In order to analyze the balance sheet and profit and loss account pertaining to any firm, ratio analysis serves as an important tool. Especially seasoned bankers and financial institutions are making use of different kinds of ratios so that they are able to arrive at effective solutions towards arriving at decisions in regard to sanction of loans and other credits to the firms who are in need of finance from such banks and financial institutions.
A ratio is an expression of linear direct relationship between two indicators; the one which forms as the broad indicator which will normally be the denominator; however, not mandatory. A ratio can be very well expressed as an integer or as percentage.
Financial ratios are used in order to compare the risk and return of a firm (or of different firms) over a period of time towards enabling the bankers and financial institutions, creditors and equity investors so as to equip them to formulate proper credit and investment decisions. Such decisions normally require an assessment of changes in the performance over time for a particular credit or investment and a comparison among all firms within a single industry at a specific point of time.
The informational needs and appropriate analytical methods utilized for these credit and investment decisions normally depend upon the decision makers’ time horizon. In reality, the short term bank and trade creditors are normally interested in the immediate liquidity of the firm.
However, when it comes to long term creditors namely; the term lenders and bond holders, they are interested in the long term solvency. Both the long term as well as short term creditors seek to minimize the risk and ensure that the resources are available for payment of interest and principal obligations to the most.
Why ratio analysis?
Ratios present a profile of the firm, its economic characteristics, competitive approach and its unique operative, financial and investment characteristics.
The following five broad ratio categories are found to measure the different aspects of risk and return relationships:
Activity analysis evaluates the revenue and output produced by the firm’s assets.
Liquidity analysis measures the adequacy of the firm’s cash resources to meet its near term cash obligations.
Solvency analysis examines the firm’s capital structure, including the mix of its financing sources and the ability of the firm towards satisfying its long terms debt and investment obligations.
Profitability analysis measures income of the firm relative to its revenues and invested capital.
Performance analysis: Performance analysis examine the revenues and expenses of the firm, either to look at cost structure or relate the sales performance to the amount of assets used in creating sales. Normally these ratios help in concentrating on the efficiency with which the assets are utilized.
The abovementioned categories are interrelated rather than independent. For example, profitability affects the liquidity and solvency and the efficiency with which the assets are utilized are found to impact the profitability to a certain degree. Thus financial analysis relies on an integrated use of many ratios and they are not confined to a selected few.