Meaning of Ratio

Financial analysis
Financial analysis is a selection, evaluation and interpretation of

financial data, to assist in investment and financial decision making. It may be used internally
to evaluate issue such as employee performance, credit policies and the efficiency of
operations, externally it is used to evaluate potential investment in credit-worthiness of
borrowers.
Investors and other external users of financial information will often

need to measure the performance and financial health of an organization. This is done in
order to evaluate the success of the business. There are many different methods that can be
used alone or together to help investor assess the financial stability of an organisation. One
of the most common methods is Financial Ratio Analysis. Financial ratio analysis can be an
invaluable resource to investors and external users who must determine the financial
stability of an organization. This is important, because financial stability represents the
efficiency of the business, soundness and also dependability of the business.
One can assess a company’s performance by employing ratio analysis, which uses a
combination of financial and operating data as a basis for making comparisons with other
companies:
 Liquidity ratios give a measure of how readily a company can meet its obligations.
 Profitability ratios give an indication of the earnings and profitability potential of a
company.
 Asset management ratios gauge how efficiently a company can change assets into
sales.
 Debt management ratios indicate how debt-leveraged a company is, and how it can
manage the debt in terms of assets and operating income.
 Dividend/market value ratios measure how well a company uses its assets to
generate earnings.
 Profitability ratios indicate earnings and potential profitability.
Advantages of financial ratio analysis:
 Regularly assessing business performance allows for longer-term and more strategic
planning, which is necessary to optimize business and market opportunities.
 Ratio analysis permits analysts to read between the lines of financial statements and
identify a company’s strengths and weaknesses.
 Financial ratios provide lead indications of potential problem areas and allow
corrective measures to be taken.
Meaning of Ratio
According to Accountant’s Handbook by Wixon, Kell and Bedford, a ratio “is an expression of
the quantitative relationship between two numbers.
Nature of Ratio Analysis
1. Selection of relevant data from the financial statements depending upon the objective of
the analysis
2. Calculation of appropriate ratios from the data obtained. Comparison of the calculated
ratios of the same firm in the past, or the ratios developed from projected financial
statements or the ratios of some other firms or the comparison with the ratios of the industry
to which the firm belongs.
3. Interpretation of the ratios.
Use and Significance of Ratio Analysis
The ratio analysis is one of the most powerful tools of financial

analysis. It is used as a device to analyze and interpret the financial health of enterprise. The
use of ratios is not confined to financial managers only. The supplier of goods on credit,
banks financial institutions, investors, shareholders and management all make use of ratio
analysis as a tool in evaluating the financial position and performance of a firm for granting
credit, providing loans or making investments in the firm.
Managerial Uses of Ratio Analysis
Helps in decision-making Helps in financial forecasting and planning Helps in communicating

Helps in control
Utility to Shareholders/Investors
An investor in the company will like to assess the financial position of the concern where he
is going to invest. His first interest will be the security of his investment and then a return in
the form of dividend or interest.
Utility to Creditors
The creditors or suppliers extend short-term credit to the concern. They are interested to
know whether financial position of the concern warrants their payments at a specified time or
not.
Utility to Employees
The employees are also interested in the financial position of the concern especially
profitability. Their wage increases and amount of fringe benefits are related to the volume of
profits earned by the concern.
Utility to Government
Government may base its future policies on the basis of industrial information available from
various units. The ratios may be used as indicators of overall financial strength of public as
well as private sector. In the absence of the reliable economic information, governmental
plans and policies may not prove successful.
Limitations of Ratio Analysis
1. Limited use of a single ratio

2. Lack of adequate standards
3. Inherent limitations of accounting
4. Change of accounting procedure
5. Window dressing Personal bias
6. Incomparable Absolute figures distortive
7. Price level changes
8. Ratios no substitutes

Meaning of Ratio

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Meaning of Ratio

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Financial analysis

Financial analysis is a selection, evaluation and interpretation of

Investors and other external users of financial information will often

Advantages of financial ratio analysis:

3. Interpretation of the ratios.

Use and Significance of Ratio Analysis

The ratio analysis is one of the most powerful tools of financial

Managerial Uses of Ratio Analysis

Helps in decision-making Helps in financial forecasting and planning Helps in communicating

1. Limited use of a single ratio

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