What is Ratio Analysis?Objectives,Limitations

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Meaning and Definition of Ratio Analysis

Ratio Analysis may be defined as an arithmetical expression which shows the relationship of one number to another. In mathematical terms, a ratio is the quotient of two numbers.

According to Kohler__” A ratio is the relation, of the amount, a, to another, b,expressed as the ratio of a to b; a:b; or as a simple fraction, integer, decimal fraction or percentage”.

According to Myers__” Ratio analysis is a study of the relationship among the various financial factors in a business”.

Ratio analysis may be used for determining financial  and efficient robustness of the business.

Objectives of Ratio Analysis

1.  Measuring the profitability: Profitability is the profit earning capacity of the business. This can be measured by Gross Profit, Net Profit, Expenses and Other Ratios. If these ratios fall we can take corrective measures.

2. Measuring Efficiency: Short-term and long-term financial position of the business can be measured by calculating liquidity and solvency ratios. In case of unhealthy short or long-term position, corrective measures can be taken.

3. Solvency of the business: Solvency ratios establish the relationship between total assets and total liabilities of a concern. It helps to show whether the firm has enough assets to fulfill its debt obligations. Any firm which has enough assets will be considered solvent.

4. Financial status of the company: It is also useful for determining and comparing long term and short term financial standing of the firm. For long term financial status, various ratios such as proprietary ratio and fixed assets ratios are used. Current and liquids ratios are used for determining short term financial status.

5. Comparative analysis: Ratios can be used for making temporal comparison between the performance of the business. It can also be used for comparing two business identities having similar or different features. This analysis helps in determining strengths and shortcomings of a business.

Benefits of Ratio Analysis

  • Helpful in financial analysis
  • For explaining financial robustness
  • Useful for Locating weak areas
  • For future forecasting
  • Inter-firm comparsion

Limitations of Ratio Analysis

  • False Results
  • Limited Utility of particular ratio
  • No fixed terminology
  • No attention to qualitative factors
  • Overlooks Inflation