It has been repeatedly said that traditional financial statements, viz. BS and P & L Alc,are to be scrutinised for changes in financial position to be rightly inferred. They both are organised summaries of much detailed information and so are themselves a form of analysis. However, further analysis of these financial statements is often possible, and is also crucial, for aiding interested parties in decision-making through proper evaluation af the financial status of the firm. Ratio Analysis is one such widely used methodology routcome on the financial soundness of the firm can be infered, or evaluated. Ratio analysis, in other words, is a process of evaluating relationships between component parts of financial statements to obtain a better understanding of the firm's financial position and business performance.
The objective and purpose of evaluation depends on the specific composition of the interested group - be they from creditors, shareholders, would-be investors, management,government, labour, etc. Short-term creditors like to judge the ability of the firm to repay currently-maturing obligations. Shareholders and would-be investors are interested in the earnings per share and the dividend payout. Debenture holders and financial institutions which lend on long-term basis are interested in the capital structure, the history of earnings and changes in financial position. Management is interested in maintaining the solvency, satisfying the creditors and ensuring adequate return (with safety and assurance) to the firm's owners. Government is interested not only in solvency but also in the several charges on the business earnings including taxes.
To cater to these various needs, the financial analyst has to select the relevant information, organise the information to highlight the significant relationships between the concerned items, and, thereby, serve the purpose of drawing inferences and conclusions, that is, of evaluation, and, hopefully, thereupon, in decision-making.The term "relationship" mentioned above can be better understood by emphasising its importance through some examples. Net profits alone can never be as meaningful aswhen it is related to (i.e. given as a ratio of), say, sales or capital employed. Current assets as a ratio of current liabilities would portray the ability of the firm to meet its short-term obligations. The ratio of debt to equity reflects the relative claims of creditors and shareholders against the assets of the firm. It must also be understood that there should be a cause and effect (or interference type) relationship between the figures whose ratio is sought, as illustrated in the above cases. Working out ratios between unrelated figures has no meaning or significance, say, for example, between premium on equity shares and sales revenue.
Types of Classification of Ratios
Three types of classifications have been in vogue :
Firstly, grouped in three classes based on location of the figures compared in the financial statements. These are :
(i) Income statement ratios, i.e. between figures in the P & L Afc; e.g. ratio of gross profit to sales;
(ii) Position statement ratios, i.e. between figures in the BS. e.g. debt-equity ratio, and current ratio; and
(iii) Interstatement ratios, i.e. one of the figures in the income statement is compared with a relatable figure in the BS, e.g. sales to fixed assets, net profit to capital employed. However, in as much as both financial statements have always to be considered together for meaningful analysis, this type of classification is not much in current use.Secondly, a four-fold classification (based on comparisons) has also been in vogue :
(i) trend ratios;
(ii) inter-firm comparison;
(iii) comparison of items within a single year's financial statements of a firm; and
(iv) comparison with standards of plans.
Trend ratios involve comparison of ratios of a firm over time and so, this is better called a study or comparison of the "trend of the ratio" rather than "trend ratio".Inter-$m comparison involves comparing the ratios of a firm with those of other firms in the same line of business or the industry average. Single year's ratios for afirm are what are dealt with in the third type of classification that follows. Comparison with standards orplans deal with the firm assessing itself as regards the realised ratio for the year vis-a-vis what the firm had planned for.
Thirdly, a four-fold classification, in respect of the third aspect mentioned under the second type of classifications above noted, deals with the performance of, and/or capability to perform by, a firm. The four broad groups of ratios are given in subsequent nslronranhc
(i)Liquidity ratios : These measure the ability of the firm to meet its short-term obligations, i.e. the short-tern solvency of the firm is assessed.
(ii) Capital ,structureAeverage ratios : These help to examine the long-term solvency of the firm. Generally, two subclassifications are recognised : solvent);ratios and coverage ratios.
(iii) Profitability ratios : These relate to the operating eficiency of afirm. This is important for the management of the firm (as against to the creditors who would look for either of the earlier two types of ratios). Generally, two subclasses are recognised : based on sales and based on investment, the latter category also being known as ownership ratios.
(iv) Activity ratios : These too are eficiency ratios but are concerned with the efficiency in assets management (or utilisation). These are called also as assel utilisation ratios, or turnover ratios, or efJiciency ratios.The third type of four-fold classification is dealt with in detail in the ensuing sections.The first two classifications together, are referred to as Financial Ratios.
The objective and purpose of evaluation depends on the specific composition of the interested group - be they from creditors, shareholders, would-be investors, management,government, labour, etc. Short-term creditors like to judge the ability of the firm to repay currently-maturing obligations. Shareholders and would-be investors are interested in the earnings per share and the dividend payout. Debenture holders and financial institutions which lend on long-term basis are interested in the capital structure, the history of earnings and changes in financial position. Management is interested in maintaining the solvency, satisfying the creditors and ensuring adequate return (with safety and assurance) to the firm's owners. Government is interested not only in solvency but also in the several charges on the business earnings including taxes.
To cater to these various needs, the financial analyst has to select the relevant information, organise the information to highlight the significant relationships between the concerned items, and, thereby, serve the purpose of drawing inferences and conclusions, that is, of evaluation, and, hopefully, thereupon, in decision-making.The term "relationship" mentioned above can be better understood by emphasising its importance through some examples. Net profits alone can never be as meaningful aswhen it is related to (i.e. given as a ratio of), say, sales or capital employed. Current assets as a ratio of current liabilities would portray the ability of the firm to meet its short-term obligations. The ratio of debt to equity reflects the relative claims of creditors and shareholders against the assets of the firm. It must also be understood that there should be a cause and effect (or interference type) relationship between the figures whose ratio is sought, as illustrated in the above cases. Working out ratios between unrelated figures has no meaning or significance, say, for example, between premium on equity shares and sales revenue.
Types of Classification of Ratios
Three types of classifications have been in vogue :
Firstly, grouped in three classes based on location of the figures compared in the financial statements. These are :
(i) Income statement ratios, i.e. between figures in the P & L Afc; e.g. ratio of gross profit to sales;
(ii) Position statement ratios, i.e. between figures in the BS. e.g. debt-equity ratio, and current ratio; and
(iii) Interstatement ratios, i.e. one of the figures in the income statement is compared with a relatable figure in the BS, e.g. sales to fixed assets, net profit to capital employed. However, in as much as both financial statements have always to be considered together for meaningful analysis, this type of classification is not much in current use.Secondly, a four-fold classification (based on comparisons) has also been in vogue :
(i) trend ratios;
(ii) inter-firm comparison;
(iii) comparison of items within a single year's financial statements of a firm; and
(iv) comparison with standards of plans.
Trend ratios involve comparison of ratios of a firm over time and so, this is better called a study or comparison of the "trend of the ratio" rather than "trend ratio".Inter-$m comparison involves comparing the ratios of a firm with those of other firms in the same line of business or the industry average. Single year's ratios for afirm are what are dealt with in the third type of classification that follows. Comparison with standards orplans deal with the firm assessing itself as regards the realised ratio for the year vis-a-vis what the firm had planned for.
Thirdly, a four-fold classification, in respect of the third aspect mentioned under the second type of classifications above noted, deals with the performance of, and/or capability to perform by, a firm. The four broad groups of ratios are given in subsequent nslronranhc
(i)Liquidity ratios : These measure the ability of the firm to meet its short-term obligations, i.e. the short-tern solvency of the firm is assessed.
(ii) Capital ,structureAeverage ratios : These help to examine the long-term solvency of the firm. Generally, two subclassifications are recognised : solvent);ratios and coverage ratios.
(iii) Profitability ratios : These relate to the operating eficiency of afirm. This is important for the management of the firm (as against to the creditors who would look for either of the earlier two types of ratios). Generally, two subclasses are recognised : based on sales and based on investment, the latter category also being known as ownership ratios.
(iv) Activity ratios : These too are eficiency ratios but are concerned with the efficiency in assets management (or utilisation). These are called also as assel utilisation ratios, or turnover ratios, or efJiciency ratios.The third type of four-fold classification is dealt with in detail in the ensuing sections.The first two classifications together, are referred to as Financial Ratios.
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