Ratio Analysis – Introduction
As we discussed in financial analysis techniques overview chapter that ratio analysis is simply a study of expected relationships between two elements of financial statements.
Most of the elements or items of the financial statements are either interdependent or have a certain relationship with others that can be observed and also expected to repeat over a period of time in the absence of any unusual event. For example with the increase in the number of employees, salary expense is expected to increase.
Ratio analysis in simple words is the evaluation or analysis of such relationships that are expected to exist between two values or pieces of information. Mostly the information is quantitative based in nature but it may involve comparisons of qualitative information with quantitative aspect as well. Ratios help express the relations either in the form of ratio or percentage or quotient.
However, one must understand that the ratios and the answers we get by applying such ratios are merely means to end i.e. they in their own are not the answers rather they are pointers and indicators that can help us gauge a certain aspect of entity as they help us identify what happened.
They may or may not provide information about why it happened as for that we need to add up more
In ratio analysis elements compared or analysed may be:
- from same financial statements e.g. gross profit margin involves gross profit and sales revenue figures from the income statement
- from two different financial statements e.g. net asset turnover involves sales revenue from income statement and total assets figure from statement of financial position
- multiple financial statements
- outside financial statements
The decision regarding what ratio to be computed depends on the purpose and matter at hand and require analysts judgement in this regard. The ratio that gives the best indications to help decide will be used.
Advantages of Ratio Analysis
- It makes the comparison very easy and effective as with ratios we are comparing the proportion and not the actual figures. For example if entity makes a profit of 20,000 in year 1 and 50,000 in year 2 it appears as if things have gone better in year 2. However, in relation to revenue the entity’s profit in year 1 was 50% whereas in year 2 it was just 10%. By numbers 50,000 looks better but knowing that it was just 10% of the revenue and actually the situation has deteriorated, knowing this only we can make better judgement.
- Ratios are grouped in different categories with each category helping analyse specific aspect of the entity makes the analysis process much more detailed and useful. This not only saves time but also confusion as most of the time decision maker face a dilemma with too much information available at their disposal so it keeps the process on track and efficient.
- Ratio analysis as they work on relationship between two items in the financial statements, they not only give you insight in entity’s past but also help analyse its current standing and not just that it can help predict entity’s performance and position if the relation stays as it is found to exist using two or multiple ratios. This way it helps decision makers make budgets and forecasts for entity as a whole or of particular segment of entity.
- It makes the process simpler by summarizing the data and information. As one does not have to go through the whole financial statements. For example a particular ration consider two or three items and provides much more meaningful information and save you from going through whole set of financial statements and later trying to digest to make the meaning out of them. And the benefits of this can be in the shape of ease of communication as well.
- Though ratio analysis is done by professional but the outcome of such ratios is such that it can be understood even by those that are not versed with accounting or analysis process. For example one who does not know how to calculate gross profit of the entity can still understand how well the entity is performing considering the gross profit margin.
Disadvantages of Ratio Analysis
- Though ratio analysis has its upside but it is definitely not without its limitations. Following are some of the factors that may render ratio analysis handicapped:
- Financial statements are based on past activities and past information cannot be expected to reflect the same in the future with certainty. No one can say with certainty that certain relations that exists now will continue to exist in the future. And this eclipse the reliability of analysis done using this technique
- Entities are operating in different environment and may connect to different type of industry. Therefore, comparing two entities that relates to two very different type of industries cannot be compared so straight.
- Even if the entities being compared are from same industries, each of them following distinct set of accounting policies that may be significantly different from the other and render the basis of preparation very different. Without common grounds, the information and analysis may lose its value in specific cases.
- Many items in the financial statements involve judgement and estimates on part of management while preparing such financial statements. The judgmental process is different from one person to the other as one might act in a different than the other in same situation. Same is the case with depreciation and other provisions that make up significant portion of financial information. These estimates affect the information and resulting analysis. If such estimates are wrong then analysis is more likely to fail in providing any good information to the users and decision makers.
- Ratios and their results are merely means to end and not the answers itself. They can only help you find the right answer but the process of finding is left on the one who is interpreting the results. And these interpretations are not guided by any standard but rather intuition, judgement and guess-work that might be wrong in the end.
- There are no standardized ratios as there is no standard setting body that dictates how a particular ratio should be calculated. As a result they may be described, defined and interpreted in a different way even by the same person in different situations. For example, what constitute returns? is it profit after tax? profit before tax? profit before interest and tax? Because of that we can have many variants of same ratios
Categories of Ratios
There are numerous ratios that are available and can categorized as follows:
- Liquidity ratios
- Activity/Efficiency ratios
- Solvency/Gearing ratios
- Profitability ratios
- Valuation ratios
Liquidity in simple words mean how able is entity to arrange liquid resources or how quickly it can adapt to the situation in short term by converting its current assets i.e. inventory, receivable and short term investments in cash. In short, liquidity ratios assess how flexible entity is to meet its shot term obligations. Examples include, current ratio, acid test ratio.
Activity or Efficiency ratios
Activity ratios as the name suggest evaluates entity’s activities majorly operating activities and gives insight regarding how efficiently entity is managing its day to day operations. For example, inventory and receivable turnover period.
- Total asset turnover
- Fixed asset turnover
- Working capital turnover
- Inventory turnover
- Trade receivables turnover
- Trade payables turnover
Solvency or Debt or Gearing ratios
Unlike liquidity ratios that concentrate on short-term perspective of entity, solvency ratios help analyse entity’s ability to meet its long-term obligations e.g. loans, debentures, redeemable preference shares and redemption of similar financial instruments. Examples include financial gearing ratios and operational gearing ratios.
Profitability ratios provides insight regarding entity’s financial performance over a period of time. The above three types of ratios are mainly concerned with financial position of the entity but this set of ratios converge on how much entity was able to using its resources optimally. In simple words they help us analyse how much return is generated against the resources consumed. Main ratios include:
- Gross profit margin
- Net profit margin
- Return on Assets (ROA)
- Return on Capital Employed (ROCE)
- Return on Equity (ROE)
These ratios help analyse how much return is associated with the investors’ interest in the business as ownership interest is best valued in terms of the return it can generate. In other words it help analyse the flow of investment in terms of initial outlay and the return. Main ratios include: price earning (P/E) ratio, dividend yield etc.