Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University

Ratio Analysis for Entrepreneurship MCOM sem 3 Delhi University:- we will provide complete details of Ratio Analysis for Entrepreneurship MCOM sem 3 Delhi University in this article.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-What is Ratio Analysis ?

Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in different industries and having different styles of conducting business can make it almost impossible to come up with a conclusion as to which company is a better investment. Ratio analysis helps creditors solve these issues. Here is how:

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-What are Financial Ratios ?

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  • Shortcut: Financial ratios provide a sort of heuristic or thumb rule that investors can apply to understand the true financial position of a company. There are recommended values that specific ratios must fall within. Whereas in other cases, the values for comparison are derived from other companies or the same companies own previous records. However, instead of undertaking a complete tedious analysis, financial ratios helps investors shortlist companies that meet their criteria.
  • Sneak-Peek: Investors have limited data to make their decisions with. They do not know what the state of affairs of the company truly is. The financial statements provide the window for them to look at the internal operations of the company. Financial ratios make financial analysis simpler. They also help investors compare the relationships between various income statement and balance sheet items, providing them with a sneak peek of what truly is happening behind the scenes in the company.
  • Connecting the Dots: Over the years investors have realized that financial ratios have incredible power in revealing the true state of affairs of a company. Analyses like the DuPont Analysis have brought to the forefront the inter-relationship between ratios and how they help a company become more profitable.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-Sources of Data

Here is where the investors get the data they require for ratio analysis:

  • Financial Statements: The financial data published by the company and its competitors is the prime source of information for ratio analysis.
  • Best Practices Reports: There are a wide range of consulting firms that collate and publish data about various companies. This data is used for operational benchmarking and can also be used for financial data analysis.
  • Market: The data generated by all the activity on the stock exchange is also important from ratio analysis point of view. There is a whole class of ratios where the stock price is compared with earnings, cash flow and such other metrics to check if it is fairly priced.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-Techniques Used in Ratio Analysis

Ratio, as the name suggests, is nothing more than one number divided by the other. However, they become useful when they are put in some sort of context. This means that when an analysts looks at the number resulting out of a ratio calculation he/she must have a reasonable basis to compare it with. Only when the analyst looks at the number and compares it what the ideal state of affairs should be like, do the numbers become powerful tool of management and financial analysis.

Dividing numbers and obtaining ratios is therefore not the main skill. In fact this part can be automated and done by the computer. Companies wouldn’t want to pay analysts for doing simple division, would they?. The real skill lies in being able to interpret these numbers. Here are some common techniques used in the interpretation of these numbers.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-Horizontal Analysis

Horizontal analysis is an industry jargon for comparison of the same ratio over time. Once a ratio is calculated, it is compared with what the value was in the previous quarter, the previous years, or many years in case the analyst is trying to make a trend. This provides more information of two grounds. They are:

  • Horizontal analysis clarifies whether the company has a stable track record or is the value of the ratio influenced by one time special circumstances.
  • Horizontal analysis helps to unveil trends which help analysts unveil trends in the performance of the business. This helps them make more accurate future projections and value the share correctly.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-Cross-Sectional Analysis

Cross sectional ratio analysis is the industry jargon used to denote comparison of ratios with other companies. The other companies may or may not belong to the same industry. Cross sectional analysis helps an analyst understand how well a company is performing relative to its peers. In a way this removes the effect of business cycles. There are many variations of cross sectional analysis. They are as follows:

  • Industry Average: The most popular method is to take the industry average and compare it with the ratios of the firm. This provides a measure of how the company is performing in comparison to an average firm.
  • Industry Leader: Many companies and analysts are not satisfied with being average. They want to be the industry leader and therefore benchmark against them.
  • Best Practice: In case, the company is the industrial leader, then it usually crosses the industry border and seeks inspiration from anyone anywhere in the world. They benchmark with the best practices across the globe.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-Limitations of Ratio Analysis

Ratio analysis, without a doubt, is amongst the most powerful tools of financial analysis. Any investor, who wants to be more efficient at their job, must devote more time towards understanding ratios and ratio analysis. However, this does not mean that it is free of limitations. Like all techniques, financial ratios have their limitations too. Understanding the limitations will help investors understand the possible shortcomings with ratios and avoid them. Here are the shortcomings:

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-Misleading Financial Statements

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The first and foremost threat to ratio analysis is deliberate misleading statements issued by the management. The management of most companies is aware that investors look at certain numbers like sales, earnings, cash flow etc very seriously. Other numbers on the financial statements do not get such attention. They therefore manipulate the numbers within the legal framework to make important metrics look good. This is a common practice amongst publically listed companies and is called “Window Dressing”. Investors need to be aware of such window dressing and must be careful in calculating and interpreting ratios based on these numbers.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-Incomparability

Comparison is the crux of ratio analysis. Once ratios have been calculated, they need to be compared with other companies or over time. However, many times companies have accounting policies that do not match with each other. This makes it impossible to have any meaningful ratio analysis. Regulators all over the world are striving to make financial statements standardized. However in many cases, companies can still choose accounting policies which will make their statements incomparable.

Ratio Analysis for Entrepreneurship MCOM sem 3 Delhi University:-Qualitative Factors

Comparison over time is another important technique used in ratio analysis. It is called horizontal analysis. However, many times comparison over time is meaningless because of inflation. Two companies may be using the same machine with the same efficiency but one will have a better ratio because it bought the machine earlier at a low price. Also, since the machine was purchased earlier, it may be closer to impairment. But the ratio does not reflect this.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University:-Subjective Interpretation

Financial ratios are established “thumb of rules” about the way a business should operate. However some of these rules of thumb have become obsolete. Therefore when companies come with a new kind of business model, ratios show that the company is not a good investment. In reality the company is just “unconventional”. Many may even call these companies innovative. Ratio analysis of such companies does not provide meaningful information. Investors must look further to make their decisions.

Ratio Analysis for Entrepreneurship Mcom sem 3 Delhi University

Preparing for MCom? - Must read below
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