RATIONALE AND CONTEMPLATION OF RATIO ANALYSIS
debt, preference and equity. They also show whether the firm is exposed to serious financial strain or is justified in the use of debt funds. Inter-firm and Intra-firm comparison: Comparison of the firm’s ratios with the industry average will help evaluate the firm’s position vis--vis the industry. It will help in analyzing the firm’s strengths and weaknesses and take corrective action. Trend Analysis of ratios over a period of years will indicate the direction of the firm’s financial policies. Budgeting: Ratios are not mere post-modern of operations. They help in depicting future financial positions. Ratios have predictor value and are helpful in planning and forecasting the business activities of a firm for future periods, e.g. estimation of working capital requirements. Ratios are useful tools for financial analysis. Howeverthe following limitations do exist. (a) Window Dressing: Ratios depict the picture of performance at a particular point of time. Sometimes, a business can make year-end adjustments in order to result in favorable ratios (e.g. current ratio, operating profit ratio, debt-equity ratio etc.) (b) Impact of Inflation: Financial Statements are affected by inflation. Ratios may not depict the correct picture. For example, fixed assets are accounted at historical cost while profits are measured in current rupee terms. In inflationary situations, the Return on Assets or Return on Capital Employed may be very high due to less investment in fixed assets. Ratios may not indicate the true position in such situations. (c) Product Line diversification: Detailed ratios for different divisions, products and market segments etc.Pages: 1 2 [3] 4 5 6
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