Ratio analysis - Introduction

Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.
Modes of Expression of Ratios:

Ratios may be expressed in any one or more of the following ways:
(a) Proportion,
(b) Rate or times
(c) Percentage.
Advantages of Ratio Analysis:
The information shown in financial statements does not signify anything individually because the facts shown are inter-related. Hence it is necessary to establish relationships between various items to reveal significant details and throw light on all notable financial and operational aspects. Ratio analysis caters to the needs of various parties interested in financial statements. The basic objective of ratio analysis is to help management in interpretation of financial statements to enable it to perform the managerial functions efficiently.
Limitations of Ratio Analysis:
Ratios are precious tools in the hands of management but the utility lies in the proper utilisation of ratios. Mishandling or misuse of ratios and using them without proper context may lead the management to a wrong direction. The financial analyst should be well versed in computing ratios and proper utilization of ratios. Like all techniques of control, ratio analysis also suffers from several ‘ifs and buts’ and for proper computation and utilization of ratios the analyst should be aware of the limitations of ratio analysis.
Uses and Users of Financial Ratio Analysis
Analysis of financial ratios serves two main purposes:

1. Track company performance
Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk.

2. Make comparative judgments regarding company performance
Comparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets.

Users of financial ratios include parties external and internal to the company:
External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers
Internal users: Management team, employees, and owners

1. MANAGEMENT ACCOUNTING Ratio Analysis By: Smt.UMA MINAJIGI REUR HEAD, DEPT. OF COMMERCE & Management Smt. V G Degree College for Women, Kalaburagi

2. MANAGEMENT ACCOUNTING B.COM SIXTH SEMESTER & BBA FOURTH SEMESTER 6.3: PRINCIPLES OF MANAGEMENT ACCOUNTING

3. B.COM SIXTH SEMESTER 6.3: PRINCIPLES OF MANAGEMENT ACCOUNTING   Unit I: Management Accounting (08 Hours): Definition and objectives of Management Accounting - Relationship between Cost, Financial and Managerial Accounting.   Unit II : Financial Statements (15 Hours): Nature, uses and limitations. Analysis and interpretations – meaning, procedure, objectives, and importance. Comparative statement, Common Size Statements and Trend Analysis - practical problems.   Unit III: Ratio Analysis (15 Hours): Definition and meaning of Ratio Analysis, importance and limitations, Profitability Ratio – Gross profit Ratio, operating Ratio, Overall profitability ratio – Earning per share. Turnover Ratios- Inventory Turnover Ratio, Debtors Turnover Ratio, Debt collection period , Creditors Turnover Ratio, Debt payment period, Liquidity Ratio- current ratio, liquid ratio. Financial positions and Leverage Ratios- Debt Equity Ratio, Proprietary Ratio - Problems thereon.   Unit IV: Analysis through Leverages (12 Hours): Meaning- types of Leverages- operating – financial and combined leverages- problems thereon.   Unit V: Fund Flow Statement (15 Hours): Meaning , uses and limitations – preparation of fund-flow statement. Cash Flow Statement: Meaning and preparation of Cash flow statement- problems thereon.

4. Management Accounting The term Management Accounting consists of two words: “Management” and “Accounting”.   Management is a technique of managing men. Its an art of getting things done by others.   Hence, for a successful execution of all activities, management has to to take various decisions at every level. To take proper decisions, correct information is required. Such information is provided by accounting.   Accounting is the process of identifying, measuring and communicating economic information to management and outsiders. Such information’s help management to take decisions.   Management Accounting is the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of financial information in order to plan the formulation of policies to plan and control the operations of the controlling of business operations.

5. Definition: J.S. Batty defines, “Management accounting is the term used to describe the accounting methods, systems and techniques which coupled with special knowledge and ability to assist management in its task of maximising profit and minimising losses.”   Management Accounting is a system for gathering data and other financial information primarily for the internal needs of management. It is designed to assist internal management in the efficient formulation, execution and appraisal of business plans.

6. An analysis of financial statements with the help of ratio is called Ratio Analysis. Ratio refers to Numerical or Quantitative relationship between two items. What are Financial Ratios? Financial ratios are created with the use of numerical values taken from  financial statements  to gain meaningful information about a company. The numbers found on a company’s financial statements –  balance sheet ,  income statement , and  cash flow statement  – are used to perform  quantitative analysis  and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.

7. Ratio analysis is a process used for the calculation of financial ratios or in other words, for the purpose of evaluating the financial wellbeing of a company. The values used for the calculation of financial ratios of a company are extracted from the financial statements of that same company. Ratio analysis can be defined as the process of ascertaining the financial ratios that are used for indicating the ongoing financial performance of a company using few types of ratios such as liquidity, profitability, activity, debt, market, solvency, efficiency, and coverage ratios and few examples of such ratios are return on equity, current ratio, quick ratio,  dividend payout ratio , debt-equity ratio, and so on.

8. A ratio is a mathematical relationship between two items expressed in a quantitative form. Ratios can be defined as “Relationships expressed in quantitative terms, between figures which have caused and effect relationships or which are connected with each other in some manner or the other”. An accounting ratio can be defined as quantitative relationship between two or more items of the financial statements connected with each other. Arithmetically ratio is a comparison of the numerator with the denominator. The essence of ratio is putting together of two figures to study their relationship. The study is in the form of analysis, interpretation and expression of all the ramifications of the relationship.

9. Modes of Expression of Ratios: Ratios may be expressed in any one or more of the following ways: (a) Proportion, (b) Rate or times (c) Percentage.

10. (a) In Proportion: In this type of expression the amounts of two items are expressed in a common denominator. An example of this form of expression is the relationship between current assets and current liabilities as “2”: “1”. (b) In Rate or Times or Coefficient: In this type of expression, a quotient obtained by dividing one item by another is taken as Unit of expression. Example of this form of expression is cost of sales divided by average stock (say 8), thus 8 times is the ratio between cost of sales and stock. (c) In Percentage: In this type of expression, a quotient obtained by dividing one item by another is multiplied by one hundred to show the relationship in terms of percentage. For example- the relationship between net profit and sales may be expressed as say 25%.

11. Advantages of Ratio Analysis: The information shown in financial statements does not signify anything individually because the facts shown are inter-related. Hence it is necessary to establish relationships between various items to reveal significant details and throw light on all notable financial and operational aspects. Ratio analysis caters to the needs of various parties interested in financial statements. The basic objective of ratio analysis is to help management in interpretation of financial statements to enable it to perform the managerial functions efficiently. The following are the advantages of ratio analysis: (1) Forecasting: Ratios reveal the trends in costs, sales, profits and other inter-related facts, which will be helpful in forecasting future events.

12. (2) Managerial Control: Ratios can be used as ‘instrument of control’ regarding sales, costs and profit. (3) Facilitates Communication: Ratios facilitate the communication function of management as ratios convey the information relating to the present and future; quickly, forcefully and clearly. (4) Measuring Efficiency: Ratios help to know operational efficiency by comparison of present ratios with those of the past working and also with those of other firms in the industry. (5) Facilitating Investment Decisions: Ratios are helpful in computing return on investment. This helps the management in exercising effective decisions regarding profitable avenues of investment.

13. (6) Useful in Measuring Financial Solvency: The financial statements disclose the assets and liabilities in a format. But they do not convey relationship of various assets and liabilities with each other, whereas ratios indicate the liquidity position of the company and the proportion of borrowed funds to total resources which reveal the short term and long term solvency position of a firm. (7) Inter Firm Comparisons: The technique of inter-firm comparisons can be carried out successfully only with the help of ratio analysis. Otherwise no firm may come forward to disclose full information. Inter-firm comparisons help the management to compare its performance with an external ‘bench­mark’ or standard.

14. Limitations of Ratio Analysis: Ratios are precious tools in the hands of management but the utility lies in the proper utilisation of ratios. Mishandling or misuse of ratios and using them without proper context may lead the management to a wrong direction. The financial analyst should be well versed in computing ratios and proper utilization of ratios. Like all techniques of control, ratio analysis also suffers from several ‘ifs and buts’ and for proper computation and utilization of ratios the analyst should be aware of the limitations of ratio analysis. The following are the limiting factors which minimise or reduce the value of ratio analysis: (1) Practical Knowledge: The analyst should have thorough knowledge and experience about the firm and industry. (2) Ratios are Means: Ratios are not an end in themselves but they are means to achieve a particular purpose or end.

15. (3) Inter-Relationship: Ratios are inter-related and therefore a single ratio cannot convey any meaning. It has to be interpreted with reference to other related ratios to draw meaningful conclusions. (4) Non Availability of Standards or Norms: Ratios will be meaningful if they can be compared with standards or norms. Except for a few financial ratios, other ratios lack standards which are universally recognised. (5) Accuracy of Financial Information: The accuracy of a ratio depends on the accuracy of information derived from financial statements. If the statements are-inaccurate, same will be the result with ratios. (6) Consistency in Preparation of Financial Statements: Inter-firm comparisons with the help of ratio analysis will be useful only if the firms use uniform accounting procedures consistently. Otherwise the comparison may be useless.

16. (7) Detachment from Financial Statements: Ratios are not substitutes to financial statements. They can be meaningful only if they are read along with information with which they are prepared. If the information is detached, ratios themselves cannot convey much useful message. (8) Time Lag: Ratio analysis will be fruitful only if the conclusions are conveyed quickly to the management. If there is a delay, the utility of the data is diminished and the purpose itself may be defeated. (9) Change in Price Level: Ratio analysis becomes redundant during periods of heavy price fluctuations. (10) Window Dressing: The information given in the financial statements is affected b window dressing i.e , showing better picture to outsiders than what is actually the financial position and profitability.

17. Uses and Users of Financial Ratio Analysis Analysis of financial ratios serves two main purposes:   1. Track company performance Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk.   2. Make comparative judgments regarding company performance Comparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets.   Users of financial ratios include parties external and internal to the company: External users:  Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers Internal users:  Management team, employees, and owners

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