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Ratio Analysis: A Brief Introduction



What is Ratio Analysis?


An analysis of the mathematical relationship between two individual figures or group of figures logically linked with each other and picked from financial statements of the concern is known as ratio analysis.

The objective for financial ratios is that all stakeholders (owners, investors, lenders, employees etc.) can draw conclusions about the Performance (past, present, and future) Strengths & weaknesses of a firm And can take decisions in relation to the firm. 
Ratio Analysis


The ratio analysis basically puts light on the fact that a single figure data by itself may not reflect any meaningful information but when expressed as a comparative to some other figure, it may definitely provide some significant information.

Ratio analysis is not just comparing different numbers from the balance sheet, income statement, and cash flow statement. It is comparing the number of previous years, other companies, the industry, or even the economy in general for the purpose of financial analysis.

The ratios can be classified into following four broad categories: Liquidity Ratios, Capital Structure/Leverage Ratios, Activity Ratios and Profitability Ratios.


The importance of ratio analysis is that it presents facts on a comparative basis and enables drawing of inferences regarding the performance of a firm. The significance of the ratio analysis are as follows:

  • With the help of ratio analysis, one can draw conclusions regarding liquidity position of a firm. The liquidity position of a firm would be acceptable if it is able to meet its obligations on due time.


  • Ratio analysis is useful for evaluating the long-term financial feasibility of a firm. This aspect of the financial position of a borrower is of concern to the long-term creditors, security analysts and the present and potential owners of a business.


  • Ratio analysis equally reflects the degree of efficiency in the management and utilization of its assets. The various activity ratios measure the operational efficiency.


  • Unlike the outsiders who are interested in one aspect of the financial position of a firm, the management is also concerned about the overall profitability of the enterprise. That is, they are anxious to know about the ability of the firm to meet it's short-term as well as long-term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum utilization of the assets of the firm. This is possible if an integrated view is taken and all the ratios are considered together.


  • Ratio analysis not only collects attention on the financial position of a firm but also serves as a stepping stone to remedial measures. This is made possible due to inter-comparison or comparison with industry averages. One of the popular techniques is to compare the ratios of a firm with the industry average.


  • Ratios are able to provide a great deal of assistance in budgeting, the budget is only an estimate of future activity based on past experience, in the making of which the relationship between different spheres of activities is invaluable. It is usually possible to estimate budgeted figures using financial ratios.


The limitations of financial ratios are listed below:

  • Many businesses operate a number of divisions in different industries. In such cases, ratios based on aggregate data cannot be used for inter-firm comparisons.


  • Historical cost values may be significantly different from true values due to inflation factor. Such distortions of financial data are also carried in the financial ratios.


  • Seasonal factors may also influence financial data.



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