Ratios are highly essential profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. Although ratios report mostly on past performances, they can be predictive too, and provide lead indications of potential problem areas.
Ratio analysis is primarily used to compare a company’s financial figures over a period of time, a method sometimes called trend analysis. Through trend analysis, you can identify trends, good and bad, and adjust your business practices accordingly. You can also see how your ratios stack up against other businesses, both in and out of your industry.
There are several considerations you must be aware of when comparing ratios from one financial period to another or when comparing the financial ratios of two or more companies.
If you are making a comparative analysis of a company’s financial statements over a certain period of time, make an appropriate allowance for any changes in accounting policies that occurred during the same time span. When comparing your business with others in your industry, allow for any material differences in accounting policies between your company and industry norms. When comparing ratios from various fiscal periods or companies, inquire about the types of accounting policies used. Different accounting methods can result in a wide variety of reported figures. Determine whether ratios were calculated before or after adjustments were made to the balance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments. In many cases, these adjustments can significantly affect the ratios. Carefully examine any departures from industry norms.
Ratio Analysis is a useful tool in the following aspects:
Evaluation of Liquidity: The ability of a firm to meet its short term payment commitments is called liquidity. Current Ratio and Quick Ratio help to assets the short-term solvency (liquidity) of the firm.
Evaluation of Profitability: Profitability ratios i.e. Gross Profit Ratio, Operating Profit Ratio, Net Profit Ratio are basic indicators of the profitability of the firm. In addition, various profitability indicators like Return on Capital Employed (ROCE), Earnings per share (EPS), Return on Assets (ROA) etc. are used to assess the financial performance.
Evaluation of Operating Efficiency: Ratios throw light on the degree of efficiency in the management and utilization of assets and resources. These are indicated by activity or performance or turnover ratios e.g. Stock Turnover Ratio, Debtors Turnover Ratio. These indicate the ability of the firm to generate revenue (sales) per rupee of investment in its assets.
Evaluation of Financial Strength: Long-term solvency strength is indicated by Capital Structure Ratios like Debt-Equity Ratio, Gearing Ratio, Leverage Ratios etc. These ratios signify the effect of various sources of finance e.g. debt, preference and equity. They also show whether the firm is exposed to serious financial strain or is justified in the use of debt funds.
Inter-firm and Intra-firm comparison: Comparison of the firm’s ratios with the industry average will help evaluate the firm’s position vis-à-vis the industry. It will help in analyzing the firm’s strengths and weaknesses and take corrective action. Trend Analysis of ratios over a period of years will indicate the direction of the firm’s financial policies.
Budgeting: Ratios are not mere post-modern of operations. They help in depicting future financial positions. Ratios have predictor value and are helpful in planning and forecasting the business activities of a firm for future periods, e.g. estimation of working capital requirements.
Ratios are useful tools for financial analysis. However the following limitations do exist.
(a) Window Dressing: Ratios depict the picture of performance at a particular point of time. Sometimes, a business can make year-end adjustments in order to result in favorable ratios (e.g. current ratio, operating profit ratio, debt-equity ratio etc.)
(b) Impact of Inflation: Financial Statements are affected by inflation. Ratios may not depict the correct picture. For example, fixed assets are accounted at historical cost while profits are measured in current rupee terms. In inflationary situations, the Return on Assets or Return on Capital Employed may be very high due to less investment in fixed assets. Ratios may not indicate the true position in such situations.
(c) Product Line diversification: Detailed ratios for different divisions, products and market segments etc. may not be available to the users in order to make an informed judgment. For example, loss in one product may be set off by substantial profits in another product line. But, the overall net profit ratio may be favorable.
(d) Impact of Seasonal Factors: When the operations do not follow a uniform pattern during the financial period, ratios may not indicate the correct situation. For example, if the peak supply season of a business is between Februarys to June, it will hold substantial stocks on the balance sheet date. This will lead to a very favorable current ratio on that date. But the position for the rest of the year may be entirely different.
(e) Differences in Accounting Policies: Different firms follow different accounting policies, e.g. rate and methods of depreciation. Straight-jacket comparison of ratios may lead to misleading results.
(f) Lack of Standards: Even though some norms can be set for ratios, there is no uniformity as to what an “ideal” ratio is. Generally it is said that Current Ratio should be 2:1. But if a firm supplies mainly to Government Departments where debt collection period is high, a Current Ratio of 4:1 or 5:1, may also be considered normal.
(g) High or Low: A number by itself cannot be “high” or “low”. Hence, a ratio by itself cannot become “good” or “bad”. The line of difference between “good ratio” and “bad ratio” is very thin.
(h) Interdependence: Financial Ratios cannot be considered in isolation. Decision taken on the basis of one ratio may be incorrect when a set of ratios are analyzed.
From the above discussion, it is felt that, the ratio is a measuring device to judge the growth, development and present condition of a concern. Further, it is found that, Each and every ratio indicates the financial position as well as it is also helpful for taking several management decisions for the future period effectively and efficiently.