The financial statement provides the basic data for financial performance analysis.
Basic limitation of the traditional financial statement comprising the balance sheet and the profit and loss account is that they do not give all the information regarding the financial operations of a firm. Nevertheless, they provide some useful information to the extent the balance sheet mirrors the financial position on a particular date in terms of the structure of assets, liabilities and owners equity, and so on. The profit and loss account shows the results of operations during a certain period of time in terms of the revenues obtained and the incurred during the year. Thus, the financial statements provide a summarized view of the financial position and operations of a firm. Therefore, much can be learnt about a firm from a careful examination of its financial statements as invaluable documents / performance reports. The analysis of financial statements is, thus, an important aid to financial analysis.
The focus of financial analysis is on key figures in the financial statements and the significant relationship that exists between them. The analysis of financial statements is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of the firm’s position and performance. The first task of financial analyst is to select the information relevant to the decision under consideration from the total information contained in the financial statement. The second step involved in financial analysis is to arrange the information in a way to highlight significant relationships. The final step is interpretation and drawing of inferences and conclusions. In brief, financial analysis is the process of selection, relation, and evaluation.
1.1.2. Tools of Financial Analysis
A financial analyst can adopt the following tools for analysis of the financial statement. These are also termed as methods of financial analysis.
18.104.22.168. Ratio analysis
Ratio analysis is a widely – used tool of financial analysis. It is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weakness of a firm as well as its historical performance and current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two items/ variables. This relationship can be expressed as: (i) percentages (ii) Fractions (iii) Proportion of numbers. Computing of ratios does not add any information not already inherent in the financial statement. The ratios reveal that relationship in a more meaningful way so as to enable us to draw conclusions from them. The rationale of ratio analysis lies in the fact that it makes related information comparable. A single figure by itself has no meaning but when expressed in terms of a related figure, it yields significant interfaces. The ratio analysis, as a quantitative tool, answers to questions such as: are the net profits adequate? Are the assets being used efficiently? Is the firm Solvent? Can the firm meet its current obligations? And so on.
It is also defined as “an expression of the quantitative relationship between two numbers”. (Wixion, Kell, Bedford 1970).
22.214.171.124Significance of Ratio Analysis
Ratio analysis determines the following
1.The ability of the Firm to meet its current obligations.
2.The extent to which the firm has used its current obligations. 3.The efficiency with which the firm is utilizing its various assets in generating sales revenue. 4.The overall operating efficiency and performance of the firm.
126.96.36.199 Limitations of Ratio Analysis
1.It is difficult to decide on the proper basis for comparison. 2.The comparison is rendered difficult because of differences in situations of two companies or of one company over years. 3.The price level changes make the interpretations of...