1. The Objectives of Ratio Analysis
Raw numbers on financial statements are difficult to interpret on their own. Ratio Analysis converts these absolute figures into relative percentages and proportions. This process uncovers patterns, trends, and relationships, allowing stakeholders to evaluate a company’s financial health, efficiency, and risk levels.
2. Comparative Frameworks
To make ratios meaningful, they must be evaluated against benchmarks:
  • Intra-Firm (Trend) Analysis: Comparing a company’s current ratios against its own historical performance to track growth or deterioration over time.
  • Inter-Firm (Competitor) Analysis: Comparing a company’s ratios against direct industry rivals to measure market competitiveness.
  • Industry Averages: Benchmarking metrics against broader sector standards to identify systemic strengths or weaknesses.

3. Limitations of Ratio Analysis
Ratios provide useful insights but come with clear limitations:
  • Historical Data Focus: Financial statements look backward, meaning ratios may not reflect current or future market changes.
  • Inflation Distortions: Historical costs of older assets can distort asset-based ratios when compared to newly purchased assets.
  • Window Dressing: Companies may alter year-end transactions to make their financial position look stronger than it is.
  • Accounting Policy Variations: Different choices in depreciation or inventory valuation methods make comparisons between companies difficult.

 
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