Accounting Ratios

Ratio Analysis

An analysis of financial statements with the help of ‘accounting ratio’ is termed as Ratio Analysis. Ratio Analysis is a process of determining and interpreting relationships between the items of financial statements. Its purpose is to provide a meaningful understanding of the performance and financial position of an enterprise. Thus, it is a technique for analyzing the financial statements by computing ratios.

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Ratio Analysis

Ratio Analysis Formulae

1. Pure

We express it as a quotient. For example, Current Ratio. The current ratio tells us about the relationship between Current Liabilities and Current Assets.

Therefore, Current Ratio = \(\frac{Current Assets}{Current Liabilities}\)

= \(\frac{₹ 2,00,000}{₹ 1,00,000}\)

Alternatively, we can also write it as 2: 1.

We express Liquidity ratios and solvency ratios in this form.

Browse more Topics under Accounting Ratios

2. Percentage

We express it in percentage. For example 25%, 40%, 60% etc. We express profitability ratios in this form.

3. Times

We express it in the number of times of a particular figure when we compare it with another figure.

For example, Trade Payables Turnover Ratio, which shows the relationship between Net Credit Purchases and Average Trade Payables, is (say) 4 times.

We express Turnover Ratios in this form.

4. Fraction

We express it in the fraction. For example, the ratio of fixed assets to share capital is (say) 3/4.

Objectives Of Ratio Analysis

Ratio analysis serves the purpose of various users who are interested in the financial statements. It simplifies summaries and systematizes the figures in the financial statements.

Objectives of Ratio Analysis are:

  1. Simplify accounting information.
  2. Determine liquidity or Short-term solvency and Long-term solvency. Short-term solvency is the ability of the enterprise to meet its short-term financial obligations. Whereas, Long-term solvency is the ability of the enterprise to pay its long-term liabilities of the business.
  3. Assess the operating efficiency of the business.
  4. Analyze the profitability of the business.
  5. Help in comparative analysis, i.e. inter-firm and intra-firm comparisons.

Learn more about Solvency Ratio here in detail.

Advantages Of Ratio Analysis

Ratio analysis plays an important role in analyzing a company’s financial performance. Therefore, the advantages of ratio analysis are:

  • Useful tools for analysis for Financial Statements
  • Simplifies accounting data
  • Helpful in assessing the operating efficiency of business
  • Useful for forecasting
  • Useful in locating the weak areas
  • Useful in inter-firm and intra-firm comparison

A useful tool for analysis of Financial Statements

Accounting ratios are useful for understanding the financial position of an enterprise. Bankers, investors, creditors, etc, all can analyze the Balance Sheet and Statement of Profit and Loss using ratios.

Simplifies accounting data

Accounting ratios simplify summaries and systematize accounting data to make it understandable.

Its main contribution lies in communicating precisely the interrelationships which exists between various elements of financial statements.

In other words, these ratios are useful because they summarize briefly the results of a complicated computation.

Helpful in assessing the operating efficiency of business

Accounting ratios are useful for assessing the financial health and performance of the company. It is assessed by evaluating liquidity, solvency, profitability, etc.

Useful for forecasting

Ratios are helpful in business planning and future forecasting. The trend of ratios can be analyzed and use as a guide for the future.

We can decide about what should be the course of action in the immediate future. Also, many times on the basis of the trend of ratios, we can calculate ratios for the number of years.

Useful in locating the weak areas

Accounting ratios assist in locating the weak areas of the business even though the overall performance is good. The management can then pay attention to the weaknesses and take remedial action.

Useful in inter-firm and intra-firm comparison

A firm may compare its performance with the other firms or with the industry standards in general. The comparison is called inter-firm comparison.

If we compare the performance of different units which belongs to the same firms then it is known as “intra-firm comparison”. Accounting ratios help in making the comparison simple.



Limitations Of Ratio Analysis

Ratio analysis is a powerful tool for assessing the strengths and weaknesses of an enterprise. But, it has certain limitations which are:

  • False result
  • Ignores Qualitative factors
  • Lack of standard ratio
  • May not be comparable
  • Price level changes are not considered
  • Window dressing

False result

We calculate ratios from the financial statements, so the reliability of the ratio and its analysis depends on the correctness of the financial statements.

If the financial statements are not true and fair, an analysis will give a false picture of affairs.

Ignores Qualitative factors

Ratio analysis provides quantitative analysis and thus, ignores qualitative factors. Such factors may be important while taking a decision.

Lack of standard ratio

There is no single standard ratio against which we can compare the ratio.

May not be comparable

Ratios may not be comparable if the different firm follows different accounting policies and procedures.

For example, if one firm follows the straight-line method of depreciation while another firm follows the diminishing balance method, then we cannot make a comparison.

Price level changes are not considered

Change in price level affects the comparability of the ratios. But a change in price levels is not considered in accounting variables from which we compute the ratios. Hence, this handicaps the utility of accounting ratios.

Window dressing

Ratios may be affected by window dressing. Manipulation of accounts is a way to conceal vital facts and present the financial position better than what it actually is.

Thus, on account of such a situation, the presence of a particular ratio may not be a definite indicator of good or bad management.

Solved Example on Ratio Analysis

Q. Explain how personal bias is a limitation for Ratio Analysis?

Ans: Personal judgment plays an important role in preparing financial statements. Hence, even accounting ratios are not free from this limitation. Since different people interpret the same ratio in different ways.

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