Accounting ratios are calculated from the financial statements to arrive at meaningful conclusions pertaining to liquidity, profitability, and solvency. Ratios are regarded as a test of earning capacity, financial soundness and operating efficiency of a business organisation. The use of ratios in accounting and financial management analysis helps the management to know the profitability, financial position (liquidity and solvency) and operating efficiency of an enterprises.
Advantages and Uses of Ratio Analysis
1. Useful in Analysis of Financial Statements: Accounting ratios are useful for understanding the financial position of the enterprise. Bankers, investors, creditors, etc.
2. Useful in Simplifying Accounting Figures: Accounting ratio simplifies, summarises and systematises a long array of accounting figures to make them understandable. Its main contribution lies in communicating precisely the interrelationships which exist between various elements of financial statements.
3. Useful in Judging the Operating Efficiency of Business: Accounting ratios are essential for understanding the affairs of an enterprise, specially its operating efficiency. Accounting ratios are also useful for diagnosis of the financial health of an enterprise. This is done by evaluating liquidity, solvency, profitability, etc. Such an evaluation enables the management to assess financial requirements and the capabilities of various business units.
4. Useful for Forecasting: Ratios are helpful in business planning and forecasting. The trend ratios are analysed and used as a guide to future planning. What should be the course of action in the immediate future is decided, many a times, on the basis of trend ratios, i.e., ratios calculated for a number of years.
5. Useful in Locating the Weak Spots: Accounting ratios are of great assistance in locating the weak spots in the business even though the overall performance may be quite good. Management can pay attention to the weakness and take remedial action. For example, if the firm finds that the increase in distribution expenses is more than proportionate to the results achieved, these can be examined in detail and depth to remove any wastage that may be there.
6. Useful in Inter-firm and Intra-firm Comparison: A firm would like to compare its performance with that of other firms and of industry in general. The comparison is called inter-firm comparison. If the performance of different units belonging to the same firm is to be compared, it is called intra-firm comparison. Such comparison is almost impossible without accounting ratios. Even the progress of a firm from year to year cannot be measured without the help of ratios. The accounting ratios are the best tools to compare the various firms and divisions of a firm.
Classification of Accounting Ratios
Accounting ratios can be grouped into the following categories:
Limitations of Accounting Ratios
Accounting ratios are very significant in analyzing the financial statements. Through accounting ratios, it will be easy to know the true financial position and financial soundness of a business concern. However, despite the advantages of ratio analysis, it suffers from a number of limitations.
1. Ignorance of Qualitative Aspect: The ratio analysis is based on quantitative aspect. It totally ignores qualitative aspect which is sometimes more important than quantitative aspect.
2. Ignorance of Price Level Changes: Price level changes make the comparison of figures difficult over a period of time. Before any comparison is made, proper adjustments for price level changes must be made.
3. No Single Concept: In order to calculate any ratio, different firms may take different concepts for different purposes. Some firms take profit before charging interest and tax or profit before tax but after interest tax. This may lead to different results.
4. Misleading Results if based on Incorrect Accounting Data: Ratios are based on accounting data. They can be useful only when they are based on reliable data. If the data are not reliable, the ratio will be unreliable.
5. No Single Standard Ratio for Comparison: There is no single standard ratio which is universally accepted and against which a comparison can be made. Standards may differ from Industry to industry.
6. Difficulties in Forecasting: Ratios are worked out on the basis of past results. As such they do not reflect the present and future position. It may not be desirable to use them for forecasting future events.