Q.1. What is Ratio Analysis? Discuss Importance and limitations of Ratio Analysis.
Meaning of ratio
The term ratio analysis is used in quantitative relationship between two variables. The Ratios are needed for
evaluating the financial statement. The use of ratios in the hands of financial experts works as a tool for evaluating different financial statements.
Definitions of Ratio Analysis
Following are some authentic definitions of Ratio Analysis.
Robert Anthony: ” Ratio as simple one number expressed in terms of another”.
Wixon, Kell and Bedford: “Ratio is expression of the quantitative relationship between two numbers.
Kohler: “A ratio is a relationship of one amount (A) to another Amount (B).
The important point to note is that ratio analysis does not add anything new but makes a statement more meaningful and helps in drawing the conclusion.
Let us take an example to illustrate the above:
$20,00,000 profit does not throw any light but when Profit is taken in relation to sales as $50,00,000 it gives some meaning as:
(Profit x 100) / Sales = ($20,00,000 x 100) / $50,00,000 = 40%
$100 as sales represent $40 as profit.
The ratios are used to explain the financial position of a concern which highlights the financial position may be good or weak. Ratio is a technique of analysis and interpretation of financial statements which is useful in decision making. It has four broad points to cover.
(a). Selection of representative figures. From financial statement select only those figures which are associated with each other.
(b) Calculation of ratio. These may be in percentage or times or proposition.
(c) Comparison. The main object of ratio is to establish relationship between related values such as ratio of gross profit to sales or debt-equity ratio etc.
(d) Interpretation of ratio. Ratio does not convey any sense if these are not analyzed properly.
importance/ Significance/merits of ratio analysis
The main points of importance are as follows:
1. Test of Solvency. The use of ratio is useful in testing the solvency position of the company. When percentage of gross profit to sales is increasing it shows the efficiency of profitability. Likewise, when ratio of
current assets to current liabilities shows upward trend, it means sufficient working capital. Thus, the claim of creditors can be paid easily.
2. Helpful in decision making. The main object of financial statement is to tell the financial position of the company upon which management takes decision.
3. Helpful in financial forecasting and planning. The ratios are of utmost use in financial planning. forecasting and work as a future guide. The ratios are used for drawing conclusions such as: Current ratio is 5:1, it means blocking up of capital as the ideal ratio is 2:1 whereas we have 5:1, thus, $3 are unnecessarily blocked.
4. Useful in knowing profitability. The ratios are most useful when comparison is made between companies for profitability. Two types of comparisons of present ratio with past ratio and the second comparison of several previous years are computed with the objective of knowing improvements or downfalls in the financial position.
5. Liquidity position. With the use of ratio analysis the meaningful conclusion regarding the sound liquidity position of the firm. The liquidity position is sound if it has the ability to pay its debts when these are due for payments.
6. Helpful in knowing operating efficiency. The ratios are important from management point of view wherein the management measures the efficiency of the assets. The sale and its percentage to net profit is increasing every year is a test of increase in efficiency.
7. Business trend. The ratio analysis speaks of the financial discipline of the firm with regard to additions and downfall. When the trend is for downfall the management can take corrective actions.
8. Helpful in cost control. Ratios are useful in measuring the performance and the cost control by the use of different ratios.
9. Helpful in analyzing the financial health of the company. The ratios are very useful in highlighting the Liquidity solvency, profitability and capital gearing. Thus, these are a useful tool for analyzing financial performance.
Limitations of Ratio Analysis
No doubt ratios are useful tools yet these should be used with utmost care as these suffer from certain drawbacks/limitations, which are as:
1. Need detailed knowledge. The calculation of ratio is not so much difficult as its interpretation. Ratios are tools of quantitative analysis and not of qualitative analysis. Thus, one should have a fair knowledge of qualitative and quantitative analysis.
2. Lack of reliable data. Ratio can give misleading results if the analyst does not know the reality and correctness of figures, for example, the value of closing stock is overstated profit will be inflated this will result in more taxation when actual profits are less than the profits on which tax has been paid.
3. Different Basis. There are different methods of valuation of closing stock. (i) LIFO (ii) FIFO in both profit will differ. Similarly, profit has different meanings. Someone may say profit before tax and interest, while others may take profit after tax and interest. Similarly, different methods of depreciation each method will show different amount of profit.
4. Different accounting policies. Different firms follow different policies with regard to depreciation; fixed installments or Diminishing balance method or stock valuation. LIFO, FIFO, thus profit so calculated will not be comparable unless adjustment for profit is not made.
5. Effect of price level change. While ratios are calculated, no thought is given to inflationary measures which are responsible for change in price level. Thus the whole utility of ratio analysis becomes stand still.
6. Bias Opinion. Ratios are only tools. it depends upon the user how to give them Practical shape. For example, profit has different meanings such as E.B.I.T. (Earning before interest and Tax). Some says profit is before interest. Thus personal opinion differs from business to business.
7. Lack of comparison. Different firms adopt different procedures, records, objectives and policies in such situations comparison will become more complicated.
8. Evaluation. There are different tools for ratio analysis. Which tool is to be needed in a particular situation depends upon the skill, training, intelligence and expertise of the analyst.