Accounting Ratios

Meaning of Ratio
Ratio Analysis is an arithmetical expression of relationship between two items of financial statements.
It describes significant relationship which exists between various items of a balance sheet and a
statement of profit and loss of a firm.
Types of Ratios
There is two-way classification of ratios:
1. Traditional classification
2. Functional classification
Traditional Classification
A. Statement of profit & loss: Ratio in which both the variables are from statement of profit & loss
is known as statement of profit and loss ratio. For example, ratio of gross profit to revenue from
operations is known as gross profit ratio.

B. Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as
balance sheet ratios. For example, ratio of current assets to current liabilities known as current
ratio. It is calculated using both figures from balance sheet.

C. Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss
and another variable from the balance sheet, it is called composite ratio. For example, ratio of
credit revenue from operations to trade receivables (known as trade receivables turnover ratio)
is calculated using one figure from the statement of profit and loss (credit revenue from
operations) and another figure (trade receivables) from the balance sheet.
Functional Classification
1. Liquidity Ratios: Liquidity refers to the firm’s ability to meet its current obligations i.e., short-
term liabilities. These ratios show the ability of the business to meet its short-term financial
obligations. There are 2 types of liquidity ratios:
Current Ratio
Liquid or Quick Ratio

2. Solvency Ratios: These ratios assess the ability of the business to meet its long-term financial
obligations. It shows the long-term financial health of the business. Solvency ratios are:
Debt to Equity Ratio
Total Asset to Debt Ratio
Proprietary Ratio
Interest coverage Ratio
 3. Activity Ratios or Turnover Ratio: This refers to the ratios that are calculated for measuring
the efficiency of operations of business based on effective utilization of resources. Hence, these
are also known as ‘Efficiency Ratios’. Activity ratios are:
Inventory turnover Ratio
Trade receivable turnover Ratio
Trade payable turnover Ratio
Working capital turnover Ratio

4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from operations or
capital employed in the business. Profitability ratios are:
Gross Profit Ratio
Operating Ratio
Operating profit Ratio
Net Profit Ratio
Return on Investment (ROI)
Earning per share (EPS)
Dividend per share (DPS)
Price/Earning ratio

Objectives of Ratio Analysis

1. To simplify the accounting information
2. To know the areas of the business which need more attention
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the
business;
4. To provide information for making comparative analysis by comparing the performance with
the best industry standards;
5. To provide information derived from financial statements useful for making projections and
estimates for the future.

Advantages of Ratio Analysis

The Ratio Analysis if properly done, make us understand various problem areas as well as the bright
spots of the business. It must be emphasised that ratios are means to an end rather than the end in
themselves. Their role is essentially indicative and that of a whistle blower. There are many advantages
derived from ratio analysis. These are summarised as follows:
1. Helps to understand efficiency of decisions: The ratio analysis helps you to understand
whether the business firm has taken the right kind of operating, investing and financing
decisions. It indicates how far they have helped in improving the performance.

2. Simplify complex figures and establish relationships: Ratios help in simplifying the complex
accounting figures and bring out their relationships. They help summarise the financial
information effectively and assess the managerial efficiency, firm’s credit worthiness, earning
capacity, etc.

3. Helpful in comparative analysis: The ratios are not be calculated for one year only. When many
year figures are kept side by side, they help a great deal in exploring the trends visible in the
business. The knowledge of trend helps in making projections about the business which is a very
useful feature
 4. Identification of problem areas: Ratios help business in identifying the problem areas as well
as the bright areas of the business. Problem areas would need more attention and bright areas
will need polishing to have still better results.

5. Various comparisons: Ratios help comparisons with certain bench marks to assess as to
whether firm’s performance is better or otherwise. For this purpose, the profitability, liquidity,
solvency, etc., of a business, may be compared:
(i) over a number of accounting periods with itself (Intra-firm Comparison/Time Series
Analysis),
(ii) with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis)

Limitations of Ratio Analysis

Since the ratios are derived from the financial statements, any weakness in the original financial
statements will also creep in the derived analysis in the form of ratio analysis. Thus, the limitations of
financial statements also form the limitations of the ratio analysis
The limitations of ratio analysis which arise primarily from the nature of financial statements are as
under:
1. Limitations of Accounting Data: Accounting data reflect a combination of recorded facts,
accounting conventions and personal judgements. For example, profit of the business is not a
precise and final figure. It is merely an opinion of the accountant based on application of
accounting policies. The soundness of the judgement necessarily depends on the competence
and integrity of those who make them. Thus, the financial statements may not reveal the true
state of affairs of the enterprises and so the ratios will also not give the true picture.

2. Ignores Price-level Changes: The financial accounting is based on money measurement

principle. It assumes that price level changes are either non-existent or minimal. But the truth is
otherwise. We are normally living in inflationary economies where the power of money declines
constantly. A change in the price-level makes analysis of financial statement of different
accounting years meaningless because accounting records ignore changes in value of money.

3. Ignore Qualitative or Non-monetary Aspects: Accounting provides information about

quantitative (or monetary) aspects of business. Hence, the ratios also reflect only the monetary
aspects, ignoring completely the non-monetary (qualitative) factors.

4. Variations in Accounting Practices: There are differing accounting policies for valuation of
inventory, calculation of depreciation, etc., available for various aspects of business transactions.
These variations leave a big question mark on the analysis of financial statements. As there are
variations in accounting practices followed by different business enterprises, a valid comparison
of their financial statements is not possible.

5. Forecasting: Forecasting of future trends based only on historical analysis is not feasible. Proper
forecasting requires consideration of non-financial factors as well.
 Let us talk about the limitations of the Ratios which does not arise primarily from the nature of
financial statements. The various limitations are:

6. Means and not the End: Ratios are means to an end rather than the end by itself.

7. Lack of ability to resolve problems: Their role is essentially indicative and of whistle blowing
and not providing a solution to the problem.

8. Lack of standardised definitions: There is a lack of standardised definitions of various

concepts used in ratio analysis. For example, there is no standard definition of liquid liabilities.
Normally, it includes all current liabilities, but sometimes it refers to current liabilities less bank
overdraft.

9. Lack of universally accepted standard levels: There is no universal measuring rod which
specifies the level of ideal ratios. There is no standard list of the levels universally acceptable,
and, in India, the industry averages are also not available.

10. Ratios based on unrelated figures: A ratio calculated for unrelated figures would essentially
be a meaningless exercise. For example, creditors of Rs. 1,00,000 and furniture of Rs. 1,00,000
represent a ratio of 1:1. But it has no relevance to assess efficiency or solvency.
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