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Unit III - Ratio Analysis


Meaning of Ratio Analysis:

Now, we have previously learned what ratios are. They are a comparison of two numbers with respect to each other. Similarly, in finance, ratios are a correlation between two numbers, or rather two accounts. So two numbers derived from the financial statement are compared to give us a more clear understanding of them. This is an accounting ratio.

Objectives of Ratio Analysis:

Interpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfils.

Advantages of Ratio Analysis:

When employed correctly, ratio analysis throws light on many problems of the firm and also highlights some positives. Ratios are essentially whistle-blowers, they draw the managements attention towards issues needing attention. Let us take a look at some advantages of ratio analysis.
Ratio analysis will help validate or disprove the financing, investment and operating decisions of the firm. They summarize the financial statement into comparative figures, thus helping the management to compare and evaluate the financial position of the firm and the results of their decisions.
It simplifies complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency, long-term positions etc.
Ratio analysis help identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the complex accounting statements, and ratios will help pinpoint such problems.
Allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons etc. This will help the organization better understand its fiscal position in the economy.

Limitations of Ratio Analysis:

While ratios are very important tools of financial analysis, they d have some limitations, such as
The firm can make some year-end changes to its financial statements, to improve their ratios. Then the ratios end up being nothing but window dressing.
Ratios ignore the price level changes due to inflation. Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial situation.
Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration the monetary aspects (quantitative)
There are no standard definitions of the ratios. So firms may be using different formulas for the ratios. One such example is Current Ratio, where some firms take into consideration all current liabilities but others ignore bank overdrafts from current liabilities while calculating current ratio
And finally, accounting ratios do not resolve any financial problems of the company. They are a means to the end, not the actual solution.
Video Lecture Links:

https://youtu.be/hMoOk6iI564
 


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