Accounting Ratios | Financial Ratios:

Learning Objectives:

1. Define and explain the term accounting ratios.
2. What are advantages and limitations of using accounting or financial ratios.
3. How financial ratios are classified.

Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured.

Definition of Accounting Ratios:

The term "accounting ratios" is used to describe significant relationship between figures shown on a balance sheet, in a profit and loss account, in a budgetary control system or in any other part of accounting organization. Accounting ratios thus shows the relationship between accounting data.
Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another. It may be expressed in the form of co-efficient, percentage, proportion, or rate. For example the current assets and current liabilities of a business on a particular date are $200,000 and $100,000 respectively. The ratio of current assets and current liabilities could be expressed as 2 (i.e. 200,000 / 100,000) or 200 percent or it can be expressed as 2:1 i.e., the current assets are two times the current liabilities. Ratio sometimes is expressed in the form of rate. For instance, the ratio between two numerical facts, usually over a period of time, e.g. stock turnover is three times a year.

Advantages of Ratios Analysis:

Ratio analysis is an important and age-old technique of financial analysis. The following are some of the advantages / Benefits of ratio analysis:

1. Simplifies financial statements: It simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of the business
2. 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.
3. 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.
4. Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of the performance of different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future.
5. 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:

The ratios analysis is one of the most powerful tools of financial management. Though ratios are simple to calculate and easy to understand, they suffer from serious limitations.

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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 Accounting Ratios:

Ratios may be classified in a number of ways to suit any particular purpose. Different kinds of ratios are selected for different types of situations. Mostly, the purpose for which the ratios are used and the kind of data available determine the nature of analysis. The various accounting ratios can be classified as follows:
 

Classification of Accounting Ratios / Financial Ratios
(A) Traditional Classification or Statement Ratios	(B) Functional Classification or Classification According to Tests	(C) Significance Ratios or Ratios According to Importance
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