Ratio Analysis

Ratio analysis implies the systematic use of ratios to interpret the financial statements so that the strength and weaknesses of a firm as well as its historical performance and current financial position can be determined. With the help of ratio analysis conclusion can be drawn regarding several aspects such as financial health, profitability and operational efficiency of the undertaking.

Ratio analysis is very useful in making inter-firm comparison as it helps to draw a comparison between the entities within the same industry or otherwise following the same accounting procedure. It provides the relevant financial information for the comparative firms with a view to improving their productivity & profitability.

Ratio analysis helps in intrafirm comparison by providing necessary data. An intrafirm comparison indicates relative position. It provides the relevant data for the comparison of the performance of different departments. If comparison shows a variance, the possible reasons of variations may be identified and if results are negative, the action may be initiated immediately to bring them in line.

However, in spite of being such a useful tool, it is not free from its limitations. A single ratio is of a limited use and it is essential to have a comparative study. The base used for ratio analysis viz: financial statements have their own limitations. Also, they consider only the quantitative aspects of business transactions where as there are various other non-quantitative aspects such as quality of work force which considerably affect profitability and productivity. Also, ratio analysis as a tool is also limited by changes in accounting procedures/policies.