RATIO ANALYSIS

It is a tool used to do a quantitative analysis of the financial statement of a company. Ratios are usually calculated with the performance of the current year to the performance of the previous year. Ratios are usually used to compare the performance of the company with respect to previous years as well as to compare the performance of the company with the other company’s performance in the market. Investors use these ratios to make investment decision. These ratios are widely used in fundamental analysis part in security analysis. This helps the investor to identify the fundamental situation of the company, performance of the company in the market, the future prospect of the company, performance of the industry as a whole, and to identify the operating efficiency. Some common ratios include the price-earnings ratio, debt-equity ratio, earnings per share, asset turnover and working capital. These ratios are used because the financial data that is released by the company are generally not conclusive in making decision. The financial data does not openly show the company position. It helps to find out how the company performs with respect to the performance of the industry as a whole. It is also important to calculate this ratio as different company use different standards of accounting.  In short it simplifies the analysis of accounting.

Some of the limitations in Ration analysis are,

• The comparability has limitation in ratio analysis, this is because different company use different standard in accounting
• A small mistake in accounting information will corrupt the entire ratio analysis part.
• Price level changes are not taken into consideration. In short the inflation part is not taken into consideration.
• Qualitative factors are not considered. Ratio analysis is a process of quantitative analysis and hence there is no scope for qualitative analysis.
• Window-dressing affects the ratio analyses to a greater extend. Window-dressing is nothing but a illegal process adopted by some companies to show the financial position of their company in a better way.
• It is a costlier technique. Only big companies can afford them.
• It is at times misleading.
• There is no standard form in calculating the ratios, which is a huge disadvantage in case of this technology. Since there is no standard different user follow different format.

Questions

• Why is Ratio analysis needed despite having the financial statements?
• What are the limitations of the ration analysis?