## Users, Applications, and Limitations of Ratio Analysis

### Users and Their Objectives

User	Objective	Key Ratios
Shareholders	Profitability and growth	EPS, DPS, P/E Ratio, Dividend Payout
Investors	Financial health and future 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 wealth vs. competitors	Liquidity, Long-term Solvency, Profitability, ROI
Government/Regulator	Tax determination, compliance	Profitability
Production Managers	Input-output efficiency	Input-Output Ratio, Raw Material Consumption
Sales Managers	Sales trends and performance	Receivables Turnover, Expense Ratios
Financial Managers	Financial strategy and forecasting	ROI, Turnover, Capital Structure
CEOs/General Managers	Overall business performance	All ratios

### Industry-Specific Ratios

Sector	Specific 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

### Applications of Ratio Analysis

1. Liquidity Position – Assesses ability to meet short-term obligations; used by banks and short-term lenders.

2. Long-term Solvency – Leverage ratios show if firm is over-indebted; profitability ratios show earning power.

3. Operating Efficiency – Activity ratios reveal how efficiently assets are used to generate revenue.

4. Overall Profitability – Integrates multiple ratios to assess returns to owners and optimal asset use.

5. Inter-firm Comparison – Identifies deviations from industry averages; guides corrective action.

6. Budgeting and Forecasting – Assists in estimating future activity and comparing actual vs. budgeted performance.

### Limitations of Ratio Analysis

#	Limitation	Explanation
1	Diversified product lines	Aggregate data ratios cannot be used for inter-firm comparison
2	Inflation distortion	Historical costs may not reflect true current values
3	Seasonal factors	Year-end data may not represent average performance
4	Window dressing	Year-end adjustments can artificially improve ratios
5	Different accounting policies	Makes two firms' ratios non-comparable
6	No standard set of ratios	Industry averages may be too high or too low for any given firm
7	Ambiguity of good/bad	A high current ratio may indicate inefficient working capital management
8	Inter-related ratios	Viewed in isolation, one ratio can mislead; multivariate analysis needed
9	Clues, not conclusions	Ratios are tools for experts; no standard ready-made interpretation

Worked example

### Example 1

Q: A bank is evaluating whether to grant a ₹50 lakh term loan to a manufacturing company. Which category of users does the bank represent, and which ratios should it focus on?

A: The bank represents Lenders. Their objective is to assess the safety and recovery of funds lent.

Key ratios to analyze:

Coverage Ratios (e.g., Interest Coverage Ratio) – Can the firm service its debt?
Solvency Ratios – Is the firm financially viable long-term?
Turnover Ratios – Is the firm operationally efficient (can it generate cash)?
Profitability Ratios – Is the firm profitable enough to repay?

### Example 2

Q: A student says: "The current ratio of Company A is 3:1 which is much higher than the industry average of 2:1. Therefore Company A is in excellent financial health." Identify the flaw in this reasoning using ratio analysis limitations.

A: This reasoning has two flaws:

1. Ambiguity of 'good or bad' – A high current ratio may indicate excessive idle current assets (e.g., overstock of inventory or uncollected debtors), which reflects inefficient working capital management, not health.

2. Ratios provide clues, not conclusions – A single ratio cannot determine overall financial health. The student should also examine inventory turnover, receivables turnover, and other liquidity ratios before concluding.

⚠️ Common exam mistakes

Saying lenders focus on liquidity ratios only – Lenders use Coverage, Solvency, Turnover, AND Profitability ratios.
Confusing shareholders with investors as user groups – Shareholders focus on EPS/DPS/P/E; Investors focus more broadly on overall financial health.
Treating window dressing as illegal – it is an ethical concern and a limitation of ratio analysis, but not necessarily illegal.
Forgetting that a HIGH ratio is not always good – high current ratio may mean inefficient working capital; high debt-equity ratio means higher financial risk.
Missing the 'inter-related ratios' limitation – ratios must be analyzed together (multivariate), not in isolation.

Reference:

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Users, Objectives, Applications, and Limitations of Ratio Analysis

Worked example

⚠️ Common exam mistakes