Ratio analysis project with Capital IQ for MBA finance

Use and Significance of Ratio Analysis

The ratio is one of the most powerful tools of financial analysis.  It is used as a device to analyze and interpret the financial health of enterprise.  Thus ratios have wide applications and are of immense use today.

Managerial uses of ratio analysis

Helps in decision making

Financial statements are prepared primarily for decision-making.  Ratio analysis helps in making decision from the, information provided in these Financial Statements.

Helps in financial forecasting and planning

Ratios analysis is of much help in financial forecasting and planning.  Planning is looking ahead and the ratios calculated for a number of years a work as a guide for the future.  Thus, ratio analysis helps in forecasting and planning.

Helps in communicating

The financial strength and weakness of a firm are communicated in a more easy and understandable manner by the use of a ratio.  Thus, ratios help in communication and enhance the value of the financial statements.

Helps in co-ordination

Ratios even help in co-ordination, which is of at most importance in effective business management. Better communication of efficiency and weakness of an enterprise result in better co-ordination in the enterprise.

Helps in control

Ratio analysis even helps in making effective control of business.  The weakness is otherwise, if any, come to the knowledge of the managerial, which helps, in effective control of the business

Utility to shareholders/investors

An investor in the company will like to assess the financial position of the concern where he is going to invest.  His first interest will be the security of his investment and then a return in form of dividend or interest.  Ratio analysis will be useful to the investor in making up his mind whether present financial position of the concern warrants further investment or not.

Utility of creditors

The creditors or suppliers extent short-term credit to the concern.  They are invested to know whether financial position of the concern warrants their payments at a specified time or not.

Utility to employees

The employees are also interested in the financial position of the concern especially profitability.  Their wage increases and amount of fringe benefits are related to the volume of profits earned by the concern.

Utility to government

Government is interested to know overall strength of the industry.  Various financial statement published by industrial units are used to calculate ratios for determining short term, long-term and overall financial position of the concerns.

Tax audit requirements

Sec44AB was inserted in the income tax act by financial act, 1984.  Clause 32 of the income tax act requires that the following accounting ratios should be given:

Gross profit/turnover.

Net profit/turnover.

Material consumed/finished goods produced.

Further, it is advisable to compare the accounting ratios for the year under consideration with the accounting ratios for earlier two years so that the auditor can make necessary enquiries, if there is any major variation in the accounting ratios.

Limitations

The above discussion reveals that ratios are exceptionally useful tools.  However they should be used with extreme care as they suffer from certain serious drawbacks, some of them are listed below:

False results

Ratios are based upon the financial statements.  In case financial statements are in correct or the data of on which ratios are based is in correct, ratios calculated will all so false and defective.  The accounting system itself suffers from many inherent weaknesses the ratios based upon it cannot be said to be always reliable.

Limited comparability

The ratio of the one firm cannot always be compare with the performance of other firm, if uniform accounting policies are not adopted by them.  The difference in the methods of calculation of stock or the methods used to record the depreciation on assets will not provide identical data, so they cannot be compared.

Absence of standard universally accepted terminology

Different meanings are given to a particular term, egg.  Some firms take profit before interest and tax; other may take profit after interest and tax.  A bank overdraft is taken as current liability but some firms may take it as non-current liability.  The ratios can be comparable only when all the firms adapt uniform terminology.

Price level changes affect ratios

The comparability of ratios suffers, if the prices of the commodities in two different years are not the same.  Change in price effect the cost of production, sale and also the value of assets.  It means that the ratio will be meaningful for comparison, if the prices do not change.

Ignoring qualitative factors

Ratio analysis is the quantitative measurement of the performance of the business.  It ignores qualitative aspect of the firm, how so ever important it may be.  It shows that ratios is only a one sided approach to measure the efficiency of the business.

Personal bias

Ratios are only means of financial analysis and an end in itself.  The ratio has to be interpreted and different people may interpret the same ratio in different ways.

Window dressing

Financial statements can easily be window dressed to present a better picture of its financial and profitability position to outsiders.  Hence, one has to be very carefully in making a decision from ratios calculated from such financial statements.

Absolute figures distortive

Ratios devoid of absolute figures many prove distortive, as ratio analysis is primarily a quantitative analysis and not a qualitative analysis.

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