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RATIO ANALYSIS

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.