups who are interested in the financial status and operating results of a business. The universally used technique for analysis of financial statements in modern times is the ‘Ratio Analysis‘. It is a principal technique so far known to judge the condition portrayed by the financial statements. The analyst can judge by its use the financial growth, development and the present condition of a business enterprise.

A ratio is a comparison of two variables which have a cause & effect relationship. A Ratio is the numerical or an arithmetical relationship between two figures. It is expressed when one figure is divided by another. The relationship is expressed in terms of a percentage, a rate, or a simple proportion.

Ratio analysis is an important means of expressing the relationship between two numbers. Accounting ratios show inter-relationships which exist among various accounting data. When relationships among various accounting data supplied financial statements are worked out, they are known as accounting ratios. To be useful, a ratio must represent a meaningful relationship, but use of ratios cannot take the place of studying the underlying data. Absolute figures are valuable but they standing alone convey no meaning unless compared with another. A financial ratio helps to express the relationship between two accounting figures in such a way that users can draw conclusions about the performance strengths and weaknesses of a firm. It is comparing the number against previous years, other companies, the industry, or even the economy in general. Ratios look at the relationships between individual values and relate them to how a company has performed in the past, and might perform in the future.

Ratios can provide clues to underlying conditions that may not be apparent from individual financial statement components. Ratios are guides or shortcuts that are useful in evaluating the financial position and operations of a company and in comprising them to previous years or to other companies. The primary purpose of ratios is to point out areas for further investigation. They should be used in connection with a general understanding of the company and its environment.

Given the large quantity of items included in financial statements, a very long list of meaningful ratios can be derives. There is no standard list of ratios or standard computation of the different ratios. Each author, each analyst and each source on financial statement analysis uses a different list. The ratios explained in this chapter are the most commonly used and discussed.

OBJECTIVES & ADVANTAGES OF RATIO ANALYSIS

Ratio analysis is one set of weapons that anyone wishing to understand a company and its accounts should add to their armoury. An analyst tries to draw conclusions or interpretation from the financial statements. The ratios are intended to give an accurate picture of a concern's financial condition and operating results in a condensed form. The success of an organisation depends mainly upon future developments, and the future may never be ‘analysed’ with accuracy. But if you have precise information as to a company's present financial position and its previous earning record, you are better equipped to gauge its future possibilities. The available information can be crystallised in such a way that its implications are classified and attention can be concentrated upon facts which are in the usual balance sheet and profit and loss account completely hidden behind a mass of figures.

An absolute figure does not convey anything unless it is related with the other relevant figures. Magnitude of current liabilities of a company does not tell anything about solvency position of the company. It is only when it is related with current assets figures of the same company an idea about solvency position of the company can be had. Ratios make a humble attempt in this direction. It is an important Technique of financial analysis. It is a way by which financial stability and health of o concern can be judged.

Ratio analysis is the most powerful tool of the financial analysis. The significance of ratio analysis lies in the fact that it presents facts on a comparative basis and enables the drawing of inferences regarding the performance of a firm Ratio analysis is relevant in assessing the performance of a firm in respect of the following aspects:

• Simplicity: Ratios are simple to calculate. They are generally one number divided by another, such figures that can be taken directly from the accounts (or the attached notes). This simplicity also makes ratios easy to understand. Only a few ratios cannot be immediately calculated using such figures. Also, the majority of ratios have a consistent formula, with only a few (e.g. ROCE) being subject to variation in definition by different people,
• Liquidity Position: With the help of ratio analysis conclusions can be drawn regarding the liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its current obligations when they become due. A firm can be said to have the ability to meet its short-term liabilities, if it has sufficient liquid funds to pay the interest on its short maturing debt usually within a year as well as the principal. This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans. 
• Long-term Solvency: Ratio analysis is equally useful for assessing the long—term financial viability of the firm. This aspect of the financial position of a borrower is of concern to the long—term creditors, security analysts and the present and potential owners of a business. The long—term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and operating efficiency.
• Operating Efficiency: Yet another dimension of the usefulness of the ratio analysis, relevant from the viewpoint of management, is that it throws light on the degree of efficiency in the management and utilisation of its assets at Capital employed. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the profit generated by the use of its assets-total as well as its components.
• Over-all Profitability: The management is constantly concerned about the overall profitability of the enterprise. That is, they are concerned about the ability of the firm to meet its short-term as well as long—term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum utilisation of the assets of the firm. This is possible if an integrated view is taken and all the ratios are considered together.
• Clues to further investigations: Ratio analysis does not provide the answers to why the results finished as they did it is simply the messenger. But the message it conveys can indicate (especially to management) which areas should be investigated further. Thus a fall in ROCE from 14 per cent to 10 per cent will prompt calculation of its constituent elements, that is, PBIT as a percentage of sales and sales/ capital employed. If the profitability is on a part with last year, then the individual assets can be shown relative to sales. If eventually it transpires that it is stock and debtors in particular, that have fallen in terms of asset turnover, questions can be asked of (or by) the sales and finance directors: Have credit terms changed? Are collections slower? Have bad debts risen? Is excess stock being kept? and so forth.
• Forecasting: If accounting ratios are calculated for a number of years, then a trend is established. This trend helps in setting up future plans and forecasting. For example, expenses as a percentage of sales can be easily forecasted on the basis of sales and expenses of the past years.
• Locating the weak spots of the business: Accounting ratios are of great assistance in locating the weak spots in the business even though the overall performance may be efficient. Weakness in financial structure due to incorrect policies in the past or present are revealed through accounting ratios. For example, if a firm finds that increase in distribution expenses is more than proportionate to the results expected or achieved, it can take remedial steps to overcome this adverse situation.
• Inter-firm Comparison: A single figure of particular ratio is meaningless unless it is related to some standard or norm. One of the popular techniques is to compare the ratios with the industry average. It should be reasonably expected that the performance of a firm should be in conformity with that of the industry to which it belongs. An inter-firm comparison would demonstrate the relative position vis-a-vis its competitors. If the results are at variance either with the industry average or with those of the competitors, the firm can seek to identify the probable reasons and, in that light, take remedial measures.

Ratios can be successfully employed to analyse and compare the working results of an enterprise for a year with that of another popularly termed as inter-firm comparison. The efficiency of the employment of capital can be determined by comparing amounts of capital, assets, liabilities, sales and costs with those of other concerns in the same industry. Secondly, comparisons of different units or plants owned by the same company can also be taken up which is known as intra firm comparison. An overall comparison can be made on the basis of overall return on capital employed, but for determining the efficiency of a department, the return of other departments can be computed. Inter-firm and intra firm comparisons can be done simultaneously also.

Inter-firm comparison may lead the concern to the determination of the following:

(i)         suitable production policy;

(ii)        suitable method of trading;

(iii)       appropriate sources and uses of funds;

(iv)       appropriate policies as regards management; and

(v)        suitable attitudes towards social obligations.

Trend Analysis

Finally, ratio analysis enables a firm to take the time dimension into account. In other words whether the financial position of a firm is improving or deteriorating over the years. This is made possible by the use of trend analysis. The significance of a trend analysis of ratios lies in the fact that the analyst can know the direction of movement, i.e., whether the movement is favourable or unfavourable. For example, the ratio may be low as compared to the norm/standard but the trend may be upward. Thus, trend analysis is of great significance.

IMPORTANCE OF RATIO ANALYSIS TO VARIOUS PARTIES INTERESTED IN FINANCIAL STATEMENTS:

The importance of Financial Statement analysis is different for the various users of information as management, investors, creditors, labourers, government and others.

1. Importance to Management: Management can get an overall view of the financial operations and condition of the company which enables them to plan and control the company's activities more effectively. They are able to spot weaknesses in the company's operations and can take corrective action. Furthermore, it tends to restrain management as they are under pressure to maintain a favourable financial position. Management can measure the effectiveness of its own policies and decisions, determine the advisability of adopting new policies and procedures, and document to owners the result of their managerial efforts.
2. Importance to Investors: Investors are concerned with the safety of their investments and the ability of the company to earn profit. The investors form their own opinion as to the soundness of investing in a company. One way the investor may form his opinion of the company's earning capacity is by computing earnings per share. The earnings per share figure can then be related to the market value of the share to arrive at a price earning ratio. Whether this ratio is good or bad depends on the amount of risk involved in the investment, the future earning potential of the company and the investment opportunities, elsewhere. Therefore, the trend of sales over the past several years, the position of the company in the industry, and the financial strength of the company are some of the other factors that are considered.Importance to Creditors: Creditors are interested in the company's ability to meet its financial obligations.  Those who have lent money for short period, are more interested in the company's ability to repay the debts as and when it will become due. In other words, they are interested in the liquid position of the company which can be broadly measured by computing current ratio and quick ratio. The long term lenders are not only interested in company's ability to repay but also in the ability of the company to realise profit on the capital employed.
3. Importance of Debenture holders: Creditors can be divided into two parts —- short term creditors and long term creditors. Short term creditors are interested in the liquidity of the concern and from the Funds Flow Statement they are able to determine whether the amounts owing to them will be paid when due, while the long term creditors determine whether their principals (capital amount) and the interest thereon will be paid when due. Hence they analyse the profit-earning capacity, capital structure and future funds flow of the concern.
4. Importance to Government: Government regulates economic activities in various spheres and for this purpose  analysis of financial statements of companies in one industry or of all companies is very helpful. Earning ratios and turnover ratios are used as barometers to indicate the health of an industry as a whole.
5. Importance to Labour: Labour has an interest in the operating results and the financial strength of a company. The remuneration of the worker must be generated from the company revenues thus, the worker's wages, to a great extent, depend upon the success of the firm. Frequently, labour unions use the information presented in the financial statements as a basis for their demand for increase in wages. The past operating performance of the firm, as well as its current financial position, is often studied to measure the ability of the firm to meet new wage commitments.
6. Importance to Others: Besides, the news agencies, trade associations, labour bureaus,  economic and commercial research institutes, stock exchanges, economists and research workers also are interested in the results arrived at analysis of financial statements to know the progress being made and the present position of an industry.

Ratio Analysis is the most commonly used technique in analysis of financial statements. In this method different financial ratios, profitability ratios, average ratios, activity ratios etc. are calculated. This technique is getting wider acceptance in accounting and mathematical world.

USE OF FINANCIAL RATIOS FOR POTENTIAL INVESTORS & MANAGEMENT

Financial ratio is the relationship expressed in mathematical terms between financial figures which are connected with each other in some way. Financial ratios are very important to various users such as investors, creditors, banks, management and executives.

1. Use of Financial Ratios by Potential Investors: Investors are interested in the return, security and growth of their investment in stocks and bonds. Therefore they took for any information which reflect operating efficiency and financial strength. Investors mainly use the following ratios:
   1. Profitability Ratios: Profitability ratios measure the operating efficiency of a firm. Profitability means profit earning ability or capacity of an enterprise. If the earning power of business is satisfactory it means that business is running successfully. Profitability can be measured by expressing profit in relation to investment and sales and investment. Popular profitability ratios are gross profit ratio, net profit ratio and Return on investment ratio.
   2. SoIvency Ratios: Investors while making investment in a company undertake (i) risk of capital loss due to decline in snare price which may be due to lower profitability of the company or on account of general economic depression; (ii) risk of bankruptcy of the company; and (iii) risk of non-payment of dividends causing suffering to investors. These ratios serve as an indicators of the impending risk to the shareholders who would appraise company's performance monthly, quarterly or annually.
   3. Share Performance: One of the concerns of shareholders remains the market performance of the shares to be able to realise the objectives of capital gains. Earnings per share and price earnings ratios and market price per share can be computed for over the years for inter
2. Use of Financial Ratio by Company‘s own Management: The management of the company is concerned with all aspects of its operations and its relation with creditors, investors, and other concerned. The management makes use of all types of ratio i.e. profitability, liquidity, leverage, activity and structural ratios. It makes use of profitability ratios to evaluate its ability to pay reasonable return to investors; liquidity and leverage ratios are used to ascertain companies ability to honour commitments to creditors whereas activity ratios are used to minimise cost order to determine whether the organisation will meet ultimate objectives of providing shareholders with a maximum return. Ratios are useful tools in the hands of management to compare the performance of the organisation in various areas over a period of time and also against the established standard in the industry.

FACTORS AFFECTING THE EFFICACY OF RATIOS

Ratio is one of the important tools of financial analysis to various end users such as management executives, investors, creditors and banks to assess the performance of company in terms of liquidity position, long term solvency, operating efficiency and profitability.

The efficacy of a company is affected by several factors. Some of these factors are discussed as under:-

1. Type of Business: Type of Business under consideration affects the ratios and conclusions drawn from them. For example, a high ratio of debt to net worth can be expected of a public utility company operating with large fixed assets with social benefit considerations 61 of a corporate entity applying trading on equity. Inventory turnover ratios vary considerably among industries. For example, grocery store chains may have a turnover of 10 to 12 times. In contrast, jewelry stores may have an average turnover of 1 to 1.6 times.
2. Seasonal Character: Seasonal character of the business affects ratio for a particular type of industry or business enterprise. For example, inventory to sales ratio for a woolen clothes merchant during the winter season has a different meaning and is supposed to be much higher than during other periods of the same year.
3. Quality of Assets: Quality of assets also affects the ratio analysis and gives different interpretation to business enterprises. Current assets to current liabilities ratio mostly 2:1 is considered more satisfactory for a liquid position of the company but if the same proportion of assets acid test ratio is calculated, it may give a different result and may depict the unsatisfactory position of availability of liquid finds with the company to meet its most urgent and pressing obligations.
4. Adequacy of Data: Adequacy of data is another consideration for comparison of particular factors with each other. For example, average collection period for bill receivables for a particular month may differ to those with other months or the average of the year. Another consideration would be whether bill receivables have been properly valued for a particular period as over valuation may render the ratio incomparable.
5. Modification of Ratios: Modification of ratios reflects only the past performance and must be modified by future trends of business.
6. Change in Accounting Policies & Accounting Estimates: With the change in accounting policies & accounting estimates their may be vast changes in financial position of a Company in comparison to the previous years which makes ratio‘s of these years incomparable.
7. Interpretation of Ratios: Interpretation of ratios should not be relied upon in isolation and should be considered with accounting documents for interpretations.
8. Accuracy: Having the wrong information can be far worse than having no information at all. It does not mean that ratios have to be calculated to four decimal places, but anyone using the figures should be able to rely on the fact that the numbers given tell a true story.
9. Relevance: This means using the appropriate ratios for objective in hand. A potential supplier does not need to know, and will not be interested in, the dividend per share, dividend cover, PE ratio, and so on. There is no point in swamping the interested party with a great deal of unwanted information. That would be a waste of time and effort on both sides.
10. Timelines: The receiver of the information wants it in order to be able to make a decision. The sooner the information is received, the swifter that decision can be reached. Indeed, if the information is too slow in arriving, the time to make the decision may have passed. This is one area where ratio analysis is open to criticism, since the numbers are based on accounts relating to a period which finished months ago.
11. Non-financial Data: Ratios based on financial data of firms should be considered with non-financial data to supplement the financial ratios and give better interpretation.

Efficacy of ratios in a company can be increased by adopting following principles:

1. Using a uniform accounting system and accounting procedures including a uniform classification of accounts and similar depreciation methods.
2. Following a uniform accounting period preferably on a natural business year basis.
3. Following similar asset valuation and amortization policies.
4. Represent a homogenous group.
5. Adopt and maintain somewhat uniform managerial policies.

SOURCES OF INFORMATION FOR DECISION MAKING:

Relying upon Ratios:

The accounts have been analysed, the ratios calculated and interpreted. A decision now has to be made, and a Solution suggests itself. But can you rely sufficiently on the ratios to be sure that your solution is correct? The answer is no. Ratio analysis is useful, but not omniscient. Ratios form part and a substantial part of research into a company, but not all of the research that should take place.

Where else to look;

There are other sources of information, some of it not financial, as follows:

1. Financial Media: There are news stories, analysis of performance, forecasts, tips & hints galore in the financial press.
2. Local Media: Stories about planned expansion or closure of sites may influence a decision about the company whether the stories are accurate or not.
3. Employees: They will always have their own opinions.
4. Company newspaper/journals: This journal will give the official view.
5. Customers and Suppliers: They can report on their trading experiences.
6. Trade Exhibitions: These events can provide general information about the company (and its competitors will probably by there too).
7. Stockbrokers: They will always have views on the merits or otherwise of individual companies.

The better the quality of the research carried out and information discovered, the more likely it is that a good decision will be made

LIMITATIONS OF RATIO ANALYSIS:

Ratio analysis is very important in revealing the financial position and soundness of the business. But, in spite of its advantages, it has some limitations which restrict its use. These limitations should be kept in mind while making use of ratio analysis for interpreting the financial statements. The following are the main limitations of accounting ratios:

Out of date: A limited company has a maximum of nine months after the end of its financial year to file its accounts with the ROC, thus making their results publicity available. Many companies, and particularly private companies, will delay submission until the last few days, even if the accounts were audited and approved within weeks of the year end. Public Companies accounts take longer to prepare and audit because of the sheer size of some of them. For whatever reason, however, several months will generally elapse between the end of the company's financial year and the availability of the accounts. That does not mean that the numbers stated are of no use the next year's performance can reasonably be expected to be close to last year's other circumstances permitting. Nevertheless, external influences do change, especially for companies operating globally; customers go into liquidation or suppliers fail, raw material prices change dramatically, foreign currencies move up and down, and so on. There is no guarantee that the future will be the some or better than the past as portrayed in the accounts. Therefore, one must accept the accounts for what they are a report on last year's activities and look around for more current information to add to that derived from the accounts,

It communicates only a relative picture: Every organisation in one way or the other is unique and comparison may not be valid. For example, company A may be working in manufacture of heavy electrical goods as a Government Company in India. It is subject to numerous audits and management may not enjoy the full freedom of decision-making due to accountability to Parliament. Its comparison with Siemens, a German Company, may not be 100% valid, because Siemens is an international giant with a different type of management. Ratios do not depict the circumstances, in which the organisations are working.

Ratios are only a tool: Ratios are simply tools of analysing and interpretating the financial position of a concern, still a great deal of investigation is needed to be done. Hence more importance must be given to those items which require investigation. Their ultimate use depends on the craftsmen who use it. The background and understanding level of the interpreter is very important in making inferences. For this reason, it is said that they are not an end in themselves. Rather they are means to an end. They only pass guiding signals,

False results if based on incorrect accounting data: Accounting ratios can be correct only if the data (on which they are based) are correct. Sometimes, the information given in the financial statements is affected by window dressing, i.e. showing position better than what actually is. For example, if inventory values are inflated or deprecation is not charged on fixed assets, not only will one have an optimistic view of profitability of the concern but also of its financial position. So the analyst must always be on the look-out signs of window dressing, if any.

Affected by Window Dressing: Sometimes, attempts are made to window dress the accounts, i.e., efforts are made to manipulate the accounts in a manner that the picture being presented is better than what actually it is. Hence an analyst must pay attention towards window dressing. For example, a company may be having a lot of capital locked in inventory. Company might have allowed unwarranted price reduction to dispose of the inventory. This particular step may have far reaching consequences, but this fact will not be revealed by ratio analysis. Another example is disposal of investments at the end of the year to pay off creditors.

Inflation distorts financial ratio analysis: No attention is paid in financial statements on changes in price level. Hence the ratios based on these financial statements are misleading. Changes in the reported performance of a company may be entirely due to inflation and not due to management. For this reason company may have to use replacement cost method or other suitable device used to differentiate the impact of inflation.

No idea of probable happenings in future: Ratios are an attempt to make an analysis of the past financial statements; so they are historical documents. Now-a-days keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future.

Variation in Accounting Methods: The two firm's results are comparable with the help of accounting ratios only if they follow the same accounting methods and policies. Comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock. Similarly, if the two firms are following two different standards and methods, an analysis by reference to the ratios would be misleading. Moreover, utilisation of inbuilt facilities, availability of facilities and scale of operation would affect financial statements of different firms. Comparison of financial statements of such firms by means of ratios is bound to be misleading.

Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. So, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis.

No Common Standards: It is very difficult to lay down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different. For example, a business with current ratio of more than 2: 1 might not be in a position to pay current liabilities in time because of an unfavourable distribution of current assets in relation to liquidity. On the other hand, another business with a current ratio of even less than 2:1 might not be experiencing any difficulty in making the payment of current liabilities in time because of its favourable distribution of current assets in relation to liquidity.

Ignores Qualification Factors: During ratio analysis no attention is paid towards the qualitative analysis because the ratios are calculated from the figures which can be expressed in monetary terms. Accounting ratios are tools of quantitative analysis only. But sometimes qualification factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted. For example, though credit may be granted to a customer on the basis of information regarding his financial position, yet the grant of credit ultimately depends on debtor's character, honesty, past record and his managerial ability.

Effect of Personal Ability and Bias of the Analyst: Accounting ratios are affected by personal ability and of the analyst. Hence they must be used with due care and skill. Ratios are based on accounting figures given in the financial statements. However, accounting figures are themselves subject to deficiencies, approximations, diversity practice of even manipulation to some extent. Therefore, ratios are not very helpful in drawing reliable conclusions.

CLASSIFICATION OF RATIOS

The ratios can be classified on the basis of requirements of various uses, e.g., creditors, bankers, investors, management, government etc.

The ratios may be classified as follows:

1. Profitability Ratios: These ratios measure how efficiently a company management has generated profit on sales and investment, e.g., operating ratio, gross profit ratio, Net Profit ratio, Return on Capital Employed, Net Profit to Net Worth ratio, etc.
2. Activity Ratios: These ratios show how efficiently a company is using its assets to generate sales, e.g., Fixer Assets turnover ratio, Working Capital turnover ratio, Inventory turnover ratio, debtor turnover ratio etc.
3. coverage Ratios: The soundness of a firm, from the view-point of long-term creditors & Preference shares, lies in its ability to service their claims. This ability is indicated by the coverage ratios.
4. Market Test Ratios: The market test ratios are especially important for investors while analysing information about a company. This analysis helps the investors to decide about a company as an investment opportunity at a point of time. These ratios are also known as stock market ratios, investment ratios or market test ratios.
5. Liquidity Ratios: These ratios show a company's ability to meet its short-term financial obligations like current ratio and quick ratio.
6. Long Term solvency Ratios: These ratios measure the extent to which a company has been financed by long-term debt obligations like debt-equity ratio. It measures the ability of an enterprise to survive over a long period of time.

The ratio analysis necessarily proceeds on the following assumptions:

1. That the financial statements show a reasonable picture of the condition of a company.
2. That the financial statements from which the ratios are calculated present a typical and up-to-date picture.
3. That the figures in the financial statements of a company are comparative with the data of other company’s financial statements.