Accounting Ratios Notes1

Study Material & Notes for the Chapter 11


I.  Meaning, Objectives & Classification of Accounting Ratios

A.  Accounting Ratios – Meaning and Definition
  • Ratio: A ratio is a relationship between two things expressed in numbers or amounts. 
  • Accounting Ratios: When ratios are calculated on the basis of accounting information, than these are called accounting ratios.
  • Ratios Analysis: It is a technique of analysis of financial statements to conduct a quantitative analysis of information in a company’s financial statements.
  • Expression of Accounting Ratio:
    1. Pure Ratio like 2:1. All liquidity and solvency ratios are expressed in pure form.
    2. Percentage like 15%. All profitability ratios are presented in percentage form.
    3. Times, rate or number like 4 times. All turnover ratios and Interest Coverage Ratio are presented in this form.
    4. Fraction like ¾ 
B. Accounting Ratios – Objectives/Uses/Advantages
  • Simplify complex figures and establish relationships
    • Ratios help in simplifying the complex accounting figures and bring out their relationships. 
    • They help summarise the financial information effectively and assess the managerial efficiency, firm’s credit worthiness, earning capacity, etc.
  • Various Comparisons
    • Ratios help comparisons with certain benchmarks to assess as to whether firm’s performance is better or otherwise.
    • For this purpose, the profitability, liquidity, solvency, etc., of a business, may be compared:
      • over a number of accounting periods with itself (Intra-firm Comparison/Time Series Analysis), 
      • with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis) 
      • with standards set for that firm/industry (comparison with standard (or industry expectations).

  • Helps to understand efficacy of decisions

    • The ratio analysis helps you to understand whether the business firm has taken the right kind of operating, investing and financing decisions. It indicates how far they have helped in improving the performance.

  • Identification of problem areas
    • Ratios help business in identifying the problem areas as well as the bright areas of the business. Problem areas would need more attention and bright areas will need polishing to get better results.

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