Accountancy · Ch 9 — Ratio Analysis
Meaning, Objectives, Limitations and Classification of Ratios
Meaning, Objectives, Limitations and Classification of Ratios
Ratio Analysis is a technique that expresses the relationship between two related figures drawn from a company's financial statements, in the form of a ratio, percentage, or number of times, so that its financial performance and position can be interpreted quickly and meaningfully. It is one of the tools of financial statement analysis introduced in the previous chapter — while comparative and common-size statements study figures in rupee/percentage form, ratio analysis condenses them into single, easily comparable numbers.
Objectives of Ratio Analysis: to assess a firm's liquidity (ability to meet short-term obligations), its solvency (ability to meet long-term obligations), its profitability (overall earning capacity), and its operating efficiency; to facilitate comparison across years and against other firms; to assist forecasting and decision-making for management, investors, creditors, and lenders.
Limitations of Ratio Analysis: it inherits every limitation of financial statement analysis generally (historical-cost basis, ignoring price-level changes, ignoring qualitative factors, distortion from differing accounting policies or window-dressing — see the previous chapter); in addition, a single ratio in isolation has limited meaning unless compared against a standard, a past trend, or another firm's ratio; and ratios computed from year-end figures may not reflect conditions that prevailed through the rest of the year (a seasonal business, for instance, can show a very different liquidity picture at different points in the year).
Classification of Ratios. Ratios are broadly grouped into four categories, each answering a different question about the firm:
| Category | Question it answers | Covered in |
|---|---|---|
| Liquidity Ratios | Can the firm meet its short-term (current) obligations? | Section 2 |
| Solvency Ratios | Can the firm meet its long-term obligations, and how is it financed? | Section 3 |
| Activity (Turnover) Ratios | How efficiently is the firm using its assets? | Section 4 |
| Profitability Ratios | How well is the firm earning a return on its sales and investment? | Section 5 |
Illustrative data used throughout this chapter. The worked examples in every section below are based on the following simplified financial statements of a company for the year ended 31st March 2024:
Balance Sheet (extract)
| Equity and Liabilities | ₹ | Assets | ₹ |
|---|---|---|---|
| Equity Share Capital | 5,00,000 | Fixed Assets (Property, Plant & Equipment) | 9,00,000 |
| Reserves and Surplus | 3,00,000 | Inventories (Closing Stock) | 2,00,000 |
| Shareholders' Funds | 8,00,000 | Trade Receivables | 1,50,000 |
| 10% Debentures (Long-term Borrowings) | 4,00,000 | Cash and Cash Equivalents | 1,00,000 |
| Trade Payables | 1,50,000 | Prepaid Expenses | 50,000 |
| Other Current Liabilities | 50,000 | ||
| Total Current Liabilities | 2,00,000 | ||
| Total | 14,00,000 | Total | 14,00,000 |
Statement of Profit and Loss (extract)
| Particulars | ₹ |
|---|---|
| Revenue from Operations (Cash Sales ₹2,00,000 + Credit Sales ₹18,00,000) | 20,00,000 |
| Less: Cost of Revenue from Operations | 14,00,000 |
| Gross Profit | 6,00,000 |
| Less: Operating Expenses | 2,00,000 |
| Operating Profit (Net Profit before Interest and Tax) | 4,00,000 |
| Less: Interest on Debentures (10% of ₹4,00,000) | 40,000 |
| Profit before Tax | 3,60,000 |
| Less: Tax | 90,000 |
| Profit after Tax (Net Profit) | 2,70,000 |
Additional information: Opening Inventory ₹1,50,000 (Closing ₹2,00,000, so Average Inventory ₹1,75,000); Opening and Closing Trade Receivables both ₹1,50,000 (Average ₹1,50,000); Net Credit Purchases ₹12,00,000, with Opening and Closing Trade Payables both ₹1,50,000 (Average ₹1,50,000).
A technique expressing the relationship between two related figures of financial statements as a ratio, percentage, or number of times, to interpret a firm's financial performance and position.
Ratios are grouped into four categories: Liquidity (short-term obligations), Solvency (long-term obligations), Activity/Turnover (efficiency of asset use), and Profitability (earning capacity).