Financial Analysis can be undertaken by the management or owners of the firm, or by external people viz., creditors, investors and others. The nature of analysis and ratios used depend upon the perspective / need of the person computing the ratios.
The term Ratio refers to the numerical or quantitative relationship between two related items / variables / accounting figures. Ratios help to make qualitative judgement. Ratios may be express as
i. Proportion of numbers e.g. 2:1; or
ii. A ‘Rate’ or ‘Time’ e.g. 2 times; or
iii. Percentages e.g. 200%; or
iv. Fraction or Quotient / decimal e.g. 2/3 or 0.667
Ratio analysis makes related information comparable. Ratios are helpful in ascertaining the financial condition of the firm, strengths and weaknesses of the firm. A single ratio like an absolute figure is not of much use. Ratios need to be compared –
a. Over a period of time i.e. trend or time series analysis
b. With competitors, industry standards, selected firms of the industry (Cross-sectional analysis)
c. Rule of thumb
Following are the steps involved in Ratio Analysis:
i. Determination of the objective of the analysis
ii. Selection of relevant data from the financial statements
iii. Comparison of ratios computed for different points of time or comparison with firms of the same industry (inter-firm comparison) etc.
iv. Interpretation of the ratios