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1 Meaning, types, impotance and limitation of ratio analysis .

Ratio analysis is the process of examining and comparing financial information by


calculating meaningful financial statement figure percentages instead of comparing line
items from each financial statement. Managers and investors use a number of different
tools and comparisons to tell whether a company is doing well and whether it is worth
investing in. The most common ways people analysis a company’s performance
are horizontal analysis, vertical analysis, and ratio analysis. Horizontal and vertical
analyzes compare a company’s performance over time and to a base or set of standard
performance numbers.

Ratio analysis is much different. Ratio analysis compares relationships between financial
statement accounts. This means that one income statement or balance sheet account is
being compared to another. These relationships between financial statement accounts will
not only give a manager or investor an idea of the how healthy the business is on a whole, it
will also give them keen insights into business operations.

Types of ratio analysis

1. Liquidity ratios

2. Asset Management ratios

3. Leverage ratios

4. Profitability ratios

5. Valuation ratios

1. Liquidity ratios Liquidity ratios asses the firm`s ability to meet its short- term
obligations using short-term assets. The short-term obligations are the ones recorded under
current liabilities that come due within one financial year. Short-term assets are the
current assets. There are three (03) important liquidity ratios.
1. Current Ratio The current ratio (CR) is equal to total current assets divided by total
current liabilities. Indicates the extent to which current liabilities can be paid off through
current assets.

2. Quick asset Ratio ;One Key problem with the current ratio is that it assumes that all
current assets can be converted in to cash in order to meet short-term obligations. We
know this assumption is highly untrue. Firms carry current assets, such as inventory and
pre-paid expenses which cannot be converted into cash quickly. To correct this problem,
the quick asset ratio (QAR) removes from current assets less liquid current assets, such as
inventory and pre-paid expenses, which cannot be converted into cash quickly. The quick
ratio, also called the acid test ratio, is equal to liquid current assets, divided by current
liabilities. It indicates the extent to which current liabilities can be paid off through liquid
current assets such as cash, marketable securities, and accounts receivables.

3. Cash Ratio The cash ratio goes a step further and examines the ability of the firm to
settle short-term liabilities using only cash and cash equivalents such as marketable
securities. In other words, the cash ratio indicates the extent to which current liabilities can
be paid through very liquid asset

2 Asset Management Ratios

Asset management ratios also known as efficiency ratios indicate the efficiency of the use of
assets in generating sales. There are five (05) more important efficiency ratios:

1. Average Collection Period

The average collection period (ACP), also known as days sales outstanding (DSO),
indicates the average length of time the firm must wait after making a credit sale before it
collects cash. In other words, it shows the average number of days accounts receivables
remain outstanding. This is an important ratio used to evaluate the credit policy of the firm
in relation to the industry norms. A higher ACP indicates a liberal policy in that the firm
gives more times to debtors for making payments. A lower ACP indicates astringent policy
in that the firm gives less time for debtors

2. Inventory / Stock Turnover The inventory turnover indicates whether inventory levels
are reasonable in relation to cost of goods sold. Lower inventory turnover ratio relative to
the industry standard may indicate excessive, obsolete, or slow moving inventory, while
higher turnover inventory and perhaps possibility of inventory shortages.
3. Cash Conversion Cycle The cash conversion cycle shows the average number of days the
cash is tied up in inventory and receivables. Typically, a firm buys inventory, and cash is
tied up in inventory for a number of days before they are sold and converted in to
receivables. Thus beyond the initial period in which cash is tied up in inventory, there is an
additional time period where cash is tied up in receivables. However, firms are also able to
obtain inventory on a credit total number of days cash is tied up in inventory and
receivables can be determined as follows.

4. Fixed asset Turnover The fixed asset turnover ratio measures the efficiency of the use of
fixed assets in generating sales. It is computed as sales divided by inadequate, low, outdated
or depreciated fixed assets.

5. Total Asset Turnover Total asset turnover ratio measures the efficiency of the use of
total assets in generating sales. Total assets are sum of current and net fixed assets.
Thetotal asset turnover is calculated as sales divided by average total assets. The average
total assets are the simple average of total assets at the beginning and end of the period.The
leverage ratios, also called debt management ratios, measure two key aspects of the use of
debt financing by the firm. The use of debt financing a called financial leverage. We want
to know the level of financial leverage used by the business as well as the ability of the firm
to service its debt obligations. The debt ratio, debt-equity ratio and interest cover is

3 Leverage ratio

The leverage ratios, also called debt management ratios, measure two key aspects of the

Use of debt financing by the firm. The use of debt financing a called financial leverage. We

Want to know the level of financial.

4 Activity ratio : These ratios demonstrate how efficiently the business operates. In other
words, you can see how well the company uses its resources, such as assets available to
generate sales. A few great examples of activity ratios investors should apply in their
research include inventory turnover, receivables turnover, payables turnover, working
capital turnover, fixed asset turnover, and total asset turnover.

5 Valuation: Since valuation ratios rely on a company's current share price, they provide a
picture of whether or not the penny stock makes a compelling investment at current levels.
Basically, how much cash, or working capital, or cash flow, or earnings, do you get for each
dollar investedSomeuation include Price/Earnings (P/E), Price/Cash Flow, Price/Sales
(P/S), and Price/Earnings/Growth Rate (PEG.
Importance and limitation of ratio analysis

Importance of Ratio Analysis

1 Helpful in assessing operating efficiency of the Business: The ratio can be used as the
measuring rod of efficiency. With the help of this, the evaluation of changes during
different period can be performed. In this way, the comparative efficiency of company can
be informed.

2 Helpful in measuring financial solvency: Ratios are useful tools for evaluating the
liquidity and solvency position of a concern. They point out the liquidity position of an
organization to meet its short and long term obligations.

3 Helpful in future forecasting: ration analysis is very helpful in financial forecasting and
planning. The ration calculation of past years works guide line for the future

4 Helpful in decision making: Ratio analysis is also very helpful for decision making. The
information provided by ration analysis is very useful for making decision on any financial
activity.

5 Helpful in corrective action: Ratio analysis can also point out the deficiencies of the
business so that corrective steps may be taken accordingly.

6 Helpful in comparing inter firm performance: Due to inter firm comparison, ratio
analysis also serves as a stepping stone to remedial measures. It helps management evolving
future 'market strategies'.

7 Helpful in communication: Ratio is an effective means of communication. Different


financial ratios communicate the strength and financial standing of the firm to the internal
and external parties.

8 Helpful in cost control: From the use of ratio, it is possible to control the different costs of
the concern.

Limitations of Ratio Analysis


The ratio analysis contributes a lot to portray the financial position of a business. But they
suffer from various limitations.

1 Limited use of single ratio


A single ratio in itself is not important. It would not be able to convey anything. For
making a meaningful conclusion, a number of ratios which makes confusion to analyst is to
be calculated.

2 Difficult to interpreter
It is very difficult task to fix an adequate standard for compression purpose. There are no
rules of thumb for all ratios which can be accepted as norm. It renders interpretation of the
ration difficult.

3 Ignored qualitative factors


Ratio analysis is related to the quantitative analysis only but not with a qualitative analysis
because it is ignored by ratio analysis.

4 Limitation of accounting record


Ratio analysis is related to financial statement. Financial statement itself is subject to
limitations. This ratio analysis also suffers from the inherent weakness of the financial
statement.