Ratio analysis is one of the most widely used tools in financial management and management accounting. It helps managers, investors, and other stakeholders interpret financial statements and evaluate a company’s overall performance. By expressing relationships between different figures in the financial statements, ratios provide insights into liquidity, profitability, efficiency, and solvency.
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Meaning and Purpose of Ratio Analysis
Ratio analysis involves comparing two or more related figures from financial statements to draw meaningful conclusions about a firm’s performance. It is a diagnostic tool that highlights strengths, weaknesses, and trends, making it easier for management to take corrective or strategic decisions.
The main purposes include:
Assessing short-term liquidity and ability to pay obligations.
Measuring profitability and returns to shareholders.
Evaluating efficiency in asset utilization.
Checking the long-term financial stability of the business.
Classification of Ratios
Liquidity Ratios
These measure the company’s ability to meet its short-term obligations.Current Ratio = Current Assets ÷ Current Liabilities
Quick Ratio (Acid Test Ratio) = (Current Assets – Inventory) ÷ Current Liabilities
Interpretation: A higher ratio indicates better liquidity, but too high may mean idle resources.
Profitability Ratios
These show how effectively a company generates profit relative to sales, assets, or equity.Net Profit Ratio = (Net Profit ÷ Net Sales) × 100
Return on Capital Employed (ROCE) = (EBIT ÷ Capital Employed) × 100
Interpretation: Higher profitability ratios indicate efficient operations and higher returns for stakeholders.
Turnover or Activity Ratios
These measure how efficiently assets are utilized in generating sales.Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory
Debtors Turnover Ratio = Net Credit Sales ÷ Average Debtors
Interpretation: Higher turnover ratios reflect better asset utilization and working capital management.
Solvency Ratios
These assess the company’s ability to meet long-term obligations.Debt-Equity Ratio = Total Debt ÷ Shareholders’ Equity
Interest Coverage Ratio = EBIT ÷ Interest Expenses
Interpretation: Lower debt-equity ratios mean lower financial risk, while higher interest coverage indicates stronger debt servicing capacity.
Limitations of Ratio Analysis
While ratio analysis is useful, it also has certain limitations:
Ratios are based on historical financial statements, which may not reflect current realities.
Different accounting policies can make comparisons misleading.
Ratios do not consider qualitative factors such as market conditions, brand value, or employee morale.
Over-reliance on ratios without context may result in wrong decisions.
Conclusion
Ratio analysis is a powerful tool for evaluating financial performance, but it should not be used in isolation. Managers must interpret ratios along with industry trends, economic conditions, and non-financial factors. When used wisely, ratio analysis helps in identifying areas of improvement, enhancing profitability, and ensuring financial stability.