Question

Why is ratio analysis is an effective tool for the Financial Analysis? What are the factors that need to be considered on the ratio analysis?

Answer 1

A single accounting figure from a balance sheet or a profit and loss account or from statement of cash flows cannot give us any meaningful information. It is pertinent to note that when ever a particular accounting figure is expressed in relation to the other then it may definitely provide some significant information. It also helps us compare the performance of an entity with in the industry, with previous year numbers etc.

Some of the factors that need to be considered on making ratio analysis are -

a) Comparability - This is the main thing to be kept in mind before considering ratio analysis . For example Quick Ratio cannot be compared with Return on capital employed . Similarly a banking company ratios cannot be compared with that of a technology firm.

b) Reliability of the underlying Financial information - Higher the reliability of the financial information better the financial ratios which inturn make the users to the financial information to make better business decisions . Financial information that were misleading lead to misleading ratio analysis .

c) Purpose for making the analysis - The ultimate goal of ratio analysis is to serve the purpose inorder to take business decisions. So clear understanding of the objects before starting the ratio analysis helps to fulfil the objectives in a better way

d) Type of ratios used - It is pertinent to note that there are various types of ratios like liquidity, leverage , activity, profitability etc . For analysing the solvency we have to use liquidity ratio. Using profitability ratios to fund the business liquidity position will not be appropriate.

e) Abnormal Items in Financial Information - Abnormal Items and one time even s in financial statements like loss of assets due to fire break out, Sudden lock down will not serve our purpose when we compare the same with the financial information of the previous year . Hence while making ratio analysis sometimes these items need to be excluded.