Ratio Analysis – An Introduction

Posted in Accounting, Financial Accounting, Management Accounting on Feb 14th, 2014 | 0 comments

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

Significance of ratio analysis:

It consolidates and simplifies the accounting information or data
It is a clear indicator of an organisation’s efficiency
It helps in the evaluation of a firm’s performance by comparing the past and present ratio
It aids the management in formulating poilicies, preparing budgets etc.,
It points out the liquidity position thereby assisting in assessing the short-term obligations and long-term solvency
It facilitates 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.
Since ratios have the power to speak, they are considered as effective means of communication

A broad classification of ratios:

Pic Courtesy : Financial Ratios

CLASSIFICATION BY FUNCTION

1. Solvency

Short-term Long-term

Current ratio Proprietory ratio

Liquid ratio Debt-Equity ratio

2. Profitability

3. Activity ratio

4. Leverage

CLASSIFICATION BY STATEMENTS

1. Balance sheet ratios

2. Profit and Loss Account ratios or Profitability ratios

3. Inter-Statement ratios or Turn-over ratios