INTRODUCTION: Ratio analysis is one of the methods of analysing financial
statements. It is an attempt to present the information of the financial statements in simplified, systematised and summarised form. It measures the profitability, efficiency and financial soundness of the business. It is based on line items in financial statements like the balance sheet, income statement and cash flow statement; the ratios of one item or a combination of items - to another item or combination are then calculated. Ratio analysis is used to evaluate various aspects of a companys operating and financial performance such as its efficiency, liquidity, profitability and solvency. The trend of these ratios over time is studied to check whether they are improving or deteriorating. Ratios are also compared across different companies in the same sector to see how they stack up, and to get an idea of comparative valuations. Ratio analysis is a cornerstone of fundamental analysis. For a specific ratio, most companies have values that fall within a certain range. A company whose ratio falls outside the range may be regarded as grossly undervalued or overvalued, depending on the ratio. For example, if the average P/E ratio of all companies in the S&P 500 index is 20, with the majority of companies having a P/E between 15 and 25, a stock with a single-digit P/E would be considered undervalued, while one with a P/E of 50 would be considered overvalued. Of course, this ratio would typically only be considered as a starting point, with further analysis required to identify if these stocks are really as undervalued or overvalued as the P/E ratios suggests. HISTORY OF RATIO ANALYSIS: Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in different industries and having different styles of conducting business can make it almost impossible to come up with a conclusion as to which company is a better investment. It helps the creditors to solve these issues. According to Myers Ratio Analysis is a study of relationship among the various financial factors of a business.
Meaning of ratio a ratio is a simple arithmetical expression of the
relationship of one number to another. It is expressed when one figure is divided by another. For example, if Rs.4000 is divided by Rs.10000, the ratio can be expressed as 0.4 or 2.5 or 40%. TYPES OF RATIOS: Pure ratio : example- current ratio: current liabilities = 2:1 Percentage ratio: example gross profit is 25% of sales Rate ratio: example if COGS is rs. 5000 and working capital is rs.1000, then it can be said that COGS is 5 times of working capital.
NATURE OF RATIO ANALYSIS
Ratio analysis is a technique of analysis and interpretation of financial statements. It is a process of establishing and interpreting various ratios for helping in making certain decisions. Calculation of mere ratios does not serve any purpose unless several appropriate ratios are analysed and interpreted. While there are numerous financial ratios, most investors are familiar with a few key ratios, particularly the ones that are relatively easy to calculate. Some of these ratios include the current ratio, return on equity, the debt-equity ratio, the dividend payout ratio and the price/earnings (P/E) ratio. The following are the 4 steps involved in the ratio analysis: a) Selection of the relevant data from the financial statements depending upon the objective of the analysis. b) Calculation of appropriate ratios from the above data. c) Comparison of the calculated ratio with the ratios of the same firm in the past, or the ratios developed from projected financial statements or the ratios of the some other firms or the comparison with ratios of the industry to which the firm belongs. d) Interpretation of the ratios.
WHY RATIO ANALYSIS?
Ratio analysis is one of the most important and powerful tool of financial analysis. It is used as a device to analyse and interpret the financial position of an enterprise. Just like a doctor, as he examines his patient by recording his body, temperature, blood pressure, etc. before making his conclusion regarding the illness and before giving his treatment. Similarly a financial analyst analyses financial statements with various tools of analysis before commencing upon the financial position or weaknesses of an enterprise. The importance of the ratio analysis can be understood by the following discussions: 1. Helpful in simplifying accounting figures: accounting ratios makes the figures simple and understandable. They simplify, summarise and systematize the long monotonous figures. The ratio can be easily understood by those who do not know accounting. The importance of the ratios lies in the fact that they provide relationship between different figures. 2. Helpful in Budgeting and Forecasting: Accounting ratios provide a reliable data, which can be compared, studied and analysed. These ratios provide sound footing for future forecasting. They indicate the future prospects. The ratios can also serve as a basis for preparing budgets and also determining future line of action. 3. Facilitating comparative analysis of the performance: Every promising company has to compare its present performance with the previous performance and discover the plus and minus points. These points can be located by the calculation of different ratios. Causes responsible for the poor performance have to be removed. Comparison with the performance of other competitive firms can also be made. Comparison tells, where the firm stands and what are its prospects. It enables both intra-firm and inter-firm comparison. 4. Helpful in decision-making: Financial statements are prepared primarily for decision making. But the informations provided by financial statements are not an end in itself and no meaningful conclusions can be drawn from these statements alone. Ratio analysis helps in making decisions from the information provided in these financial statements.
5. It indicates the true efficiency and the profitability of the business
concern: Financial statements i.e. Trading and Profit and Loss account and Balance Sheet may indicate the amount of profit or the Balance sheet of different accounts but the profitability can be known by analysing financial statements i.e. calculation of accounting ratios. 6. Helps in communicating: The financial strengths and weaknesses of a firm are communicated in a more easy and understandable manner by the use of ratios. 7. Helps in co-ordination: ratios even help in co-ordination which is of great importance in effective business management. Better communication of efficiency and weakness of an enterprise results in better co-ordination in the enterprise. 8. Judging the operational efficiency of management: The operational efficiency of the business can be ascertained by calculating operating ratio. As the operating ratio shows the operational costs of the business so it will be in the interest of business, if it is lower. We can use operating net profit for calculating operating net profit ratio, wherein non-operating expenses and incomes are not taken into consideration. 9. Helps in assessing solvency position of the business: we can ascertain whether the firm is solvent or not by calculating solvency ratios. Solvency ratios shows relationship between liabilities and assets. If total assets are lesser than the outside liabilities it shows unsound position of the business. In such case the business will try its best to improve its solvency position or to pay the loan. 10.
Measuring short term and long term financial position of the
company: we can know the short term and long term financial position of the business by calculating various ratios. Current and Liquid ratios indicates short term financial positions. Whereas debt-equity ratios, fixed assets ratios and proprietory ratios shows long term financial position.