Points to recall

. Introduction Student activity . Read the following statement. A sole trader earns ` , , per annum from business.

• Is this a high profit? State the reasons. • Do you think the above information is enough to say that it is high profit or not? • What more information, do you need to decide that the trader’s business’ performance is good?

Think on the above points and discuss in the class. The financial status and operational performance of business entities can be assessed through financial analysis. Analysis of financial statements involves study of items in the financial statements and making a logical conclusion. There are various tools available for financial analysis such as common size statement, comparative statement, ratio analysis, cash flow analysis, etc.

Ratio analysis is one of the important tools of financial analysis. Ratio analysis involves computation of various ratios for analysing the financial statements. It is the most important and powerful tool for measuring performance of a business enterprise. .

. Meaning of accounting ratios Ratio is a mathematical expression of relationship between two related or interdependent items. It is the numerical or quantitative relationship between two items. It is calculated by dividing one item by the other related item.

When ratios are calculated on the basis of accounting information, these are called ‘accounting ratios’. Accounting ratios can be expressed in any of the following forms: (i) Pure : It is expressed as a quotient. Example: or : . (ii) Percentage : It is expressed in percentage.

Example: %. (iii) Times : It is expressed as certain number of times of a particular figure. Example: times. .

. Meaning and definition of ratio analysis Ratio analysis is a tool which involves analysing the financial statements by calculating various ratios. It is a tool of financial statement analysis, in which, inferences are drawn based on the computation and analysis of different ratios. According to Myers, “Ratio analysis is a study of relationship among various financial factors in a business”.

. . Objectives of ratio analysis Following are the objectives of ratio analysis: (i) To simplify accounting figures (ii) To facilitate analysis of financial statements (iii) To analyse the operational efficiency of a business (iv) To help in budgeting and forecasting (v) To facilitate intra firm and inter firm comparison of performance . .

Classification of ratios Ratios may be classified in the following two ways: (i) Traditional classification (ii) Functional classification . . . Traditional classification Traditional classification of ratios is done on the basis of the financial statements from which the ratios are calculated.

Under the traditional classification, the ratios are classified as: (i) Balance sheet ratios, (ii) Income statement ratios and (iii) Inter-statement ratios. Figure . shows some of the examples of ratios as per traditional classification: (i) Balance sheet ratio If both items in a ratio are from balance sheet, it is classified as balance sheet ratio. (ii) Income statement ratio If the two items in a ratio are from income statement, it is classified as income statement ratio.

(iii) Inter-statement ratio If a ratio is computed with one item from income statement and another item from balance sheet, it is called inter-statement ratio. . . .

Functional classification Functional classification of ratios is based on the purpose for which ratios are computed and it is the most commonly used classification. Under the functional classification, the ratios are classified as follows: (i) Liquidity ratios (ii) Long term solvency ratios Figure . Traditional classification of ratios (iii) Turnover ratios (iv) Profitability ratios Figure . shows some of the examples of ratios as per functional classification: