Accounting Ratios

1 Financial statements aim at providing financialinformation about a business enterprise to meetthe information needs of the statements prepared by a businessenterprise in the corporate sector are published andare available to the decision-makers. Thesestatements provide financial data which requireanalysis, comparison and interpretation for takingdecision by the external as well as internal users ofaccounting information. This act is termed asfinancial statement analysis . It is regarded as anintegral and important part of Accounting . Asindicated in the previous chapter, the mostcommonly used techniques of financial statementsanalysis are comparative statements, common sizestatements, trend analysis , Accounting Ratios andcash flow analysis . The first three have beendiscussed in detail in the previous chapter.

2 Thischapter covers the technique of Accounting ratiosfor analysing the information contained in financialstatements for assessing the solvency, efficiency andprofitability of the Meaning of Accounting RatiosAs stated earlier, Accounting Ratios are an importanttool of financial statements analysis . A ratio is amathematical number calculated as a reference torelationship of two or more numbers and can beexpressed as a fraction, proportion, percentage anda number of times. When the number is calculatedby referring to two Accounting numbers derived fromLEARNING OBJECTIVESA fter studying this chapter,you will be able to : explain the meaning,objectives and limitationsof Accounting Ratios ; identify the varioustypes of Ratios commonlyused ; calculate various ratiosto assess solvency,liquidity, efficiency andprofitability of the firm; interpret the variousratios calculated forintra-firm and inter-firm Ratios52022-23195 Accounting Ratiosthe financial statements, it is termed as Accounting ratio.

3 For example, if thegross profit of the business is Rs. 10,000 and the Revenue from Operations areRs. 1,00,000, it can be said that the gross profit is 10% 10,0001001,00,000 of the Revenue from Operations . This ratio is termed as gross profit ratio. Similarly,inventory turnover ratio may be 6 which implies that inventory turns into Revenue from Operations six times in a needs to be observed that Accounting Ratios exhibit relationship, if any,between Accounting numbers extracted from financial statements. Ratios areessentially derived numbers and their efficacy depends a great deal upon thebasic numbers from which they are calculated. Hence, if the financial statementscontain some errors, the derived numbers in terms of ratio analysis would alsopresent an erroneous scenario.

4 Further, a ratio must be calculated usingnumbers which are meaningfully correlated. A ratio calculated by using twounrelated numbers would hardly serve any purpose. For example, the furnitureof the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio ofpurchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any reason is that there is no relationship between these two Objectives of Ratio AnalysisRatio analysis is indispensable part of interpretation of results revealed by thefinancial statements. It provides users with crucial financial information andpoints out the areas which require investigation. Ratio analysis is a techniquewhich involves regrouping of data by application of arithmetical relationships,though its interpretation is a complex matter. It requires a fine understandingof the way and the rules used for preparing financial statements.

5 Once doneeffectively, it provides a lot of information which helps the analyst:1. To know the areas of the business which need more attention;2. To know about the potential areas which can be improved with theeffort in the desired direction;3. To provide a deeper analysis of the profitability , liquidity, solvencyand efficiency levels in the business;4. To provide information for making cross-sectional analysis bycomparing the performance with the best industry standards; and5. To provide information derived from financial statements useful formaking projections and estimates for the Advantages of Ratio AnalysisThe ratio analysis if properly done improves the user s understanding of theefficiency with which the business is being conducted. The numerical2022-23196 Accountancy : Company Accounts and analysis of Financial Statementsrelationships throw light on many latent aspects of the business.

6 If properlyanalysed, the Ratios make us understand various problem areas as well as thebright spots of the business. The knowledge of problem areas help managementtake care of them in future. The knowledge of areas which are working betterhelps you improve the situation further. It must be emphasised that Ratios aremeans to an end rather than the end in themselves. Their role is essentiallyindicative and that of a whistle blower. There are many advantages derivedfrom ratio analysis . These are summarised as to understand efficacy of decisions: The ratio analysis helpsyou to understand whether the business firm has taken the right kindof operating, investing and financing decisions. It indicates how farthey have helped in improving the complex figures and establish relationships: Ratios help insimplifying the complex Accounting figures and bring out theirrelationships.

7 They help summarise the financial information effectivelyand assess the managerial efficiency, firm s credit worthiness, earningcapacity, in comparative analysis : The Ratios are not be calculated forone year only. When many year figures are kept side by side, they helpa great deal in exploring the trends visible in the business. Theknowledge of trend helps in making projections about the businesswhich is a very useful of problem areas: Ratios help business in identifyingthe problem areas as well as the bright areas of the business. Problemareas would need more attention and bright areas will need polishingto have still better SWOT analysis : Ratios help a great deal in explaining thechanges occurring in the business. The information of change helpsthe management a great deal in understanding the current threatsand opportunities and allows business to do its own SWOT (Strength-Weakness-Opportunity-Threat) comparisons: Ratios help comparisons with certain benchmarks to assess as to whether firm s performance is better or this purpose, the profitability , liquidity, solvency, etc.

8 , of a business,may be compared: (i) over a number of Accounting periods with itself(Intra-firm Comparison/Time Series analysis ), (ii) with other businessenterprises (Inter-firm Comparison/Cross-sectional analysis ) and(iii) with standards set for that firm/industry (comparison with standard(or industry expectations).2022-23197 Accounting limitations of Ratio AnalysisSince the Ratios are derived from the financial statements, any weakness in theoriginal financial statements will also creep in the derived analysis in the form ofratio analysis . Thus, the limitations of financial statements also form thelimitations of the ratio analysis . Hence, to interpret the Ratios , the user shouldbe aware of the rules followed in the preparation of financial statements andalso their nature and limitations .)

9 The limitations of ratio analysis which ariseprimarily from the nature of financial statements are as of Accounting Data: Accounting data give an unwarrantedimpression of precision and finality. In fact, Accounting data reflect acombination of recorded facts, Accounting conventions and personaljudgements which affect them materially. For example, profit of thebusiness is not a precise and final figure. It is merely an opinion of theaccountant based on application of Accounting policies. The soundnessof the judgement necessarily depends on the competence and integrityof those who make them and on their adherence to Generally AcceptedAccounting Principles and Conventions . Thus, the financial statementsmay not reveal the true state of affairs of the enterprises and so theratios will also not give the true Price-level Changes: The financial Accounting is based onstable money measurement principle.

10 It implicitly assumes that pricelevel changes are either non-existent or minimal. But the truth isotherwise. We are normally living in inflationary economies where thepower of money declines constantly. A change in the price-level makesanalysis of financial statement of different Accounting years meaninglessbecause Accounting records ignore changes in value of Qualitative or Non-monetary Aspects: Accounting providesinformation about quantitative (or monetary) aspects of , the Ratios also reflect only the monetary aspects, ignoringcompletely the non-monetary (qualitative) in Accounting Practices: There are differing accountingpolicies for valuation of inventory, calculation of depreciation, treatmentof intangibles Assets definition of certain financial variables etc.