A NOTE ON FINANCIAL RATIO ANALYSIS

 

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COMMON SIZE INCOME STATEMENT OF HLL

COMMON SIZE BALANCE SHEET OF HLL

From the above common size income statement we can see that the expenditure on raw materials, wages and salaries, fuel and electricity is decreasing year after year, indicating improving operating efficiency at HLL. The increase in marketing and distribution expenses indicates that the company has increased its investment in its marketing efforts. The increase in HLL's overall profits indicates that the financial performance of the company has improved.

ADVANTAGES OF RATIO ANALYSIS

Financial ratios are essentially concerned with the identification of significant accounting data relationships, which give the decision-maker insights into the financial performance of a company. The advantages of ratio analysis can be summarized as follows:

• Ratios facilitate conducting trend analysis, which is important for decision making and forecasting.

• Ratio analysis helps in the assessment of the liquidity, operating efficiency, profitability and solvency of a firm.

• Ratio analysis provides a basis for both intra-firm as well as inter-firm comparisons.

• The comparison of actual ratios with base year ratios or standard ratios helps the management analyze the financial performance of the firm.

LIMITATIONS OF RATIO ANALYSIS

Ratio analysis has its limitations. These limitations are described below:

• A ratio in isolation is of little help. It should be compared with the base year ratio or standard ratio, the computation of which is difficult as it involves the selection of a base year and the determination of standards.

• Inter-firm comparison may not be useful unless the firms compared are of the same size and age, and employ similar production methods and accounting practices.

• Even within a company, comparisons can be distorted by changes in the price level.

• Ratios provide only quantitative information, not qualitative information.

• Ratios are calculated on the basis of past financial statements. They do not indicate future trends and they do not consider economic conditions.

CONCLUSION

Ratio analysis has a major significance in analyzing the financial performance of a company over a period of time. Decisions affecting product prices, per unit costs, volume or efficiency have an impact on the profit margin or turnover ratios of a company. Similarly, decisions affecting the amount and ratio of debt or equity used have an affect on the financial structure and overall cost of capital of a company. Understanding the inter-relationships among the various ratios, such as turnover ratios and leverage and profitability ratios, helps managers invest in areas where the risk adjusted return is maximum. In spite of its limitations, ratio analysis can provide useful and reliable information if relevant data is used for analysis.