FINANCIAL RATIO ANALYSIS
Financial Ratio Analysis is the process of determining and interpreting relationships between the items of financial statements to provide a meaningful understanding of the performance and financial position of an enterprise. Ratio analysis is basically a technique of:
- Establishing meaningful relationship between significant variables of financial statements
- And interpreting the relationship to form judgment regarding the financial affairs of the unit.
ACCORDING TO JOHN N MYERS
“Ratio analysis is a study of relationship among various financial factors in a business.”
Financial Ratio analysis can be used for two types of analysis which are as follows:
CROSS-SECTIONAL ANALYSIS
The cross-sectional analysis involves comparison of one firm with the other firm. This analysis is used to provide the conclusive evidence of the existence of the problem which in turn helps to take the corrective actions.
TIME SERIES ANALYSIS
In time series analysis, the current ratios of the firm are compared with the past ratios of the same firm. This is also known as trend analysis. Such an analysis gives an indication of direction of change or developing trends. These changes show whether the position of firm has improved, remained constant or deteriorated. While conducting such analysis, following points should be considered such as changes in government policy, change in accounting policy, technological development and competition over the period of time.
BENCHMARKS FOR RATIO ANALYSIS
A single ratio conveys no meaning in itself. It should be compared with another to get some useful results. The benchmarks to compare the financial ratio analysis are as follows:
PAST RATIO: A ratio could be compared with the last year’s ratio. It is also known as time series analysis.
RATIO OF SIMILAR FIRMS: A ratio could be compared with the ratios of similar firms in the same industry at the point of time. It is also known as the cross-sectional analysis.
RULE OF THUMB: Certain ‘rule of thumbs’ based upon well proven conventions have evolved over a period of time. For example: current ratio has 2:1 rule of thumb, liquid ratio has 1:1 rule of thumb, absolute liquid ratio has 0.5:1 rule of thumb.
OBJECTIVES OF FINANCIAL RATIO ANALYSIS
The objectives of Ratio Analysis are as follows:
ANALYSIS OF FINANCIAL STATEMENTS
The main aim of ratio analysis is to facilitate the analysis of the financial statements. The financial statements include statement of profit and loss and position statement i.e. balance sheet. It helps the bankers, trade payables, investors, shareholders etc. in acquiring enough knowledge about the profitability and financial health of the business. In the light of the knowledge so acquired by them, they can take necessary decisions about their relationships with the concern.
SIMPLIFICATION OF ACCOUNTING DATA
Accounting ratio simplifies and summarizes a long array of accounting data and makes them understandable. It discloses the relationship between two such figures which have a cause and effect relationship with each other.
ACCORDING TO BIRAMN AND DRIBIN
“Financial ratios are useful because they summarize briefly the results of detailed and complicated computation.”
COMPARISON
With the help of ratio analysis two types of analysis can be made: cross-sectional analysis and time series analysis. The accountant can generate useful results by comparing the current ratios of the firm with another firm. Also the ratios can be compared with the past ratios of the same concern to find out the development, deterioration in the working or performance of the concern.
LOCATION OF WEAK SPOTS IN THE BUSINESS
Time series analysis by the ratio analysis helps in locating the weak spots of the business. The current ratios are compared with the past ratios and areas of deficiency are found out. This helps in taking the remedial actions in the areas of need.
TO FORECAST THE FUTURE
Accounting ratios are very helpful in preparing the plans about the future. For example: If sales or revenue of operations of the firm during the year was Rs. 10 lakhs and average amount of inventory during this year was Rs.2 lakhs i.e. 20% of the revenue from operations. If the firm wants to increase its sales from Rs. 10 lakhs to Rs. 15 lakhs, the firm will plan to invest in the inventory Rs. 3,00,000 i.e. (20% of 15 lakhs).
Similar other estimates for future can be worked out by establishing a relationship between capital and revenue from operations; trade receivables and revenue from operations; expenses and revenue from operations etc.
ESTIMATE ABOUT THE TREND OF THE BUSINESS
If accounting ratios are prepared for a number of years, they will reveal the trend of costs, revenue from operations, profits and other important facts.
FIXATION OF IDEAL STANDARDS
Ratios help us in establishing standards of the different items of the business. By comparing the actual ratios calculated at the end of the year with the ideal ratios, the efficiency of business can be easily measured.
EFFECTIVE CONTROL
Ratio analysis discloses the liquidity, solvency and profitability of the business enterprise. Such information enables management to assess the changes that have taken place over a period of time in the financial activities of the business. It helps them in discharging their managerial functions of planning, organising, directing, communicating and controlling very effectively.
STUDY OF FINANCIAL SOUNDNESS
Ratio analysis discloses the position of business with different view-points. It discloses the position of the business with the liquidity point of view, solvency viewpoint, profitability point of view etc. With the help of such a study we can draw conclusions regarding the financial health of the business enterprise.
GUIDELINES OR PRECAUTIONS FOR THE USE OF THE RATIOS/ FACTORS CONSIDERED IN RATIO ANALYSIS
The calculation of ratios may not be a difficult task but their use is not easy. There are many factors that influence the use of the ratios which are as follows:
ACCURACY OF FINANCIAL STATEMENTS
The ratios are calculated from the data available in the financial statements. If the data provided in financial statements is true and best to the knowledge, then the ratios calculated from the data given will also generate accurate results. For this an accountant must ensure:
- Proper following of accounting concepts and conventions.
- Proper auditing of the accounts.
- Proper internal check system.
All this will ensure that the financial statements are accurate and data contained in it is accurate.
OBJECTIVES OR PURPOSE OF ANALYSIS
The types of ratios to be used depend upon the purpose of the analysis. The purpose is usually based on the nature of information needed and type of the user. Different ratios have been developed for different types of users. These are as follows:
Liquidity ratios like current ratio, liquid ratio and absolute liquid ratio is studies with a view to get information about the liquidity position of the firm.
Activity or Efficiency ratios like debtor’s turnover ratio, creditors turnover ratio, stock turnover ratio etc are studied with a view to get the information about the efficiency of the operations of the firm.
Profitability Ratios like gross profit ratio, operating ratio, net profit ratio, operating profit ratio is calculated to know about the profitability position of the firm.
Solvency ratios like proprietary ratio, debt-equity ratio, total assets to debt ratio are calculated to know about the long term as well as short term solvency position of the firm.
So the analyst must know the purpose of analysis beforehand before selecting the type of ratio to be calculated.
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 may confuse the things instead of solving them. Only those ratios should be selected which can throw proper light on the matter to be discussed.
USE OF STANDARDS
The ratios will give an indication of financial position only when discussed with reference to certain standards. The standards for comparing the ratios can be:
PAST RATIO: A ratio could be compared with the last year’s ratio. It is also known as time series analysis.
RATIO OF SIMILAR FIRMS: A ratio could be compared with the ratios of similar firms in the same industry at the point of time. It is also known as the cross-sectional analysis.
RULE OF THUMB: Certain ‘rule of thumbs’ based upon well proven conventions have evolved over a period of time. For example: current ratio has 2:1 rule of thumb, liquid ratio has 1:1 rule of thumb, absolute liquid ratio has 0.5:1 rule of thumb.
The comparison of calculated ratios with the standards will help the analyst in forming his opinion about financial situation of the concern.
CALIBRE OF THE ANALYST
The ratios are the only tools of analysis and their interpretation will depend upon the caliber and competence of the analyst. He should be familiar with the various financial statements and the significance of changes etc. A wrong interpretation may create havoc for the concern since wrong conclusions may lead to wrong decisions. The utility of ratios is linked to the expertise of the analyst.
RATIOS PROVIDE ONLY A BASE
The ratios are only guidelines for the analyst. These are not the entire base for taking the decision. The ratio analysis can be a support to the decision taken. Also other information like
- Changes in business environment
- Policy of management
- Situation in the concern
- Competition in the market
- Government regulation etc.
should be taken into consideration before taking any decision. The interpreter should use the ratios as a guide and may try to solicit any other relevant information which helps in reaching a correct decision.
ADVANTAGES/ USES/ SIGNIFICANCE OF RATIO ANALYSIS
The advantages or uses or significance of ratio analysis is not only confined to the financial managers only. It helps all other parties that are interested for knowing the financial position of a firm. The uses of ratio analysis are as follows:
UTILITY TO MANAGEMENT
Ratio analysis is of utmost use for the management. This can be made clear with the help of following points:
HELPS IN DECISION MAKING: The financial statements prepared by the accountants do not convey any result unless these are properly analyzed. The ratio analysis is a tool to analyze the financial statements and draw out the results which are helpful for the management in taking the decisions for the business firm.
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. Meaningful conclusions can be drawn for the future from these ratios. Thus, ratio analysis helps in forecasting and planning.
HELPS IN COMMUNICATING: Ratio analysis helps in communicating the financial strengths and weaknesses of the business firm in more easy and understandable form. There are various user of the accounting information such as:
- Creditors
- Suppliers
- Banks and financial institutions
- Lenders
- Employees
- Owners/ shareholders
- Tax authorities, etc.
All these parties depends upon the ratio analysis to get information about the solvency, liquidity and profitability position of the business.
HELPS IN COORDINATION: Ratios even help in coordination which is of utmost importance in effective business management. Better communication of efficiency and weakness of an enterprise results in better coordination of the enterprise.
HELPS IN CONTROL: Ratio analysis helps in exercising effective control over the business. Ratios are calculated and then compared with the standards. Any deviation found can be rectified by taking proper corrective measures.
OTHER USES: Ratio analysis has also many other uses as it is of utmost importance in budgetary control and standard costing.
UTILITY TO SHAREHOLDERS/INVESTORS
Shareholders or investors are the persons who have invested their funds in the business. The shareholders are interested in knowing the
- Security of the amount invested by them in the business
- Return to generated on the invested funds.
For this they want to know about the profitability and solvency ratios like net profit ratio, earnings per share ratio, proprietary ratio etc. Ratio analysis will be useful to the investor in making up his mind whether present financial position of the firm warrants further investment or not.
UTILITY TO CREDITORS
Creditors are the persons to whom business owes. Creditors are interested to know about the short term liquidity of the business. Creditor will deal with the business only if the creditworthiness of the business is strong and sound. For this purpose liquidity ratios such as liquid ratio, current ratio, absolute liquid ratio is calculated.
UTILITY TO EMPLOYEES
The employees are interested in the profitability position of the firm. The increase in their wages, payment of bonuses and benefits are directly related to the amount of profits earned by the business. Various profitability ratios like gross profit ratio, net profit ratio, operating ratio, operating profit ratio enable the employees to put forward their viewpoints for the increase in their wages.
UTILITY TO GOVERNMENT
Government is interested to know the overall strength of the industry. Various financial statements published by the industrial units are used to calculate ratios for determining the long term and short term and overall financial positions of the concerns. Profitability indexes can also be prepared with the help of the ratios. The ratios may be used as indicators of overall strength of public as well as private sector. In the absence of the reliable economic information, governmental plans and policies may not prove successful.
UTILITY FOR TAX AUDIT REQUIREMENTS
Section 44 AB inserted by the Finance Act 1984 in the Income Tax Act 1961. Under this section every Assessee engaged in any business and having turnover or gross receipts exceeding Rs. 40 lakhs is required to get the accounts audited by the chartered accountant and submit the tax audit report before the due date for filing the return of income under section 139 (1). In case of a professional, a similar report is required if the gross receipts exceed Rs. 10 lakh. Clause 32 of the Income Tax Act 1961 requires that the following accounting ratios should be given:
- Gross profit/ turnover ratio
- Net profit/ turnover ratio
- Stock in trade ratio
- Material consumed .
Further, it is advisable to compare the accounting ratios for the year under consideration with the accounting ratios for the earlier two years so that the auditor can make necessary enquiries, if there is any major variation in the accounting ratios.
LIMITATIONS OF RATIO ANALYSIS
Accounting ratios are very important tool for financial analysis. But despite its being indispensable, the ratios suffer from a number of limitations. These limitations should be kept in mind while making use of accounting ratios:
FALSE ACCOUNTING DATA GIVES FALSE RATIOS
Accounting ratios are calculated on the basis of data given in Profit and Loss statement and balance sheet. Therefore, they will be only as correct as the accounting data on which they are based. For example: If the closing inventory is overvalued, not only the profitability is overstated but also the financial position appears to be better. Therefore, unless the profit and loss statement and balance sheet are reliable, the ratios based on them will not be reliable.
COMPARISON NOT POSSIBLE
There are many different accounting policies adopted by different firms with regard to providing depreciation, creation of provision for doubtful debts, method of valuation of stock etc. For instance, one firm may adopt the policy of charging depreciation on straight line basis while other may charge on written down value basis. Such differences make the accounting ratios incomparable.
PRICE LEVEL CHANGES
Price level over the years goes on changing, therefore the ratios of various years cannot be compared. For example: one firm sells 1,000 machines for Rs. 10 lakhs during 2018. It again sells 1,000 machines of same types in 2019 but owing to rising price in sales price was Rs. 15 lakhs. On the basis of the ratios it will be concluded that the sales have increased by 50% whereas in actual, sales have not increased at all. Hence, the figures of the past years must be adjusted in the light of the price level changes before the ratios for these years are compared.
GIVES MISLEADING RESULTS
Ratio analysis may give misleading results if the comparison is made between the firms which are different from each other. For example: X company produces 10 lakh meters of cloth in 2018 and 15 lakh meters of cloth in 2019, the progress is 50%. Y company raises its production from 10 thousand meters in 2018 to 20 thousand meters in 2019; the progress is 100%. Comparison of these two firms made on the basis of ratio is quite misleading because if the difference in the size of the two firms. It is therefore, essential to study the ratios along with the absolute data on which they are based.
LIMITED USE OF A SINGLE RATIO
The analyst should not merely rely on a single ratio. He should study several connected ratios before reaching a conclusion. For example, the current ratio of a firm may be quite satisfactory, whereas the quick ratio may be unsatisfactory.
WINDOW DRESSING
Some companies in order to cover up their bad financial position resorts to window dressing i.e. showing a better position than the one which really exists. They change their balance sheet in such a way that the important facts and truth may be concealed. For example: the current assets of a company are Rs. 2,00,000 and its current liabilities are Rs. 1,00,000, so the current ratio is 2:1. After that, it purchased the goods for Rs. 1,00,000 for credit in the month of March. If it records the purchases, the current assets will increase to Rs.3,00,000 and current liabilities will increase to Rs. 2,00,000. As a result, the current ratio will be reduced to 3:2 to 1.5:1. The company may pass the entry for purchase in the beginning of next year or may postpone the purchase itself for a few days more.
LACK OF PROPER STANDARDS
Circumstances differ from firm to firm hence no single standard ratio can be fixed for all the firms against which the actual ratio may be compared. For example: the current ratio of 2:1 is generally accepted as an ideal ratio, which means that the current assets should be at least twice in comparison to the current liabilities. But if a firm has such type of arrangement with its bankers that the bankers will provide necessary credit to the firm in case of need, the ideal current ratio for such firm may be less than 2:1.
IGNORES QUALITATIVE FACTORS
Financial Ratio analysis is a quantitative measurement of the performance of the business. It ignores qualitative factors which are essential for interpretation. For example: credit may be granted to a customer on the basis of certain ratios of his business but the character and managerial ability of the customer must also be taken into consideration.
RATIOS ALONE ARE NOT ADEQUATE FOR PROPER CONCLUSIONS
Ratios derived from analysis of statements are not sure indicators of good or bad financial position and profitability of the firm. They merely indicate the profitability of favorable or unfavorable position. The analyst has to carry out further investigations and exercise his judgment in arriving at a correct diagnosis. This is for this reason that an analyst has to use other tools of financial analysis in addition to the tool of ratio analysis.
EFFECT OF PERSONAL ABILITY AND BIAS OF THE ANALYST
Another important point is to be kept in mind is that the different persons draw different meanings of different terms. One analyst may calculate ratios on the basis of profit after interest and tax, whereas other analyst may consider profits before interest and tax, a third may consider profits after interest but before tax. Therefore, before making comparisons, one must be sure that the ratios have been calculated from the same basis.