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Ratio Analysis – An Introduction

Ratio Analysis – An Introduction

What is Ratio?

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

It refers to the systematic use of ratios to interpret the financial statements in terms of  operating performance and financial position of a firm.

Some important definitions: 

  • “The relation of one amount, a to another b, expressed as the ratio of a to b”– Kohler
  • “Ratio is the relationship or proportion that one amount bears to another, the first number being the numerator and the later denominator” – H.G.Guthmann 

ratio analysis

Significance of ratio analysis: 

  1. It consolidates and simplifies the accounting information or data
  2. It is a clear indicator of an organisation’s efficiency
  3. It helps in the evaluation of a firm’s performance by comparing the past and present ratio
  4. It aids the management in formulating poilicies, preparing budgets etc.,
  5. It points out the liquidity position thereby assisting in assessing the short-term obligations and long-term solvency
  6. It facilitataes inter-firm and intra-firm comparison, the former to understand the position of firm in the market and latter to gauge the performance of different divisions of the firm.
  7. Since ratios have the power to speak, they are considered as effective means of communication 

A broad classification of ratios: 

CLASSIFICATION BY FUNCTION

1. Solvency 

Short-term         Long-term

Current ratio      Proprietory ratio

Liquid ratio         Debt-Equity ratio

2. Profitability

  •  Gross profit ratio
  • Net profit ratio
  • Operating profit ratio
  • Return on Investment ratio

3. Activity ratio

  • Fixed assets turnover ratio
  • Debitors turnover ratio
  • Creditors turnover ratio
  • Stock turnover ratio

4. Leverage

  •  Financial leverage ratio
  • Operating leverage ratio
  • Capital gearing ratio

CLASSIFICATION BY STATEMENTS

1. Balance sheet ratios

  • Current ratio
  • Liquid ratio
  • Proprietory ratio
  • Debt-Equity ratio
  • Capital Gearing ratio

2. Profit and Loss Account ratios or Profitability ratios

  •  Gross profit ratio
  • Net profit ratio
  • Operating profit ratio
  • Return on Investment ratio

3. Inter-Statement ratios or Turn-over ratios

  •  Fixed assets turnover ratio
  • Debitors turnover ratio
  • Creditors turnover ratio
  • Stock turnover ratio

Advantages and Limitations of Ratio Analysis – Management Guru

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