Financial Analysis can be undertaken by the management or owners of the firm, or by external people viz., creditors, investors and others. The nature of analysis and ratios used depend upon the perspective / need of the person computing the ratios.
| Analysed by | Area of Interest | Area of Finance |
| Trade Creditors | Firm’s ability to meet short term claims | Liquidity Position |
| Lenders of the Long term debt | – Firm’s ability to pay interest and repay principal amount – Relationship between various sources of funds -Future Solvency and Profitability | -Long-term Solvency – Consistency in Profitability – Capital Structure Relationships – Projected Financial Statements |
| Investors | Steady growth in earnings | -Present & future profitability -Influence of financial structure on earning ability and risk |
| Management | Most effective & efficient use of the resources and sound financial condition | Every aspect of financial analysis |
The term Ratio refers to the numerical or quantitative relation- ship between two related items / variables / accounting figures. Financial ratios relating items in income statement to total assets in the balance sheet are calculated. The financial ratios are calculated as a percent to total assets.
Ratios help to make qualitative judgment Ratios may be express as
- Proportion of numbers e.g. 2:1; or
- A ‘Rate’ or ‘Time’ e.g. 2 times; or
- Percentages e.g. 200%; or
- Fraction or Quotient / decimal e.g. 2/3 or 0.667 Ratio analysis makes related information comparable. Ratios are helpful in ascertaining the financial condition of the firm, strengths and weaknesses of the firm.
A single ratio like an absolute figure is not of much use. Ratios need to be compared –
- Over a period of time i.e. trend or time series analysis
- With competitors, industry standards, selected firms of the industry (Cross-sectional analysis)
- Rule of thumb
Following are the steps involved in Ratio Analysis:
- Determination of the objective of the analysis
- Selection of relevant data from the financial statements
- Comparison of ratios computed for different points of time or comparison with firms of the same industry (inter-firm comparison) etc.
- Interpretation of the ratios