Rogers Barco

CHAPTER 3

RATIO ANALYSIS

and weaknesses underlying the performance of an enterprise. In order to calculate a ratio, a relevant relationship between two numbers of financial statements is established and the result of the same is interpreted in order to derive meaningful conclusions. Two numbers are needed to calculate a ratio. One number is put as the numerator and the other as the denominator. For example, if we want to know the relative market share of a brand of toothpaste (say X), we will calculate a ratio. This ratio will have the number of units sold of Brand X in the numerator and the total size of the market for toothpaste in the denominator. Let us assume that these numbers are 200 and 1000 respectively. So the ratio turns out to be 20%, i.e.

200 1000 × 100 . It implies that the

LEARNING OBJECTIVES After studying this chapter, you will be able to :

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Appreciate the concept of ratio analysis ; Understand cross-sectional and time-series analyses ; Analyse liquidity, solvency, activity and profitability of a business enterprise by using relevant ratios.

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In the previous chapter you studied about the various tools of financial analysis and interpretation, viz., comparative statements, common-size statements and ratio analysis etc. This chapter is devoted to the concept and use of ratio analysis in the interpretation of financial statements.

3.1 Concept of Ratio Analysis

Ratio analysis involves the method of calculating and interpreting financial ratios in order to assess the strengths

market share of Brand X is 20%. A very important aspect of this process is that the numerator and denominator must be logically related to each other. Otherwise, the ratio will

RATIO ANALYSIS

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not provide information needed for decision-making. For example, in the previous example, if we put 200 (number of units sold of Brand X) in the numerator and 2000 (number of users of washing machines) in the denominator, we get a ratio of 10%....