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Accounting Ratios: Introduction and Types

Meaning Of Accounting Ratios

Accounting Ratios are mathematical expressions that show the relationship between two related accounting variables or figures from the financial statements. They are calculated by dividing one figure by another figure. Ratios simplify the complex financial data and make them understandable and comparable.

For instance, the ratio between Sales and Cost of Goods Sold indicates the Gross Profit Margin. The ratio between Current Assets and Current Liabilities indicates the short-term solvency of the business.

Ratios can be expressed in various forms:

Accounting ratios serve as building blocks for financial analysis and interpretation.


Objectives Of Ratio Analysis

Ratio analysis is performed with several key objectives in mind, primarily aimed at assessing the financial performance and position of a company.

1. To Assess Profitability

Ratios help in measuring the earning capacity of the business. They indicate the efficiency with which the company is managed. Objectives include assessing overall profitability, profitability relative to sales, investments, or equity.

2. To Assess Liquidity

Ratios help in determining the ability of the enterprise to meet its short-term obligations when they fall due. This is crucial for suppliers, banks, and other short-term creditors.

3. To Assess Solvency

Ratios help in evaluating the long-term financial stability of the company. They indicate the company's ability to meet its long-term debts and the interest thereon. This is important for debenture holders, long-term lenders, and shareholders.

4. To Assess Efficiency (Activity or Turnover)

Ratios help in measuring how efficiently the company is utilising its resources or assets to generate sales. They indicate the speed at which assets are converted into sales or cash.

5. To Facilitate Comparative Analysis

Ratios standardise financial data, making it easier to compare the performance and position of:

6. To Identify Trends

By calculating ratios over several years, trends in important financial variables can be identified, helping in forecasting future performance.

7. To Simplify Financial Data

Ratios reduce large amounts of financial data into simple numbers, making the statements easier to understand and analyse.

In essence, ratio analysis transforms raw financial data into actionable insights about a company's financial health, performance, and efficiency.


Advantages Of Ratio Analysis

Ratio analysis offers several benefits to different users of financial statements:

1. Useful for Financial Forecasting and Planning

Trends revealed by ratio analysis help management forecast future sales, profits, and other financial variables, which is essential for effective planning and budgeting.

2. Useful for Performance Evaluation

Ratios provide a quantitative measure of performance, enabling management to evaluate the overall efficiency and effectiveness of the business and its various departments or activities.

3. Useful for Inter-firm Comparison

Ratios facilitate comparison of a company's performance with that of competitors or industry averages, helping to identify areas of strength and weakness relative to others.

4. Useful for Identifying Areas for Improvement

By highlighting deviations from standards or industry norms, ratios help pinpoint specific areas (e.g., inventory management, debt collection) that require attention and improvement.

5. Simplifies Financial Statements

Ratios condense detailed financial information into a few key figures, making the analysis of financial statements more manageable and less time-consuming.

6. Useful for Investment Decisions

Investors use ratios to assess the risk and return characteristics of a company, compare different investment opportunities, and make informed decisions.

7. Useful for Assessing Creditworthiness

Lenders and creditors rely on ratios to evaluate the company's ability to service debt (both principal and interest), which is crucial for deciding whether to extend credit.

Overall, ratio analysis is a powerful tool that enhances the utility of financial statements by providing a structured approach to understanding the company's financial position and performance.


Limitations Of Accounting Ratios

Despite their usefulness, accounting ratios have certain limitations that must be considered when using them for analysis and interpretation.

1. Based on Historical Data

Ratios are computed from historical financial statements. Therefore, they reflect past performance and position, which may not necessarily be indicative of future trends or conditions.

2. Ignore Qualitative Factors

Ratio analysis deals only with quantitative financial data. It does not consider important qualitative factors such as the quality of management, labour relations, customer satisfaction, technological changes, or industry competitiveness, which significantly influence a company's success.

3. Affected by Window Dressing

If the financial statements are manipulated or 'window dressed' to show a better picture, the ratios computed from such statements will also be misleading and will not reflect the true financial position or performance.

4. Lack of Standard Definitions and Bases

There is no universal standard for defining or calculating all ratios. Different companies or analysts may use slightly different formulas or definitions for the same ratio, making comparisons difficult. Also, different bases for comparison (e.g., end-of-year inventory vs. average inventory) can lead to different results.

5. Problem of Price Level Changes

Financial statements are usually prepared ignoring changes in the price level (inflation/deflation). Ratios calculated from such statements, especially when comparing data over different periods, may not provide a true picture due to the impact of changing prices on asset values and expenses.

6. Difficulty in Comparing Different Firms

Comparing ratios across companies can be difficult due to variations in accounting policies, nature of business, size, operating periods, and external factors. Comparing a manufacturing company's ratios with a service company's ratios might not be meaningful.

7. Ratios Provide only Indicators

Ratios only highlight relationships and symptoms; they do not provide causes or solutions. For example, a low Net Profit Ratio indicates poor profitability, but it doesn't explain *why* it is low or *how* to improve it.

8. Need for Expert Judgment

Interpretation of ratios requires expertise and understanding of the business, industry, and economic environment. A single ratio in isolation is often meaningless; a group of ratios analysed together provides a better insight.

Therefore, ratios should be used cautiously and supplemented with other relevant information and analysis for drawing valid conclusions.


Types Of Ratios

Accounting ratios are typically classified into different categories based on the financial aspect of the business they measure. The most common classifications are:

1. Liquidity Ratios

These ratios measure the company's ability to meet its short-term obligations (due within one year or the operating cycle). They indicate the short-term financial solvency of the business.

Key Ratios:

2. Solvency Ratios

These ratios measure the company's ability to meet its long-term obligations (including principal and interest). They indicate the long-term financial solvency and capital structure of the business.

Key Ratios:

3. Activity Ratios (or Turnover Ratios / Efficiency Ratios)

These ratios measure the efficiency with which a company is utilising its assets to generate sales. They relate cost of goods sold or sales to various assets or groups of assets.

Key Ratios:

4. Profitability Ratios

These ratios measure the company's ability to earn profits. They indicate the operational efficiency and financial performance of the business.

Key Ratios (based on Sales):

Key Ratios (based on Investment):

Understanding these categories helps in conducting a structured analysis of financial statements, focusing on different aspects of the business's performance and position.