## Ratio Analysis – Framework and Application
### Why Financial Statements Alone Are Insufficient
Balance Sheet and P&L present financial position and performance but cannot by themselves reveal financial strengths and weaknesses — analytical tools are needed.
### Definition of Ratio
A financial ratio is a mathematical expression of the relationship between two accounting figures drawn from financial statements, selected in a logical manner.
### What Ratio Analysis Covers
1. Calculation: Expresses a logical relationship between two figures from financial statements
2. Objective: Enables all stakeholders to assess:
- Past, present, and future performance
- Strengths and weaknesses of a firm
- Support for decision-making
### Types of Comparison
| Type | Description |
|---|---|
| Intra-firm | Comparing current year with prior years of the same company |
| Inter-firm | Comparing with other companies in the industry |
| Industry / Economy | Comparing with industry benchmarks or economy-wide standards |
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### Sources of Financial Data
1. Annual Reports
2. Interim Financial Statements
3. Notes to Accounts
4. Statement of Cash Flows
5. Business Periodicals
6. Credit and Investment Advisory Services
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### Users and Their Ratios
| User | Objective | Key Ratios |
|---|---|---|
| Shareholders | Profitability and growth | EPS, DPS, P/E Ratio, Dividend Payout |
| Investors | Financial health and prospects | Profitability, Capital Structure, Solvency, Turnover |
| Lenders | Safety and recovery of funds | Coverage, Solvency, Turnover, Profitability |
| Creditors | Short-term payment capacity | Liquidity, Short-term Solvency |
| Employees | Financial health vs competitors | Liquidity, Long-term Solvency, Profitability, ROI |
| Government / Regulator | Tax determination and compliance | Profitability |
| Production Managers | Input-output efficiency | Input-Output Ratio, Raw Material Consumption |
| Sales Managers | Sales trends and performance | Receivables Turnover, Expenses Ratios |
| Financial Managers | Strategy and forecasting | ROI, Turnover, Capital Structure |
| Chief Executives | Overall performance | All ratios |
### Industry-Specific Ratios
| Sector | Ratios |
|---|---|
| Telecom | Call Ratios, Revenue per Customer, Expenses per Customer |
| Banking | Loan to Deposit Ratio, Operating Expense to Income |
| Hotels | Room Occupancy Ratio, Bed Occupancy Ratio |
| Transport | Passenger-Kilometre Ratio, Operating Cost per Passenger-Kilometre |
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### Applications of Ratio Analysis
1. Liquidity Position: Assess ability to meet short-term obligations (used by banks and lenders)
2. Long-term Solvency: Evaluate debt burden and long-term financial viability
3. Operating Efficiency: Measure asset utilization through activity/turnover ratios
4. Overall Profitability: Integrated view — obligations, returns to owners, asset use
5. Inter-firm Comparison: Identify deviations from industry norms; guide corrective action; aid forecasting
6. Budgeting: Estimate future activity; measure actual vs budgeted performance
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### Limitations of Ratio Analysis
| # | Limitation | Implication |
|---|---|---|
| 1 | Diversified product lines | Aggregate data unusable for inter-firm comparison |
| 2 | Inflation distortion | Historical cost ≠ current economic value |
| 3 | Seasonal factors | Year-end data may not reflect average performance |
| 4 | Window dressing | Year-end adjustments artificially improve ratios |
| 5 | Different accounting policies | Makes two firms' ratios non-comparable |
| 6 | No universal standard | Industry averages may be too low or high for a specific firm |
| 7 | Good vs bad is ambiguous | High current ratio may reflect poor working capital management |
| 8 | Ratios are interrelated | One ratio in isolation can mislead; multivariate view needed |
| 9 | Clues, not conclusions | Expert interpretation required; no standard ready-made answer |
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### Types of Financial Analysis
| Type | Method | Use |
|---|---|---|
| Horizontal Analysis | Compare same item across two or more years | Identify trends and changes over time |
| Vertical Analysis | Express each item as % of a base (P&L: % of gross sales; BS: % of total assets) | Inter-firm comparison within a single year |