Ratio Analysis: Frequently Asked Questions

QUESTION NO 1: WHAT REALLY IS RATIO ANALYSIS?

Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance.

QUESTION NO 2: WHO IS INTERESTED IN RATIO ANALYSIS?

Since it’s able to assess a firm’s financial condition and performance, hence it is of Interest to all users group as narrated in my earlier article on Users of the financial statements

QUESTION NO 3: HOW MANY TYPES OF RATIO COMPARISONS CAN YOU USE?

Ratio comparisons can be broadly classified into three types:

1. Trend or Time-Series Analysis
   • To evaluate a firm’s performance over time.
2. Cross-Sectional Analysis
   • To compare one firm’s financial performance to the industry’s average performance. Cross-sectional analysis is used to compare different firms at the same point in time.
3. Combined Analysis
   • A combination of both time series analysis and cross-sectional analysis.

QUESTION NO 4: DO YOU KNOW THAT RATIO ANALYSIS HAS CERTAIN LIMITATIONS?

Ratios must be considered together

Financial statements that are being compared should be dated at the same point in time.

Use audited financial statements when possible.

Merely numbers & data hard to get.

Be wary of inflation distortions, historical cost, different accounting policies, management manipulation & different definitions.

It is difficult to define categorically what a good or bad ratio value should be.

QUESTION NO 5: DO YOU KNOW THERE ARE HOW MANY TYPES OF FINANCIAL RATIO CLASSIFICATION?

Broadly classified under:

1. Liquidity
2. Asset Management
3. Profitability
4. Financial leverage management
5. Market-based ratios inclusive of dividend policy
6. Bankruptcy