Top 5 tips for doing ratio analysis
Ratio analysis or financial ratio as it is also called, is a list of financial tests that determine
the financial functionality, stability and the overall condition of a business concern. These
financial ratios are used mainly by finance managers, bankers, shareholders, creditors, etc
for various purposes.
The topic of ratio analysis can be generally found in advanced management accounting.
Some of the very popular ratios include Current ratio, Liquidity ratio, Acid test ratio, Cash
Ratio, Operation cash flow ratio, Assets turnover ratio, stock turnover ratio, Inventory
conversion ratio, Debt ratio, Debt to equity ratio, Long term debt to equity ratio, Earnings
per share, Payout ratio, Dividend cover, etc and many more.
Each of these ratios has its own benchmark levels and one ratio’s benchmark level may not
be relevant to another ratio’s benchmark level. And these ratios are divided and segregated
under various heads like Liquidity Ratios, Activity Ratios, Profitability Ratios, Debt Ratios,
Market Ratios, etc. In order to calculate these ratios, you would need two or more financial
statements which include the Balance Sheet, Income Statement or Profit & Loss Accounts.
This is the reason why not just profitability or profit earned is not the only area of concern
for any company. But, overall financial health which includes all the above mentioned and
other ratios’ calculation.
Tips for doing ratio analysis
Remember the most important ratios: It is one of the basic criteria for mastering ratio
analysis. Though, the calculation part is pretty easy, the steps involved and sometimes the
formulae used for calculating the ratios can be pretty tough to remember. So, the first thing
is to understand each of the ratios’ importance and remember them thoroughly.
Practice: The only way to master ratio analysis is by practicing it many number of times with
various scenarios, permutations and combinations. Only when you practice each and every
ratio thoroughly, you can remember the steps very well. Thereby you don’t have to struggle
before your exams.
Remember ratios with thumb rules: Most ratios can be remembered by practice, but there
are some ratios which need heavy prior calculations before arriving at the answer. For such
ratios, the prior calculations are very important without which the answer would be totally
wrong. So, remember such ratios with some easy thumb rules that you can recall very easily.
Ex: Cash flow to debt ratio, you need to calculate the cash flow before calculating the ratio.
Be thorough with your math: In order to calculate the ratios accurately and perfectly, you
need to be thorough with your math. You need to be quick in your calculations, especially
multiplication and division. If you’re perfect here, the final answers would definitely be very
Analysis of given ratios: After all the calculations have been done, sometimes, you might
have to determine the financial position of company just by looking at the ratios only.
Determining the health of a company with just the ratios can be tough, but an approximate
determination can mean that you have a good grip over the subject.