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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124 videos|152 docs|43 tests

### Summary: Accounting Ratios

- Video | 08:45 min
### NCERT Solution (Part - 3) - Accounting Ratios

- Doc | 2 pages
### Advantages and disadvantages of Ratio Analysis

- Video | 09:21 min
### Limitations of Ratio Analysis

- Video | 06:08 min
### Types of Ratios

- Video | 22:41 min
### Liquidity Ratios

- Video | 10:19 min

- NCERT Solution (Part - 2) - Accounting Ratios
- Doc | 2 pages
- Concept & Classification of Accounting Ratios
- Video | 10:08 min