Accounting Ratio

Meaning of Ratio: - Ratio' is an arithmetical expression of relationship between two interdependent or related items. Ratios, when calculated on the basis of accounting information, are called Accounting Ratios. Accounting ratio may be expressed as an arithmetical relationship between two accounting variables.

EXPRESSION OF RATIOS: - Accounting Ratios can be expressed in any of the following forms:

(A) Pure: It is expressed as a quotient. For example, Current Ratio which expresses the relationship between Current Assets and Current Liabilities is (say) 2.

Current Ratio = Current Assets ÷ Current Liabilities

2,00,000 ÷1,00,000 = 2

Alternatively, it may also be expressed as 2:1.

(B) Percentage: It is expressed in percentage. For example, Net Profit Ratio which relates Net Profit to Revenue from Operations, i.e., Net Sales Net Profit Ratio= Net Profit Revenue from Operations, i.e., Net Sales X100= (say) 25%.

(a)  Times: It is expressed in number of times. For example, Trade Payable Turnover Ratio, which shows relationship between Net Credit Purchases and Average Trade Payable, is (say) 4 Times.

(b) Fraction: It is expressed in fraction. For example, ratio of fixed assets to share capital is (say) 3/4 (i.e. 0.75).

MEANING OF RATIOS ANALYSIS:- Ratio Analysis is a technique of Financial Statements Analysis. It is the most widely used tool to interpret quantitative relationship between two variables of the financial statements. An Analysis of monetary statements with the assist of 'accounting ratio' is termed as 'Ratio Analysis'.

Ratio evaluation is a procedure of deciding and decoding relationships between the gadgets of economic statements to supply a significant perception of the overall performance and economic role of an enterprise. Thus, it is a technique of analysing the financial statements by computing ratios.

OBJECTIVE OF RATIO ANALYSIS: - Ratio analysis serves the purpose of various users who are interested in the financial statements. It simplifies, summaries and systematizes the figures in the financial statements. The objectives of ratio analysis are:

1. To simplify the accounting information.

2. To determine liquidity (Short-term solvency and Long-term solvency of the business.

3. To assess the operating efficiency of the business.

4. To analyse the profitability of the business.

5. To help in comparative analysis, i.e., inter-firm and intra-firm comparisons.

ADVANTAGES OF RATIO ANALYSIS: - The advantages of ratio analysis are as follows:

1. Useful Tool for Analysis of Financial Statements: Accounting ratios are beneficial for perception the monetary role of an enterprise. Bankers, investors, creditors, etc., all analyse Balance Sheet and Statement of Profit and Loss using ratios.

2. Simplifies Accounting Data: Accounting ratio simplifies, summaries and systematizes accounting data to make it understandable. Its main contribution lies in communicating precisely the interrelationships which exist between various elements of financial statements.

3. Useful in Assessing the Operating Efficiency of Business: Accounting ratios are beneficial for assessing the economic fitness and overall performance of an enterprise. It is assessed by evaluating liquidity, solvency, profitability, etc.

4. Useful for Forecasting: Ratios are useful in enterprise planning and forecasting. The trend of ratios is analysed and used as a guide for future planning. What should be the course of action in the future is decided, many a times on the basis of ratio analysis.

5. Useful in Locating the Weak Areas: Accounting ratios assist in locating the weak areas of the business even though the overall performance may be good. The management can then pay attention to the weaknesses and take remedial action.

6. Useful in Inter-firm and Intra-firm Comparison: A firm may compare its performance with that of other firms or with the industry standards in general. The comparison is called Inter-firm Comparison or Cross-sectional Analysis. If the performance of different units belonging to the same firm is to be compared, it is called Intra-firm Comparison or Time series Analysis. Accounting ratios make the comparison simple.

LIMITATIONS OF RATIO ANALYSIS: -- Ratio analysis is a powerful tool in assessing the strengths and weaknesses of an enterprise. It also has certain limitations which are discussed below:

1. False Result: Ratios are calculated from the financial statements, so the reliability of ratio and its analysis is dependent upon the correctness of the financial statements. If the financial statements are not true and fair, the analysis will give a false picture of the affairs.

2. Qualitative Factors are Ignored: Ratio evaluation is an approach of quantitative evaluation and thus, ignores qualitative factors, which can also be necessary in choice -making.

3. Lack of Standard Ratio: There is no single standard ratio against which the ratio can be compared.

4. May not be Comparable: Ratios may not be comparable if different firms follow different accounting policies and procedures. For example, one firm may follow Straight Line Method of Depreciation while another may follow Diminishing Balance Method.

5. Price Level Changes are no longer considered: Change in rate degree impacts the comparability of the ratios.  But price level changes are not considered in accounting variables from which ratios are computed. This handicaps the utility of accounting ratios.

6. Window Dressing: Ratios may be affected by window dressing. Manipulation of money owed is a way to conceal necessary information and current the monetary function higher than what it genuinely is.  On account of such a situation, presence of particular ratio may not be a definite indicator of good or bad management.

7. Personal Bias: Personal judgments play an important role in preparing financial statements and, therefore, the accounting ratios are also not free from this limitation. The ratios have to be interpreted but different people may interpret the same ratio in different ways.

Classification of types of ratio: - Ratios may be classified into following four categories:

1. Liquidity Ratios: These ratios show the ability of the enterprise to meet its short-term financial obligations. Important Liquidity Ratios are: (i) Current Ratio, and (ii) Quick Ratio.

2. Solvency Ratios: These ratios are calculated to assess the long-term financial position of the enterprise. Solvency means ability of the enterprise to meet its long-term financial obligations. Important Solvency Ratios are: (i) Debt to Equity Ratio, (ii) Total Assets to Debt Ratio, (iii) Proprietary Ratio, and (iv) Interest Coverage Ratio.

3. Activity Ratios or Turnover Ratios: These ratios show how efficiently a company is using its resources. Important Activity Ratios are: (i) Inventory Turnover Ratio, (ii) Trade Receivables Turnover Ratio, (iii) Trade Payable Turnover Ratio, and (iv) Working Capital Turnover Ratio.

4. Profitability Ratios: Profitability of a firm can be measured by its profitability ratios. Important Profitability Ratios are: (i) Gross Profit Ratio, (ii) Operating Ratio, (iii) Operating Profit Ratio, (iv) Net Profit Ratio, and (v) Return on Investment (ROI).

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