Ratio

Meaning:

Accounting

Relationship between various figures is called as ratio. Accounting ratios are relationships expressed in mathematical terms between figures, which are connected with each other in some manner. Obviously, absolute figures are unfit for comparison. Ratio analysis is a process of determining relationship between accounting figures of financial statements and presenting this relationship for the purpose of interpretation so, that reasonable conclusion may be derived.

Importance (Utility) and Objectives of Accounting Ratios:

1. Earning capacity of a company for various years can be compared on the basis of ratios. 2. Earning capacity of t o or more similar companies can be compared on the basis of ratios. 3. Ratios help in understanding the financial position of the company for various years. 4. They help in comparing the financial position of similar companies. 5. All future plans of the company are based on accounting ratios. Without these ratios basis of
planning may be defective.

6. !rogress of the company can be nown through accounting ratios. 7. Accounting ratios present the overall position of the company in an impressive manner and
very little time is re!uired to ma e interpretation on the basis of these ratios.

8. "ometimes with the help of these ratios estimates about certain amounts may be made. "or
e#ample, ratio between administrative expenses # total cost is given. $f the amount of administrative expenses is given, on the basis of this ratio, amount of total cost can be found out. 9. Out of various tools for analysis of financial position, ratio method is more satisfactory because through ratios, relationship in various items and various groups can be easily found out. 10. c$ange. Accounting ratios tabulated for a numbers of years indicate the trend of

%imitation of Accounting Ratios:

1. Ratio analysis is based on the balance sheet prepared on the accounting date. This practice,
in some cases, may lead to window- dressing to cover up bad financial position during the ear. !o" ratios based on such figures are not reliable.

2. Ratio analysis is based on financial statements which are themselves sub%ect to severe
limitations. Therefore, any ratio analysis based on such statements suffers from similar limitations. 1. Accounting ratios are based on relations$ip among different variables. $f the variables are not related, ratios will be useless.

2. &ue to changes in price level of various years, comparison of ratios of such years cannot
give correct conclusions.

3. While comparing the accounting ratios of one period with other period, one must see that no
change has ta en place in the met$od of accounting in both the periods. 'hanges in method of accounting limit the scope of comparison.

4. The position of two companies is compared on the basis of their ratios but if the accounting
policies in both the companies are different, then correct conclusions cannot be derived by comparing ratios.

5. Ratio analysis is only a tool and is helpful to spot out the symptoms. The analyst has to carry
out further investigations and exercise his %udgment in arriving at a correct diagnosis.

6. (nless the various terms li e gross profit, operating profit, current liabilities, current assets, etc are properly defined, comparisons become meaningless. 6. $n the case of inter&firm comparison no two firms are similar in age' si(e' and product unit. Therefore, any comparison of ratios of two such firms must ta e these factors into account. 8. Ratio analysis is the !uantitative measurement of the performance of the business. $t ignores the !ualitative aspects of the firm, how so ever important it may be. $t shows that ratio is only one)sided approach to measure the efficiency of the business.

'omplied by *rof. A.+. Arsiwala