Ratio Analysis: Definitions

The term ratio analysis is used to refer to the investigation of the quantitative relationships between two variables. Financial experts use these ratios as tools for evaluating different financial statements.

Definitions of Ratio

Notable definitions of ratio are given below:

Robert Anthony: ” A ratio is simply one number expressed in terms of another.”

Wixon, Kell, and Bedford: “A ratio is the expression of the quantitative relationship between two numbers.”

Kohler: “A ratio is a relationship of one amount (A) to another amount (B).”

The important point to note is that ratio analysis does not add anything new but makes a statement more meaningful and helps in drawing the conclusion.

Example

To clarify the concept of ratio analysis, let’s consider an example.

Knowing only that a business has earned $2,000,000 in profit does not tell us much. However, when profit is considered in relation to sales (e.g., sales of $5,000,000), this gives some meaning as:

(Profit x 100) / Sales = ($20,00,000 x 100) / $50,00,000 = 40%

So, $100 in sales translates into $40 in the form of profit.

As this example shows, ratios are used to gain insight into a firm’s financial position (e.g., whether it is strong or weak). Ratio analysis, more generally, seeks to cover four broad points:

(a) Selection of representative figures. From financial statements, select only those figures that are associated with each other.

(b) Calculation of ratios. Ratios can be calculated as percentages or times or propositions.

(c) Comparison. The main object of ratio analysis is to establish relationships between related values (e.g., the ratio of gross profit to sales or the debt-to-equity ratio.

(d) Interpretation of ratios. Ratios do not convey meaning unless they are analyzed and interpreted effectively.

Importance, Significance, and Merits of Ratio Analysis

The main points of importance are as follows:

1. Test of solvency. Ratios can illuminate the solvency of a firm. For example, when the ratio of current assets to current liabilities is increasing, this indicates sufficient working capital. Thus, creditors can be paid easily.

2. Helpful in decision-making. The main aim of financial statements is to inform users about the financial position of the company, as well as to serve as a decision-making aid for managerial personnel.

3. Helpful in financial forecasting and planning. Ratios are critical in financial planning and forecasting. For example, if a firm’s current ratio is 5:1, this means that capital is blocked up. As the ideal ratio is 2:1, we have 5:1, meaning that $3 is unnecessarily blocked.

4. Useful in discovering profitability. Ratios are also useful when comparing the profitability of different companies. Present and past ratios can be compared, for example, to discover trends in the historical and future performance of companies.

5. Liquidity position. With the use of ratio analysis, meaningful conclusions can be obtained about the sound liquidity position of the firm. A firm’s liquidity position is sound if it can pay its debts when these are due for payments.

6. Useful for operating efficiency. From a management perspective, ratios enable managers to measure the efficiency of assets. When sales and their contribution to net profit increase every year, this is a test of higher efficiency.

7. Business trends. Ratio analysis can expose trends that managers may use to take corrective actions.

8. Helpful in cost control. Ratios are useful to measure performance and facilitate cost control.

9. Helpful in analyzing corporate financial health. Ratio analysis can provide information about liquidity, solvency, profitability, and capital gearing. Thus, they are valuable for learning about financial health.

Limitations of Ratio Analysis

Although ratios are useful tools, they should be used with the utmost care. This is because they can suffer from drawbacks and limitations, including:

1. Need for technical knowledge. Ratios are quantitative and not qualitative indicators. Thus, to use them, one needs some knowledge of quantitative analysis.

2. Lack of reliable data. When figures are incorrect (e.g., value of closing stock is overstated), ratios will give misleading results.

3. Different basis. Different methods are available for the valuation of closing stock: LIFO and FIFO. In both, profit will differ. Similarly, profit has different meanings.

For example, some companies may take profit before tax and interest, while others may take profit after tax and interest. Similarly, different methods of depreciation will show different amounts of profit.

4. Different accounting policies. Different firms follow different policies with regard to depreciation (e.g., fixed installments or diminishing balance method, or stock valuation). Therefore, unless adjustments for profit are made, profit will not be comparable.

5. Effect of price level change. When ratios are calculated, no thought is given to inflationary measures that are responsible for changes in price. Thus, the utility of ratio analysis becomes questionable in these cases.

6. Bias. Ratios are only tools. They depend on the user for practical shape. For example, profit has different meanings, including EBIT (earnings before interest and taxes). Thus, personal opinion differs from business to business.

7. Lack of comparison. Different firms adopt different procedures, records, objectives, and policies. Due to this, comparisons become complex.

8. Evaluation. There are different tools for ratio analysis. The question of which tool to use in a particular situation depends upon the skill, training, knowledge, and expertise of the analyst.

Frequently Asked Questions

What is a ratio analysis?

The term ratio analysis is used to refer to the investigation of the quantitative relationships between two variables. Financial experts use these ratios as tools for evaluating different Financial Statements.

What is a ratio?

Notable definitions of ratio are given below:robert anthony: ” a ratio is simply one number expressed in terms of another.”Wixon, kell, and bedford: “a ratio is the expression of the quantitative relationship between two numbers.”Kohler: “a ratio is a relationship of one amount (a) to another amount (b).”The important point to note is that ratio analysis does not add anything new but makes a statement more meaningful and helps in drawing the conclusion.

What does a ratio analysis measure?

Ratio analysis seeks to cover four broad points:1. Selection of representative figures2. Calculation of ratios3. Comparison4. Interpretation of ratios

What is the importance of ratio analysis?

The main points of importance are as follows:1. Test of solvency2. Helpful in decision-making3. Helpful in financial forecasting and planning4. Useful in discovering profitability5. Liquidity position6. Useful for operating efficiency7. Business trends8. Helpful in cost control9. Helpful in analyzing corporate financial health

What is the importance of ratio analysis?

Although ratios are useful tools, they should be used with the utmost care. This is because they can suffer from drawbacks and limitations, including:1. Need for technical knowledge2. Lack of reliable data3. Different basis4. Different accounting policies5. Effect of price level change6. Bias7. Lack of comparison8. Evaluation

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.