IMPORTANT TOPIC FOR SEBI GR A 2020 EXAM COMMERCE & ACCOUNTS
RATIO ANALYSIS
Ratio Analysis and its Applications
Ratio analysis is a medium to understand the financial weakness and soundness of an organization. Keeping in mind the objective of analysis, the analyst has to select appropriate data to calculate appropriate ratios. Interpretation depends upon the caliber of the analyst.
Ratio analysis is useful in many ways to different concerned parties according to their respective requirements. Ratio analysis can be used in the following ways:
To know the financial strength and weakness of an organization.
To measure operative efficiency of a concern.
For the management to review past year’s activity.
To assess level of efficiency.
To predict the future plans of a business.
To optimize capital structure.
In inter and intra company comparisons.
To measure liquidity, solvency, profitability and managerial efficiency of a concern.
In proper utilization of assets of a company.
In budget preparation.
In assessing solvency of a firm, bankruptcy position of a firm, and chances of corporate sickness.
Advantages of Ratio Analysis
· It is powerful tool to measure short and long-term solvency of a company.
· It is a tool to measure profitability and managerial efficiency of a company.
· It is an important tool to measure operating activities of a business.
· It helps in analyzing the capital structure of a company.
· Large quantitative data may be summarized using ratio analysis.
· It relates past accounting performances with the current.
· It is useful in coordinating the different functional machineries of a company.
· It helps the management in future decision-making.
· It helps in maintaining a reasonable balance between sales and purchase and estimating working capital requirements.
Limitations of Ratio Analysis
Although Ratio Analysis is a very useful accounting tools to analyze and interpret different accounting equations, it comes with its own set of limitations:
· If the data received from financial accounting is incorrect, then the information derived from ratio analysis could not be reliable.
· Unauthenticated data may lead to misinterpretation of ratio analysis.
· Future prediction may not be always dependable, as ratio analysis is based on the past performance.
· To get a conclusive idea about the business, a series of ratios is to be calculated. A single ratio cannot serve the purpose.
· It is not necessary that a ratio can give the real present situation of a business, as the result is based on historical data.
· Trend analysis is done with the help of various calculated ratios that can be distorted due to the changes in the price level.
· Ratio analysis is effective only where same accounting principles and policies are adopted by other concerns too, otherwise inter-company comparison will not exhibit a real picture at all.
· Through ratio analysis, special events cannot be identified. For example, maturity of debentures cannot be identified with ratio analysis.
· For effective ratio analysis, practical experience and knowledge about particular industry is essential. Otherwise, it may prove worthless.
· Ratio analysis is a useful tool only in the hands of an expert.
Types of Ratio
Ratios can be classified on the basis of financial statements or on the basis of functional aspects.
Classification on the Basis of Financial Statement
Balance Sheet Ratios
Ratios calculated from taking various data from the balance sheet are called balance sheet ratio. For example, current ratio, liquid ratio, capital gearing ratio, debt equity ratio, and proprietary ratio, etc.
Revenue Statement Ratio
Ratios calculated on the basis of data appearing in the trading account or the profit and loss account are called revenue statement ratios. For example, operating ratio, net profit ratio, gross profit ratio, stock turnover ratio.
Mixed or Composite Ratio
When the data from both balance sheet and revenue statements are used, it is called mixed or composite ratio. For example, working capital turnover ratio, inventory turnover ratio, accounts payable turnover ratio, fixed assets turnover ratio, return of net worth ratio, return on investment ratio.
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