Ratio analysis involves the construction of ratios using specific elements from the financial statements in ways that help identify the strengths and weaknesses of the firm. Ratios help measure the relative performance of different financial measures that characterize the firm’s financial health. We could just look at the dollar value of each financial measure and draw conclusions about performance; however, using ratios often provides a standardized measure which is easier to interpret.
CLASSIFICATION OF RATIOS
1. Liquidity Ratios: These ratios measure the ability of a company to meet its current obligations, and indicate the short-term financial stability of the company. The parties interested in the liquid ratio would be employees, bankers and short-term creditors.
2. Profitability Ratios: These measure the overall effectiveness in terms of returns generated, with profits being related to sales and adequacy of such profits as to sales or investment. The profitability ratios are important to internal management, to bankers, to investors and to the owners.
3. Leverage Ratios: These measure the extent to which the company has been financed through borrowing (debt financing whether short or long-term). Those interested would be bankers, owners and investors.
4. Activity Ratios: These measure the extent to which the company has been financed through borrowing (debt financing whether short or long-term). Those interested would be bankers, owners and investors.
5. Solvency Ratios: These ratios would give a picture of the company so that an early forewarning is available for remedial action in time.
6. Financial Ratios: These enable quick spotting of over or under-capitalization of a business, so that a proper, balance is achieved between owner’s funds, borrowed funds and shareholder’s funds.
MEANING OF RATIO ANALYSIS
Ratio analysis is an important technique of making financial analysis. Under this method, financial statements are analysed by calculating various financial ratios by taking the relevant data contained in the financial statements (income statement and balance sheet).
Comparing the ratios calculated with the past ratios of the same firm or with the ratios of other firms or with the ratios of the industry to which the firm belongs and interpreting the ratios calculated.
ADVANTAGES/ USES AND LIMITATIONS OF RATIO ANALYSIS
Ratio analysis is a useful tool for users of financial statements. It has following advantages:
1) It simplifies the financial statements.
2) It helps in comparing companies of different size with each other.
3) It helps in trend analysis which involves comparing a single company over a period.
4) It highlights important information in a simpler form quickly. A user can judge a company’s financial position and profitability by just looking at few ratios instead of reading the whole financial statements
Despite advantages, ratio analysis has some disadvantages. Some key demerits of financial ratio analysis are:
1) Different companies operate in different industries, each having different environmental conditions such as regulation, market structure, etc. Such factors are so significant that a comparison of two companies from different industries might be misleading.
2) Financial accounting information is affected by estimates and assumptions. Accounting standards allow different accounting policies, which impairs comparability and hence ratio analysis is less useful in such situations.
3) Ratio analysis explains relationships between past information while users are more concerned about current and future information.
4) There may be window dressing of financial statements by the management of the company which may lead to misleading information. Many times comparison of ratios over time is meaningless because of inflation.
IMPORTANCE/ ADVANTAGES OF RATIO ANALYSIS
Ratio analysis is an important tool for analysing a company’s financial statements (Income statement and Balance sheet). The following are the important advantages of the accounting ratios:
1. Analysing the Financial Statements:
Ratio analysis is an important technique of financial statement analysis. Accounting ratios are useful for understanding the financial position of the company. Different users such as investors, management, bankers and creditors use the ratio to analyse the financial situation of the company for their decision-making purpose.
2. Judging the efficiency of the company:
Accounting ratios are important for judging the company’s efficiency in terms of its operations and management. They help judge how well the company has been able to utilize its assets and earn profits.
3. Locating the weakness of the company:
Accounting ratios can also be used in locating weakness of the company’s operations even though its overall performance may be quite good. Management can then pay attention to the weakness and take remedial measures to overcome them.
4. Formulating Plans:
Although accounting ratios are used to analyse the company’s past financial performance, they can also be used to establish future trends of its financial performance. As a result, they help formulate the company’s future plans.
5. Comparing the performance of the company:
It is essential for a company to know how well it is performing over years or as compared to the other firms of the similar nature. Besides, it is also important to know how well its different divisions are performing among themselves in different years. Ratio analysis facilitates such comparison.
LIMITATIONS OF FINANCIAL RATIOS
There are some important limitations of financial ratios that analysts should be conscious of: Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry average ratios.
Inflation may have badly distorted a company’s balance sheet. In this case, profits will also be affected. Thus, a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgement.
Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer’s inventory may be high in the summer in preparation for back-to-school season. As a result, the company’s accounts payable will be high and its ROA low.
Different accounting practices distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.)
It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.
LIMITATIONS OF RATIO ANALYSIS
Ratio analysis, without a doubt, is amongst the most powerful tools of financial analysis. Any investor, who wants to be more efficient at their job, must devote more time towards understanding ratios and ratio analysis. However, this does not mean that it is free of limitations. Like all techniques, financial ratios have their limitations too. Understanding the limitations will help investors understand the possible shortcomings with ratios and avoid them. Here are the shortcomings:
1) Misleading Financial Statements
The first ad foremost threat to ratio analysis is deliberate misleading statements issued by the management. The management of most companies is aware that investors look at certain numbers like sales, earnings, cash flow etc. very seriously. Other numbers on the financial statements do not get such attention. They therefore manipulate the numbers within the legal framework to make important metrics looks good. This is a common practice among publicly listed companies and is called “Window Dressing”. Investors need to be aware of such window dressing and must be careful in calculating and interpreting ratios based on these numbers.
Comparison is the crux of ratio analysis. Once ratios have been calculated, they need to be compared with other companies or over time. However, many times companies have accounting policies that do not match with each other. This makes it impossible to have any meaningful ratio analysis. Regulators all over the world are striving to make financial statements standardized. However, in many cases, companies can still choose accounting policies which will make their statements incomparable.
3) Qualitative Factors
Comparison over time is another important technique used in ratio analysis. It is called horizontal analysis. However, many times comparison over time is meaningless because of inflation. Two companies may be using the same machine with the same efficiency but one will have a better ratio because it bought the machine earlier at a low price. Also, since the machine was purchased earlier, it may be closer to impairment. But the ratio does not reflect this.
4) Subjective Interpretation
Financial ratios are established “thumb of rules” about the way a business should operate. However, some of these rules of thumb have become obsolete. Therefore, when companies come with a new kind of business model, ratios show that the company is not a good investment. In reality the company is just “unconventional”. Many may even call these companies innovative. Ratio analysis of such companies does not provide meaningful information. Investors must look further to make their decisions