Another technique of analyzing financial statements is RATIO ANALYSIS which involves calculating different
ratios based on figures of financial statements (this will be more clearly evident from next pages). By calculating financial ratios and then comparing these with industry ratios, one can extract a lot of useful information for decision making.
Types of Ratios
Broadly ratios can be categorized in following five:
- Short term solvency (liquidity) ratios
- Long term solvency ratios
- Profitability ratios
- Asset utilization or efficiency ratios
- Market (investors) ratios
Each broader category contains several ratios that have been explained on coming pages.
Ratio Analysis vs. Horizontal and Vertical Analysis
Horizontal analysis provides a historic trend without scrutinizing in detail the reasons of such trend, on the other hand vertical analysis although drills down in breakup of financial position but lacks explaining performance and efficiency. Ratio analysis covers both these aspects. Besides ratio analysis uses non financial information as well for interpreting ratios, thus becomes more powerful tool than horizontal or vertical analysis.
Limitations of Ratio Analysis
Like every technique, ratio analysis has its own limitations. Among many, following are some common limitations:
- There is no universal standard / rule for calculation of ratios. Different people use different (slightly different) formulas for calculation and accordingly interpret.
- Ratios are more meaningful when compared with industry; however each and every ratio for industry is not available. Thus limiting the usefulness of ratios.
- Non financial information required for interpretation of ratios might not be always available. Companies normally do not disclose sensitive information for several reasons (e.g. competition).
- In ratio analysis historical information is used thus interpretation for decision making is based on historical information which does not include the impact of future changes for example inflation or recession.
What to expect from ratio analysis guidance?
Ratio analysis is considered a difficult topic to be understood, comprehended and applied. I believe that using the method as listed below for explaining each and every ratio you will find ratio analysis as easy as a topic of 2nd GRADE SCHOOL. For each ratio, I will give you
First question comes in mind is HOW TO CALCULATE THE PARTICULAR RATIO? I will write down the most common formula used for calculating a ratio along with alternative, if any.
With example I will calculate the ratio using the formula given above. PLEASE NOTE THAT, in examples I will use data from HYPOTHETICAL FINANCIAL STATEMENTS (as given here)so that you can calculate ratios from real financial statements in you practical life.
In which unit the ratio is measured i.e. in currency unit (dollars), percentages, days or whatever.
After calculating the ratio, the next logical question that comes in mind is WHAT DOES THIS RATIO MEAN? So I will teach
- How to interpret the ratio; and
- What particular user needs this ratio addresses. (You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).
- INTERPRETATION ALONG WITH OTHER RATIOS
A ratio gives useful information however when interpreted along with other ratios, the meaning and usefulness of ration increases manifolds. Therefore I will teach you what a ratio means when interpreted with the combination of several other ratios.
HOW TO IMPROVE RATIO?
Although improving the ratio is concern of management as compared to external users but I find it appropriate to include it here as management is responsible for taking care of several users (i.e. both at input and output level).
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