If any lending decision is to be properly made, the risk involved in the transaction should be properly evaluated. Risk evaluation primarily consists in the ascertainment of the ability of the prospective borrower to repay the proposed loan. To ascertain this ability, apart from financial analysis many other vital considerations such as the character of the borrower, his managerial ability, technical and operational skill and the productive use to which the funds would be applied would come into operation. The computation of ratios assists analyst to evaluate significant relationships in financial statements.
There are many methods and techniques are used in analysis of financial statements such as (i). Comparative statements/Trend Analysis (Comparison is done of current performance with past figures of the same business concern), which is called Historical standard. (ii). External Standards (comparison between two business concerns engaged in same line of business, with more or less same infrastructure and production capacities. Comparison can also be made with ‘Industry average’), iii. Goals/Corporate planning & Policies (Comparing the actual performance with the budgeted performance, to find out whether actual performance is good, to the set in goal in the prevailing circumstance.) (iv). Experience (We have to accept that the information provided in the financial statements is not an end in itself, as no meaningful conclusions can be inferred from these statements alone. Therefore banker builds up his own judgment by appraising schedule of changes in working capital, common size percentages, funds analysis etc.). The comprehensive and up-to-date information is needed to an analyst in risk assessment and credit evaluation.
From the following related links you will be able to make out ‘How different ratios are computed and for what purpose those ratios are used’
Thus, the findings based on ratio analysis have to be studied along with the funds flow analysis, Cash flow analysis, other financial data such as Notes to balance sheet, Auditor’s report, Director’s report and other non-financial data having a bearing on financial events. The ratios may not make conclusion themselves, however, ratio analysis are of immense use to financial analysts for making further investigation and in making final decisions. This is because; ratios provide financial analyst certain yard stick to evaluate the financial condition and performance of a firm, as ratios reduce large figures to an easily understandable relationship. Therefore, ratio analysis has gained wide acceptance as a quantitative technique of financial management. The ‘ratio technique’ is also widely used by banks and financial institutions all over the world.
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