Meaning and Rationale
Ratio analysis is a widely-used tool of financial analysis. It can be used to compare the risk and return relationships of firms of different sizes. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical and current financial condition can determined. The term ratio refers to the or quantitative relationship between two items/variables. This relationship can percentages, say, net profits are 25 per cent of sales (i) (assuming net profits of (20,000 and sales of Rs 1,00,000), (ii) fraction (net profit is one-fourth of sales) and the proportion of numbers (the relationship between net profits and sales is 1:4). These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratios does not add any information n. It already from the above figures of profits and sales. What the ratios do is that they reveal relationship in a most meaningful way so as to enable equity investors, management and lenders make better investment and credit decisions.
The rationale of ratio analysis in the fact that it makes related information comparable. Itself has no meaning but when expressed in the related figure, it yields significant inferences. For instance, the fact that the net profits of a firm amount to, throw no light on it adequacy or otherwise. The figure of net profit has to be consider. Variables to stand in relation to sales, What docs it represent by way of return on used or total capital employed? If therefore, net profits are shown in terms of their relationship with items such as capital employed, equity capital and so on, meaningful conclusions drawn regarding their adequacy. To, carry the above example further, employee to be Rs 50 lac and Rs 100 lac, the net profits are 20 per cent and 10 per cent respectively. Ratio analysis, thus, as a quantitative tool enables analysts to draw quantitative answers to questions such as. Me the net profits adequate- Are the assets being used efficiently? Is the firm solvent? Can the firm meet its current obligations and so on?