Ratio analysis constitute a major tool in the financial appraisal of the entity.
It essentially involves reducing the magnitude of information on the statement of accounts of an entity.
This can be either eliminating, combining or rearranging them and settling them in a statistical relation with reach other.
What is ratio analysis
Ratio analysis is a short form of conveying crucial facts about an entities operation and financial situation to any interested party.
Ratios could also be described as the relationship between two accounting figures espressed mathematically.
Financial ratio analysis points out relationships, which may not be obvious from raw data, and could also highlight factors associated with successful and unsuccessful performance of the firm.
They essentially look at the trend a firm appears to be moving, as well as it’s profitability and current financial position.
Approaches to ratio analysis
There are three approaches to ratio analysis used in ensuring a meaningful and successful financial ratio analysis.
They include the followings;
- Cross section analysis
- Time series analysis
- Combined analysis
Cross section analysis
This involves the comparison of the different firm’s financial ratios at the same point of time.
The approach, supplemented with industry average, assist in evaluating the financial position of a firm at a point.
The approach adopts three distinct steps in the evaluation of the financial condition of a firm.
The approach are;
1. There is a comparison of the firm’s that performance for a current period with previous year’s performance.
2. Comparison of performance in the current period, with the industry average.
3. A comparison of the firm performance with that of a competitor.
Time series analysis
This approach does an evaluation of the firm’s operation over a period, the purpose being to evaluate the firm’s performance over this specific interval of time.
The comparison of the current and past performance using ratio analysis allows the firm to determine whether it is progressing as planned or not.
A trend analysis is very useful in the time series approach.
The trends assist in multi year comparisons, and also in planning the future operations of the firm.
In this case, any significant year to year changes can be evaluated to assess whether they are indicative of a major problem or not.
The critical issues in time series ratio analysis include;
1. Evaluate the firm’s performance in relation to it’s past performance.
2. Developed trends in the performance.
3. Take appropriate actions to direct the firm towards the goal.
Another point of view shows that the above issues entails highlighting the important trends in the firm’s data, determining shifts in the trend, and the determination of the deviations from the results of the values derived.
Time series ratio analysis is often helpful in verifying the objectivity of the firm’s projected financial statement.
Combined analysis
This approach combines the cross sectional and time series approach into one.
This approach endures the assessment of the trend in the behavior of a ratio in relation to the trend for the industry.
Advantages of ratio analysis
The advantages of ratio analysis for any firm or entity could be summarized as follows;
1. Ratio are indispensable in identifying the problem areas of a business.
2. It has an important impact in evaluating the performance of a business entity, especially when combined with other tools of analysis.
3. It provides a standard of comparison at any point in time, and allows comparison to be made with industry averages.
4. Ratio analysis is useful in analyzing the trends in the performance of a firm, and also the shifts in these trends.
5. Ratios are easy to calculate compared to other measures of performance.
6. It can be used as a tool for forecasting the future financial conditions of a firm.
Types of ratio analysis
The number and types of ratio analysis that can be derived from a given sat of financial statements are almost infinite.
Different types of ratios could be calculated from the financial statement of a firm, depending on the information required and the interest of analyst.
We have five types of ratios and they include;
1. Liquidity Ratio
Liquidity ratio measures the firm ability to meet current and maturing obligations. Two commonly used liquidity ratio are the current ratio and the quicj or acid test.
A low ratio indicates insufficiency of funds to retire immediate obligations and the financing of the day to day operation of the firm.
However, this may result result in the loss of confidence by creditors and most times, legal embrassments.
On the other hand, a high ratio indicates that too much funds are tied down unduly in current assets, which might negatively affect the profitability of the business.
Thus, it is important to balance the liquidity and profitability of the firm, in planning the cash needs of the firm or entity.
2. Asset Utilization / Activity Ratio
The asset utilization or activity ratio measures how efficiently a firm manages it’s assets.
The ratio here examine the extent to which a firm has been able to use it’s assets to generate sales turnover and income.
The ratio also seek to identify the root cause of any poor performance of a firm, and also what the firm is making of the assets at it’s disposal.
The assets of the firm is intended to assist in generating sales turnover and in earning incomes.
Thus, these ratios seek to ascertain the performance of the firm in this regard.
3.Debt / Equity Ratios
The debt or the equity ratios deal with the firm long term financial condition.
It also seek to indicate the ability of the firm to meet long term obligations as they fall due.
Here, the financial analyst usually takes into consideration the debt ratios in assessing the financial strength of the firm.
4. Profitability Ratio
This measures the overall efficiency of the firm, and it’s management in terms of returns generated by the firm generally.
It assist the financial analyst to assess the capability of the firm in generating profits in the future.
Generally, these measures assist the analyst to evaluate the earnings of the firm with respect to sales, the profit in relation to investments or share value, and also profit in relation to assets.
Profitability is important to firm in view of it’s role in attracting outside capital.
It is also important to shareholders who ordinarily expect a reasonable return on their investment.
It a measure of the level of managerial efficiency and instills confidence in the creditors including the firm’s bankers.
5. Investment Ratio
The investment ratio which can also be called the return on total assets captures the overall effectiveness of management of a firm in generating profit and consequently return on investment with it’s available assets.
Firms that are efficiently managed have a relatively high return on investment, while less efficient firms have a low return on investment.
The rate of return in an investment relates the size of the firm to profits.
Thus, the return on investment ratio assist in explaining the causes of any poor or exceptional profit performance of a firm.
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That’s all on ratio analysis and pproaches to financial ratio analysis