Financial
Ratios - Accounting Ratios
Short Financial Ratios Overview
Financial ratios are used to describe significant
relationship between figures shown on a balance sheet, in a profit and
loss account, in off-balance items, in a budgetary control system or in any
other part of an accounting organization.
Ratios show how one number is related to another. It may be
expressed in the form of co-efficient, percentage, proportion, or rate.
Advantages
of Ratios Analysis:
Simplifies financial statements - It simplifies the comprehension of financial statements.
Ratios tell the whole story of changes in the financial condition of the
business;
Facilitates inter-firm comparison - It
provides data for inter-firm comparison. Ratios highlight the factors associated
with with successful and unsuccessful firm. They also
reveal strong firms and weak firms, overvalued and undervalued firms;
Helps in planning - It helps in
planning and forecasting. Ratios can assist management, in its basic functions
of forecasting. Planning, co-ordination, control and communications;
Makes inter-firm comparison possible - Ratios
analysis also makes possible comparison of the performance of different divisions/departments
of the firm. The ratios are helpful in deciding about their efficiency or
otherwise in the past and likely performance in the future;
Help in investment decisions - It
helps in investment decisions in the case of investors and lending decisions in
the case of bankers etc.
Limitations of Ratios Analysis:
Limitations of financial statements - Ratios are based only on the information which has been recorded
in the financial statements. Financial statements themselves are
subject to several limitations. Thus ratios derived, there from, are also
subject to those limitations. For example, non-financial changes though
important for the business are not relevant by the financial statements. Financial
statements are affected to a very great extent by accounting conventions
and concepts. Personal judgment plays a great part in determining the figures
for financial statements;
Comparative study required - Ratios are
useful in judging the efficiency of the business only when they are compared
with past results of the business. However, such a comparison only provide
glimpse of the past performance and forecasts for future may not
prove correct since several other factors like market conditions,
management policies, etc. may affect the future operations;
Ratios alone are not adequate - Ratios are only
indicators, they cannot be taken as final regarding good or bad financial
position of the business. Other things have also to be seen;
Problems of price level changes - A change in
price level can affect the validity of ratios calculated for different time
periods. In such a case the ratio analysis may not clearly indicate the trend
in solvency and profitability of the company. The financial statements,
therefore, be adjusted keeping in view the price level changes if a meaningful
comparison is to be made through accounting ratios;
Lack of adequate standard - No fixed
standard can be laid down for ideal ratios. There are no well accepted
standards or rule of thumb for all ratios which can be accepted as norm. It
renders interpretation of the ratios difficult;
Limited use of single ratios - A single ratio,
usually, does not convey much of a sense. To make a better interpretation, a
number of ratios have to be calculated which is likely to confuse the analyst
than help him in making any good decision;
Personal bias - Ratios are only means of financial analysis and not an end in
itself. Ratios have to interpreted and different people may interpret the same
ratio in different way;
Incomparable - Not only industries differ in their nature, but also the firms
of the similar business widely differ in their size and accounting procedures
etc. It makes comparison of ratios difficult and misleading.
Classification of Financial Ratios |
||
(A) |
(B) |
(C) |
- Profit and loss account ratios
or revenue/income statement ratios
- Balance sheet ratios or position
statement ratios
- Composite/mixed ratios or inter
statement ratios
|
- Profitability ratios
- Liquidity ratios
- Activity ratios - Leverage ratios or long term solvency
ratios |
- Primary ratios - Secondary ratios
|