This chapter covers the technique of accounting ratios for analysing the information contained in financial statements for assessing the solvency, efficiency
Explanation -The quick ratio or acid test ratio is a liquid- ity ratio that measures the ability of a com- pany to pay its current liabilities when they
Accounting ratios are calculated from the financial statements to arrive at meaningful conclusions pertaining to liquidity, profitability, and solvency
[Class XII : Accountancy] 337 Expression of ratios: Ratios are expressed in following four ways: Pure Ratio Like 2:1 All liquidity and solvency ratios
Financial Ratios Covers Information from Accounting 201 and 202 Financial ratios are useful indicators of a firm's performance and financial situation
financial statements, it is termed as accounting ratio Helpful in comparative analysis: The ratios are not being calculated for one year only
Class discussion; ? Homework on various question types; ? Quiz on formula of accounting ratios; ? Test on calculation and analysis of accounting
ACCOUNTANCY ACCOUNTING RATIOS www topperlearning com 2 ACCOUNTING RATIOS Introduction to Accounting Ratio and Ratio Analysis
interpret a full range of accounting ratios 14 1 Introduction Historically, of course, financial statements have been prepared for the benefit of
iii. It is a process of determining and interpreting relationships between items of financial
statements to provide a meaningful understanding of the financial performance and position of an enterprise. Objectives of Ratio Analysis: i. It simplifies understanding of financial information presented in the financial statement. ii. It helps in determining short-term and long-term solvency of the business. iii. It helps in assessing the operating efficiency of the business. iv. It analyses profitability of the business. v. It helps in comparative analysis which can be either intra-firm or inter firm comparisons. Advantages of Ratio Analysis: i. Tool for analysis of Financial Statements: It helps the users of financial statements to analyse the financial position of an enterprise. Such users can be bankers, investors, creditors, etc. who are concerned about the performance of an enterprise. ii. Simplifies Accounting Data: It simplifies understanding of accounting information presented in the financial statement. Calculation of ratios summarises briefly the results of detailed and complicated information. iii. Assessment of Operating Efficiency of Business: Operating efficiency can be determined by assessing and evaluating liquidity, solvency and profitability of an enterprise. Calculation of ratios helps in determining and evaluating such aspects.v. Identifies Weak Areas: Calculation and analysis of various ratios help to identify and
interpret the favourable and unfavourable ratios which can are used to identify the weak
areas or unfavourable factors in the enterprise. Enterprise can then work upon such areas or factors to improve the performance. vi. Facilitates Inter-firm and Intra-firm Comparison: When a firm compares its performance with that of other firms or with its industry standards in general, it is known as Inter-firm Comparison or Cross Sectional Analysis. On the other hand, if the performance of different units is belonging to the same firm is to be compared, it is known as Intra-firm Comparison. Accounting ratios are widely used for such comparisons. Limitations of Ratio Analysis: i. Reliability of Ratios: Since, ratios are calculated based on the financial information, if theinformation available is not correct ratios calculated using such information will also be
incorrect. Therefore, such ratios are not completely reliable to make any future decisions for an enterprise. ii. Only Quantitative Factors considered: Calculation of ratios takes into consideration only quantitative factors and all the related qualitative factors are ignored, which may be important for future decision making of an enterprise. iii. No Standard Ratio: In order to determine whether a ratio is favourable or adverse, there should be a standard with which the ratio can be compared. However, there is no single standard against which the ratio can be compared. iv. Non Comparable: It is possible that different firms belonging to the same industry may follow different policies and procedures for the purpose of accounting. The amounts computed using such different policies and procedures will also be different. Therefore, ratios calculated by such firms will not be comparable as the information used in calculating such ratios by the different firms is not the same. v. Price Level Changes Ignored: It is necessary to understand that comparability of the ratios depends upon the change in the price levels. However, such change in price levels is not considered in accounting variables from which ratios are computed. vi. Window Dressing: If the accounts are manipulated in order to window dress the financial performance and position of the business, the information available for computing ratios will not be accurate. This will lead to incorrect ratios being computed which in turn will affect the decisions taken based on analysis of such incorrect ratios. vii. Personal Bias: Since, preparation of financial statements is highly influenced by personal judgments, accounting ratios computed based on such information is also not free from such limitation. Types of Ratios: Ratios are classified based on following aspects: i. Liquidity (short-term solvency): These are the ratios which show the ability of the enterprise to meet its short-term financial obligations. It includes: a. Current Ratio b. Quick Ratio ii. Solvency (long-term solvency): These are the ratios which assess the long-term financial position of the enterprise. They assess the ability to meet the long-term financial obligations of the enterprise. It includes: a. Debt to Equity Ratio b. Total Assets to Debt Ratioa. It is a ratio which calculates the relationship between the current assets and current liabilities.
b. It is a liquidity ratio that measures the ability of the enterprise to pay its short-term financial
obligations i.e., current liabilities.c. It helps to identify whether the enterprise will be able to meet its short-term financial
obligations when they become due for payment. d. It is expressed as a pure ratio. e. Formula:a. It is a liquidity ratio which measures the ability of the enterprise to meet its short-term financial
obligations, i.e., Current Liabilities. b. It is a relationship of liquid assets with current liabilities.c. It is an indicator of short-term debt paying capacity of an enterprise and is therefore, a better
indicator of liquidity. d. A high Liquid Ratio compared to Current Ratio may indicate understocking while a low Liquid