Ratio Analysis Theory

According to Rama Gopal (2009), ratio analysis is an important and powerful technique or method, generally, used for analysis of Financial Statements. Ratios are used as a yardstick for evaluating the financial condition and performance of a firm. Analysis and interpretation of various accounting ratios gives a better understanding of financial condition and performance of the firm in a better manner than the perusal of financial statements.

Brigham and Houston (2011) stated that ratios help us evaluate financial statements. Financial statements analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company. This is accomplished by examining trends in key financial

Financial ratio analysis helps management (1) maintain sufficient working capital to support operations; (2) project how changes in sales, costs, prices and so on will affect capital needs and profits; (3) analyze management performance; and (4) measure the profitability of company units, products and departments.

From a management perspective, the rationale for use of financial ratio analysis is that by expressing several figures from financial statements as ratios, information will be revealed that is missed when the individual numbers are observed. The theory is that managers can then use this information to improve the efficiency and profitability of their operation. Associated with this theory is the implicit assumption that information from ratio analysis, especially trend analysis, enables management to foresee and possibly avoid business failure (Thomas III and Evanson, 2006).

Several practitioner-oriented publications suggest that financial ratios do not vary with firm size within an industry (Westwick 1987 and Centre for Interfirm Comparison 1977). However, a number of authors provide evidence that ratios do vary across different size firms. Many of these studies have examined the relationship between size and the use of

(2008), financial ration variables remain the primary variables for predicting corporate financial distress. Upon examining the predictor variables for corporate financial distress at one, two, and three years prior to distress, it was found that financial ratio variables were the main ones at one and two years prior to distress, while at three years prior to distress there was one financial ratio variable and two ownership structure variables that shoed significant differences. Financial structure, solvency, profitability, and cash flow indicators are the principal financial ratio