Notes On Financial Ratio Of A Company:

      Ratios as a tool of measuring liquidity, profitability, efficiency and financial position of company can be classified into four basic categories:

1. Liquidity Ratios:

       Liquidity ratios provide test to measure the ability of the corporation to cover its short term obligations out of its short term resources. Interpretation of liquidity ratios provides considerable insight into the present cash solvency of the corporation and its ability to remain solvent in times of adversities.

       The two commonly used liquidity ratios are:

  1. Current Ratio and
  2. Acid Test Ratio.
2. Leverage Ratio:

       Leverage ratios are generally designed to measure the contribution of the company's owners and the funds provided by the creditors. These ratios are computed along the following lines.

  1. The company's ability to wither away times of stress and to cover all its obligations-both short term and long term.
  2. The margin of safety offered to the creditors.
  3. The extent of control of the shareholders over the enterprise.
  4. The potential earnings from the use of loan funds.

       Leverage ratios can be examined in three ways:

  1. Debt Ratio
  2. Debt-Equity Ratio.
  3. Time Interest Earned
3. Activity Ratio:

       It reflects how effectively the company is managing its resources. The ratio expresses the level of sales and the investment in various assets:

       The important activity ratios are:

  1. Inventory Turnover
  2. Average Collection Period
  3. Fixed Assets Turnover
  4. Total Assets Turnover.
4. Profitability Ratio:

       The profitability ratios are the best indicator of the overall efficiency of the business concern because they compare return of value over and above the values put into the business.

       Profitability ratios are of two types:

  1. Profitability as related to sales and
  2. Profitability as related to investment.
Limitations of Ratios:

       Though ratios are simple and easily understandable, they suffer from some serious drawbacks:

1. Limited Use:

       A single ratio usually does not convey much sense. To make better interpretation, a number of ratios have to be calculated which is like to confuse the analyst than help him.

2. Inadequate Standard:

       There are no well accepted standard or rule of thumb for all ratios which can be accepted as norms. This makes interpretation of the ratios difficult.

3. Accounting Limitations:

       Ratios suffer from accounting limitations. Ratios of the pasts are not necessarily true indicators of the future.

4. Change of Accounting Procedure:

       Change of accounting procedure by a firm often makes ratio analysis misleading. E.g. Change in the methods of valuation of inventories form FIFO to LIFO increases the cost of sales and reduces the value of closing stock which makes stock turnover ratio lucrative.

5. Window Dressing:

       Financial Statements can be easily altered to show a position better than what it is. As such, one has to maintain caution while conclusions from such financial statements.

6. Personal Bias:

       Ratios are just a means and not an end in itself. It needs to be interpreted for drawing conclusion and different people interpret the same ratio differently.

7. Incomparable:

       Ratios cannot be compared and if done it will mislead as firms and industries of similar business differ in size and accounting procedure.

8. Changes in the Level of Price:

       While making ratio analysis no consideration is paid to the changes in the level of prices.