Financial Analysis

Financial statements by themselves are only a list of figures. Their real meaning appears when the figures are compared with one another and with the past or with other firms. Financial analysis is the process of examining these relationships, and its most widely used tool is ratio analysis. A ratio simply expresses one accounting figure as a proportion of another, turning raw rupee amounts into a comparable measure of liquidity, efficiency, indebtedness, profitability or market standing.

Importance of ratio analysis

A ratio is a mathematical relationship between two related figures drawn from the financial statements. Ratio analysis matters because a single figure, say a profit of Rs. 5,00,000, tells us little until we know the sales or the capital that produced it. By reducing figures to ratios we can judge performance meaningfully and compare across time and across firms.

The main uses of ratio analysis are:

• Judging liquidity, that is the firm's ability to meet its short-term obligations as they fall due.
• Judging profitability, showing how well the firm converts sales and assets into profit.
• Judging solvency and the use of debt, showing the long-run financial stability of the firm.
• Judging operating efficiency, showing how effectively assets are used to generate sales.
• Enabling comparison, both over years within the same firm (trend analysis) and between the firm and its industry.
• Helping planning and control, since ratios reveal weak spots that management can then correct.

Ratio analysis does have limits. It is based on historical accounting figures, it can be distorted by different accounting policies and by inflation, and a single ratio can mislead if read in isolation. It is therefore used as an aid to judgement, not a replacement for it. Ratios are conventionally grouped into liquidity, asset management, debt management, profitability and market value ratios, and this grouping structures the rest of the chapter. The worked figures below use one illustrative firm throughout.

Illustrative data: current assets Rs. 6,00,000 (of which inventory Rs. 2,00,000), current liabilities Rs. 3,00,000, sales Rs. 20,00,000, cost of goods sold Rs. 15,00,000, net profit Rs. 2,00,000, total assets Rs. 12,00,000, common equity Rs. 8,00,000, total debt Rs. 4,00,000, EBIT Rs. 3,00,000, interest Rs. 60,000.