Concepts of financial ratio and its analysis
Financial ratio embraces the relationship between two financial data. These financial data are available in profit and loss account or income statement and balance sheet of a firm. The analysis of financial statements can be best done when financial data are expressed as ratios or percentages. Ratio analysis is certainly a very admirable device because it is simple and has a predictive value.
Financial analysis is the interpretation of the financial statements of a firm. Financial analysis offers a system of appraisal and evaluation of a firm’s performance. The financial statements mainly include
(i) profit and loss account or income statement;
(ii) balance sheet or statement of affairs;
(iii) Statement of retained earnings;
(iv) Cash flow statement and
(v) fund flow statement.
Useful Information of Financial Statements for Financial Ratios
Financial statements are those, which provide useful financial information of a firm. They are usually prepared at the end of a particular period, normally say, a year. The financial statements provide useful information regarding the financial position of the enterprises. The proper analyses of these statements provide valuable insight into the financial conditions and operations of an enterprise. That is, these statements help financial management of the enterprises in measuring the efficiency or otherwise of their financial policies and decisions.
  • The income statement or profit and loss account indicates earning capacity i.e. profitability of an enterprise. That is, whether a firm is making profit or incurring loss in a particular financial year is reflected in the income statement.
  • The balance sheet of a firm shows the financial position at the end of a financial period. The nature as well as the composition of assets and liabilities, properties and capital is also reflected in the balance sheet.
  • Statement of retained earnings reflects the changes in the firm’s retained earnings as a result of the income generated and retained during the year.
  • Cash flow statement shows the various sources and uses of cash; whereas the fund flow statement shows the various sources and uses of funds.
Significance of Financial Ratio Analysis
Ratio is a powerful test of financial analysis . In financial analysis, ratios are helpful as a benchmark for evaluating the financial position and performance of a firm. The absolute financial figures reported in the financial statements do not provide a meaningful understanding of the performance of financial position of a firm. Therefore, a financial figure when related to another figure conveys a meaningful understanding.
For example, 5 million net profit earned in a financial year look impressive and also sound well; but do not bear testimony to the good financial condition. But, if net profit is related to sales or investment; only then the firm’s profitability can be predicted as good or bad as compared to the previous year profitability. Financial ratios help summarizing large quantities of financial data and to make qualitative judgment about the financial performance, based on quantitative judgment.
As for example, consider the case of current ratio of a firm during particular financial year. Current ratio expresses the quantified relationship between the current assets and current liabilities of that firm in that financial year. This relationship is an index or yardstick which allows a qualitative judgment to be formed about the firm’s liquidity and hence ability to meet its current obligations. It measures the firm’s liquidity. The greater the ratio, the greater the firm’s liquidity and viceversa. Therefore, the point to note here that a financial ratio expresses a quantitative relationship; but also helps forming qualitative judgment.