A ratio is relative size of two numbers. It represents the result of one number divided by another. It can be shown in different ways like number of times, in %, proportion of one to another.
The relationship between two accounting figures expressed mathematically is known as financial ratio or accounting ratio.
Accounting ratio, a form of financial statement analysis, enables the analyst to compares two aspect of financial statement and conveys the relationship of one metric with another and interprets the key information in the financial statement.
Ratio analyses allow the comparison between the company, industries, time period of one company (Time series analysis), and company with industry average and provide relative performance. Therefore ratio analysis has no meaning unless benchmarked against something else.
For example if a company ABC ltd has P/E multiple of 10x, it has no meaning unless we know the industry benchmark or some other company multiple. But if it is known that industry average P/E multiple is 12x, than we can simply say that ABC ltd is undervalued or out performing in the industry on the basis of P/E.
Accounting Ratio enables to access the credit risk profile of borrower, enable the credit rating of the borrower and therefore ensure the safety of fund to be lending.
Also it helps in valuation of company (Relative valuation) by making comparisons of various valuations multiple like P/E Multiple, EV/EBITDA etc.
Ratio analyses enable the trend analysis and help the management to take decision by looking into the past.
It Enables Development of an industry average by comparing various companies in same industry.
The information related to ratio of company is available on resource ‘Bloomberg – ‘FA 6’ & S&P capital IQ under Financial for particular company.
Ratio analysis is unable to do out of industry comparisons because acceptable ratio vary by industry, even within the same industry comparisons may not be accurate because of different accounting assumptions, different division of a large firm and also trend analysis is imprecise due to inflation etc.
A company may have some bad and good ratio and so it becomes hard to tell whether company is good or bad.
Also ratio is hard to interpret. For example: A high working capital ratio is considered to be good for short term liquidity position for the company whereas same also reflect the large amount of inventory etc
In conclusion, an astute ratio analysis can give some insight information whereas if done in thoughtless manner can lead to bogus information