Ratio analysis is a widely – used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two items/variables. This relationship can be expressed as (i) percentages, say, net profits are 25 per cent of sales (assuming net profits of Rs 25,000 and sales of Rs 1,00,000), (ii) fraction (net profit is one-fourth of sales) and (iii) proportion of numbers (the relationship between net profits and sales is 1:4). These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratios does not add any information not already inherent in the above figures of profits and sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.
The rationale of ratio analysis lies in the fact that it makes related information comparable. A single figure by itself has no meaning but when expressed .in terms of a related figure, it yields significant inferences. For instance, the fact that the net profits of a firm amount to, say, Rs 10 lakhs throws no light on its adequacy or otherwise. The figure of net profit has to be considered in relation to other variables. How does it stand in relation to sales? What does it represent by way of return on total assets used or total capital employed? If, therefore, net profits are shown in terms of their relationship with items such as sales, assets, capital employed, equity capital and so on, meaningful conclusions can be drawn regarding their adequacy. To carry the above example further, assuming the capital employed to be Rs 50 lakh and Rs 100 lakh, the net profits are 20 per cent and 10 per cent respectively. Ratio analysis, thus, as a quantitative tool, enables analysts to draw quantitative answers to questions such as: Are the net profits adequate? Are the assets being used efficiently? Is the firm solvent? Can the firm meet its current obligations and so on?
Basis of Comparison
Ratios, as shown above, are relative figures reflecting the relationship between variables. They enable analysts to draw conclusions regarding financial operations. The use of ratios, as a tool of financial analysis, involves their comparison, for a single ratio, like absolute figures, fails to reveal the true position. For example, if in the case of a firm, the return on capital employed is 15 per cent in a particular year, what does it indicate? Only if the figure is related to the fact that in the preceding year the relevant return was 12 per cent or 18 per cent, it can be inferred whether the profitability of the firm has declined or improved.
Alternatively, if we know that the return for the industry as a whole is 10 per cent or 20 per cent, the profitability of the firm in question can be evaluated. Comparison with related facts is, therefore, the basis of ratio analysis. Four types of comparisons are involved: (i) trend ratios, (ii) inter-firm comparison, (iii) comparison of items within a single year‘s financial statement of a firm, and (iv) comparison with standards or plans. .
Trends ratios involve a comparison of the ratios of a firm over time, that is, present ratios are compared with past ratios for the same firm. The comparison of the profitability of a firm, say, year 1 through 5 is an illustration of a trend ratio. Trend ratios indicate the direction of change in the performance-improvement, deterioration or constancy-over the years.
The inter-firm comparison involving comparison of the ratios of a firm with those of others in the same line of business or for the industry as a whole reflects its performance in relation to -its competitors. Other types of comparison may relate to comparison of items within a: single year‘s financial statement of a firm and comparison with standards or plans.