RATIO ANALYSIS

Ratio analysis is a widely used tool of financial analysis..It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weakness of a firm as well s its historical performance and current financial condition can be determined. A ratio is an arithmetical relationship between two figures. Financial ratio analysis is a study of ratios between two figures. Financial ratio analysis is a study of ratios between various items or groups of items in financial statements. An accounting ratio is defined as quantitative relationship between two or more items of financial statements.

DEFINITION: According to Accountants Handbook by Wixon , kell and Bedford, a ratio is an expression of the quantitative relationship between two numbers. According to Kohler, a ratio is the relation, of the amount, a, to another, b, expressed as the ratio of a to b; a: b; or as a simple fraction, integer, decimal, fraction or percentage.

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 decisions. It is only a means of better understanding of financial strengths and weaknesses of a firm. There are a number of ratios which can be calculated from the information given in the financial statements, but the analyst has to select the appropriate data and calculate only a few appropriate ratios from the same keeping in mind the objective of analysis.

INTERPRETATION OF RATIOS: Though calculation of ratios is an important task it is only a clerical task whereas interpretation needs skill, intelligence, and foresightedness. The inherent limitations of ratios analysis should be kept in mind While interpreting them.

The interpretation of ratio can be made in the following ways: 1. SINGLE ABSOLUTE RATIO One cannot draw any meaningful conclusion When a single ratio is considered in isolation.

2. GROUP RATIO: Ratios may be interpreted by calculating a group of related ratios. A single ratio supported by other related additional ratios becomes more understandable and meaningful.

3. HISTORICAL COMPARISON: One of the easiest and most popular ways of evaluating the performance of the firm is to compare its present ratio with past ratios called comparison over time.

4. PROJECTED RATIOS: Ratios an also be calculated for future standards based upon the projected or proforma financial statements.

5. INTER-FIRM COMPARISON Ratio of one firm can also be compared with the ratios of some other selected firms in the industry at the same point of time. This kind of comparison helps in evaluating relative financial position and performance of the firm.

GUIDELINES OR PRECAUTIONS FOR USE OF RATIOS The following are the guidelines or factors that may be kept in mind while interpreting various ratios . ACCURACY OF FINANCIAL STATEMENTS The ratios are calculated from the data available in financial statements. The reliability of ratios is linked to the accuracy of information in these statements. Before calculating ratios, one should see whether proper concepts and conventions have been used for preparing financial statements or not. Competent auditors should also properly audit these statements. OBJECTIVE OR PURPOSE OF ANALYSIS The type of ratios to be calculated will depend upon the purpose for which these are required. If the purpose is to study current financial position then ratios relating to current asset and current liabilities will be studied. The purpose of user is also important for the analysis of ratios.

SELECTION OF RATIOS

Another precaution in ratio analysis is the proper selection of appropriate ratios. The ratios should match the purpose for which these are required. Calculation of large number of ratios without determining their need in the present context in the present context may confuse the things instead of solving them.

USE OF STANDARDS The ratios will give an indication of financial position only when discussed with reference to certain standards. Unless and otherwise these ratios are compared with certain standards, one will not be able to reach at conclusions. These standards may be rule of thumb as in case of current ratio (2:1) and acid test ratio (1:1), may be industry standards, may be budgeted or projected ratios, etc.

CALIBER OF THE ANALYST The ratios are only the tools of analysis and their interpretation will depend upon the caliber and competence of the analyst. He should be familiar with various financial with various financial statements and the significance of changes, etc. The utility of ratios is linked to the expertise of the analyst.

USE OF RATIO ANALYSIS The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analysis and interpret the financial health of enterprise. With the use of ratio analysis, one can measure the financial condition of a firm and can point out whether the condition is strong, good, questionable or poor.

a.

MANAGEMENT USE OF RATIO ANALYSIS HELPS IN DECISION-MAKING Financial statements are prepared primarily for decision-making. But the information provided in financial statements is not an end in itself and no meaningful conclusions can be drawn from these statements alone. Ratio helps in making decisions from the information provided in these financial statements. HELPS IN FINANCIAL FORECASTING AND PLANNING

RATIO ANALYSIS IS OF MUCH HELP IN FINANCIAL FORECASTING AND PLANNING. Planning is looking ahead and the ratios calculated for a number of years work as a guide for the future.

HELPS IN COMMUNICATING The financial strength and weakness of a firm are communicated in a more easy and understandable manner by the use of ratios.

HELPS IN CO-ORDINATION Ratios even help in co-ordination, which is of utmost importance in effective business management.

HELPS IN CONTROL Ratio analysis helps in having effective control over the business. Standards ratios are set based on past performance. Variances or deviations, if any, can be found out by comparing the actual, with the standards so as to take a corrective action at right time.

b. UTILITY TO SHAREHOLDERS/INVESTORS An investor in the company will like to assess the financial position of the concern where he is going to invest. His first interest will be the security of his investments and then a return in the form of dividend or interest. For the first purpose he will try to assess the value of fixed assets and the loans raised against them. Long-term solvency ratios will help him in assessing financial position of the concern. Profitability ratios, on the other hand, will be useful to determine profitability position.

c. UTILITY TO CREDTORS The creditors or suppliers extend short term credit to the concern. They are interested to know whether financial position of the concern warrants their payments at a specified time or not. The concern pays short-term creditors out of its current assets. If the current assets are quite sufficient to meet current liabilities then the creditors will not hesitate in extending credit facilities.

d. UTILITY TO EMPLOYERS The employees are also interested in the financial position of the concern especially, profitability. Their wages increases and amount of fringe benefits are directly related to the volume of profits earned by the concern. The employees make use of information available in financial statement.

e. UTILITY OF GOVERNMENT Government is interested to know the overall strength of the industry. Various financial statements published bi industrial units are used to calculate ratios for determining short-term, long term and overall financial position of the concerns. Government may frame its future policies on the basis of industrial information available from various units.

f.

TAX AUDIT REQUIREMENTS Sec 44 AB was inserted in the Income Tax Act by finance act 1984. Under this section every assessee engaged in any business and having turnover or gross receipts exceeding Rs. 40lakhs is required to get the accounts audited by a charted accountant and submit the tax report before the due date for filling the return of income under section 139(1). Clause 32 of Income tax act requires that the following accounting ratios should be given: 1 2 3 Gross profit/Turnover Net profit/Turnover Stock-in-trade/Turnover

LIMITATIONS OF RATIO ANALYSIS LIMITED USE OF A SINGLE RATIO A single ratio, usually, does not convey much of a sense. To make a better

Interpretation a number a number of ratios have to be calculated which is likely to confuse the analyst than help him in making any meaningful conclusion.

LACK OF ADEQUATE STANDARD There are no well-accepted standards or rules of thumb for all ratios, which can be accepted as norms.

INHERENT LIMITATIONS OF ACCOUNTING Like financial statement, ratios also suffer from the inherent weakness of accounting records such as their historical nature. Ratios of the past are not necessarily true indicators of the future.

CHANGE OF ACCOUNTING PROCEDURE Change in accounting procedure by a firm often makes ratio analysis misleading.

WINDOW DRESSING Financial statements can easily be window dresses to present a better picture of its financial and profitability position to outsiders. Hence, one has to be very careful in making a decision from ratios calculated from such financial statement.

PERSONAL BIAS Ratios are only means of financial analysis and not an end in itself. Ratios have to be interpreted and different people may interpret the same ratio in different ways.

UNCOMPARABLE Not only industries differ in their nature but also the firms of the similar business widely differ in their size and accounting procedures, etc.

ABSOLUTE FIGURE DISTORTIVE Ratios devoid of absolute figures may prove distortive, as ratio analysis is primarily quantitative analysis and not a qualitative analysis.

PRICE LEVEL CHANGES While making ratio analysis, no consideration is made to changes in price levels and this makes interpretation of ratios invalid.

RATIOS NO SUBSTITUTE Ratio analysis is merely a tool of financial statements. Hence, ratios become useless if separated from the statements from which they are computed.