26 Accounting Ratios- Meaning, Significance and Limitations

Deepika Gautam

LEARNING OBJECTIVES:

Ratio Analysis is one of the principal tools of financial analysis. Ratio analysis helps in assessing how various each items in a firm’s financial statements relate to each another. This module will focus on how to interpret financial statements with the use of financial tool i.e., Ratios as interpretation of ratios is an important factor and the precautions or guidelines to be kept in mind while interpreting various ratios. As it is only a means of better understanding of financial strengths and weaknesses of a firm. It is only with the help of ratios the financial statements can be analyzed more clearly and decisions made from such analysis. An attempt has been made to clear the concept so that student may kept in mind the impact of various factors like change in accounting policies, window dressing etc. while interpreting the financial statement with the help of ratio analysis.

INTRODUCTION:

Ratio analysis involves establishing a relevant financial relationship between components of financial statements. Two companies may have earned the same amount of profit in a year, but unless the profit is related to sales or total assets, it is not possible to conclude which of them is more profitable. The data given in financial statements either Balance Sheet or Profit and Loss Account, in absolute form are silent or dump and are unable to say anything. Ratio analysis are relative from and is one of the most powerful, important and widely used tool of analysis of financial statements. It is the process of establishing and interpreting various ratios (quantitative relationship between figures and groups of figures). It is with the help of ratios that the financial statements can be analyzed more clearly and decisions can be taken by the top management. The tool of ratio analysis performs in a way that it makes the process of comprehension of financial statements simpler, at the same time; it reveals the necessary changes happen in the financial condition of a concern. ROE (Return on Equity) is the starting point for ratio analysis in any company form of organization and in the next step it is important to evaluate the three drivers of Returns on Equity, which are net profit margin (The rate of profit earning by the company), asset turnover (The rate of assets converted in to cash) and financial leverage (The ratio of using the mixture of debt and equity).ROE determined the sustainable growth rate of the firm (The rate at which it can grow without altering its operating, investment and financing policies) and its dividend policy.

MEANING:

Financial ratios can be calculated by dividing one number by another, and are usually expressed in the form of percentage (%). Ratio analysis enables business owners to examine the relationships between seemingly unrelated items which help in decision-making. Financial ratios are simple to calculate, easy to use, easily understandable by the layman and provide a wealth of information that cannot be gotten anywhere else. Ratios are tools that aid judgment and cannot take the place of experience. They do not replace good management, but they can make a good manager better. Virtually any financial statistics can be compared with another by using the concept of ratio analysis. Small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements are needed. Different organizations require different types of ratio depends upon the scale of business operation, the age of the business, the point in the business cycle, and any particular information sought. In simple words “Different ratios are used for different problems”. As, some ratios indicate the trend or progress or downfall of the business firm. However, ratio analysis is not an end in itself. It is only a means of better understanding of financial strengths and weaknesses of the financial position of the concern.

Thus, the ratio of two figures 200 and 100 may be expressed in any of the following ways:

(a)    2:1

(b)   2/1

(c)    2 to 1

(d)   200%

In all these cases the inference is that the first figure is double, 200% or 2 times than that of the second. Ratios provide clues to the financial position of the concern. These are the pointers of financial soundness of enterprises.

DEFINITIONS:

1.      “Financial ratios allow the analyst to assess and analyze the strengths and weaknesses of a given company … on an absolute basis and by comparison to other companies in its industry or to an industry standard(Hitchner)

2.      “It is an expression of the quantitative relationship between two numbers” (Wixon, kell and Bedford)

3.      “A ratio is the relation, of the amount, a to another, b expressed as the ratio of a to b; a:b (a is to b); or as a simple fraction, integer, decimal, fraction of percentage” (Kohler)

4.      “Ratio Analysis is a study of relationship among various financial factors in a business” (Myers)

5.      “The term accounting ratio is used to describe significant relationship which exists between figures shown in a balance sheet, in a profit and loss account, in a budgetary control system or in any part of the accounting organization” (J. Betty)In Simple terms Ratios are

Ø   The numerical relationship between variables is considered as ratio.

Ø   The relationship between two figures can be established on the basis of some logical methods.

Ø   The relation of one number with other.

OBJECTIVES OF RATIO ANALYSIS IN A CONCERN

For purpose of analysis, accounting ratios are indispensable. A meaningful analysis of the financial situation and performance is the first great advantage of accounting ratios. This requires ratios and their comparison which may be:

(i)   Within the same firm over a period of years, or

(ii) The comparison of one firm with the another, or

(iii)  One firm against the industry as a whole or against predetermined standards, or

(iv)For one division or department of a firm against other divisions or departments of the same firm.

Inter-firm comparison and intra-firm comparison are, thus possible on the basis of accounting ratios; this can also be attempted in other ways but accounting ratios are indispensible in this respect.

Example: To judge which firm has the best overall efficiency, one should compare the rate of profit on capital employed for the firms concerned- the size of the profit as such is not relevant.

Accounting ratios not only indicate the present position, they also indicate the causes leading up to the position to a large extent. For instance, accounting ratios may indicate not only that financial position is precarious but also the past policies or actions which have caused it. Best results are obtained when ratios for a number of years are put in a tabular form so that the figures for one year can be easily compared with those of other years. Some other significance is as follows:

Ø  Ratio analysis is an aid to measure general efficiency

   Ø  Ratio analysis is an aid in comparison of financial data

Ø   Ratio analysis helps in planning and forecasting various issues.

Ø   Ratio analysis is an aid in Intra firm comparison

Ø   Ratio analysis helps in facilitating decision making

Ø   Ratio analysis  used to test profitability

Ø   Ratio analysis to test solvency position

Ø   Ratio analysis is an effective tool for management

EXPRESSIONAL FORM OF RATIO

Accounting ratios express the relationship between two financial variables of the financial statements.

They are expressed in any one of the following forms:

(i)   Pure: It is expressed as a quotient

(ii)  Percentage: It is expressed in percentage

(iii) Times: It is expressed in a number of times a particular figure is compared to another figure.

(iv)Fraction: It is expressed in fraction

STEPS IN THE RATIO ANALYSIS

Step-1	Relevant data is to be selected from the financial statements depending upon the objectives of
	the concern
Step-2	Calculation of appropriate ratios from the above data (Step-1)
Step-3	Comparison of the calculated ratios with the ratios of the same firm in the past, or the
	ratios developed from projected financial statements or the ratios of some other firms.
Step-4	Interpretation of the calculated ratios

RATIOS INTERPRETATION

Interpretation of the Ratio is an important factor as it requires skill, intelligence and foresightedness. The impact of various factors like price level changes, change in accounting policies, window dressing etc., should keep in mind while interpreting the financial statement through this tool i.e. Ratio Analysis. A single ratio in itself does not convey much of the sense. To make ratios useful, they have to be further interpreted. The interpretation can be done in the various ways few of them are as follows:

1.      Single Absolute Ratio: When single is considered in isolation one cannot draw any meaningful conclusion but single ratios may be studied in relation to certain rules of thumb which are based upon well proven conventions.

2.      Number of Ratios: Ratio can be interpreted by calculating number of related ratios because when a single ratio supported by other related additional ratios, becomes more understandable and meaningful.

3.      Comparison: The simple and best method of evaluating the performance of the firm is to compare its present ratios with the past ratios as it gives an indication of the direction of change and reflects whether the firm’s performance and financial position has improved, deteriorated or remained constant over a period of time.

4.      Projected Ratios: Ratios can be calculated for future standards based upon the projected or Performa financial statements. These future ratios may be taken as standard for comparison and the ratios calculated on actual financial statement can be compared with the standard ratios to find out variances, if any. Such variances help in interpretation.

5.      Inter Firm Comparisons: Ratio of one firm can be compare with the ratios of another firm at the same point of time. This type of comparison helps in evaluating relative financial position of the firm. It is consider as inter- firm comparison.

GUIDING PRINCIPLES FOR USE OF RATIOS

The calculation of ratios may not be difficult task but their use is not easy. The information on which they are based is important which influence the use of ratios. Following guiding principles need to be followed while interpreting different ratios:

1.      Data available in financial statements: The ratios are calculated from the data available in financial statements. The reliability of ratios is linked to the accuracy of information in these statements. Before calculating ratios one should see whether proper concepts and conventions have been used for preparing financial statements or not.

2.      Objective of Analysis: The type of ratios is to be calculated will depend upon the purpose for which these are required. The purpose of user is also important for the analysis of the ratio. Different objectives may require the study of different types of ratios.

3.      Choice of Ratios: The proper choice of appropriate ratios is also one of the important factors. The ratio should match the purpose for which these are required and only those ratios should be selected which can throw proper light on the matter to be discussed then only relevant conclusion can be come.

4.      Following Standards: The ratios will give an indication of financial statements only when discussed with reference to certain standards. These standards can be considered as rule of thumb. The comparison of calculated ratios with the standards will help the analyst in forming his opinion about financial health of the concern.

5.      Caliber of the Analyst: The ratios are only the tools of analysis and their interpretation will depend upon the caliber and competence of the analyst. He should be familiar with various financial statements as wrong interpretation may create havoc for the concern since wrong conclusions may lead to wrong decisions.

SIGNIFICANCE OF RATIO ANALYSIS

Financial Ratio Analysis is a useful tool for detecting the company’s strengths and weaknesses. Some stakeholders use it to make important decisions when it comes to investments. The concept reviews the most essential elements and applications of Financial Ratio Analysis.

1.      For Management:

(a)    Decision-making: Financial statements are prepared primarily for decision making. But the information provided in financial statements is not an end in itself and no meaningful conclusion can be drawn from these statements alone. Ratio analysis helps in making various decisions.

(b)   Forecasting and planning: Ratio analysis is of much help in financial forecasting and planning. As Planning is looking ahead and decide what to do, how to do, when to do and by whom to do in future, the ratios calculated for a number of years work as a guide for the future.

(c)    Communication: Ratio Analysis helps in communicating the financial strength and weakness of a firm to all the interested parties. The information contained in the financial statement is conveyed in a manner so that it may serve the purpose.

(d)   Co-Ordination: Ratios help in co-ordination which is of utmost importance in effective business management. Better communication of exact financial health of the concern results in better co-ordination in the enterprise.

(e)    Control: Ratio analysis helps in making effective control of the business. Standard ratios can be compared with the actual one and if any variance may occur then control can be made to rectify the deviation.

2.   For Shareholders:

An investor in the company will like to assess the financial position of the concern where he is going to invest. Their first interest will be the security of their investment and then return in the form of dividend (Dividend is that part of the profit which is distributed among the shareholders). For the first purpose they will try to assess the value of fixed assets and the status of loans. The investors will feel satisfied only if the concern has sufficient amount of assets. Ratio analysis will be useful to the investors in making up his mind whether present financial position of the concern warrants future investment or not.

3.   For Suppliers:

Any business firm not only deals in cash but they have to purchase and sale goods on credit as well. The Suppliers extend short-term credit to the concern so they are interested to know whether financial position of the concern warrants their payments at specified time or not. The concern pays short term creditors out of its current assets.

4.      For Employees:

Employees are considered to be the basic assets of any firm. Their wages and salary increases and amounts of fringe benefits are related to the volume of profits. They are also interested in the financial position of the concern.

5.      For Government:

Government is interested to know the overall strength of a concern. Profitability index can also be prepared with the help of ratios. Government may base its future policies on the basis of industrial information available from various units.

6.      For Income Tax Authorities:

Under the Income Tax Act 1961 every assessee engaged in any business and having turnover or gross receipts exceeding

Rs 40 lakhs requires that the following ratios should be given:

(i)    Gross Profit

   (ii)    Net Profit

(iii)     Stock in Trade

(iv)      Material Consumed

Parties Interested	Application of Ratio			To use
	(i)	Operating ratio
	(ii)	Return   on	capital
		employed
Management	(iii)	Stock turnover			Profitability
	(iv)	Debtors Turnover
	(v)	Solvency Ratio
Creditors, Money lenders and	Current Ratio
Investors	(ii)	Solvency Ratio
	(iii)	Creditors Turnover	Liquidity or Solvency
	(iv)	Fixed Assets Ratio
	(v)	Debt Service Ratio
	(i)	Return	on
		Shareholders fund
Shareholders,	(ii)	Capital gearing Ratio
Employee, Government	Dividend cover Ratio		Capital Structure
	(iv)	Yield rate Ratio
	(v)	Proprietary Ratio
	(vi)	Dividend Rate Ratio
	(vii)	Assets cover of share

BENCHMARKS FOR THE RATIOS:

As ratios are relationships or comparisons, a student must know the standard or the benchmark against which company may evaluate the financial performance of the company. A ratio analysis is meaningless if no prior standards set before using this tool.

(i)    Competitor’s ratios: Every Company must have the ratios of its competitors. This helps the company to evaluate its competitive edge in the market.

(ii) Industry ratios: The industry to which the company belongs has its own standards regarding the different inputs and outputs. Hence, the industry ratios help the company to evaluate its industry competitiveness.

(iii)   Past ratios: The past ratios of the company help to compare its performance over a period of time and judge whether it has improved or not.

(iv)   Forecasted ratios: Many a time, the company sets future plans for itself where it forecasts its growth and profits. Similarly, if the ratios are forecasted for the future the company can understand where the company stands and how much improvement is required.

LIMITATIONS OF RATIOS ANALYSIS

The ratio analysis is one of the most powerful tools of financial management. The ratio analysis is very fashionable these days and is useful but one should be aware of its limitations also. Even when the ratios are worked out correctly, it should be remembered that they can at best be used as a doctor uses symptoms-indications that something is wrong somewhere. Just as the doctor will try to get to the real reason, in the same manner the analyst should try to locate the real factor leading to the present state of affairs.

• Ø A single ratio in itself is not important, or has limited value because trend is more significant in the analysis.
• Ø A simple ratio would not be able to convey everything.
• Ø Lack of proper standard.
• Ø Difference in definitions.
• Ø Effect of personal opinion.
• Ø Absolute figures distortive.
• Ø Ratios may make the comparative study complicated and misleading an account of changes in price level.
• Ø Ratios become meaningless if detached from the details from which they are derived.
• Ø Ratios are compared on the basis of past experience and past are not an indicator of future.

SUMMARY:

This module presents the most important key tool of financial analysis that is Ratio Analysis. This tool allows the analyst to examine a firm’s performance and its financial condition, given its strategy and goals. Ratios are calculated on the basis of accounting information and the objectives of ratio analysis are to judge the earning capacity, financial soundness and operating efficiency of an enterprise. Ratio analysis is useful in analysis of financial statements and also for Intra-firm and Inter-firm comparison. Accounting ratios provide a quantitative relationship which the analyst may use to make a qualitative judgment about various aspects of financial position and performance of an enterprise.

Suggested Readings:

• Gupta, K. Shashi (2011), “Financial Management”. New Delhi- 110 002: Kalyani Publishers.
• Jaiswal. Pawan & Singh. P Nidhi (2007) “Business Finance” Goel Printers Allahabad.
• Narayanaswamy, R, (2005) “Financial Accounting”. Prentice-Hall of India Private Limited, new Delhi.
• Sahni, N.K & Gupta Meenu (2011), Financial Management. New Delhi- 110 002: Kalyani Publishers.
• Sahni, N.K & Gupta Meenu (2011), Financial Management. New Delhi- 110 002: Kalyani Publishers.

Points to Ponder:

1. Ratio Analysis are relative from and is one of the most powerful and widely used tool of analysis of financial statements.
2. Financial ratios are determined by dividing one number by another, and are usually expressed as a percentage.
3. Financial ratios are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else.
4. A single ratio in itself does not convey much of the sense so it is advisable to use group of ratios for proper conclusion.
5. Accounting ratios not only indicate the present position, but also help in forecasting and planning.
6. The ratios are calculated from the data available in financial statements.
7. The insights gained from analyzing a firm’s financial ratios are valuable in forecasts of the firm’s future prospects.