Practical Use of Ratio Analysis

Understanding Ratio Analysis

Ratio analysis is a core tool used in accounting to evaluate a business’s financial position.
It involves converting monetary facts and figures into meaningful ratios, making it easier to draw inference and make decisions.
Helps in identifying financial strengths and weaknesses of a firm.
Aids in monitoring the business’s financial performance over period of time (trend analysis) and making relative comparisons with industry norms.

Liquidity ratios: Measures the ability of a business to pay its short-term debts.
- Current ratio & acid test ratio are two key liquidity ratios.
Profitability ratios: Analyses if a business is making sufficient profits; includes gross profit ratio, net profit ratio, return on capital employed, etc.
Efficiency ratios: Evaluate overall efficiency of a business.
- Inventory turnover and debtor days are common efficiency ratios.
Gearing ratios: Focused on long-term financial stability; lower gearing ratio means more financial security.

A single ratio, in isolation, is of little help. It should be seen in connection with other related ratios for meaningful interpretation.
Always compare the ratio with the past ratios, the projected ratios and the ratios of similar firms (industry norms) to gain a clearer picture.
The interpretation of ratios must take the nature of the business and the industry practices into account.

Ratio analysis is based on financial statements which may not reflect the exact financial status due to window-dressing of accounts.
Ratios are useful for comparison only when the firms followed similar accounting policies.
Ratios don’t consider qualitative aspects of business, so they cannot fully express a firm’s performance.

In calculating liquidity ratios like Current Ratio, remember that a ratio of 2:1 is traditionally viewed as ‘safe’, but it may vary as per industry norms.
When evaluating profitability using ROCE, higher value is better; benchmark against the industry average and past trends.
Applying efficiency ratios like Debtor Days, longer credit period represents high risk; industry averages provide the norm.
Gearing Ratio application requires examining business’s long-term borrowing practices; 50% ratio is commonly marked as a warning, but it also depends on industry norms.