Simply speaking, ratios based on financial statement are known as â€˜Accounting Ratiosâ€™ or â€˜Financial Ratiosâ€™. Hence, Accounting Ratio is an arithmetic connection between two accounting variables.
Accounting ratio is the term used to describe huge relationship existing between the figures in Profit and Loss Account, Balance Sheet, budgetary control system, or any other accounting system in accounting organisation.
In short, I prefer accounting ratios because they define a quantitative bond which may be used by accounting ratio homework solutions to make quantitative analysis in different aspects of performance and financial position of business.
What is Ratio Analysis?
Ratio Analysis involves determining, calculating, and expressing the relationship of agroup of items or relationship of items of financial statements to provide a clear insight of the financial position and performance of a business organisation.
Hence, Ratio Analysis is a technique or a tool to present the figures of financial statements in a concise, simple, understandable and sensible manner.
Ratio analysis is studying the relationship between various financial aspects of the business. It is a technique of analysis of the financial statements done by accounting ratio homework solutions and interpreting the same to figure out meaningful conclusions.
Accounting Ratios Expressing Methods
Here are few important methodologies.
Percentage Method â€“ A quotient calculated by dividing one figure to another is multiplied by 100, and it turns the profitability ratios, i.e. percentage form of expression.
Rate Method â€“ A quotient calculated by dividing one figure to another is considered as an expression unit of the number of times a figure is when compared to another. When figures are based on a fixed period like Activity ratios, this method is used.
Fraction â€“ In this method, ratio relationship is defined in fraction. Ratio relationship is often defined regarding days or months.
Proportionate Method â€“ Relationship of two items is expressed directly in proportion in this method. This method is also called as Pure Ratio, Ratio Method or Simple Ratio. For example, Liquidity Ratios. I recommend this method because of its accuracy.
Objectives of Ratio Analysis
Accounting ratio homework solutions test the efficiency, profitability and financial stability of a company. There are different purposes of ratio analysis â€“
- Determining Profitability â€“
Simply speaking, profitability is the capacity of earning a profit in an organisation. It can be determined by Net Profit, Gross Profit, Expenses and other ratios. We can consider corrective measures if these ratios fall.
- Calculating Operational Efficiencyâ€“
Operating/Activity ratios can be calculated to determine the operational efficiency of business.
- Comparative Analysis â€“
Current performance of the company is compared with last year performance to find out the plus and minus points. You can also compare the performance of other competitors. In my opinion, it is the best way to determine your companyâ€™s performance.
- Measuring Financial Status â€“
Liquidity and solvency ratios are measured to calculate the financial status of business for short term and long term. In the case of unhealthy position, it is important to take corrective measures.
- Showing Overall Efficiency â€“
The amount of net profit is shown in Profit & Loss Account, and the value of liabilities, capital and various assets are shown in Balance Sheets. But it is easy to determine the profitability by estimating the financial ratios.
- Budgeting & Forecasting â€“
Ratio analysis is very helpful in financial planning and forecasting. Ratios estimated for several years are considered as a guide for future. With these ratios, insightful conclusions can be found.
Benefits of Accounting Ratio Analysis
Here we discuss about few of its advantages.
- Analysis of Financial Statements â€“
Accounting Ratios is very useful for the analysis of financial statements. Investors, Bankers, Creditors, etc. can analyse the Profit & Loss Account and Balance Sheet of the company through ratios.
- Simplify Accounting Figures â€“
Accounting ratio homework solutions summarise, simplify, and systematise the widest range of accounting figures so they can easily be understood. Absolute figures donâ€™t carry much sense. They are very important when estimated with other figures.
- Proper Control â€“
In ratio analysis, you can figure out different information which is helpful in management to determine changes took place over a certain period in a business firm. It is helpful in management to make controlling even more effective and discharge management functions.
- Detect Weak Spots in the Business â€“
Accounting Ratios are helpful to measure the performance and efficiency of each department and unit of a company. Weak spots may be determined in this process. Owners look at these weak areas and make it more profitable.
- Ideal for Comparison â€“
Accounting ratio homework solutions are helpful to make intra-firm and inter-firm comparisons. A company can compare the performance with industry trends and find out whether to take effective measures.
Downsides of Ratio Analysis
Ratio Analysis is among the most effective tools of financial management. Ratios are easy to calculate and understand. But there are some issues with it too.
- Ignorance of Quality Factors â€“
Ratio analysis is only about quantity. It avoids the qualitative sides of the firm. For instance, customer satisfaction, the ability of a manager, etc. are very important as compared to quantitative factors. If current assets have several useless and old assets, liquidity position cannot be known effective.
- Lack of Standard â€“
No single standard ratio is accepted universally, and comparison cannot be made against it. Circumstances vary from company to company as well as industry to industry. It is used to render the interpretation of ratios to some extent.
- Ratios alone are not ideal for conclusions â€“
Ratios estimated from financial statements cannot assure worst or good financial status. It is important for the analyst to conduct some more investigations and plan his judgment to arrive at some solid conclusion. Hence, an analyst is required to implement other financial analysis techniques along with ratio analysis.
- Different Terms & Different Meanings â€“
Here, the confusion is that different terms have different meanings. For example, profit is taken before tax and interest in some firms, while it has been taken after tax and before interest in others. Also, some firms take bank overdraft as anon-current item while some take it as current liabilities. Ratios are compared only when both companies adopt the same terms.
- Window Dressing â€“
To show the beautiful image of their business, several companies hide their major facts and show their false position. So, ratios based on their financial position and their financial statements may get defective. By the term â€˜window dressingâ€™, I mean showing better position than it exists. For instance, understatement of Current Liabilities, overstatement of Current Assets, recording transactions for next financial year, etc. It limits the effectiveness of ratio analysis.
Steps Covered in Ratio Analysis
Despite the fact that ratio analysis faces various limitations, it is still very helpful and most sought-after tool for analysis of financial statements â€“
- Calculation of correct ratios and selection of data sets that are matched to the purpose of analysis. For instance, a trade creditor may want to know the companyâ€™s ability to meet its existing obligations and would consider liquid ratio and current ratio.
- Another step involves comparison of ratios with standard ones. Standard ratios can be the ratios of the same company or industry standards.
- Drawing and presenting conclusions as reports.
Along with helping business owners and management to estimate the financial status of their business or firm, accounting ratio homework solutions help managers to make informed decisions regarding projects or investments that companies are looking to take, for example, expansion or acquisitions.