## Introduction to Ratio Analysis
### Role of Financial Statements
Financial statements (Balance Sheet and P&L Account) provide the foundation for financial analysis and decision-making — but alone they are insufficient to assess financial strengths and weaknesses.
Solution: Use analytical tools, most importantly Ratio Analysis.
### Definition of a Ratio
> "The indicated quotient of two mathematical expressions and the relationship between two or more things."
In accounting, a financial ratio is a mathematical expression of the relationship between two accounting figures.
### Ratio Analysis – Two Dimensions
1. Calculation Basis:
- Mathematical relationship between two figures
- Both figures connected in a logical manner
- Both selected from the same financial statements
2. Objective:
- Enable stakeholders (owners, investors, lenders, employees) to draw conclusions about:
- Past, present, and future performance
- Strengths and weaknesses of the firm
- Basis for decision-making
### Why Single Figures Are Not Enough
A single accounting figure alone gives no meaning. Example: Net Profit of ₹10 lakh means nothing without knowing Sales (₹100 lakh = 10% margin; ₹20 lakh = 50% margin).
### Three Types of Comparison
| Type | Description |
|---|---|
| Intra-firm | Compare with previous years within the same company (trend analysis) |
| Inter-firm | Compare with other companies in the same industry |
| Industry/Economy | Compare with industry averages or economic benchmarks |
### 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
### Horizontal vs Vertical Analysis
| Type | Basis | Use |
|---|---|---|
| Horizontal Analysis | Comparison across 2+ years | Identify trends and changes over time |
| Vertical Analysis | Single year's statement | Each P&L item as % of gross sales; each BS item as % of total assets. Useful for inter-firm comparison. |