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Ratio Analysis

Ratio Analysis Assignment / Homework Help

The relationship between two numbers expressed mathematically is called a ratio.

Ratio Analysis

Ratio analysis is a systematic use of ratios to interpret and assess the performance and status of a firm. It is a widely used tool of financial analysis. The use of ratios as a tool of financial analysis involves their comparison as otherwise, a single ratio, and an absolute figure fails to reveal the true position. Four types of comparison are involved:

  • Trend ratios

    Trend ratios involve evaluation of financial performance over a period of time, say 5 years or 10 years, depending upon the requirement, using financial ratio analysis
  • Inter-firm Comparison

    It involves comparison of different firm's financial ratios which are in the same industry, at a particular point of time
  • Comparison of items within a single year’s financial statement of a company and
  • Comparison with standards fixed

Types of Ratios

Ratios can be classified into the following categories according to its function:
  • Liquidity Ratios
  • Capital Structure ratios (Leverage Ratios)
  • Profitability ratios
  • Activity/Efficiency Ratios
  • Integrated analysis of ratios and
  • Growth Ratios

Advantages of Ratio Analysis:

  • Enables measuring liquidity position in time for want of arrangement of funds
  • Measures long-term solvency, reveals the strength and weaknesses of a firm
  • Enables measuring operating efficiency
  • Enables measuring overall profitability
  • Enables inter-firm comparison
  • Enables a firm to take the time dimension into account by trend analysis

Limitations of Ratio Analysis:

  • Difficulty in comparison due to different procedures adopted by various firms
  • Impact of inflation disregarded when using historical costs in financial statements
  • Diversity in concepts used – there is difference of opinion regarding the various concepts used to compute the ratios

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