Ratio is a relationship between two figures of financial statements. It is important tool to analyze company’s financial performance. It is used to it is used to evaluate a number of issues with an entity, such as its liquidity, efficiency of operations, and profitability.
This type of analysis is particularly useful to analysts outside of a business as it would be their primary source of information about an organization.
Ratio analysis is less useful to corporate insiders, who have better access to more detailed operational information about the organization.
It can be expressed in the following terms:
- Ratio method: this method shows the relationship between two figures in ratio (e.g. 2:1, 3:4, etc.)
- Rate method: this method shows the relationship in times (e.g. 3 times, 4 times, etc.)
- Percentage method: the relations between two figures that can be presented in percentages (e.g. 20%, 30%, etc.)
Importance or advantage of ratio analysis
- It is important to analyze the financial position of the company. Different users (investors, management, bankers, creditors, etc.) Use such ratios for decision making purpose.
- It is helpful in the evaluation of the performance efficiency (i.e. the measurement of profitability at different levels).
- It measures liquidity and solvency positions of a firm, which justifies its economic soundness.
- It measures activity of a business, which helps to see the size, quantity and quality of sales through stock turnover, debtor’s turnover and debt collection period, etc.
- It provides comparisons facility of various ratios like liquidity, solvency, activity, profitability, etc. Of a concern over a series of years.
Limitations of ratio analysis
- Ratio analysis is based on historical data. It ignores the impact of price level changes and fails to disclose the current worth of the enterprises.
- It ignores the qualitative aspects, which might equally important for the organizational success i.e. sound relationship between workers and management, customer satisfaction, public attitude towards business, employee motivations, etc.
- It is not suitable for future planning as it uses the past financial data which may not be relevant for forecasting for future.
- Financial statement may not be reliable to outsiders as there is high chance of window dressing
- Financial ratios are done as per the personal judgement of analysts. They may choose various alternatives and it may not be free from personal biasness.
Types of accounting ratios:
- Liquidity ratio
- Current ratio
- Quick ratio
- Leverage ratio
- Debt equity ratio
- Debt to total capital ratio
- Activity ratio
- Inventory turnover ratio
- Debtor turnover ratio
- Average collection period
- Fixed assets turnover ratio
- Total assets turnover ratio
- Capital employed turnover ratio
- Profitability ratio
- Gross profit margin
- Net profit margin
- Return on assets
- Return on capital employed
- Earnings per share
- Dividend per share