Accounting Ratios | Financial Ratios:
Define and explain the term accounting ratios.
What are advantages and limitations of using
accounting or financial ratios.
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.
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
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.
Ratio analysis is an important and age-old technique of financial analysis.
The following are some of the advantages / Benefits of ratio analysis:
financial statements: It simplifies the comprehension of financial statements.
Ratios tell the whole story of changes in the financial condition of the
- 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
- 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 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.
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.
- 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
- 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
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
Traditional Classification or
Functional Classification or
Classification According to Tests
Significance Ratios or Ratios
According to Importance
- Profit and loss account ratios or revenue/income
- Balance sheet ratios or position statement
- Composite/mixed ratios or inter statement ratios
- Primary ratios
- Secondary ratios