UNIT 4 RATIO ANALYSIS

 UNIT 4 

5 Marks :

  1. ratio analysis- meaning, uses, limitations
  2. mixed ratios

10 Marks

  1. Types of ratios
  2. what is an accounting ratio? what are the uses of accounting ratios?




1Q) RATIO ANALYSIS-USES, LIMITATIONS

        Ratio analysis is referred to as the study or analysis of the line items present in the financial statements of the company. It can be used to check various factors of a business such as profitability, liquidity, solvency, and efficiency of the company or the business.

Ratio analysis is mainly performed by external analysts as financial statements are the primary source of information for external analysts.

Analysts very much rely on current and past financial statements to obtain important data for analyzing the financial performance of the company. The data or information thus obtained during the analysis helps determine whether the financial position of a company is improving or deteriorating.

 

Use of Ratio Analysis

Ratio analysis is useful in the following ways:

1. Comparing Financial Performance: One of the most important things about ratio analysis is that it helps in comparing the financial performance of two companies.

2. Trend Line: Companies tend to use the activity ratio to find any kind of trend in the performance. Companies use data from financial statements that are collected from financial statements over many accounting periods. The trend that is obtained can be used for predicting future financial performance.

3. Operational Efficiency: Financial ratio analysis can also be used to determine the efficiency of managing assets and liabilities. It helps in understanding and determining whether the resources of the business are over-utilized or under-utilized.



LIMITATIONS OF RATIO ANALYSIS:

Some of the most important limitations of ratio analysis include:

  • Historical Information: Information used in the analysis is based on real past results that are released by the company. Therefore, ratio analysis metrics do not necessarily represent future company performance.
  • Inflationary effects: Financial statements are released periodically and, therefore, there are time differences between each release. If inflation has occurred in between periods, then real prices are not reflected in the financial statements. Thus, the numbers across different periods are not comparable until they are adjusted for inflation.
  • Changes in accounting policies: If the company has changed its accounting policies and procedures, this may significantly affect financial reporting. In this case, the key financial metrics utilized in ratio analysis are altered, and the financial results recorded after the change are not comparable to the results recorded before the change. It is up to the analyst to be up to date with changes to accounting policies. Changes made are generally found in the notes to the financial statements section.
  • Operational changes: A company may significantly change its operational structure, anything from its supply chain strategy to the product that they are selling. When significant operational changes occur, the comparison of financial metrics before and after the operational change may lead to misleading conclusions about the company’s performance and future prospects.
  • Seasonal effects: An analyst should be aware of seasonal factors that could potentially result in limitations of ratio analysis. The inability to adjust the ratio analysis to the seasonality effects may lead to false interpretations of the results from the analysis.
  • Manipulation of financial statements: Ratio analysis is based on information that is reported by the company in its financial statements. This information may be manipulated by the company’s management to report a better result than its actual performance. Hence, ratio analysis may not accurately reflect the true nature of the business, as the misrepresentation of information is not detected by simple analysis. It is important that an analyst is aware of these possible manipulations and always completes extensive due diligence before reaching any conclusions.

2Q) MIXED RATIOS /  COMPOSITE /  COMBINED RATIOS

A composite ratio or combined ratio compares two variables from two different accounts. One is taken from the Profit and Loss A/c and the other from the Balance Sheet. For example the ratio of Return on Capital Employed. The profit (return) figure will be obtained from the Income Statement and the Capital Employed is seen in the Balance Sheet. A few other examples are Debtors Turnover Ratio, Creditors Turnover ratio, Earnings Per Share, etc.




                                                                   10 MARKS

1Q)  TYPES OF RATIOS


1. Liquidity Ratios: Liquidity ratios help determine the ability of the company to meet its debt obligations by using the current assets. At times of financial crisis, the company can utilize the assets and sell them to obtain cash, which can be used for paying off the debts.

Some of the most commonly used liquidity ratios are quick ratio, current ratio, cash ratio, etc. The liquidity ratios are used mostly by creditors, suppliers, and any kind of financial institutions such as banks, money lending firms, etc for determining the capacity of the company to pay off its obligations as and when they become due in the current accounting period.

2. Solvency Ratios: Solvency ratios are used for determining the viability of a company in the long term or in other words, it is used to determine the long-term viability of an organization.

Solvency ratios calculate the debt levels of a company about its assets, annual earnings, and equity. Some of the important solvency ratios that are used in accounting are debt ratio, debt-to-capital ratio, interest coverage ratio, etc.

Solvency ratios are used by government agencies, institutional investors, banks, etc to determine the solvency of a company.

3. Activity Ratio: Activity ratios are used to measure the efficiency of business activities. It determines how the business is using its available resources to generate the maximum possible revenue.

These ratios are also known as efficiency ratios. These ratios hold special significance for businesses in a way that whenever there is an improvement in these ratios, the company can generate revenue and profits much more efficiently.

Some examples of activity or efficiency ratios are asset turnover ratio, inventory turnover ratio, etc.

4. Profitability ratios: The purpose of profitability ratios is to determine the ability of a company to earn profits when compared to its expenses. A better profitability ratio shown by a business as compared to its previous accounting period shows that the business is performing well.

The profitability ratio can also be used to compare the financial performance of a similar firm, i.e. it can be used for analyzing competitor performance.

Some of the most used profitability ratios are return on capital employed, gross profit ratio, net profit ratio, etc.

 

 

 2Q) What is an accounting ratio? what are the uses of accounting ratios?

Accounting ratios also referred to as financial ratios, are applied to compute the performance and profitability of a firm grounded on its financial statements. They furnish a way of stating the association between one accounting data point to another and are the source of ratio analysis.

To put it in other words, an Accounting ratio implies a quantitative agreement that is employed for the purpose of decision-making and analysis. It furnishes the basis for intra-firm as well as inter-firm comparisons. Further, to make the ratios efficient, they are compared with ratios of the base period with the industry average ratios or with criteria.

Types of Accounting Ratios:

Ratios in accounting can be classified into traditional and functional types.

Based on traditional classification

  1. Profit and Loss Ratio
  2. Balance Sheet Ratio
  3. Composite Ratio

Based on functional classification

  1. Liquidity Ratio
  2. Profitability Ratio
  3. Leverage Ratio
  4. Activity Ratio
  5. Coverage Ratios or Solvency Ratios


Objectives of Accounting Ratio:

Ratio analysis is a vital part of the analysis of outcomes unveiled by financial statements. It furnishes the users with essential financial data and points out the areas which demand research. Ratio analysis is a method that includes regrouping information by utilization of arithmetical associations, though its interpretation is a complicated concern. It needs a fine knowledge and the laws used for outlining the financial statements. Once it is done efficiently, it furnishes a lot of data which helps the analyst :

  • To be aware of the areas of the trade which require more concentration
  • To know about the possible areas which can be developed with the effort in the solicited direction
  • To furnish a deeper analysis of liquidity, solvency, efficiency, and profitability degrees in the trading concern
  • To furnish data for making a cross-sectional investigation by comparing the achievement with the valid business models
  • To furnish data procured from financial statements beneficial for making forecasts and estimations for the prospect


 

 

 

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