Accounting Ratios and Analysis
This blog is written by Mr. Anwar A. Gondal, Assistant Manager Internal Audit. Please read this blog and provide your valued comments.
Definition of Accounting Ratios: Accounting ratios are crucial for interpreting the financial statements. The financial statement merely provides the organization with information related to the firm’s financial position. Moreover, these statements require undergoing further analysis to derive solid conclusions. This interpretation is accurate and effective with the right usage of various accounting ratios.
Important factors, interpretation and limitation ratios analysis
- Quality of Financial statements:
The reliability of ratios is linked with the quality of financial statements. Financial statements which have been prepared by faithful adherence to GAAP. Generally accepted, accounting principles are likely to contain reliable data. Calculation of ratios from such financial statements is bound to be more useful and trustworthy.
- Purpose of analysis:
Users of accounting information are different such as short-term and long-term creditors; owners and would be investors; trade unions. Tax authorities; competitors etc., object of each group of interested parties is also different such as liquidity or solvency or profitability, etc. So, undertaking the analysis, one should be clear about the object of analysis. It is the object of analysis which determines the area (liquidity, Solvency, profitability, leverage, activity etc.) to be studied, analyzed and interpreted.
- Selection of ratios:
There is no end to the number of ratios which can be calculated. In 919, Alexander Wall developed an elaborated system of ratio analysis. The same has been extended and modified over the period of time. So the ratios to be calculated should be selected judiciously taking into Consideration the object of analysis. The selected should serve the purpose of analysis. For example, short term creditor’s purpose is liquidity whereas owner’s purpose may be served by solvency.
- Standards to be applied:
Any ratio in itself i.e. in isolation is meaningless. It must be compared with some standard to arrive at any logical conclusion. The analyst can choose the comparing standard from (a) rule of thumb (b) past ratios (c) projected standards or (d) industry standards. Selection of standards for the purpose of interpretation will also depend upon the object of the analysis and the capacity of the analyst. For example, management (being the insider) can opt. For projected Standards whereas any outsider’s choice shall be limited to the published information of the unit.
- Capability of the analyst:
Ratios is a tool in the hands of the analyst. Knife (as a tool) in the hands of a criminal may take the life but the knife (as a tool) in the hands of a surgeon may give a new life to a patient. Interpretation Depends on the educational background; professional skill; experience and intuition of the professional conducting it.
- Ratios to be used only as guide
Ratios can provide, at the best, the starting point. The analyst, before arriving at the conclusion, should take into consideration all other relevant factors financial and non-financial; macro and micro. For example, general condition of economy; values of society; priorities of the government etc., are the important factors.
INTERPRETATION OF CURRENT RATIO:
Current ratio indicates the liquidity of current assets or the ability of the business to meet its maturing current liabilities. High current ratio finds favour with short-term creditors whereas low ratio causes concern to them. An increase in the current ratio reflects improvements in the liquidity position of the business while the decrease signals that there has been a deterioration in the liquidity position of the business. As a convention 2: 1 is regarded as satisfactory level i.e. current assets should be almost double than the current liabilities. The idea is to provide for loss in the value of current assets due to probably decrease in the market value and to offer for any possible delay in the realization of current assets .However there is no scientific reasoning behind 2:1 norm. Current ratio compares only the quantity of current assets rather than the quality of assets. A high current ratio though considered to be desirable may prove to be otherwise due to following reason:
(1) In case of slow moving stocks, these will pile up and will lead to higher ratio.
(2) In case of slow collection of trade debts it will also lead to higher ratio.
(3) Cash and bank balance may be more than necessary consequently significant portion may remain idle which is not at all desirable.
On the other hand if the current ratio is low due to the following reasons it is again undesirable.
(1) Lack of sufficient funds to meet current obligations and
(2) Trading level beyond the capacity of the business.
Before arriving at any conclusion based on the interpretation of current ratio the following factors should be considered:
NATURE OF BUSINESS:
Public utility undertakings like electricity boards, transport corporations, municipal committees have the legal force to collect their dues in time so even a low current ratio need not cause any worry but normal trading business must have satisfactory current ratio.
NATURE OF PRODUCT:
A business dealing in consumer goods will require better current ratio as compared to a business which is dealing in durable or capital goods.
REPUTATION OF THE BUSINESS ALSO INFLUENCES THE REQUIREMENT OF LIQUIDITY:
A business having better reputation can do with small cash and bank balance as compared to comparatively unknown business house. It is so because well-known business shall enjoy favorable terms of credit.
In a business where raw material is a seasonal commodity like wheat or sugarcane, it will require the purchase of annual the purchase of annual consumption in the season itself, thus, requiring higher investment in stock as compared to the business where purchase can be spread over evenly throughout the year.
INTERPRETATION OF QUICK RATIO:
As it eliminates inventory and prepared expenses for matching against current liabilities therefore it is a more rigorous test of liquidity as compared to current ratio. When used along with current ratio it gives a clearer picture of business’s liquidity position. Rule of thumb for acid test ratio is 1:1 i.e., if business liquid assets are 100percent of its current liabilities it is consider to be having fairly good current financial position. However care must be exercised in depending upon to much on role of thumb stated above. Just like any other ratio. Interpretation of this ratio is also subject to the same factors ad conditions as the current ratio.
Interpretation Debtor\RECEIVABLES TURNOVER RATIO:
Normally higher the turnover ratio better it is. Higher turnover signifies speedy and effective collection leading to the doubts that receivables might contain significant doubtful debts. Receivables collection period is expressed in number of days. It should be compared with the period of credit allowed by the management to the customers as a matters of policy. Such comparison will help to decide whether receivables collection management is efficient or inefficient.
Interpretation CREDIATORS\PAYABLES TURNOVER RATIO:
Shorter average payment period or higher payable turnover ratio may indicate less period of credit enjoyed the business it may be due to the fact that either business has better liquidity position; believe in availing cash discount and consequently enjoys better credit standing in the market or business credit rating among suppliers is not good and therefore they do not allow reasonable period of credit. The above two alternative conclusion are contradictory of each other therefore the ratio should be interpreted with caution.
LIMITATIONS OF RATIOS ANALYSIS:
Ratio analysis is a widely used and useful technique to evaluate the financial position and performance of any business unit but it suffers from a number of limitations. These limitations must be kept in mind by the analyst while using this technique.
(1) Reliability is linked with accounting data:
Ratios are calculated on the basis of accounting information. Accounting system has certain in built limitations like historical cost, going concern value, stable monetary value, etc. So, limitations of accounting data affect the quality of ratios also. After, all ratios can’t be more reliable than the reliability of data itself.
(2) Qualitative factors are ignored:
Ratios analysis is only a quantitative. Sometimes qualitative factors may be more important. For example, management may be justified in making huge purchases of raw material anticipation of large demand of its product for the coming period. But ratios are not capable of considering qualitative factors.
(3) Isolated ratios is meaningless:
Ratios assume significance only when studied in proper context and if compared with norms or over a period. Ratio in itself does not convey any sense.
(4) Ratios analysis in historical:
Ratios are based on the facts contained in financial statements. These statements contain past records. Past may be less important or irrelevant for the management than present and future.
(5) Different accounting practice render ratios incomparable:
Accounting permits alternative treatment of many items like depreciation, valuation of tock, deferred expenses etc. Ratios based on statements prepared by following different practices are not comparable.
(6) Price level changes affect the utility of ratio analysis:
Comparison of ratios over a period of time relating to same unit may be static in quantity but higher in rupee value due to inflation.
(7) Incompetence or bias of analyst:
Much depends upon the skill, integrity and competence of the analyst to use ratios judiciously.
(8) Lack of adequate standards:
There are no well-excepted standards or rule of thumb for all ratios which might be accepted as norms for comparison. It renders interpretation of ratios difficult and to some extent arbitrary.
(9) Window dressing:
Financial statements can easily be WINDOW DRESSED to depict better than real picture of the enterprise. Moreover the analyst depending only upon published financial statements will not be in a position to get inside information.
Anwar Ahmed Gondal