Introduction….

The company’s financial information is contained in Balance Sheet and Profit

and Loss Account. The figures contained in these statements are absolute
and sometimes unconnected with one another. An absolute figure does not
convey much meaning. However it is only in the light of other information
that the significance of a figure is realized. Company’s profitability cannot be
known unless together expressed mathematically is called a Ratio. The ratio
refers to the numerical or quantitative relationship between two variables or
items. A ratio is calculated by dividing one item of the relationship between
two variables or items. A ratio refers to the numerical or quantitative
relationship between two variables or items. A ratio is calculated by dividing
one item of the relationship with other. The ratio analysis is one of the most
useful and common method of analyzing financial statements. As compared
to other tools of financial analysis, the analysis provides very useful
conclusions about various aspects of the working of an enterprise. The need
for ratios arises due to the fact that absolute figures are often misleading.
Absolute figures are certainly valuable but their value increases manifold if
they are studied with another through ratio analysis. Ratios analysis is an
instrument for diagnosis of the financial health of an enterprise. Ratios, in
fact, are full of meaning and communicate the relative importance of the
various items appearing in the balance sheet and Profit and Loss Account.

Meaning of ratio
A ratio is only a comparison of the numerator with the denominator. The
term ratio refers to the numerical or quantitative relationship between two
figures. A ratio is the relationship between two figures, and obtained by
dividing the former by the latter. Ratios are designed to show how one
number is related to another. It is worked out by dividing one number by
another.

Ratio analysis is an important and age old technique of financial analysis.

The data given in financial statements, in absolute form, are dump and are
unable to communicate anything. Ratios are relative form of financial data
and very useful technique to check upon the efficiency of a firm. Some ratios
indicate the trend or progress or downfall of the firm.
Functions
As a tool of financial management, ratios are of crucial significance. The
importance o ratio analysis lies in the fact that it presents fact on a
comparative basis and enables the drawings of inferences regarding the
performance of firm. Ratio analysis is relevant in assessing the performance
of in respect of the following aspect.

1.Liquidity ratios –
With the help of ratio analysis conclusions can be drawn
regarding the liquidity position of firm. The liquidity position of the firm would
be satisfactory if it is able to meet its current obligations when they become
due. A firm can be said to have the ability to meet its short term liabilities if it
has sufficient liquid funds to pay the interest on its short term maturing debt
usually within a year as well as to repay the principal. This ability is reflected
in the liquidity ratios of firm. The liquidity ratios are particularly useful in
credit analysis by banks &other supplier of short term loans.

1. long term solvency –

Ratio analysis is equally useful for assessing the long term financial viability
of a firm. This aspect of the financial position of a borrower is to thee long
term creditors, security analysts, and the present and potential; owner of a
business. The long term solvency is measured by leverage/capital structure
and profitability ratios which focus on earning power and operating
efficiency. Ratio analysis reveals the strength & weakness of firm in this
respect. The leverage ratios, for instance, will indicate whether a firm has a
reasonable proportion of various sources of finance or whether heavily
loaded with debt in which case its solvency is exposed to serious strain.
Similarly, the various profitability ratios would reveal whether or not the firm
is able to offer adequate returns to its owners consistent with the risk
involved.

2. Operating efficiency-

Yet another dimension of usefulness of ratio analysis, relevant from the

viewpoint of management, is that it throws the light on the degree of
efficiency in the management and utilization of its assets. The various
activity ratios measure this kind of operational efficiency. In fact, the
solvency of the firm is, in the ultimate analysis, dependent upon the sales
 revenue generated by the use of its assets total as well as its
components.

4. Overall profitability-

Unlike the outside parties which are interested in one aspect of the
financial position of a firm, the management is constantly concern about the
overall profitability of the enterprise. That is, they are concerned about the
ability of the firm to meet its short terms as well as long term obligation to its
creditors, to ensure reasonable returns to its owners and secure optimum
utilization of the assets of the firm. This is possible if an integrated view s
taken and all the ratios are considered together

5. Inter firm comparison-

Ratio analysis not only throws light on the financial position of a firm but also
serves as a stepping stone to remedial measures. This is made possible due
to inter firm comparison with industry average. A single figure of particular
ratio is meaningless unless it is related to some stander or norms. One of the
popular techniques is to compare the ratio of the firm with the industry
average. It should be reasonably expected that the performance of the firm
should be in broad conformity that of the industry to which it belongs. An
inter firm comparison would demonstrate the relative position vis-à-vis its
competitors. If the results are at variance either with the industry average or
with those of the competitors, the firm can seek to identify the probable
reasons and, in that light, take remedial measures.

6. Trend analysis-
Finally, ratio analysis enables the firm to take the time dimension into
account .in other words, it enables us to know whether the financial position
of a firm is improving or deteriorating over the years. This is made possible
by the use of trend analysis. The significance of trend analysis of the ratios
lies in the fact that the analysis can know the direction of movement, that is,
whether the movement is favorable or unfavorable. For example the ratio
can be low as compared to the norms/standard but the trend may be
upward. On the other hand, though the present level may be satisfactory but
the trend may be declining one. Thus, trend analysis is of great significance.
Classification of ratios:
Financial ratios have been classified in several ways. A number of
standpoints may be used as base for classifying the ratios. It is a matter of
great surprise that no uniformity has been achieved in this regard. Different
authors have classified the ratios in varying groups. To illustrate, the short-
term creditors main interest in the long-term solvency and profitability
analysis of the firm’s financial conditions; management is interested in
evaluating every activity of the firm because they have to protect the
interests of all parties. Thus accounting ratios may be classified on the
following bases leading to somewhat overlapping categories.

Classification by statements

The traditional classification is based on those statements from which

information is obtained for calculating the ratios. The ratios are classified as
follows:

Balance sheet ratios: Financial ratios quantify many aspects of a business

and are an integral part of financial statement analysis. Financial ratios are
categorized according to the financial aspect of the business which the ratio
measures. Liquidity ratios measure the availability of cash to pay debt.
Activity ratios measure how quickly a firm converts non-cash assets to cash
assets. Debt ratios measure the firm's ability to repay long-term debt.
Profitability ratios measure the firm's use of its assets and control of its
expenses to generate an acceptable rate of return. Market ratios measure
investor response to owning a company's stock and also the cost of issuing
stock.

Financial ratios allow for comparisons

• between companies
• between industries
• between different time periods for one company
• between a single company and its industry average

The ratios of firms in different industries, which face different risks, capital
requirements, and competition, are not usually comparable.

Profit and loss account ratio: profit earning is the main objective of each
business concern. A company should earn profits to survive and to grow over
long period. A measure of profitability is the overall measure of efficiency.
Profitability and profits are two different elements. Profit refers to the
absolute quantum of profit whereas profitability refers to the ability to earn
profits. It is a test of efficiency and a measure of control to the management.
It is a measure of the worth of owner’s investment. It is the margin of safety
to creditors. It is a source of fringe benefits to employees. Profit is a measure
of taxpaying capacity to the government. To customers, it is a hint to
demand for better quality and price cuts. Operation ratios and activity ratios
or efficiency ratios are calculated to measure the profitability of an
enterprise.

There are two types of profitability ratios. They are profit margin ratios and
rate of return ratios. Profit margin ratios show relationship between profit
and sales. Rate of return ratios reflect the relationship between profit and
investments.

Combined ratios: This category of ratios includes those ratios, which

highlight upon the activity and operational efficiency of the business
concern. the funds of creditor and owners are invested in various kinds of
assets to generate sales and profits. The better the management of assets,
the larger the amount of sales. This category ratios use elements of both
balance sheet as well as revenue statements for computation of ratios. These
ratios are always expressed as turnover or in number of times i.e. rate of
turning over or rotation
Classification by users: this classification is based on the parties who are
interested in making the use of ratios.

Classification according to importance: this basis of classification of

ratios has been recommended by the British Institute of management. They
are of two types:

Classification by purpose/ function

This is a classification based on the purpose for which an analyst computes
these ratios. The modern approach of classifying the ratios is according to
purpose or object of analysis. Normally, ratios are used for the purpose of
assessing the profitability and sound financial position. Thus, ratios according
to the purpose are more meaningful. There can be several purposes which
can be listed. For analysis, it is customary to group the purpose into broad
headings. The following are the broad categories of accounting ratios from
financial point of view:
Limitation of ratio analysis:
Ratio analysis is, as already mentioned, a widely-used tool of financial
analysis. It is because ratios are simple and easy to understand. But they
must be used very carefully. They suffer from various limitations. For
instance, financial statements suffer from a number of limitations and may
therefore; affect the quality of ratio analysis. If due care is not taken, they
might confuse rather than clarify the situation. Different firms may use these
terms in different senses or the same firm may use them to mean different
things at different times. Some of the limitations of the ratio analysis are
given below:

1. Differences in definition: comparisons are made difficult due to

differences in definition of various financial terms. Lack of standard
formula for working out ratios makes it difficult to compare them. They
are worked out on the basis of different items in different industries.

2. Limitation of accounting records: ratio analysis is based on financial

statements which are themselves subject to limitations. Thus, ratio
calculated on the figure given in the financial statement, also suffers
from similar limitations.

3. Lack of proper standards: it is very difficult to ascertain the standard

ratio in order to make proper comparison. Because, it differs from firm
to firm, industry. Apart from this, it may also have happened than in
one firm, a current ratio of 2:1 is found is found to be quite satisfactory,
whereas in another firm 2.5:1 may be unsatisfactory. Again, a high
current ratio may not necessarily mean sound liquid position when
current assets include large inventory or inventory consisting of
obsolete items.

4. No allowance for price level changes: due to changes in price level

of various years, comparison of ratio of such years cannot give correct
conclusion. A change in the price level can seriously affect the validity
of comparison of ratio computed for different time periods. For instance,
a firm which has purchased an asset at a lower price will show a higher
return, than the firm which has purchased the asset at a higher price.

5. Changes in accounting procedure: Comparisons between two

variables prove worth provided their basis of valuation is identical. But
in reality it is not possible, such as methods of valuation of stock (FIFO
 OR LIFO) or charging different methods of depreciation on fixed asset
etc. thus, if different methods are followed by different firms for their
valuation, then comparison will practically be of no use.

6. Qualitative factors are ignored: ratios are tools of quantitative

analysis only and normally qualitative factors which may generally
influence the conclusion derived are ignored while computing ratios. For
instance, a high current ratio may not necessarily mean sound liquid
position when current asset include a large inventory consisting of
mostly obsolete items. Therefore it is very difficult to generalize
whether a particular ratio is GOOD or BAD.

7. Limited use of single ratio: a single ratio would not be able to

convey anything. Ratio can be useful only when they are computed in a
sufficient large number. If too many ratios are calculated, they are likely
to confuse instead of revealing meaningful conclusions.
8. Background is overlooked: when inter-firm comparison is made, they
differ substantially in age, size, nature of product etc> when an inter-
firm comparison is made, these factors are not considered. Therefore
ratio analysis cannot give satisfactory results.
9. Limited use: ratio analysis is only a beginning and gives just a fraction
of information needed for decision-making. Ratio analysis is not a
substitute for sound judgment. But ratios are tools to aid in applying
judgment. Conclusions drawn from the ratio analysis are not sure
indicators of bad or good management. They merely convey certain
observations which need further investigations, otherwise wrong
conclusions may be drawn. Computation of ratios is not useful unless
they are interpreted.
10. Personal bias: Ratios have to be interpreted and different people may
interpret the same ratio in different ways. Ratios are only means of
financial analysis but not an end in themselves. Ratios are simple to
understand and easy to calculate. Therefore, there is a tendency to
over employ them. It should be clearly noted that ratios are only tools
and the personal judgment of analyst is more important. The analyst
has to carry further investigations and exercise his judgment in arriving
at a correct diagnosis.
11. Arithmetical window Dressing: window-dressing means
manipulation of accounts in a way so as to conceal vital facts and
present the statements in a way to show better position than what is
 actually is. By doing so, it is possible to cover up bad financial position.
Therefore, ratios based on such figures are not reliable.

12. Changing policies: Ratios are computed on the basis of past result.
Past is not an indicator of future. Ratios computed from historical data
are used for predicting and projecting the likely events in the future.
Such ratios may provide a glimpse of firm’s past performance. But
forecast for the future may not be correct as several other factors like
management policies, market conditions etc. may induce future
operations.

13. No exactness: Financial standard data are not exact, and have,
therefore, to be treated with great caution.

14. Ratios are likely to be misused. There are some situations in which
they may appear to be misleading.

15. V.V. Desai point out that the advancing artistry of the technique of
ratio analysis has miserably failed to accomplish the expected
impeccability or immaculacy. Moreover, it has made the technique
more complicated and complex far beyond the understanding of
ordinary businessmen.