Ratio analysis is an important discipline as well as a complex one in the accounting field of study. It entails the examination and interpretation of financial statement and their results respectively with the aid of ratios. This provides a means by which the expected financial trends of a business enterprise can be predicted. It is a wide and complex topic with different aspects that will be discussed. The main issues however discussed in this research paper includes the meaning and significance of accounting ratios, the persons who benefit from such information, the methods of analyzing ratios, principles of selecting ratios and the advantages and limitations of using financial ratios. A greater chunk of the discussion will also be dedicated to and examination of the various ways of classifying ratios.
Meaning of Accounting Ratios and Its Significance
Different authors have defined financial ratios in a variety of ways. J. Batty for instance defines it as a means of describing important relationship between data exhibited on a balance sheet, profit and loss account, in a budgetary management system or in any other sector of the accounting company. John Myers on the other hand defined it as a study of the relationship between different financial aspects of an enterprise. Last but not least, Wixon, Kell and Bedford are of the view that ratios express the numerical relationship between two figures. Generally, however, accounting ratio provide a means by which the connection between one financial outcome and another is expressed with the aim of providing a beneficial comparison.
Ratio analysis is a significant technique for evaluating an organization’s financial performance. They assist in comprehending the business’s fiscal position, the efficacy of the company’s management, identifying the company’s operational flaws, establishing future trends of a company’s financial performance for purposes of planning and for comparing an organization’s performance over many years and with other businesses.
Users of Accounting Ratios
Investors and managers are some of the major stakeholders who benefit from ratio analysis information. They use this knowledge mainly for decision-making purposes. For banking institutions and credit advance organizations, this information is useful as it reveals an organization’s financial state hence informs their decision on whether to grant credit advances or not. Other people who benefit from the analysis include customers.
Ways of Interpreting Ratios
There are various methods of evaluating fiscal ratios. The most popular approaches used include interpretation of Individual ratio, examination by referring to a set of ratios, analysis of fractions by trend and examination of ratios by inter-organizational assessment.
When interpreting ratios, this ought to be done in segregation from other information. In addition, certain factors must be put into consideration including the overall fiscal situation of the firm, risk acceptance, future prospects and opportunities, interpretation and analysis methods utilized by other businesses in the industry as well as the industry’s accounting system.
Principles of Selecting Ratios
Before selecting ratios, one should ensure that the ratio is logically interconnected. Another principle to be upheld is that quasi ratios should be circumvented. The ratio must measure a quantifiable aspect of an enterprise and the cost of acquiring information should be considered. Other principles stipulate that ratios should be in the simplest figures and should be facility comparable.
Advantages and Limitations of Ratio Analysis
Some of the advantaged that are associated with the use of ratio examination includes:
- It enables the summarizing and simplification of financial information.
- It highlights the interrelationship between these details and quantities of various divisions of business.
- It helps eradicate all sorts of wastages and inadequacies.
- It provided managers with information that aids in decision making.
- Managers also use the information in discharging their managerial duties which include planning, organizing, controlling, directing and predicting.
- By analyzing ratios, a firm can be able to tell if an action is profitable or not.
- It is a tool used to evaluate the efficacy of performance of an organization’s activities.
The above list is however not exhaustive. On the other had too, we have certain disadvantages that may accrue as a result of the use of financial ratios. This is because ratio analysis is dependent on the information availed in financial reports. When ratios are misrepresented, they may result in mistaken interpretation to the management’s detriment. These disadvantages include among other:
- The disadvantages of financial statement may extend to ratio analysis hence interfering with its accuracy.
- The accuracy of this method of analysis may limit the possibility of getting accurate interpretations since it only takes into account numerical data and ignores qualitative factors.
- Ideal ratios have no established standards that are sufficient to measure a company’s performance.
- It raises questions of the accuracy of comparative analysis especially in firms where the methods of accounting used differ.
- In analyzing ratios no consideration is given to price changes. Therefore, the inferences drawn may not be meaningful.
Classification Of Ratios
Financial ratios are categorized based on the grounds of the different parties who are having an interest in utilizing the information form such examinations. Different authors have classified these ratios into different classes as will be discussed in the subsequent paragraphs.
The first mode of classification divides ratios into three broad groups including classification on the basis of balance sheet, profit and loss account and lastly, categorization on the grounds of mixed statements or balance sheet as well as the income statement. For the first class, the ratios comprise the statement of financial situation proportions, which reveal the correlation between items featured in the statement of financial situation of an organization such as current and liquidity ratios. The subsequent category, which classifies the ratios depending on the profit and loss account, the ratios deal with the connection between two things or two sets of items found within the Income Statement. The final method of classification includes ratios known as mixed ratios or Inter Statement ratios. Some of the ratios dealt calculated under this class include total asset ratios and turnover ratios.
There is also a minor way in which ratios can be classified on the basis of importance. Unlike in the above classification formulae, ratios in this case are divided according to their importance with the primary ratios being more important that the secondary ratios. They are useful in cases inter organizational comparisons are being made.
The third mode of classification groups the ratios into four major categories, which forms the basis of this research paper as, will be discussed below.
Classification According to Purpose
- Liquidity Ratios
These ratios are also referred to as short-term solvency ratios. Liquidity can be used to denote the extent to which a firm’s assets can be easily converted into cash so as to meet its short-term obligations. The ratios are therefore important to show a firm’s ability to satisfy its short-term liabilities as they fall due. The following ratios are used to indicate a business entity’s liquidity;
a. Current ratio -This ratio sets out the relationship between current assets and current liabilities. It shows how many times an entity’s current assets can be used to extinguish its current liabilities. The perfect ratio for an organization to have is 2:1. A higher value than this indicates that the firm is holding too much of current assets, which could be better utilized elsewhere while a lower ratio is indicative that the firm may have, challenges in satisfying its obligations as and when they fall due.
b. Quick ratio -This ratio is also known as acid test ratio. It measures an organization’s ability to meet its short-term obligations using cash in hand. A ratio of 1:1 is considered ideal. A higher ratio indicates that the firm is holding too much cash which it ought to invest elsewhere whereas a lower ratio would indicate that the entity’s liquidity position is not good.
c. Absolute liquid ratio -This ratio is also known as the cash position ratio. Absolute liquid assets refer to the sum of the cash in hand, at bank and marketable securities. The ratio establishes the relationship between absolute liquid assets and current liabilities. A ratio of 1:2 is considered ideal and a lower ratio would demonstrate that the firm’s daily cash management’s practices are poor.
Advantages of Liquidity Ratios
Solvency ratios are very vital in accounting because they help in measuring the ease with which a company can repay its assets as they fall due. The ratio also shows how adequate the company is in maintaining its working capital. The ratio also shows how well the company can be insulated against claims from creditors.
These ratios are not adequate to reflect the true position as the business is dependent on many other numerous factors. Another drawback of these ratios is that the figures used can be subjectively determined and hence not accurate for example the value of stock. In addition the ratios only measure the quantitative liquidity aspects as opposed to the qualitative for example the methods do not consider whether a particular stock is obsolete.
- Profitability Ratios
These ratios evaluate how efficient the entity is in transforming of the various resources it has into profits. There are numerous profitability ratios because profitability is generally related to the level of sales or the amount of investments. The following ratios denote profitability of a business;
a) Gross profit ratio -The gross profit margin is among the most essential profitability ratios and is expressed as a percentage of the gross earnings of the net sales made. A high percentage indicates that the business is highly profitable which can be attributable to increases in the selling price, reduction in the cost of goods sold and an increase in the sales mix.
b) Operating ratio -This ratio brings out the relationship between the total operating expenditure and sales and is expressed as a percentage. It signifies an organization’s ability to cover its total operating expenses. It is important to note that the expenses included in this calculation include all the company’s expenditure including the cost of sales.
c) Net Profit Ratio -This ratio shows the relationship between net profit and the sales made by the company. It is also known as the profit margin ratio and is usually expressed in percentage. it is worth noting that net income entails gross profit as well as other non-operating incomes which includes items such as dividends, discount received etc. a high net profit ratio is an indication that the standard performance of the business is good. The main advantage of this ratio is that it measures the profitability as well as liquidity. It also measures the efficiency of the concern as a whole rather than operations alone.
d) Return on Investments (ROI) -ROI measures what the owner(s) of the business gets back as a percentage of the money is invested into the business. This ratio illuminates the success of the business from the owner’s perspective. In addition, it facilitates the efficient correct decision-making especially with respect to handling an investor’s investment.
e) Return on Capital Employed -This ratio exhibits the relationship between the profits made and the capital employed. Return means any profits made while capital employed refers to the total investments made into the business and it could be the gross capital employed, net capital employed, average capital employed or proprietor’s net capital employed. However, the most commonly used is the gross capital employed which is the sum of current assets and fixed assets.
f) Earnings Per Share (EPS) -This ratio depicts the amounts of profit generated by each unit of capital, that is, shares. It gives this from the equity owner’s point of view and it helps in determining the value of the share in the market. This ratio is very important because it assists in setting the value of stock in the market. It also assists to show the entity’s ability to pay dividends to pay dividends. Another advantage of EPS is that it can be utilized as a benchmark to measure the overall performance of the business.
g) Dividend Yield Ratio -This ratio indicates the link involving dividend paid on capital and market worth of the company’s equity shares. It establishes the profitability from the investor’s point of view.
- Turnover ratios
These ratios also known as efficiency or activity ratios and they illustrate the efficacy with which assets are utilized within the business set up. They include the following ratios;
a)Stock turnover ratio -This ratio shows whether assets in the company are being effectively utilized. This ratio shows the amount of times stock has been exchanged in the entity within a particular period. The more times inventory is purchased by the company, the more efficient the company is in utilizing its stock.
b) Debtor’s turnover ratio -This ratio exhibits how quickly a company converts its trade receivables into cash. It establishes the relationship between debtors and sales. The debt collection period can also be used in conjunction with this ratio as it shows the duration a customer takes to pay the company. The shorter the payment period the more efficient is the entity considered in utilization of its assets.
c) Creditor’s turnover ratio -Is similar with the debtors turnover except that it now measures the duration it takes the organization to pay its dues to suppliers. The higher the period the more efficient the company is considered in handling its finances. The ratio can also be used in conjunction with the creditor’s payment period.
d) Working capital turnover ratio -This ratio measures how effective the organization is efficient in utilizing the working capital with respect to sales. It sets up the connection between cost of sales and working capital.
- Solvency Ratios
Generally, solvency ratios show the ability of the company to carry on its operations smoothly and at the same time be in a position to meet its long term debt obligations. It shows the level of risk with which the company carries on its operations due to the structure of finance in the business (Davies & Crawford, 2011). Examples of solvency ratios include;
a) Debt – equity ratio -The ratio is computed so as to ascertain the entity’s commitment to creditors in relation to the funds invested by the shareholders. It also indicates all creditors claims compared to the shareholders claims. A ratio of 1:1 is deemed to be perfect.
b) Gearing Ratio -Gearing elucidates the relationship between fixed interest bearing securities and the equity shareholders fund. It is calculated by dividing the equity share capital by the amount of interest due to the bearing securities. A high gearing implies that a firm has is financed more by external interest bearing capital compared to equity share capital.
c) Times interest earned ratio -This ratio shows the relationship between the net profit before interest and tax and fixed interest charges. This ratio is essential to lenders as it shows the number of times the net profit is able to cover the amounts of interest payable.
The above discussion has brought out an in-depth analysis of accounting ratios. The paper commenced by explaining what accounting ratios are and their significance not only to accountants but to other stakeholders as well. The principles used in interpreting them as well as factors considered before using a particular ratio such as logic has also been discussed. Some of the merits and demerits have also been discussed. The main focus of the paper which is the classification of ratios in different ways has been discussed at length and in some instances the advantages as well as the demerits of some of the specific ratios.