write the limitations of accounting ratios
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Accountancy > Accounting Ratios > Meaning, Objectives, Advantages and Limitations of Ratio Analysis
Accounting Ratios
Meaning, Objectives, Advantages and Limitations of Ratio Analysis
Once the financial statements of an organization are prepared they then need to be analyzed. One such tool to analyze and asses the financial situation of a firm is Ratio Analysis. It allows the stakeholder to make better sense of the accounts and better understand the current fiscal scenario of an entity. Let us take an in-detail look at ratio analysis.
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Meaning of Ratio Analysis
Now, we have previously learned what ratios are. They are a comparison of two numbers with respect to each other. Similarly, in finance, ratios are a correlation between two numbers, or rather two accounts. So two numbers derived from the financial statement are compared to give us a more clear understanding of them. This is an accounting ratio.
Let us take an example. The income for the year from operations is let us say 1,00,000/- for a given year. The Purchases and other direct expenses cost around 75,000/-. So the Gross Profit of the year is 25,000/-. Now it can be said that the Gross Profit is 25% of the Operations Revenue. We calculate this as
G.P. Ratio = \frac{GP}{Sales/Revenue}
Sales/Revenue
GP
×100
G.P.Ratio = \frac{25,000}{1,00,000}
1,00,000
25,000
×100
G.P. Ratio = 25%
One factor to be kept in mind is that ratio analysis is used only to compare numbers that make sense and give us a better understanding of the financial statement. Comparing random financial accounts should be avoided.
Ratio Analysis
Objectives of Ratio Analysis
Interpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfils.
Browse more Topics under Accounting Ratios
Types of Ratios
Liquidity Ratios
Activity (or turnover) Ratios
Solvency Ratios
Profitability Ratios
1] Measure of Profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.
2] Evaluation of Operational Efficiency
Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is important that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets.
3] Ensure Suitable Liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.
4] Overall Financial Strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage ratios etc.
5] Comparison
The organizations’ ratios must be compared to the industry standards to get a better understanding of its financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see the progress of the company. This is known as trend analysis.
Advantages of Ratio Analysis
When employed correctly, ratio analysis throws light on many problems of the firm and also highlights some positives. Ratios are essentially whistleblowers, they draw the managements attention towards issues needing attention. Let us take a look at some advantages of ratio analysis.
Ratio analysis will help validate or disprove the financing, investment and operating decisions of the firm. They summarize the financial statement into comparative figures, thus helping the management to compare and evaluate the financial position of the firm and the results of their decisions.
It simplifies complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency, long-term positions etc.
Ratio analysis help identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the complex accounting statements, and ratios will help pinpoint such problems.