NCERT Textbook - Accounting Ratios Commerce Notes | EduRev

Accountancy Class 12

Created by: Nipun Tuteja

Commerce : NCERT Textbook - Accounting Ratios Commerce Notes | EduRev

 Page 1


F
inancial statements aim at providing financial
information about a business enterprise to meet
the information needs of the decision-makers.
Financial statements prepared by a business
enterprise in the corporate sector are published and
are available to the decision-makers. These
statements provide financial data which require
analysis, comparison and interpretation for taking
decision by the external as well as internal users of
accounting information. This act is termed as
financial statement analysis. It is regarded as  an
integral and important part of accounting. As
indicated in the previous chapter, the most
commonly used techniques of financial statements,
analysis are comparative statements, common size
statements, trend analysis, accounting ratios and
cash flow analysis. The first three have been
discussed in detail in the previous chapter. This
chapter covers the technique of accounting ratios
for analysing the information contained in financial
statements for assessing the solvency, efficiency and
profitability of the enterprises.
5.1 5.1 5.1 5.1 5.1 Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios
As stated earlier, accounting ratios are an important
tool of financial statements analysis. A ratio is a
mathematical number calculated as a reference to
relationship of two or more numbers and can be
expressed as a fraction, proportion, percentage and
a number of times. When the number is calculated
by referring to two accounting numbers derived from
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter ,
you will be able to :
• Explain the meaning,
objectives and
limitations of analysis
using accounting ratios;
• Identify the various
types of ratios
commonly used ;
• Calculate various ratios
to assess solvency,
liquidity, efficiency and
profitability of the firm;
• Interpret the various
ratios calculated for
intra-firm and inter-
firm comparisons.
Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios 5 5 5 5 5
Page 2


F
inancial statements aim at providing financial
information about a business enterprise to meet
the information needs of the decision-makers.
Financial statements prepared by a business
enterprise in the corporate sector are published and
are available to the decision-makers. These
statements provide financial data which require
analysis, comparison and interpretation for taking
decision by the external as well as internal users of
accounting information. This act is termed as
financial statement analysis. It is regarded as  an
integral and important part of accounting. As
indicated in the previous chapter, the most
commonly used techniques of financial statements,
analysis are comparative statements, common size
statements, trend analysis, accounting ratios and
cash flow analysis. The first three have been
discussed in detail in the previous chapter. This
chapter covers the technique of accounting ratios
for analysing the information contained in financial
statements for assessing the solvency, efficiency and
profitability of the enterprises.
5.1 5.1 5.1 5.1 5.1 Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios
As stated earlier, accounting ratios are an important
tool of financial statements analysis. A ratio is a
mathematical number calculated as a reference to
relationship of two or more numbers and can be
expressed as a fraction, proportion, percentage and
a number of times. When the number is calculated
by referring to two accounting numbers derived from
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter ,
you will be able to :
• Explain the meaning,
objectives and
limitations of analysis
using accounting ratios;
• Identify the various
types of ratios
commonly used ;
• Calculate various ratios
to assess solvency,
liquidity, efficiency and
profitability of the firm;
• Interpret the various
ratios calculated for
intra-firm and inter-
firm comparisons.
Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios 5 5 5 5 5
203 Accounting Ratios
the financial statements, it is termed as accounting ratio. For example, if the
gross profit of the business is Rs. 10,000 and the ‘Revenue from Operations’ are
Rs. 1,00,000, it can be said that the gross profit is 10% (10,000/1,00,000) 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 year.
It needs to be observed that accounting ratios exhibit relationship, if any
between accounting numbers extracted from financial statements, they are
essentially derived numbers and their efficacy depends a great deal upon the
basic numbers from which they are calculated. Hence, if the financial statements
contain some errors, the derived numbers in terms of ratio analysis would also
present an erroneous scenerio. Further, a ratio must be calculated using
numbers which are meaningfully correlated. A ratio calculated by using two
unrelated numbers would hardly serve any purpose. For example, the furniture
of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio of
purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance.
The reason is that there is no relationship between these two aspects.
5.2 5.2 5.2 5.2 5.2 Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis
Ratio analysis is indispensable part of interpretation of results revealed by the
financial statements. It provides users with crucial financial information and
points out the areas which require investigation. Ratio analysis is a technique
which involves regrouping of data by application of arithmetical relationships,
though its interpretation is a complex matter. It requires a fine understanding
of the way and the rules used for preparing financial statements. Once done
effectively, it provides a wealth 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 the
effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency
and efficiency levels in the business;
4. To provide information for making cross sectional analysis by
comparing the performance with the best industry standards; and
5. To provide information derived from financial statements useful for
making projections and estimates for the future.
5.3 5.3 5.3 5.3 5.3 Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis
The ratio analysis if properly done improves the user’s understanding of the
efficiency with which the business is being conducted. The numerical
relationships throw light on many latent aspects of the business. If properly
analysed, the ratios make us understand various problem areas as well as the
Page 3


F
inancial statements aim at providing financial
information about a business enterprise to meet
the information needs of the decision-makers.
Financial statements prepared by a business
enterprise in the corporate sector are published and
are available to the decision-makers. These
statements provide financial data which require
analysis, comparison and interpretation for taking
decision by the external as well as internal users of
accounting information. This act is termed as
financial statement analysis. It is regarded as  an
integral and important part of accounting. As
indicated in the previous chapter, the most
commonly used techniques of financial statements,
analysis are comparative statements, common size
statements, trend analysis, accounting ratios and
cash flow analysis. The first three have been
discussed in detail in the previous chapter. This
chapter covers the technique of accounting ratios
for analysing the information contained in financial
statements for assessing the solvency, efficiency and
profitability of the enterprises.
5.1 5.1 5.1 5.1 5.1 Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios
As stated earlier, accounting ratios are an important
tool of financial statements analysis. A ratio is a
mathematical number calculated as a reference to
relationship of two or more numbers and can be
expressed as a fraction, proportion, percentage and
a number of times. When the number is calculated
by referring to two accounting numbers derived from
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter ,
you will be able to :
• Explain the meaning,
objectives and
limitations of analysis
using accounting ratios;
• Identify the various
types of ratios
commonly used ;
• Calculate various ratios
to assess solvency,
liquidity, efficiency and
profitability of the firm;
• Interpret the various
ratios calculated for
intra-firm and inter-
firm comparisons.
Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios 5 5 5 5 5
203 Accounting Ratios
the financial statements, it is termed as accounting ratio. For example, if the
gross profit of the business is Rs. 10,000 and the ‘Revenue from Operations’ are
Rs. 1,00,000, it can be said that the gross profit is 10% (10,000/1,00,000) 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 year.
It needs to be observed that accounting ratios exhibit relationship, if any
between accounting numbers extracted from financial statements, they are
essentially derived numbers and their efficacy depends a great deal upon the
basic numbers from which they are calculated. Hence, if the financial statements
contain some errors, the derived numbers in terms of ratio analysis would also
present an erroneous scenerio. Further, a ratio must be calculated using
numbers which are meaningfully correlated. A ratio calculated by using two
unrelated numbers would hardly serve any purpose. For example, the furniture
of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio of
purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance.
The reason is that there is no relationship between these two aspects.
5.2 5.2 5.2 5.2 5.2 Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis
Ratio analysis is indispensable part of interpretation of results revealed by the
financial statements. It provides users with crucial financial information and
points out the areas which require investigation. Ratio analysis is a technique
which involves regrouping of data by application of arithmetical relationships,
though its interpretation is a complex matter. It requires a fine understanding
of the way and the rules used for preparing financial statements. Once done
effectively, it provides a wealth 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 the
effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency
and efficiency levels in the business;
4. To provide information for making cross sectional analysis by
comparing the performance with the best industry standards; and
5. To provide information derived from financial statements useful for
making projections and estimates for the future.
5.3 5.3 5.3 5.3 5.3 Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis
The ratio analysis if properly done improves the user’s understanding of the
efficiency with which the business is being conducted. The numerical
relationships throw light on many latent aspects of the business. If properly
analysed, the ratios make us understand various problem areas as well as the
204 Accountancy : Company Accounts and Analysis of Financial Statements
bright spots of the business. The knowledge of problem areas help management
take care of them in future. The knowledge of areas which are working better
helps you improve the situation further. It must be emphasised that ratios are
means to an end rather than the end in themselves. Their role is essentially
indicative and that of a whistle blower. There are many advantages derived from
ratio analysis. These are summarised as follows:
1. Helps understand efficacy of decisions: The ratio analysis helps you
understand whether the business firm has taken the right kind of
operating, investing and financing decisions. It indicates how far they
have helped in improving the performance.
2. Simplify complex figures and establish relationships: Ratios help in
simplifying the complex accounting figures and bring out their
relationships. They help summarise the financial information effectively
and assess the managerial efficiency, firm’s credit worthiness, earning
capacity, etc.
3. Helpful in comparative analysis: The ratios are not be calculated for
one year only. When many year figures are kept side by side, they help
a great deal in exploring the trends visible in the business. The
knowledge of trend helps in making projections about the business
which is a very useful feature.
4. Identification of problem areas: Ratios help business in identifying
the problem areas as well as the bright areas of the business. Problem
areas would need more attention and bright areas will need polishing
to have still better results.
5. Enables SWOT analysis: Ratios help a great deal in explaining the
changes occurring in the business. The information of change helps
the management a great deal in understanding the current threats
and opportunities and allows business to do its own SWOT (Strength-
Weakness-Opportunity-Threat) analysis.
6. Various comparisons: Ratios help comparisons with certain bench
marks to assess as to whether firm, performance is better or otherwise.
For this purpose, the profitability, liquidity, solvency, etc. of a business
may be compared: (i) over a number of accounting periods with itself
(Intra-firm Comparison/Time Series Analysis), (ii) with other business
enterprises (Inter-firm Comparison/Cross-sectional Analysis), and
(iii) with standards set for that firm/industry (comparison with standard
(or industry) expectations).
5.4 5.4 5.4 5.4 5.4 Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis
Since the ratios are derived from the financial statements, any weakness in the
original financial statements will also creep in the derived analysis in the form of
Page 4


F
inancial statements aim at providing financial
information about a business enterprise to meet
the information needs of the decision-makers.
Financial statements prepared by a business
enterprise in the corporate sector are published and
are available to the decision-makers. These
statements provide financial data which require
analysis, comparison and interpretation for taking
decision by the external as well as internal users of
accounting information. This act is termed as
financial statement analysis. It is regarded as  an
integral and important part of accounting. As
indicated in the previous chapter, the most
commonly used techniques of financial statements,
analysis are comparative statements, common size
statements, trend analysis, accounting ratios and
cash flow analysis. The first three have been
discussed in detail in the previous chapter. This
chapter covers the technique of accounting ratios
for analysing the information contained in financial
statements for assessing the solvency, efficiency and
profitability of the enterprises.
5.1 5.1 5.1 5.1 5.1 Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios
As stated earlier, accounting ratios are an important
tool of financial statements analysis. A ratio is a
mathematical number calculated as a reference to
relationship of two or more numbers and can be
expressed as a fraction, proportion, percentage and
a number of times. When the number is calculated
by referring to two accounting numbers derived from
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter ,
you will be able to :
• Explain the meaning,
objectives and
limitations of analysis
using accounting ratios;
• Identify the various
types of ratios
commonly used ;
• Calculate various ratios
to assess solvency,
liquidity, efficiency and
profitability of the firm;
• Interpret the various
ratios calculated for
intra-firm and inter-
firm comparisons.
Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios 5 5 5 5 5
203 Accounting Ratios
the financial statements, it is termed as accounting ratio. For example, if the
gross profit of the business is Rs. 10,000 and the ‘Revenue from Operations’ are
Rs. 1,00,000, it can be said that the gross profit is 10% (10,000/1,00,000) 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 year.
It needs to be observed that accounting ratios exhibit relationship, if any
between accounting numbers extracted from financial statements, they are
essentially derived numbers and their efficacy depends a great deal upon the
basic numbers from which they are calculated. Hence, if the financial statements
contain some errors, the derived numbers in terms of ratio analysis would also
present an erroneous scenerio. Further, a ratio must be calculated using
numbers which are meaningfully correlated. A ratio calculated by using two
unrelated numbers would hardly serve any purpose. For example, the furniture
of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio of
purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance.
The reason is that there is no relationship between these two aspects.
5.2 5.2 5.2 5.2 5.2 Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis
Ratio analysis is indispensable part of interpretation of results revealed by the
financial statements. It provides users with crucial financial information and
points out the areas which require investigation. Ratio analysis is a technique
which involves regrouping of data by application of arithmetical relationships,
though its interpretation is a complex matter. It requires a fine understanding
of the way and the rules used for preparing financial statements. Once done
effectively, it provides a wealth 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 the
effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency
and efficiency levels in the business;
4. To provide information for making cross sectional analysis by
comparing the performance with the best industry standards; and
5. To provide information derived from financial statements useful for
making projections and estimates for the future.
5.3 5.3 5.3 5.3 5.3 Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis
The ratio analysis if properly done improves the user’s understanding of the
efficiency with which the business is being conducted. The numerical
relationships throw light on many latent aspects of the business. If properly
analysed, the ratios make us understand various problem areas as well as the
204 Accountancy : Company Accounts and Analysis of Financial Statements
bright spots of the business. The knowledge of problem areas help management
take care of them in future. The knowledge of areas which are working better
helps you improve the situation further. It must be emphasised that ratios are
means to an end rather than the end in themselves. Their role is essentially
indicative and that of a whistle blower. There are many advantages derived from
ratio analysis. These are summarised as follows:
1. Helps understand efficacy of decisions: The ratio analysis helps you
understand whether the business firm has taken the right kind of
operating, investing and financing decisions. It indicates how far they
have helped in improving the performance.
2. Simplify complex figures and establish relationships: Ratios help in
simplifying the complex accounting figures and bring out their
relationships. They help summarise the financial information effectively
and assess the managerial efficiency, firm’s credit worthiness, earning
capacity, etc.
3. Helpful in comparative analysis: The ratios are not be calculated for
one year only. When many year figures are kept side by side, they help
a great deal in exploring the trends visible in the business. The
knowledge of trend helps in making projections about the business
which is a very useful feature.
4. Identification of problem areas: Ratios help business in identifying
the problem areas as well as the bright areas of the business. Problem
areas would need more attention and bright areas will need polishing
to have still better results.
5. Enables SWOT analysis: Ratios help a great deal in explaining the
changes occurring in the business. The information of change helps
the management a great deal in understanding the current threats
and opportunities and allows business to do its own SWOT (Strength-
Weakness-Opportunity-Threat) analysis.
6. Various comparisons: Ratios help comparisons with certain bench
marks to assess as to whether firm, performance is better or otherwise.
For this purpose, the profitability, liquidity, solvency, etc. of a business
may be compared: (i) over a number of accounting periods with itself
(Intra-firm Comparison/Time Series Analysis), (ii) with other business
enterprises (Inter-firm Comparison/Cross-sectional Analysis), and
(iii) with standards set for that firm/industry (comparison with standard
(or industry) expectations).
5.4 5.4 5.4 5.4 5.4 Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis
Since the ratios are derived from the financial statements, any weakness in the
original financial statements will also creep in the derived analysis in the form of
205 Accounting Ratios
ratio analysis. Thus, the limitations of financial statements also form the
limitations of the ratio analysis. Hence, to interpret the ratios, the user should
be aware of the rules followed in the preparation of financial statements and
also their nature and limitations. The limitations of ratio analysis which arise
primarily from the nature of financial statements are as under:
1. Limitations of Accounting Data: Accounting data give an unwarranted
impression of precision and finality. In fact, accounting data “reflect a
combination of recorded facts, accounting conventions and personal
judgements and the judgements and conventions applied affect them
materially. For example, profit of the business is not a precise and
final figure. It is merely an opinion of the accountant based on
application of accounting policies. The soundness of the judgement
necessarily depends on the competence and integrity of those who
make them and on their adherence to Generally Accepted Accounting
Principles and Conventions”. Thus, the financial statements may not
reveal the true state of affairs of the enterprises and so the ratios will
also not give the true picture.
2. Ignores Price-level Changes: The financial accounting is based on
stable money measurement principle. It implicitly assumes that price
level changes are either non-existent or minimal. But the truth is
otherwise. We are normally living in inflationary economies where the
power of money declines constantly. A change in the price level makes
analysis of financial statement of different accounting years meaningless
because accounting records ignore changes in value of money.
3. Ignore Qualitative or Non-monetary Aspects: Accounting provides
information about quantitative (or monetary) aspects of business.
Hence, the ratios also reflect only the monetary aspects, ignoring
completely the non-monetary (qualitative) factors.
4. Variations in Accounting Practices: There are differing accounting
policies for valuation of inventory, calculation of depreciation, treatment
of intangibles, definition of certain financial variables etc. available for
various aspects of business transactions. These variations leave a big
question mark on the cross sectional analysis. As there are variations
in accounting practices followed by different business enterprises, a
valid comparison of their financial statements is not possible.
5. Forecasting: Forecasting of future trends based only on historical
analysis is not feasible. Proper forecasting requires consideration of
non-financial factors as well.
Now let us talk about the limitations of the ratios. The various limitations
are:
1. Means and not the End: Ratios are means to an end rather than the
end by itself.
Page 5


F
inancial statements aim at providing financial
information about a business enterprise to meet
the information needs of the decision-makers.
Financial statements prepared by a business
enterprise in the corporate sector are published and
are available to the decision-makers. These
statements provide financial data which require
analysis, comparison and interpretation for taking
decision by the external as well as internal users of
accounting information. This act is termed as
financial statement analysis. It is regarded as  an
integral and important part of accounting. As
indicated in the previous chapter, the most
commonly used techniques of financial statements,
analysis are comparative statements, common size
statements, trend analysis, accounting ratios and
cash flow analysis. The first three have been
discussed in detail in the previous chapter. This
chapter covers the technique of accounting ratios
for analysing the information contained in financial
statements for assessing the solvency, efficiency and
profitability of the enterprises.
5.1 5.1 5.1 5.1 5.1 Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios Meaning of Accounting Ratios
As stated earlier, accounting ratios are an important
tool of financial statements analysis. A ratio is a
mathematical number calculated as a reference to
relationship of two or more numbers and can be
expressed as a fraction, proportion, percentage and
a number of times. When the number is calculated
by referring to two accounting numbers derived from
L L L L LEARNING EARNING EARNING EARNING EARNING O O O O OBJECTIVES BJECTIVES BJECTIVES BJECTIVES BJECTIVES
After studying this chapter ,
you will be able to :
• Explain the meaning,
objectives and
limitations of analysis
using accounting ratios;
• Identify the various
types of ratios
commonly used ;
• Calculate various ratios
to assess solvency,
liquidity, efficiency and
profitability of the firm;
• Interpret the various
ratios calculated for
intra-firm and inter-
firm comparisons.
Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios Accounting Ratios 5 5 5 5 5
203 Accounting Ratios
the financial statements, it is termed as accounting ratio. For example, if the
gross profit of the business is Rs. 10,000 and the ‘Revenue from Operations’ are
Rs. 1,00,000, it can be said that the gross profit is 10% (10,000/1,00,000) 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 year.
It needs to be observed that accounting ratios exhibit relationship, if any
between accounting numbers extracted from financial statements, they are
essentially derived numbers and their efficacy depends a great deal upon the
basic numbers from which they are calculated. Hence, if the financial statements
contain some errors, the derived numbers in terms of ratio analysis would also
present an erroneous scenerio. Further, a ratio must be calculated using
numbers which are meaningfully correlated. A ratio calculated by using two
unrelated numbers would hardly serve any purpose. For example, the furniture
of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio of
purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance.
The reason is that there is no relationship between these two aspects.
5.2 5.2 5.2 5.2 5.2 Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis Objectives of Ratio Analysis
Ratio analysis is indispensable part of interpretation of results revealed by the
financial statements. It provides users with crucial financial information and
points out the areas which require investigation. Ratio analysis is a technique
which involves regrouping of data by application of arithmetical relationships,
though its interpretation is a complex matter. It requires a fine understanding
of the way and the rules used for preparing financial statements. Once done
effectively, it provides a wealth 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 the
effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency
and efficiency levels in the business;
4. To provide information for making cross sectional analysis by
comparing the performance with the best industry standards; and
5. To provide information derived from financial statements useful for
making projections and estimates for the future.
5.3 5.3 5.3 5.3 5.3 Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis Advantages of Ratio Analysis
The ratio analysis if properly done improves the user’s understanding of the
efficiency with which the business is being conducted. The numerical
relationships throw light on many latent aspects of the business. If properly
analysed, the ratios make us understand various problem areas as well as the
204 Accountancy : Company Accounts and Analysis of Financial Statements
bright spots of the business. The knowledge of problem areas help management
take care of them in future. The knowledge of areas which are working better
helps you improve the situation further. It must be emphasised that ratios are
means to an end rather than the end in themselves. Their role is essentially
indicative and that of a whistle blower. There are many advantages derived from
ratio analysis. These are summarised as follows:
1. Helps understand efficacy of decisions: The ratio analysis helps you
understand whether the business firm has taken the right kind of
operating, investing and financing decisions. It indicates how far they
have helped in improving the performance.
2. Simplify complex figures and establish relationships: Ratios help in
simplifying the complex accounting figures and bring out their
relationships. They help summarise the financial information effectively
and assess the managerial efficiency, firm’s credit worthiness, earning
capacity, etc.
3. Helpful in comparative analysis: The ratios are not be calculated for
one year only. When many year figures are kept side by side, they help
a great deal in exploring the trends visible in the business. The
knowledge of trend helps in making projections about the business
which is a very useful feature.
4. Identification of problem areas: Ratios help business in identifying
the problem areas as well as the bright areas of the business. Problem
areas would need more attention and bright areas will need polishing
to have still better results.
5. Enables SWOT analysis: Ratios help a great deal in explaining the
changes occurring in the business. The information of change helps
the management a great deal in understanding the current threats
and opportunities and allows business to do its own SWOT (Strength-
Weakness-Opportunity-Threat) analysis.
6. Various comparisons: Ratios help comparisons with certain bench
marks to assess as to whether firm, performance is better or otherwise.
For this purpose, the profitability, liquidity, solvency, etc. of a business
may be compared: (i) over a number of accounting periods with itself
(Intra-firm Comparison/Time Series Analysis), (ii) with other business
enterprises (Inter-firm Comparison/Cross-sectional Analysis), and
(iii) with standards set for that firm/industry (comparison with standard
(or industry) expectations).
5.4 5.4 5.4 5.4 5.4 Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis Limitations of Ratio Analysis
Since the ratios are derived from the financial statements, any weakness in the
original financial statements will also creep in the derived analysis in the form of
205 Accounting Ratios
ratio analysis. Thus, the limitations of financial statements also form the
limitations of the ratio analysis. Hence, to interpret the ratios, the user should
be aware of the rules followed in the preparation of financial statements and
also their nature and limitations. The limitations of ratio analysis which arise
primarily from the nature of financial statements are as under:
1. Limitations of Accounting Data: Accounting data give an unwarranted
impression of precision and finality. In fact, accounting data “reflect a
combination of recorded facts, accounting conventions and personal
judgements and the judgements and conventions applied affect them
materially. For example, profit of the business is not a precise and
final figure. It is merely an opinion of the accountant based on
application of accounting policies. The soundness of the judgement
necessarily depends on the competence and integrity of those who
make them and on their adherence to Generally Accepted Accounting
Principles and Conventions”. Thus, the financial statements may not
reveal the true state of affairs of the enterprises and so the ratios will
also not give the true picture.
2. Ignores Price-level Changes: The financial accounting is based on
stable money measurement principle. It implicitly assumes that price
level changes are either non-existent or minimal. But the truth is
otherwise. We are normally living in inflationary economies where the
power of money declines constantly. A change in the price level makes
analysis of financial statement of different accounting years meaningless
because accounting records ignore changes in value of money.
3. Ignore Qualitative or Non-monetary Aspects: Accounting provides
information about quantitative (or monetary) aspects of business.
Hence, the ratios also reflect only the monetary aspects, ignoring
completely the non-monetary (qualitative) factors.
4. Variations in Accounting Practices: There are differing accounting
policies for valuation of inventory, calculation of depreciation, treatment
of intangibles, definition of certain financial variables etc. available for
various aspects of business transactions. These variations leave a big
question mark on the cross sectional analysis. As there are variations
in accounting practices followed by different business enterprises, a
valid comparison of their financial statements is not possible.
5. Forecasting: Forecasting of future trends based only on historical
analysis is not feasible. Proper forecasting requires consideration of
non-financial factors as well.
Now let us talk about the limitations of the ratios. The various limitations
are:
1. Means and not the End: Ratios are means to an end rather than the
end by itself.
206 Accountancy : Company Accounts and Analysis of Financial Statements
2. Lack of ability to resolve problems: Their role is essentially indicative
and of whistle blowing and not providing a solution to the problem.
3. Lack of standardised definitions: There is a lack of standardised
definitions of various concepts used in ratio analysis. For example,
there is no standard definition of liquid liabilities. Normally, it includes
all current liabilities, but sometimes it refers to current liabilities less
bank overdraft.
4. Lack of universally accepted standard levels: There is no universal
yardstick which specifies the level of ideal ratios. There is no standard
list of the levels universally acceptable, and, in India, the industry
averages are also not available.
5. Ratios based on unrelated figures: A ratio calculated for unrelated
figures would essentially be a meaningless exercise. For example,
creditors of Rs. 1,00,000 and furniture of Rs. 1,00,000 represent a
ratio of 1:1. But it has no relevance to assess efficiency or solvency.
Hence, ratios should be used with due consciousness of their limitations
while evaluatory the performance of an organisation and planning the future
strategies for its improvement.
Test your Understanding – I Test your Understanding – I Test your Understanding – I Test your Understanding – I Test your Understanding – I
1. 1. 1. 1. 1. State which of the following statements are True or False. State which of the following statements are True or False. State which of the following statements are True or False. State which of the following statements are True or False. State which of the following statements are True or False.
(a) The only purpose of financial reporting is to keep the managers informed
about the progress of operations.
(b) Analyses of data provided in the financial statements is termed as financial
analysis.
(c) Long-term borrowing are concerned about the ability of a firm to discharge
its obligations to pay interest and repay the principal amount.
(d) A ratio is always expressed as a quotient of one number divided by another.
(e) Ratios help in comparisons of a firm’s results over a number of accounting
periods as well as with other business enterprises.
(f) A ratio reflects quantitative and qualitative aspects of results.
5.5 5.5 5.5 5.5 5.5 Types of Ratios Types of Ratios Types of Ratios Types of Ratios Types of Ratios
There is a two way classification of ratios: (1) traditional classification, and
(2) functional classification. The traditional classification has been on the basis
of financial statements to which the determinants of ratios belong. On this basis
the ratios are classified as follows:
1. ‘Statement of Profit and Loss’ Ratios: A ratio of two variables from the
statement of profit and loss is known as statement of profit and loss
ratio. For example, ratio of gross profit to revenue from operations
known as gross profit ratio is calculated using both figures from the
statement of profit and loss.
Read More
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