Steps involved in financial ratio analysis
The following are the steps involved in the financial ratio analysis.
1. An analyst should decide the objectives of ratio analysis.
2. Select th0 appropriate ratios on the basis of objectives of ratio analysis.
3. Calculation of the selected such ratios.
4. Comparison of the calculated ratios with the ratios of the same business concern in the past.
5. Comparison of the calculated ratios with the same type of ratios of other similar business concern.
6. Comparison of the calculated ratios with the same type of ratios of the industry to which the business concern belongs.
7. Interpretation of the ratios.
How to interpret financial ratios?
The mere calculation of ratio is clerical work. But, the interpretation of ratio requires skill, intelligence and foresightedness. Each ratio has its own limitations. Such limitations should be bear in mind by the analyst while interpreting the ratios. Moreover, some factors are also affecting the ratios. They are price level changes, change in accounting policies, window dressing and the like. Hence, these factors are also kept in mind while interpreting the ratios by the analyst.
Interpretation of financial ratio analysis can be done in the following five ways.
1. Single Ratio: An analyst can not draw a worthwhile interpretation from a single ratio. In such a situation, single ratio can be studied through some rule of thumb convention. For example, current ratio standard is 2:1. It is considered as good ratio for current assets to current liabilities.
2. Group of Ratios: Interpretation of ratios may be done by a group of ratios. A meaningful interpretation is possible through a group of ratios. For example: short term solvency is assessed by preparing current ratio, liquid ratio and cash position ratio.
3. Historical Comparison of ratios: The comparison of present ratios with past ratios is called historical comparison of ratios. If financial ratios are compared over a period of time, it gives an indication of the direction of change and reflects whether the performance and financial position of the business concern has improved, declined or unchanged over a period of time.
4. Projected Ratios: Sometimes projected financial statements are prepared. In such a case, ratios are calculated from the contents of the projected financial statements. These ratios are called projected ratios. Moreover, actual ratios are calculated from the actual financial statements. Then, the actual ratios are compared with projected ratios to find variances. If there is vast variance, the management can take corrective actions through interpretation for improvement in future.
5. Inter-firm Comparison: Ratios of one firm can also be compared with the ratios of other selected firms to find out how much both the ratio varies across same industry at a given time. In such a case, an analyst is very careful regarding various methods of accounting, procedures, policies adopted by other firms etc.