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Accounting ratios are crucial for interpreting the financial statements. The financial statement merely provides the organization with information related to the firm’s financial position. Moreover, these statements require undergoing further analysis to derive solid conclusions. This interpretation is accurate and effective with the right usage of various accounting ratios.

However, in accounting, there are 2 broad classifications of accounting ratios.

  • Financial accounting ratios
  • Cost accounting ratios

What are Accounting Ratios?

Before we learn about accounting ratios, let us discuss the concept of ratios and how is it related to accounting. A ratio is an arithmetical expression that studies the relationship of one number to another. Similarly, a financial ratio or an accounting ratio is the relationship between two accounting figures. These accounting figures are mathematically expressed.

Accounting ratios are very important to analyse financial statements. A ratio is usually in the form of a fraction, a proportion, a percentage or a number of times. When you calculate the number by referring to 2 accounting numbers from financial statements, it is an accounting ratio.

The Objectives of Ratio Analysis

Ratio analysis is an indispensable aspect of every financial interpretation. It is crucial in revealing the results of the statements. Moreover, not only does it provide users with crucial information but also locates the area for improvements. It also helps in spotting and locating the areas which require further investigation.

Also, ratio analysis is a technique that involves regrouping of data and applying arithmetical relationships. Usually, this method of interpretation is rather difficult and requires an immense level of knowledge. However, some of the major objectives of accounting ratios are as follows.

  • Analysts can get to know about the areas in the business that require improvisation.
  • The firm can identify the strong aspects of the business and work on its emphasis.
  • Analysts can figure out the areas that require a lot of attention.
  • The business can locate the potential areas that require moving in a particular direction.
  • This direction can be established with ease.
  • The cross-sectional analysis will be possible with the help of accounting ratios.
  • Analysts can gain a deeper understanding of the firm’s profitability, liquidity, solvency and efficiency.
  • Moreover, to make sure that the financial information undergoes interpretations that are helpful to estimate the future projections.

The Advantages of Ratio Analysis

Discussed below are some of the advantages of ratio analysis.

  • Helps in understanding the efficiency and efficacy of decisions. The ratios help in understanding whether the business has taken the right kind of business decisions.
  • Simplifies complex figures and further establishes relationships amongst them. The ratios help in summarizing the financial information in an effective manner.
  • Helps in carrying forward comparative analysis.
  • Identifies the areas where problems exist. This is crucial in knowing what actions to avoid in order to stay away from the problem. Ratio analysis plays a major role in this.
  • Identifies the areas that require attention for improvisation.
  • Enables to carry on SWOT analysis. Knowing the Strength, Weakness, Opportunity and Threat of the business is very important. Ratio analysis helps in the process SWOT analysis.
  • Helps in carrying various comparisons.

Limitations of Ratio Analysis

Discusses below are some of the disadvantages of ratio analysis.

  • Ratio analysis suffers from the limitation of accounting data. Financial statements often may not reveal the true state of affairs of the firm. Hence, the ratio analysis will also not give the true position and picture of the firm.
  • Ratio analysis ignores the changes in price levels. Because of this, a change in the price level makes the analysis of the financial statement of different accounting years meaningless.
  • Ratio analysis ignores the qualitative aspects of the firm’s transaction. In other words, it also ignores the non-monetary aspects of the firm’s activities.
  • Ratios are means to an end rather than the end by itself.
  • Ratios lack the ability to resolve problems and derive at solutions.
  • Ratio analysis lacks universally accepted standard levels.
  • Moreover, ratios are often based on unrelated figures.

Types of Accounting Ratios

Liquidity Ratio calculates to measure the short-term solvency of a business. In other words, it measures the firm’s ability to meet its current and continuous obligation.

  1. Current Ratio is the proportion of current assets to current liabilities. The excess of current assets over current liabilities provides a safety margin. This safety margins is always available against uncertainity. The ideal current ratio is 2:1. You can calculate it as: Current Ratio = Current Assets : Current Liabilities
  2. Quick Ratio is the ratio of the liquid assets to the current liabilities. The ratio measures the business’s capacity to meet its obligations without any flaw. A high ratio shows unnecessary development. And a low ratio shows high risk. Hence, the ideal quick ratio is 1:1. You can calculate it as: Quick ratio = Quick Assets : Current Liabilities

Solvency Ratio is related to the people who have advanced long-term basis money to the business. Such people are interested in the safety of their periodic payment of interest. They are also interested in the repayment of principle amount at the end of the loan period. Hence, solvency ratios measure the ability of the business to service its debt in the long run.

  1. Debt-Equity Ratio measures the relationship between long-term debt and equity. Equity is also another name for shareholder’s funds. Moreover, it is safe to have a capital structure with less debt and more quality. But again, this varies from industry to industry. And hence, the ideal ratio is 2:1. You can calculate it as: Debt-Equity Ratio = Long − term Debts / Shareholders’ Funds.
  2. Debt to Capital Employed Ratio is the ratio of long-term debt tp total external and internal funds. Capital employed and Net assets are other terms for the total of external and internal funds. If this ratio is low, it provides securities ot its lenders. However, a high ratio helps the management to trade on equity. You can calculate it as: Debt to Capital Employed Ratio = Long-term Debt/Capital Employed (or Net Assets)
  3. Proprietary Ratio is the ratio of the shareholder’s funds to the net assets of the firm. instead of using net assets, this ratio can include total assets. Moreover, the total od debt to capital employed ratio and proprietary ratio is equal to 1. You can calculate it as: Proprietary Ratio = Shareholders, Funds/Capital employed (or net assets)
  4. Total Assets to Debt Ratio is the ratio of the total assets to the long-term debts only. This ratio measures the extent to which the total assets can cover the long-term debts. You can calculate it as: Total assets to Debt Ratio = Total assets/Long-term debts.

Profitability Ratios mainly summarize the statement of P&L. They analyse the earning capacity of the business. This capacity is the outcome of the optimum use of resources. You can derive these ratios by multiplying them into 100.

  1. Gross Profit Ratio as a percentage of revenue from operations is computed to
    have an idea about gross margin. You can calculate it as:
    Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100
  2. Operating Ratio computes to analyse the cost of operation in relation to revenue from operations. You can calculate it as:
    Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/Net Revenue from Operations × 100
  3. Net Profit Ratio is an all-inclusive concept of profit. It relates revenue from
    operations to net profit after operational as well as non-operational expenses
    and incomes. You can calculate it as:
    Net Profit Ratio = Net profit/Revenue from Operations × 100
    Generally, net profit refers to profit after tax (PAT).
  4. Return on Capital Employed explains the overall utilization of funds by a business enterprise. capital employed means the long-term funds that are a part of the business. It includes shareholders’ funds, debentures and long-term loans. You can compute it as: Return on Investment (or Capital Employed) = Profit before Interest and Tax/ Capital Employed × 100.

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