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CHAPTER - V
THEORETICAL FRAMEWORK OF FINANCIAL
PERFORMANCE EVALUATION
5.1 INTRODUCTION
Business concern needs finance to meet their requirements in the economic
world. Any kind of business activity depends on the finance. Hence, it is called as
lifeblood of business organization. Whether the business concerns are big or small,
they need finance to fulfil their business activities.
In the modern world, all the activities are concerned with the economic
activities and very particular to earning profit through any venture or activities.
The entire business activities are directly related with making profit. According to
the economics concept of factors of production, rent given to landlord, wage given
to labour, interest given to capital and profit given to shareholders or proprietors.
Success and survival of a firm depends upon how well its finance function
is managed. The firm may have abundant resources but if the available funds are
not properly utilised for the benefit of the firm, it will approach an early end. Every
effort should be made to make the finance function as effective as possible.
Financial analysis is the approach to judge the effectiveness of the finance
function of a firm. Financial analysis is the process of determining the significant
operating and financial characteristics of a firm from accounting data. The profit
and loss account and balance sheet are indicators of two significant factors-
profitability and financial soundness. Analysis of statement means such a
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treatment of the information contained in the two statements as to afford a full
diagnosis of the profitability and financial position of the firm concerned.
Financial statement analysis is largely a study of relationship among the various
financial factors in a business as disclosed by a single set of statements.1
The financial performance evaluation is mainly depends upon the financial
statements analysis or the financial performance evaluation can be done with the
help of financial statement. Analysis of financial statement gives comprehensive
understanding of business operations and their impact on the financial health. The
financial performance of the banks denotes the level of efficiency, effectiveness
and timeliness with which various activities of banks were being undertaken as per
the objectives stated in the bylaws.
Properly analysed and interpreted financial statements can provide valuable
insights into a firm’s performance. Analysis of financial statements is of interest to
lenders (short-term as well as long-term), investors, security analysts, managers
and others. Financial statement analysis may be done for a variety of purposes. It
helpful to spotlights the significant (profit & loss account and balance sheet) facts
and relationship concerning managerial performance, corporate efficiency,
financial strengths and weaknesses and creditworthiness of the firm.2
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5.2 FINANCIAL STATEMENT
In order to take right decision at right time, the management is equipped
with sufficient past and present information about the firm and its operations.
Much of the information that is used by the management is derived from the
financial statement is known as financial information.
The financial statement contains summarised information of the firm’s
financial affairs, organised systematically. They are means to present the firm’s
financial situation to users. Financial statements are the outcome of summarising
process of accounting. It is prepared for the purpose of presenting a periodical
review or reports on the progress by the management and deal with the status of
the investments in the business and results achieved during the period under
review.
According to John N. Mayer, “The financial statement provide a summary
of the accounts of business enterprise, the balance sheet reflecting the assets,
liabilities and capital as on a certain date and the income statement showing the
results of operations during a certain period”.3
Preparation of financial statements is the responsibility of top management.
They are the means to present the financial situation to the users. These statements
are used to evaluate the firm’s performance in order to make investments decisions
along with it should prepare to full fill the statutory requirements. For this reason
financial statements should provide maximum and true information regarding firm
to the users of these statements along with it should prepare as per the statutory
requirements.
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These statements are contained in a company’s annual report along with
chairman’s speech which source of information on a company’s internal and
external environment, mission, objectives, products, organisation philosophy etc.
Director’s report which provide a true and fair view of the state of a company’s
affairs. According to policies, which are adopted or changed and its effect etc.
Nature of Financial Statement
Financial statement consists of balance sheet and profit and loss account are
supported by number of schedules, annexure supplementary statements,
explanatory notes, footnotes, etc. All of these also a part and partial of the
financial statements. The factor, which influences financial statements are below.
1. Recorded Facts: The term “Recorded Facts” refers to the situation where
the data used for preparing financial statements are drawn from the
accounting records. The record is made only of those facts which can be
expressed in monetary terms.
2. Accounting Conventions: The financial statements are affected to very
great extend by accounting principles, concepts and convention. The
concepts and convention like business entity, cost, money measurement,
realisation, constancy, periodicity, matching, conservatism, going concern,
accrual, dual aspect, make financial statements comparable, simple and
realistic.
3. Personal Judgment: Although concepts and conventions provide a good
guideline to the accountant in preparing the financial statement. Still
personal judgment of the accountant plays a major part. He can select any
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one alternative form the different alternative solution based on sound
principle. For instance an accountant, the rate of depreciation, valuing the
stock in trade, the rate of written off of the deferred revenue expenditure
etc.4
Objectives of Financial Statements
The objectives of financial statements are as:
1. To serve as the basis for future operations.
2. To provide sufficient financial information to various parties interested in
financial statements to analyse and to make economic decisions.
3. To provide financial data on economic resources and obligations of any
concern.
4. To reveal implications of operating profit of a concern.
5. To present fair and true view of the business.
Various Financial Statements:
1. Profit And Loss Account (Statement of Income)
Profit and loss account present the summary of revenues, expenses and net
income (or net loss) of a firm. It is prepared usually for a period of twelve months.
The earning capacity and potential of a firm are reflected by profit and loss
account. If revenue is more than expenses the result is profit if expenses are more
than revenue the result is loss.
2. Balance Sheet (Position Statement):
Balance sheet is the most important financial statements, which indicate the
financial position of the firm at a particular date. It communicates information
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about assets, liabilities and owners equity. To make balance sheet more meaningful
to reader, assets and liabilities are grouped on its nature.5
The Balance Sheet Serves The Following Important Functions:
1. It gives a concise summary of the firm’s resources and liabilities and
owners equity.
2. It is a measure of the firm’s liquidity.
3. It is a measure of the firm’s solvency.
3. Statement of Retained Earnings:
It is also called P & L appropriation account. As the name suggests it does
the company earn an appropriation of profits. The previous year balance of profit is
first brought forward and the net profit for the current year is added to it. From this
dividend declared both on equity and preference share capital, the amount
transferred to general reserve or development rebate reserve or any other reserve
are appropriation. The balance of this account is shown in the balance sheet.
Therefore cannot be appropriation without profits.
4. Fund flow statement:
The fund flow statement shows the various sources and application of
funds. The Fund Flow Statement is a financial statement which reveals the
methods by which the business has been financed and how it has used its funds
between the opening and closing balance sheet dates. Thus, it is a report non
movement of funds explaining where from working capital originates and where
into the same goes during an accounting period. The “fund” refers to the working
capital or net current assets (CA – CL). This statement shows the various sources
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from which fund has been raised and the uses to which this was put. This statement
improves the understanding of the operation and activities of an enterprise for the
reporting period.
These statements is also great importance to creditors and owner’s as it
enable them to obtain information concerning financing and investing activity of
the business enterprises and the consequent changes in its financial position for a
period.
5. Cash Flow Statement:
A cash flow statement it designed to indicate changes in financial position
of enterprises on cash basis. It summarizes the causes for change in cash position
of business enterprises between two balance sheet dates. It shows the movement
of cash into and out of a business by listing the sources of cash receipts and uses or
disbursement of cash the difference being the “Net Cash Flow”.
Cash flow statement is an essential tool for analysing short-term financial
solvency. With the help of this, management can evaluate its ability to its
obligations, such as repayment of loans, payment to creditors, payment of interest,
dividend and taxes.
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6. Schedules:
A number of schedules are prepared to supplement the information supplied
in the balance sheet. The schedules of investments, fixed assets, debtors and
creditors etc., are prepared generally by business enterprises. 6
Persons Interested in Financial Statement:
The following parties are interested in financial statements
1. Owners: The owners provide funds or capital for the organisation. They
possess curiosity in knowing whether the business is being conducted on
sound lines or not and whether the capital is being employed properly or
not. Owners, being businessmen, always keep an eye on the returns from
the investment. Comparing the accounts of various years helps in getting
good piece of information.
2. Management: The management of the business is greatly interested in
knowing the position of the firm. The accounts are the basis, on which the
management can study the merits and demerits of the business activity.
Thus, the management is interested in financial statement to find whether
the business carried on is profitable or not. The financial statements are the
“eyes and ears of management and facilitate in drawing future course of
action, further expansions etc.” For future taking sound decisions and also
framing the policies and procedure.
3. Creditors: Creditors are the persons who supply goods on credit, or
bankers or lenders of money. They include both long term and short term
creditors. These groups are interested to know the financial soundness
before granting credit. The progress and prosperity of the firm, to which
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credits are extended, are largely watched by creditors from the point of
view of security and further credit. Profit and loss account and balance
sheet are nerve centres to know the soundness of the firm.
4. Employees: Payment of bonus depends upon the size of profit earned by
the firm more important point is that the workers expect regular income for
the bread. The demand for wage rise, bonus, better working conditions etc.,
depends upon the profitability of the firm and in turn depends upon
financial position. For these reasons, this group is interested in financial
statements.
5. Investors: The prospective investors, who want to invest their money in a
firm, of course wish to see the progress and prosperity of the firm, before
investing their money. They include both short-term and long-term
investor they are the suppliers of basic capital to run the business they
sacrifice their present consumption for investment, expecting for future
benefits. So, the investors by analysing the company performance through
the financial statement of the firm. This is to safeguard the investment. For
this purpose, this group is eager to go through the accounting statements
which enable them to know the safety of investment.
6. Government: Big concern like company it is compulsory to prepare
financial statement according section 209 of the Indian Companies Act and
how to be published in its annual reports. The small business concern will
prepare voluntary to be know its result and financial position. Financial
statements are used by various government department like income tax,
sales tax, excise duty, etc., to determine the tax liability of the company.
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7. Other Interested Groups: Financial statement also served the needs of
many other user groups like stock exchanges, banks, consumers etc.7
Limitations of Financial Statements:
Most of the limitations are mainly due to the cumulative effect of recorded
facts, accounting conventions, postulates and personal judgment on financial
statements. Financial statements have a number of limitations they are:
1. Information is Incomplete and Inexact: The financial statement is
essentially interim reports usually prepared for an accounting period.
Hence, the information as revealed by them is incomplete. The true
financial position or the ultimate gain or loss can be known only when the
business is closed down. The financial position of a concern is affected by
several factors (economic, social and financial) but, only financial factors
are being recorded in financial statements. Therefore, information is far
away from truth and exactness.
2. Qualitative Information is Ignored: Financial statements depicts only
those items of quantitative information which can be expressed in monetary
terms. But, number of qualitative factors, such as reputation and prestige of
management with public, cordial industrial relations and efficiency of
workers, customer satisfaction, competitive strength etc., which cannot
expressed in monetary terms are not depicted by financial statements.
3. Balance Sheet is a Static Document: it is so because it reflects the
position of the concern at a moment of time. But, the real position of the
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concern may be changing day to day. Hence, balance sheet is rightly called
as instantaneous photograph.
4. Balance Sheet is not a Valuation Statement: Values shown in the balance
sheet are not real values as the impact of price level changes is completely
ignored. Values shown are not those at which assets may be sold. Thus,
exact position of concern cannot be ganged or depicted from the balance
sheet.
5. Profit Disclosed by Profit and Loss Account is not Real Profit: It will
exhibit a profit which is never accurate because number of items shown in
it is just estimated. Example: depreciation, provision for doubtful debts.
6. Personal Judgments Influence Statements: Many items in the financial
statements are left to the personal judgments of the accountant. For
example the method of inventory valuation, the method of depreciation,
treatment of deferred revenue expenditures etc., depend on the personal
judgment of the accountant. The true value of such items lies on the
soundness of such judgments which in turn, depends on the experience,
skill, integrity and competence of the accountant. Accountant may make
improper assumption either mistakenly or in order to distort the real picture.
7. Financial Statements Fail to Depict the Most Valuable Asset i.e., Men
Behind the Whole Show: The success of a business concern depends to a
greater extent upon the energy, ability and efficiency of the management
and badly enough this is not shown in the statements in monetary value.8
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5.3 FINANCIAL STATEMENT ANALYSIS
Financial statements are prepared primarily for decision making. The
statements are not an end in themselves, but are useful in decision making.
Financial analysis is the process of determining the significant operating and
financial characteristics of a firm from accounting data. The profit and loss account
and balance sheet are indicators of two significant factors – profitability and
financial soundness. Financial statement analysis is largely a study of relationship
among the various financial factors in a business as disclosed by a single set of
statements and a study of the trend of these factors as shown in a series of
statements. The main function of financial analysis is the pinpoint of the strength
and weakness of a business undertaking by regrouping and analysis of figures
contained in the financial statements, by making comparisons of various
components and examining their content. The financial statements are the best
media of documenting the results of managerial efforts to the owners of the
business, its employees, its customers and the public at large and thus become
excellent tools of the public relations.
The analysis of financial statements provides valuable information for
managerial decisions. Financial statement doesn’t speak anything. It merely
contains financial about business events. The user may gain from these data
through his own analysis and interpretation of the information.9
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Meaning of Analysis of Financial Statements:
Analysis of financial statements is the systematic numerical calculation of
the relationship between one fact with the other to measure the profitability,
operational efficiency, solvency and the growth potential of the business. The
analysis of financial statement to simplify summarized and systematizes the
monotonous figures to communicate the stake holders.
In the words of John N.Myers “Financial statement analysis is largely a
study of the relationships among the various financial factors in a business as
disclosed by a single set of statements and a study of the trends of these factors as
shown in a series of statements”10
Robert H. Wessel has defined “Analysis and Interpretation of Financial
Statements as a technique of x-raying the financial position as well as the progress
of a company”.11
According to Keneddy and Mamallaz “The analysis and interpretation of
financial statements are an attempt to determine the significance and meaning of
financial statements data, so that a forecast may be made of the prospects of future
earning, ability to pay interest and debt maturities (both short and long term) and
profitability of sound dividend policy”.12
In simply words financial statement analysis involves a systematic
examination of the information contained in the financial statement.
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Steps in Financial Statement Analysis:
• Determination of objectives and scope of analysis.
• Study of financial statements.
• Collection of relevant information.
• Arrangement of data.
• Analysis of data.
• Interpretation, presentation and preparation of reports.
Importance of Financial Analysis for Different Parties:
Every person concerned with the affairs of the business has an interest in
the financial statements of the business. The information available from the
analysis serves the interest of different section. The following parties have an
interest in the analysis of financial statements.
1) Management for the purpose of analysis of financial statements to
formulate for effective business plans and policies.
2) Shareholders to know the profitability and future prospectus of the
business.
3) Workers for the purpose of analysis of profits by the workers for
demanding of higher wages or bonus.
4) Creditors are interested to know the financial soundness of the business.
5) Potential investors for the intention of know the risk and return of company
or organization.
6) Stock exchange is an institution which deals in securities.
7) Government parties are interested for economic development, formulating
the effective plans.
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8) Economist and researcher, these parties are interested in the financial
activities of the business, so that they may study the financial health of the
economic structure of the business.13
Types of the Financial Statement Analysis:
1. External Analysis: the external analysis of financial statements done by
the outside agencies like investors, financial analysts, lenders, government
agencies, research scholars etc., the detailed records and accounting
information is not available to the outside agencies and they mostly on
published financial statements and information for analysis.
2. Internal Analysis: The internal analysis done by those who have access to
detailed financial records of the firm. Generally, management is interested
in the analysis of financial statement for measuring the effectiveness of its
own policies and decisions. Sometimes, officers appointed by court or
government under statute will conduct internal analysis.
3. Horizontal Analysis: When evaluation is done for several years
simultaneously at a time for making conclusions, it is called ‘horizontal
analysis’. This is based on the data from year to year rather than one time
available information. Horizontal analysis is done for finding the trend
ratios and in comparative financial statements.
4. Vertical Analysis: It is the study of quantitative relationship of one
financial item to another based on financial statement on a particular date.
Common size statements and ratio analysis are the examples for vertical
analysis.
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5. Long-term Analysis: The long-term analysis of financial statements is
done with a view to evaluate the long term solvency, profitability, liquidity,
financial health, earning capacity of the firms, debt servicing capacity etc.,
of the business enterprise. The objective of long-term analysis is to
determine whether the earning capacity of the firm is sufficient to meet the
targeted rate of return on investment and is adequate for future growth and
expansion of business.
6. Short-term Analysis: The short-term analysis of financial statements is
undertaken mainly determine the liquidity position of the firm and short-
term solvency of the firm. The analysis is oriented on efficiency of working
capital management and profitability of current operations.14
5.4 TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS
For analysis of financial statements, they should be rearranged to reveal the
relative significance and effect of various items of data in relation to time period
and for making inter-firm comparison while rearranging the data. Logical
relationship and sequence should be given consideration. The analysis of financial
statements will help in interpretation and logical conclusions. The important
techniques used in analysis of financial statements are as follows:
(a) Comparative Financial Statements
(b) Common – size Statements
(c) Trend Analysis or Trend Ratios
(d) Ratio Analysis
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I. Comparative Financial Statements:
Comparative of financial statements is one of the very important tools of
analysis of financial statements. It has been seen that balance sheet and profit and loss
accounts are the two most important financial statements. In these statements figures
for two or more periods are placed side by side to facilitate comparison. These
statements render comparison between two periods of time, exhibit the magnitude and
direction of historical changes in the operating result i.e., comparative income
statement and financial statement i.e., comparative balance sheet of a business.
Financial statements of two or more firms may also be compared for
drawing inferences. This is known as inter-firm comparison. The comparative
statements reveal the followings:
a) Absolute data (money value or rupee amount)
b) Increase or reduction in absolute data in terms of money value
c) Increase or reduction in absolute data in terms of percentage.
A. Comparative Income Statement- It shows the absolute figures for two or
more period and the absolute change from one period to another. Since the
figures are shown side by side, the user can quickly understand the
operational performance of the firm in different periods and draw
conclusions.
B. Comparative Balance Sheet- Balance sheets as on two or more different
dates are used for comparing the assets, liabilities and the net worth of the
company. Comparative balance sheet is useful for studying the trends of an
undertaking.15
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II) Common Size Statements:
It is a type of comparative financial statements in which each item of the
financial statement is expressed as a percentage of the appropriate total. The
appropriate total is taken as 100% and each item is shown as a proportion of this
100%. Such a statement is known as 100% statement or ‘vertical analyses. It
should be noted that when a comparative statement is prepared for a number of
years to show the trend. It is known as ‘Horizontal Analysis’. A common size
statement may be prepared for balance sheet as well as income statement.16
Common size income statement analysis is stating every line item on the
income statement as a percentage of sales. If more than one year of financial data,
compare income statements to see financial progress. This type of analysis will see
how the revenues and the spending on different types of expenses change from one
year to the next. The items of the income statement as a percentage of sales figures,
it is easy to compare the income and expenses and understand the financial
position of the company. Common size analysis is an excellent tool to compare
companies of different sizes or to compare different years of data for the same
company. Common size analysis is not as detailed as trend analysis using ratios. It
does not provide enough data for sophisticated investing decisions. For managers
of small businesses who do not have a lot of formal education in financial
management, vertical analysis provides a simple way for them to analyze their
financial statements.
Under this statement all figures are converted into a common unit by
expressing them as a percentage of key figures in the statement. Assets and
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liabilities are shown as percentage of total assets and total equities respectively in
common size balance sheet.17
Two components of the common size financial statement are:
1. Balance sheet
2. Income statement
When both these components are clubbed together, a common size financial
statement is obtained.
III) Trend Analysis:
Trend analysis or trend ratios are the index numbers of the movements of
select major financial items in the financial statements to arrive at the conclusions
for important changes. The trend ratio of different items is calculated for various
periods for compares on purpose. The calculation of trend ratios are based on
statistical technique called index numbers18.
It is an example for Horizontal analysis. This method of comparing the past
performance or data over a period of time with that of a base year is called trend
analysis. In this method, the profit and loss account and the balance sheet of an
accounting year are taken as the base. The base year may be the earliest year
involved in the comparison or the latest year or any intervening year. Normally the
earliest year in the study period is taken as the base year. Every item in the base
years financial statement is taken as equivalent to 100. All the corresponding
figures in the financial statements of other years are expressed as percentage of
their value in that base year’s financial statements.19
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Procedure for Calculation Trends
1. One year is taken as a base year. Generally, the first or the last is taken as a
base year.
2. The figures of base year are taken as 100.
3. Trend percentages are calculated in relation to base year. If a figure in other
year is less than the figure in base year the trend percentage will be less
than 100 and it will be more than 100 if figure is more than base year
figure. Each year’s figure is divided by the base years figure.
4. Tabulate the trend ratios for analysis of trend over a period.
The trend percentages are calculated for select major financial items in the
financial statements to arrive at the conclusions for important changes. The trend
may sometimes be affected by external factors like government policies, economic
conditions, changes in income distribution, technology development, population
growth, changes in tasted and habits etc. the trend analysis is a simple technique
and does not involve tedious calculations.20
Limitations of Trend Analysis:
a) The trend ratios are incomparable, if there is inconsistency in accounting
policies and practices.
b) The price level changes are represented in trend ratios.
c) The trend ratio must be studied along with absolute data for correct
analysis.
d) While analyzing the trend ratios, non-financial data should also be
considered, otherwise conclusions would be misleading.
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IV. Ratio Analysis:
Though a simple procedure of comparing the financial and operative data as
under the first three methods or tools of analysis and interpretation is possible and
useful, the real picture becomes clear only when the relationship between the two
items having cause and effect relationship with each other is worked out and
compared.21
The ratio is a simple arithmetical expression of the relationship of one
number to another. In other words the relationship between two accounting figures
is known as “Ratio”. It also defined as the relationship or proportion that one
amount bears to another, the first number being the numerator and the later
denominator”22. The analysis and interpretation of financial statements is made
with the help of ratios is called ratio analysis. The ratio analysis is an effective tool
or device to diagnose the financial and operational health and diseases of business
enterprises.
The ratio analysis is one of the techniques of financial analysis where ratios
are used as a yardstick for evaluating the financial condition and performance of
the firm. Analysis and interpretation of various accounting ratios gives a skilled
and experienced analysts, a better understanding of the financial condition and
performance of the firm than what he/she could have obtained only through a
perusal of financial statements.23
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Objectives of Ratio Analysis:
Accounting ratios are true test of the profitability, efficiency and financial
soundness of the company. These ratios have the following objectives.
• Facilitating comparative analysis of the performance
• Helpful in budgeting and forecasting
• Assessing the efficiency of the business
• Measurement of the profitability
• Judgment the operational efficiency of management
• Measuring short and long term financial position of the company
• Indicator of true efficiency
• Helpful in simplifying accounting figures.
Importance of Ratio Analysis:
� Ratios act as an index of efficiency of a firm
� They serve as an instrument of management control
� They are useful in evaluating performance
� They facilitate and help in forecasting future events
� They help management in exercising effective decisions
� They help management in take corrective actions
� They facilitate intra firm comparisons
� They play effective role for easy and clear communications
� To ensure secrecy
� They facilitate inter-firm comparisons.
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Steps Involved in the Ratio Analysis:
1. Selection of relevant data from the financial statements depending upon the
objective of the analysis
2. Calculation of appropriate ratios from the above data
3. Comparison of the calculated ratios with the ratios of the same firm in the
past, or the ratios developed from projected financial statements or the
ratios of some other firms or the comparison with ratios of the industry to
which the firm belongs.
4. Interpretation of the ratios.
Guidelines for use of Ratios:
The calculation of ratios may not be difficult task but their use is not easy.
The information on which these are based, the constraints of financial statements,
objective for using them, the calibre of the analyst, etc., are important factors
which influence the use of ratios.
1. Accuracy of Financial Statements:
The ratios are calculated from the data available in financial statements.
The reliability of ratios is linked to the accuracy of information in these statements.
Before calculating rations one should see whether proper concepts and conventions
have been used for preparing financial statements or not. These statements should
also be properly audited by competent auditors. The precautions will establish the
reliability of data given in financial statements.
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2. Objective of Analysis:
The type of ratios to be calculated will depend upon the purpose of which
these are required. If the purpose is to study current financial position then ratios
relating to current assets and current liabilities will studied. This purpose of “user”
is also important for the analysis of ratios. A creditor, a banker, an investor, a share
holder, all has different objects for studying ratios. The purpose or object for which
ratios are required to be studied should always be kept in mind for studying various
ratios. Different objects may require the study of different ratios.
3. Selection of Ratios:
Another precaution in ratio analysis is the proper selection of appropriate
ratios. The ratios should match the purpose for which these are required.
Calculation of large number of ratios without determining their need in the present
context may confuse the things instead of solving them. Only those ratios should
be selected which can throw proper light on the matter to be discussed.
4. Use of Standards:
The ratios will give an indication of financial position, only when discussed
with reference to certain standards. Unless otherwise these ratios are compared
with certain standards one will not be able to reach at conclusions. These standards
may be rule of thumb as in case of current ratio (2:1) and acid – test ratio (1:1),
may be industry standards, may be budgeted or projected ratios, etc., the
comparison of calculated ratios with the standards will help the analyst in forming
his opinion about financial situation of the concern.
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5. Calibre of the Analyst:
The ratios are only the tools of analysis and their interpretation will depend
upon the calibre and competence of the analyst. He should be familiar with various
financial statements and the significance of changes, etc., a wrong interpretation
may create havoc for the concern since wrong conclusions may lead to wrong
decision. The utility of ratios is linked to the expertise of the analyst.
6. Ratios Provide Only Base:
The ratios are only guidelines for the analyst, he/she should not base his
decisions entirely on them. He/she should study any other relevant information,
situation in the concern, general economic environment, etc., before reaching final
conclusions. They study of ratios in isolation may not always prove useful. A
businessman will not afford a single wrong decision because it may have far-
reaching consequences. The interpretation should use the ratios as guide and may
try to solicit any other relevant information which helps in reaching a correct
decision.24
Users of Ratio Analysis:
• Utility to shareholders/investors
• Utility to creditors
• Utility to employees
• Utility to government
• Utility to financial institutions.
• Other users
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Advantages of Ratio Analysis:
1. Simplifies Financial Statements: Ratio analysis simplifies the
comprehension of financial statements. Ratios tell the whole story of
changes in the financial condition of the business.
2. Facilitates Inter-firm Comparison : Ratio analysis provides data for inter-
firm comparison. Ratios highlight the factors associated with successful
firms. They also reveal strong firms and weak firms, overvalued and under-
valued firms.
3. Makes Intra-firm Comparison Possible: Ratio analysis also makes
possible comparison of the performance of the different divisions of the
firm. The ratios are helpful in deciding about their efficiency or otherwise
in the past and likely performance in the future.
4. Helps in Planning: Ratio analysis helps in planning and forecasting. Over
a period of time, a firm or industry develops certain norms that may
indicate future success or failure. If relationship changes in firm’s data over
different time periods, the ratios may provide clues on trends and future
problems. Thus, “ratios can assist management in its basic function of
forecasting, planning, co-ordination, control and communication”.
5. Useful in Judging the Efficiency of a Business: The ratios help in judging
the efficiency of a business. Liquidity, solvency, profitability etc. of a
business can be easily evaluated with the help of various accounting ratios
like current ratio, liquid ratio, debt-equity ratio, net profit ratio, etc., such an
evaluation enables the management to judge the operating efficiency of the
various aspects of the business.25
176
Limitations of Ratio Analysis:
1. Comparative Study Required: Ratios are useful in judging the efficiency
of the business only when they are compared with the past results of the
business or with the result of a similar business. However, such a
comparison only provides a glimpse of the past performance and forecast
for future may not be correct since several other factors like market
conditions, management policies, etc., may affect the future operations.
2. Limitations of Financial Statements: Ratios are based only on the
information which has been recorded in the financial statements. As
indicated that financial statement suffer from a number of limitations, the
ratios derived there from therefore, are also subject to those limitations.
3. Ratios Alone are not Adequate: Ratios are only indicators they cannot be
taken as final regarding good or bad financial position of the business.
Other things have also to be seen. The value of a ratio should not be
regarded as good or bad inter say. It may be an indication that a firm is
weak or strong in a particular area, but it must never be taken as proof.
“Ratios may be linked to railroad. They tell the analyst, “stop, look and
listen”.
4. Window Dressing: The term window dressing means manipulation of
accounts in a way so as to conceal vital facts and present the financial
statements in a way to show a better position than what it actually is. On
account of such a situation, presence of a particular ratio may not be a
definite indicator of good or bad management.
177
5. Problem of Price Level Changes: Financial analysis based on accounting
ratios will give misleading results, if the effects of changes in price level
are not taken into account.
6. Ratios Ignore Qualitative Factors: Ratios are as a matter of fact, tools of
quantitative analysis. It ignores qualitative factors which sometimes are
equally or rather more important than the quantitative factor. As a result of
this, conclusions from ratio analysis may be distorted.26
178
REFERENCES:
1. Arora M.N.(2012), “Cost and Management Accounting”, Himalaya
Publication House, New Delhi, p.13.2.
2. Pandey I.M.(2013), “Financial Management”, Vikas Publishing House pvt.
Ltd., New Delhi, p.30.
3. Madegowda J (2012), “Advanced Management Accounting”, Himalaya
Publication House, New Delhi, p.72.
4. Varshney J.C. (2006), “Accounting and Financial Analysis” Wisdom
Publications, Delhi; ISBN; 81-89547-13-5, pp.344-346.
5. Pandey I.M.(2013), “Financial Management”, Vikas Publishing House pvt.
Ltd., New Delhi, p.12.
6. Ravi M. Kishore (2012), “Financial Management”, Taxmann’s
Publications (p) Ltd. p.39.
7. Arora M.N. (2012), “Cost and Management Accounting”, Himalaya
Publication House, New Delhi p.13.2.
8. Madegowda J (2012), “Advanced Management Accounting”, Himalaya
Publication House, New Delhi, pp.73-74.
9. Pillai R.S.N. & Bagavathi, “Management Accounting”, Sultan Chand &
Company LTD. New Delhi, pp. 41-42.
10. Varshney J.C. (2006), “Accounting and Financial Analysis” Wisdom
Publications, Delhi; ISBN; 81-89547-13-5, pp.347-350.
11. Arora M.N. (2012), “Cost and Management Accounting”, Himalaya
Publication House, New Delhi p.13.2.
179
12. Madegowda J (2012), “Advanced Management Accounting”, Himalaya
Publication House, New Delhi, p.75.
13. Varshney J.C. (2006), “Accounting and Financial Analysis” Wisdom
Publications, Delhi; ISBN; 81-89547-13-5, p.344.
14. Ravi M. Kishore (2012), “Financial Management”, Taxmann’s
Publications (p) Ltd., pp.50-51
15. Arora M.N. (2012), “Cost and Management Accounting”, Himalaya
Publication House, New Delhi p.13.6
16. Varshney J.C. (2006), “Accounting and Financial Analysis” Wisdom
Publications, Delhi; ISBN; 81-89547-13-5, pp.350-351.
17. Ravi M. Kishore (2012), “Financial Management”, Taxmann’s
Publications (p) Ltd., p.57
18. Madegowda J (2012), “Advanced Management Accounting”, Himalaya
Publication House, New Delhi.
19. Paramasivan C & Subramanian T., “Financial Management”, New Age
International publishers.
20. Ravi M. Kishore (2012), “Financial Management”, Taxmann’s
Publications (p) Ltd.
21. Madegowda J (2012), “Advanced Management Accounting”, Himalaya
Publication House, New Delhi., p.120
22. Shashi K. Gupta, Sharma R.K. & Neeti Gupta (2009), “Management
Accounting”, Kalyani Publishers, pp 4-5.
180
23. Khatri P.V. and Sudhanshu Verma (2010), “Management Accounting”,
Global Vision Publishing House New Delhi, ISBN- 978-81-8220-330-3,
p.86.
24. Pillai R.S.N. & Bagavathi, “Management Accounting”, Sultan Chand &
Company LTD. New Delhi,
25. Khatri P.V. and Sudhanshu Verma (2010),“Management Accounting”,
Global Vision Publishing House New Delhi, ISBN- 978-81-8220-330-3, p.
113.
26. Khatri P.V. and Sudhanshu Verma (2010), “Management Accounting”,
Global Vision Publishing House New Delhi, ISBN- 978-81-8220-330-3,
pp.125-126.
