Ratio Analysis

Topics: Balance sheet, Working capital, Inventory Pages: 11 (3271 words) Published: March 14, 2013


The traditional financial statements that comprise of the balance sheet and profit and loss account do not give enough information related to financial operations of the company. These financial statements prepared as per the statutory requirement of law need to be analyzed in order to evaluate the past performance of the company and the future prospects. The most widely used tool is Ratio Analysis.

A way of expressing the relationship between one accounting result and another, which is intended to provide a useful comparison .Ratios assist in measuring the efficiency and profitability of a company based on its financial reports. Accounting ratios form the basis of fundamental analysis.

Ratio analysis is the most widely used tool since it compares risk and return relationships of firms from various aspects. Ratio analysis is the method or process by which the relationship of items or group of items in the financial statements are computed, determined and presented. It is an attempt to derive quantitative measures or guides concerning the financial health and profitability of a business enterprise. It can be used both in trend and static analysis. There are several ratios at the disposal of an analyst but the group of ratios he would prefer depends on the purpose and objectives of analysis. tool used by individuals to conduct a quantitative analysis of information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company. Ratio analysis is predominately used by proponents of fundamental analysis. ROLE OF RATIO ANALYSIS

Ratio Analysis is one of the best possible techniques available to the management to impart the basic functions like planning and control. As the future is closely related to the immediate past, ratios calculated on the basis of historical financial statements may be of good assistance to predict the future. For example, on the basis of inventory turnover ratio or debtors turnover ratio in the past, the level of inventory and debtors can easily be ascertained for any given amount of sales. Similarly, the ratio analysis may be able to locate and point out the various areas which need the management’s attention in order to improve the situation. For example, current ratio which shows a constant declining trend may indicate the need for further introduction of long term finance in order to improve the liquidity position. It should be remembered that a few specific ratios indicate certain specific aspects of the conduct of business. As such, the importance of various ratios may vary for different category of persons as well. For example, the commercial bankers, trade creditors and lenders of short term credit are basically interested in the liquidity position of the organisation and as such the ratios like current ratio, acid test ratio, inventory turnover ratio and average collection period are more important. Ratio Analysis is not a creative technique in the sense that it uses the same figures and information which are already appearing in the financial statements. At the same time, it is also true that what can be achieved by the technique of Ratio Analysis cannot be achieved by the mere preparation of financial statements. Ratio Analysis helps to appraise the firms in terms of their profitability and efficiency of performance, either individually or in relation to those of other firms in the same industry. The process of this appraisal is not complete until the ratios so computed can be compared with something, as the ratios by themselves do not mean anything. This comparison may be an intra-firm comparison, inter-firm comparison or comparison with standard ratios. Thus, proper comparison of ratios may reveal where a firm is...
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