Meaning and Nature of ratio analysis
The term “ratio” simply means one number expressed in terms of another. It describes in mathematical terms the quantitative relationship that exists between two numbers, the terms “accounting ratio”. J. Batty points out, is used to describe significant relationships between figures shown on a Balance Sheet, in a Profit and Loss Account, in a Budgetary control System or in any other Part of the accounting organisation. Ratio Analysis, simply defined, refers to the analysis and interpretation of financial statements through ratios. Nowadays it is used by all business and industrial concerns in their financial analysis. Ratio are considered to be the best guides for the efficient execution of basic managerial functions like planning, forecasting, control etc.
Ratios are designed to show how one number is related to another. It is worked out by dividing one number by another. Ratios are customarily presented either in the form of a coefficient or a percentage or as a proportion. For example, the current Assets and current Liabilities of a business on a particular date are Rs. 2.5 Lakhs and Rs. 1.25 lakhs respectively. The resulting ratio of current Assets and current Liabilities could be expressed as (i.e. Rs. 2,00,000/1,25,000) or as 200 per cent. Alternatively in the form of a proportion the same ratio may be expressed as 2:1, i.e. the current assets are two times the current liabilities.
Ratios are invaluable aids to management and others who are interested in the analysis and interpretation of financial statements. Absolute figures may be misleading unless compared, one with another. Ratios provide the means of showing the relationship which exists between figures. Though there is no special magic in ratio analysis, many prefer to base conclusions on ratios as they find them highly useful for making judgments more easily. However, the numerical relationships of the kind expressed by ratio analysis are not an end in themselves, but are a means for understanding the financial position of a business. Generally, simple ratios or ratios compiled from a single year financial statements of a business concern may not serve the real purpose. Hence, ratios are to be worked out from the financial statements of a number of years.
Ratios, by themselves, are meaningless. They derive their status partly from the ingenuity and experience of the analyst who uses the available data in a systematic manner. Besides, in order to reach valid conclusions, ratios have to be compared with some standards that are established with a view to represent the financial position of the business under review. However, it should be borne in mind that after computing the ratios one cannot categorically say whether a particular ratio is god or bad as the conclusions may vary from business to business. A single ideal ratio cannot be applied for all types of business. Speedy compiling of ratios and their presentations in the appropriate manner are essential. A complete record of ratios employed in advisable and explanation of each, and actual ratios year by year should be included. This record may be treated as a part of an Accounts Manual or a special Ratio Register may be maintained.
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