August 20, 2014
The term “ratio analysis” refers to the analysis of the financial statements in conjunction with
the interpretations of financial results of a particular period of operations, derived with the help
of ‘ratio’. Ratio analysis is used to determine the financial soundness of a business concern.
In this blog post, we will introduce ratio analysis, what it is used for, what are the advantages and
disadvantages of it and its limitations.
Ratio analysis is a conceptual technique which dates back to the inception of accounting, as a
concept. Financial analysis as a scientific tool is used to carry out the calculations in the area of
accounting. In order to appraise the valid and existent worth of an enterprise, financial tool comes
handy, regularly. Besides, it also allows the firms to observe the performance spanning across a
long period of time along with the impediments and shortcomings. Financial analysis is an essential
mechanism for a clear interpretation of financial statements. It aids the process of discovering, the
existence of any cross-sectional and time series linkages between various ratios.
Formerly, Security qualified as a major requisite for banks and financial institutions, to consider
and grant loans and advances. However, there’s been a complete paradigm shift in the structure.
Currently, lending is based on the evaluation of the actual need of the firms. Financial viability of a
proposal, as a base to grant loans, is now been given precedence over security. Further, an element
of risk is an imperative in every business decision. Credits, run a higher risk, as a part of any decision
making in business and so, Ratio analysis and other quantitative techniques mitigate the risk to some
extent by providing a fair and rational assessment of risks.
Ratio analysis broadly explains the process of computing, acts as a vital tool in determination and
presentation of the relationship of related items and groups of items of the financial statements.
Financial position of a unit is concretely and clearly encapsulated by the means of ratio analysis. The
significance of Ratio Analysis for a holistic Financial Analysis remains unflinchingly supreme.
Ratio can be used in the form of percentage, Quotient and Rates. In other words, it can be expressed
as a to b; a: b (a is to b) or as a simple fraction, integer and decimal. A ratio is calculated by dividing
one item or figure by another item or figure.
In order to establish the relationship between two accounting figures, application of Ratio Analysis is
necessary. Application of the same provides the significant information to the management or users
who can analyse the business situation. It also facilitates meaningful and productive monitoring of
the annual performance of the firm. Illustrated below are the advantages of ratio analysis:
Limitations of Ratio Analysis
different companies, operating in different industries. Significance of such factors is
extremely high. This variation may lead to a difference or an element of discrepancy, while
comparing the two companies from diverse industries.
and assumptions. Accounting standards allow scope for incorporating different accounting
policies, which impairs comparability and hence functionality of ratio analysis is less in such
information is of more relevance and application to the users.
In our next article we will discuss classification of ratios and look at different ratios in detail.