What are Ratios
A ratio is a mathematical expression that represents the relationship between two quantities or values. It is typically expressed as a fraction, with the numerator representing the first quantity and the denominator representing the second quantity
What are Accounting Ratios
Accounting ratios are statistical measures that are used to evaluate the financial performance and financial position of a business. These ratios are calculated by dividing one financial metric by another, and they provide insights into various aspects of a business such as its profitability, liquidity, solvency, efficiency, and investor returns.
Accounting ratios can be a useful tool for financial analysis and decision making, but it is important to use them in conjunction with other financial information and to consider the specific circumstances and industry of the business.
How are accounting ratios expressed
Accounting ratios can be expressed in the following ways :
A pure ratio is a ratio that represents a simple comparison of two quantities or values. It is typically expressed as a fraction, with the numerator representing the first quantity and the denominator representing the second quantity.
They can be simplified or reduced to their lowest terms by dividing both the numerator and denominator by their greatest common factor.
In accounting we try to make the denominator as 1 and accordingly the numerator is expressed. For example – Suppose Current Assets are Rs 500000 and Current Liabilities are Rs 200000 then current ratio will be Current Assets/ Current liabilities which is equal to 500000/200000 and in pure ratio terms it will be 2.5:1
Expressing as pure ratio greatly increases the ease of understanding. So if I say I have Rs 2 Lakhs Current Liabilities and Rs 5 Lakhs Current Assets. Now compare this with, for every Rs 1 of Current Liability I have Rs 2.5 of Current Assets. Clearly the understanding in the second case is much better and easy to understand.
Percentage ratios are ratios that are expressed as a percentage. They are calculated by dividing one quantity or value by another and multiplying the result by 100%. Profitability ratios are often expressed as percentage ratios
Such ratios are expressed in number of times a particular figure is when compared to another figure. Activity ratios are often expressed in this manner. For example, if trade receivables turnover ratio is 4 times, then we say that our credit sales are four times our average trade receivables.
Such ratios are simply expressed in fractions and the denominator is not necessarily made 1. So this is similar to pure ratios with a difference that here we do not try to make the denominator as 1 and express the relationship in its simplest form only. Example 2/3 , 3/4, etc.
Objectives of Ratio Analysis
Just like we assess human health similarly it is necessary to assess the health of a business. For assessing the human health we often use parameters such as blood pressure, body temperature, etc.
Similarly, for assessing the health of the business, we use accounting ratios. The key objectives of using ratio analysis, are as follows.:
- To determine liquidity or short term solvency of business
- To determine operating efficiency of the business
- To Analyse the profitability of business
- To simplify the accounting information
- Compare between various companies or between various periods of the same company
Advantages of Ratio Analysis
- Provides a comprehensive view of the business: Ratio analysis allows for the evaluation of various aspects of a business, such as its profitability, liquidity, solvency, efficiency, and investor returns. This can provide a more comprehensive view of the business and help to identify trends and potential issues.
- Inter firm and Intra Firm Comparison : Ratio analysis allows for the comparison of a business to industry benchmarks or to its own performance in prior periods. This can help to identify strengths and weaknesses relative to peers or to identify trends over time.
- Simplification of financial data : Ratios provide a simplified way to analyze financial information and to understand the relationships between different financial metrics. This can make it easier to interpret financial statements and to identify potential areas of concern.
- Helps to identify potential issues and opportunities: Ratio analysis can help to identify potential issues or opportunities that may impact a business, such as liquidity constraints or opportunities for cost savings.
- Enables better decision making: Ratio analysis can provide valuable insights that can inform decision making, such as investment decisions or strategic planning.
- Forecasting : Often business has to prepare the budgets and the future performance metrics. Accounting ratios help a great deal in preparing the same.
Limitations of Ratio Analysis
- Reliance on historical data: Ratio analysis is based on historical financial data, which may not accurately reflect the current or future financial performance or position of a business.
- Limited context: Ratios may not provide a complete picture of a business, as they do not take into account non-financial factors such as market conditions, competitive landscape, or management quality.
- Different accounting methods: Different companies may use different accounting methods or assumptions, which can impact the accuracy and comparability of financial ratios. Example different companies may use different methods of providing depreciation or different methods for valuation of inventory, etc.
- Differences in industry conditions: Different industries may have different financial characteristics, such as different levels of risk or capital intensity, which can impact the relevance and comparability of financial ratios.
- Dependence on the quality of financial statements: The accuracy of financial ratios is dependent on the accuracy and completeness of the financial statements on which they are based. If the financial statements are not reliable, the resulting ratios may not be accurate.
- Price level changes are ignored : Inflation is all around us and it impacts the financial numbers as well. However the financial statements are prepared on historical cost basis and hence the ratios which are based on financial statements also follows historical cost basis. Hence price level changes do not impact the accounting ratios. For Example – Suppose company A was established 10 years back. So, the cost of its fixed assets is as existed 10 years back. Consider Company B in the same industry but established recently. Its fixed assets will be as per cost that exists today. Definitely the cost of fixed assets for Company B will be much higher than for Company A. So, all ratios based on Fixed assets cost like ‘Asset Turnover ratio’ will show poor performance for Company B.
- Window Dressing : Sometimes company management is involved in the manipulation of books of accounts to conceal some important facts and try to present a better financial position for the company. The ratios, which are based on such inaccurate financial statements, will also show a misleading picture.
- Personal Bias : Ratios are just mathematical calculations. For arriving at any decision, one has to interpret the meaning behind the ratios and the relationship between different ratios. Does significant personal judgment is involved. This can bring personal bias in the decision making based on accounting ratios.