What we should know before doing this analysis

The foremost thing we should know before interpreting financial ratios is to

understand ratios set alone. We know a ratio is of the form

2:1 or is called 2 to 1 or can be represented as a fraction 2/1.

It is actually the comparison of one variable with another. Financial ratios are
presented in fraction form where we have numerator at the top and denominator
at the bottom. The key thing to understand how one quantity in the
numerator/denominator affects the result of the fraction. As for example we have
75/50 or simply put 3/2 in the simplest form. We can also express this ratio as 1.5,
which in turn will give the same manning as of the ratio 75/50. Now coming back
to number 1.5 as we know the quantity in the numerator is larger than the
quantity in the denominator. But what about a ratio of 0.75 means, it means the
quantity in the denominator is larger than the quantity in the numerator i.e. 2/3.
This logic is quiet important when studying the ratios. I would say the bench mark
should be set equal to 1. Where actual ratio is 2/2 let’s say. So if we increase the
quantity in the numerator the number gets larger than 1. For example 5/2 which
is 2.5 and on the other hand if we increase the quantity in the denominator the
ratio gets smaller than 1 for example 1/2 which is 0.5. So in fact we are comparing
the ratios with a standard ratio of 1. If our financial ratio is less than 1, we can say
that the quantity in the numerator is less than the quantity in the denominator.
And if this ratio is larger than 1 than we can say that the quantity in the
numerator is larger than 1. We can study these phenomena in more detail in the
following analysis. Also these financial ratios are used to compare the
performance of one accounting period with previous accounting periods.
Therefore rational for these ratios is to compare number for period to period and
company to company.
Clearly these are just numbers and we cannot infer anything from them (unless
we are interested to know the balance of a specific account) in term of financial
performance and financial health. Therefore we really need some measuring tool
in order to get useful information.