Application of financial analysis | APPLICATION OF RATIO ANALYSIS IN FINANCIAL DECISION MAKING: A popular technique for analyzing the performance of a business concern is financial ratio analysis. As a tool of financial management, they are of crucial significance. The importance of ratio analysis lies in the fact that it presents facts on a comparative basis and enables the drawing of inferences regarding the performance of a firm. Ratio analysis is relevant in assessing the performance of a firm in respect of the following aspects:
Application of financial analysis | Financial Ratios for Evaluating Performance
(a) Liquidity Position: With the help of ratio analysis one can draw conclusions regarding the liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its obligations when they become due This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans.
(b) Long-term Solvency: Ratio analysis is equally useful for assessing the long-term financial viability 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.
Long-term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and operating efficiency.
The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or whether it is heavily loaded with debt in which case its solvency is exposed to serious strain. Similarly, the various profitability ratios would reveal whether or not the firm is able to offer adequate returns to its owners consistent with the risk involved.
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(c) Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets – total as well as its components.
(d) Overall Profitability: Unlike the outside parties which are interested in one aspect of the financial position of a firm, the management is constantly concerned about the overall profitability of the enterprise. That is, they are concerned about the ability of the firm to meet its 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.
(e) Inter-firm Comparison: Ratio analysis not only throws light on the financial position of a firm but also serves as a stepping stone to remedial measures. This is made possible due to inter-firm comparison/comparison with industry averages.
be satisfactory if it is able to meet its obligations when they become due This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans.
(b) Long-term Solvency: Ratio analysis is equally useful for assessing the long-term financial viability 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.
The long-term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and operating efficiency.
The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or whether it is heavily loaded with debt in which case its solvency is exposed to serious strain. Similarly, the various profitability ratios would reveal whether or not the firm is able to offer adequate returns to its owners consistent with the risk involved.
(c) Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets – total as well as its components.
(d) Overall Profitability: Unlike the outside parties which are interested in one aspect of the financial position of a firm, the management is constantly concerned about the overall profitability of the enterprise. That is, they are concerned about the ability of the firm to meet its 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.
(e) Inter-firm Comparison: Ratio analysis not only throws light on the financial position of a firm but also serves as a stepping stone to remedial measures. This is made possible due to inter-firm comparison/comparison with industry averages.
A single figure of a particular ratio is meaningless unless it is related to some standard or norm. One of the popular techniques is to compare the ratios of a firm with the industry average. It should be reasonably expected that the performance of a firm should be in broad conformity with that of the industry to which it belongs.
An inter-firm comparison would demonstrate the relative position vis-a-vis its competitors. If the results are at variance either with the industry average
or with those of the competitors, the firm can seek to identify the probable reasons and, in the light, take remedial measures.
Ratios not only perform a post-mortem of operations but also serve as a barometer for the future. Ratios have predictor values and they are very helpful in forecasting and planning business activities for the future.
Conclusions are drawn on the basis of the analysis obtained by using ratio analysis. The decisions affected may be whether to supply goods on credit to a concern, whether bank loans will be made available, etc.
(f) Financial Ratios for Budgeting: In this field, ratios are able to provide a great deal of assistance. A 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. Ratios also can be made use of for measuring actual performance with budgeted estimates. They indicate directions in which adjustments should be made either in the budget or in performance to bring them closer to each other.
LIMITATIONS OF FINANCIAL RATIOS
The limitations of financial ratios are listed below.
(i) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases, ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.
(ii) Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried out in the financial ratios.
(iii) Seasonal factors: It may also influence financial data. Example: A company deals in cotton garments. It keeps a high inventory during October – January every year. For the rest of the year, its inventory level becomes just 1/4th of the seasonal inventory level.
So, the liquidity ratios and inventory ratios will produce a biased picture. The year-end picture may not be the average picture of the business. Sometimes it is suggested to take monthly average inventory data instead of year-end data to eliminate seasonal factors. But for external users, it is difficult to get monthly inventory figures. (Even in some cases monthly inventory figures may not be available).
(iv) To give a good shape to the popularly used financial ratios (like current ratio, debt-equity ratios, etc.): The business may make some year-end
adjustments. Such window dressing can change the character of financial ratios which would be different had there been no such change.
(v) Differences in accounting policies and accounting period: It can make the accounting data of two firms non-comparable as also the accounting ratios.
(vi) No standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then the industry average becomes a low standard. On the other hand, for a below-average firm, industry averages become too high a standard to achieve.
(vii) Difficulty to generalize whether a particular ratio is good or bad: For example, a low current ratio may be said ‘bad’ from the point of view of low liquidity, but a high current ratio may not be ‘good’ as this may result from inefficient working capital management.
(viii) Financial ratios are interrelated, not independent: Viewed in isolation one ratio may highlight efficiency. But when considered as a set of ratios they may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis (analyzing the relationship between several variables simultaneously).
Financial ratios provide clues but not conclusions. These are tools only in the hands of experts because there is no standard ready-made interpretation of financial ratios.
FINANCIAL ANALYSIS
It may be of two types: – Horizontal and vertical.
Horizontal Analysis: When the financial statements of one year is analyzed and interpreted after comparing with another year or years, it is known as horizontal analysis. It can be based on the ratios derived from the financial information over the same time span.
Vertical Analysis: When the financial statement of a single year is analyzed then it is called vertical analysis. This analysis is useful in inter-firm comparison. Every item of Profit and loss account is expressed as a percentage of gross sales, while every item on a balance sheet is expressed as a percentage of total assets held by the firm.
SUMMARY
Financial Analysis and its Tools: For the purpose of obtaining the material and relevant information necessary for ascertaining the financial strengths and weaknesses of an enterprise, it is necessary to analyze the data depicted in the financial statement. The financial manager has certain analytical tools which help in financial analysis and planning. The main tools are Ratio Analysis and Cash Flow Analysis.
Ratio Analysis: The ratio analysis is based on the fact that a single accounting figure by itself may not communicate any meaningful information but when expressed as a relative 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 against previous years, other companies, the industry, or even the economy in general for the purpose of financial analysis.
Type of Ratios and Importance of Ratios Analysis: The ratios can be classified into the following four broad categories:
(i) Liquidity Ratios
(ii) Capital Structure/Leverage Ratios
(iii) Activity Ratios
(iv) Profitability Ratios
A popular technique for analyzing the performance of a business concern is of financial ratio analysis. As a tool of financial management, they are of crucial significance. The importance of ratio analysis lies in the fact that it presents facts on a comparative basis and enables the drawing of inferences regarding the performance of a firm.
Ratio analysis is relevant in assessing the performance of a firm in respect of the following aspects:
I Liquidity Position
II Long-term Solvency
III Operating Efficiency
IV Overall Profitability