What is Ratio Analysis?

Ratio Analysis – Is this a true indicator of financial status of a company

What is Ratio Analysis?

It is difficult to read and make sense of large financial statements. So to make things easy financial ratios have been introduced which briefly explains the financial position of a company. This is one of the oldest methods of financial statements analysis. Banks and other lenders have developed this to evaluate various competing companies for credit. In some cases, there are recommend values for ratios which indicate healthy financial status. Some other ratios are analyzed in comparison with competitors and the companies’ past records.

Investors generally have minimum data to make decisions about a company. Financial statements provide a basis to analyze the internal operations of the company. Financial ratios would simplify these statements. These ratios also help to compare among various financial statements. Analysis like DuPont analysis would relate financial ratios and profitability of the company in an investor sensible way.

Primary source of data would be financial statements released by the companies and their competitors. Data can also be accessed from various reports published by consultancy firms. The various activities by companies on stock market can also be tracked to get the data useful for financial ratio analysis.

How to interpret the ratios?

Ratios are used to understand the financial status of a company. This is done either with respect to the company’s past performance or it compared to the industry benchmarks. Horizontal analysis is used to compare the same ratio over time. Cross-sectional analysis is used to compare one company with that of the industry benchmarks.

In horizontal analysis, one compare the present ratios of a company with the previous quarters’ and previous years’ values. With this one can understand the financial stability of an organization. Having the past track record also helps analysts in projecting future financials accurately.

Cross-sectional analysis helps analysts to evaluate a company on relative basis. There are different benchmarks to compare a company with. One may use industry average to see how best the company have performed over and above an average company in the industry. Those who are not satisfied being average would like to take industry leader as benchmark. If the company under consideration is industry leader in itself then best practices across the globe will be considered as benchmark.

Who uses Ratio Analysis?

There are numerous ratios in practice. It is important to know how these ratios can be used by different group of people for different purposes. Shareholders of any company are worried about the return on their investments. Hence they consider profitability ratios followed by cash flow ratios. In contrast the management is more bothered about the cause rather than the result. Hence they consider turnover ratios and operating performance ratios.

Debt holders and suppliers of any company are concerned if the company pay back the debts in the stipulated time. Hence they are concerned about the short term liquidity of the firm. Ratios that might useful to such groups is liquidity ratios and cash flow ratios. Unlike debt holders, credit rating agencies are concerned about the long term existence of the company. They use solvency ratios to see if the company can clear its obligations in the long run.

What are the Limitations?

Ratio analysis with no doubt is a best tool to understand the financial status of a company with least efforts. But, like any other technique, this also has its limitations.

It is possible that the company might deliberately show misleading financial statements. The companies do know what really fascinates the investors. Hence they try to show the financials accordingly within legal frameworks. So ratios cannot depict true picture of the company.

Different companies might be having different financial policies. Hence it becomes absurd to compare the financial ratios of such companies. Though regulators have been putting efforts to standardize the financial policies across the globe, still companies have the choice to choose their own policies.

Financial ratios are established thumb rules for conventional companies. But in the world of ecommerce, thousands of companies are being established each day with innovative business plans. Financial ratios analysis hardly gives any meaningful insights into such companies.

Financial ratios are in many ways the best tools to get insight into the financial status of any company. Considering their limitations, one should use them as supporting tools for analysis rather than depending solely on them.

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