Every trade has sets of tools that are used by professionals in that trade so as to deliver on their promises. Ratios are quantitative tools that finance professionals use to analyse sets of financial information. A financial planner or analyst for example uses ratio as part of its tools in carrying out some duties like; business valuation, business analysis or even fundamental analysis. the ultimate aim of these experts is to aid the decision making process of their clients.
WHAT IS RATIO ANALYSIS
Ratio analysis is the application of ratios in comparing similar variables. Ratio analysis is the process of systematically manipulating figures from the fiancial statements of a company to produce information that are used as part of investment decision making process. It is the application arithemetic on financial information that is contained in the annual report of a business entity.
Strictly speaking, a ratio is a relation between two items of same properties (i.e same size, same units, same weight, same hieght, same number, etc). This then presuposes that a ratio can only be applied to like items. Comparing disimilar items would not produce the result that is hoped for. The amount of energy and resources put into computing and comparing items of a financial statement of a company would be useless if there is no similarity in properties of the variables used in the ratio analysis.
The most difficult part of ratio analysis is finding the right proxy upon whcih to base and analyse the numbers calculated from the ratio calculation excercise. Ratio analysis does not end in the calculation of numbers. Infact, the number crunching apsect of ratio analysis only accounts for about 35% – 40% of the amount of work needed in conducting a meaningful ratio analysis excercise.
The bulk of the job is on the interprepation part of the process. What is numbers if there are no words attached to them? These words are what gives meaning to the numbers. If you have taken any accounting exam that requires you to evaluate a company’e performance based on some sets of accounting information, you will appreciate the fact that more marks are allocated to the analysis of the company using the information from the ratios calculated than the ratios.
In todays business word that is practically run by technology, ratios are quickly and more efficiently calculated by accounting softwares that humanly generated ratios are looked with suspicon as they may contain some errors.
TYPES AND CATEGORIES OF RATIO ANALYSIS
Broadly speaking, ratio analysis can be done under any category as long as the elements of the set are comparable. Some of the most common categories of ratio analysis are;
- Ratio analysis by industry
- Ratio analysis by department
- Intercompany ratio analysis
- Ratio analysis by period
- Ratio analysis by company
- Ratio analysis based on geographical location
- Ratio analysis by age of a company
An investment accountant whose duty includes managing and reporting on investment portfolio relies on ratio analysis to make some economically informed decision. Investment ratios, profitability ratios, performance ratios, financing ratios, liquidity ratios, stock market ratios, and activity ratios are some most commonly calculated class of ratios. Auditors also use ratio analysis as part of the analytical procedure that is performed when performing a risk based auditing.
IMPORTANCE, SIGNIFICANCE AND USEFULNESS OF RATIO ANALYSIS
- To give meaning to absolute figure: most numbers that are found in the financial statements of companies will be vague and meaningless if a scientific method of ratio analysis is not performed on the figures. For example, EPS of £2.30 will not make much if there is no information on what EPS was for last year or what the earnings per share of companies of similar sizes are.
- For planning and forcasting: managers through ratio analysis can find a trend and based on that trend, project into forseable future what an item of financial statement would most likley be.
- As a basis of decision making: the output of ratio analysis can be used as a basis for making investment decision. An investor who after calculating some investment ratios would be better equipped to make decision of whether to invest in a project or not to invest.
- To compare results and performance: by calculating ratios, an insight of how management are doing can be obtained. Note that ratio analysis is predominantly financial factors. Other non financial factors needs to be considered, the use of a balanced scorecard for example will do just in performance measurement matters.
- For analysis of strenghts and weakness: through ratio analysis, management can find out department or division that is not relatively doing well and then take some corrective actions.
- For analysing change in the form of trend: professional investors will always say that the trend is your friend. This trend is found using ratios and ratio analysis.
Ratios are tools that are used by trained professionals in their bid to deliver value to those that have entrusted them with the management of their businesses and investments. Ratio analysis is the application of the tools (ratios) in a productive and efficient way with the aim of understanding relationships that exists amongst different variables. For optimal result, ratio analysis has to be combined with other management accounting tools like variance analysis and contribution analysis.