Management Accounting Ratio Analysis - Accounting Basics

What is a Ratio?

The mathematical representation of a relationship between two or more items is known as a Ratio. A meaningful and useful relation between the accounting data is called Accounting Ratio. Simple fraction, integer or fraction can be used for representing a Ratio.

For instance, If the current assets of a concern is Rs 4,00,000 and the current liabilities is Rs 2,00,000, then the ratio of current assets to current liabilities is given as 4,00,000 / 2,00,000 = 2. The ratio can be expressed in terms of percentage by multiplying it with 100. The ratio between 200 and 100 can be represented in the following ways:

  • 2 : 1
  • 2/1
  • 200%
  • 2 to 1
  • 2

What is Accounting Analysis?

Accounting Analysis is defined as the comparative analysis and interpretation of accounting data. Some information is passed to the data users when accounting data is presented in relation to some other data.

What is Ratio Analysis and what are its applications?

Financial weakness and soundness of an organization is understood by a medium called Ratio analysis. It is on the analyst to select appropriate data for calculating appropriate ratios. Interpretation depends upon the caliber of the analyst.

To different parties according to their requirements, ratio analysis is useful in many ways:

  • To identify the financial strength and weakness of an organization.
  • To measure operative efficiency of a concern.
  • To review the previous year activity of the management.
  • To assess the level of efficiency.
  • To predict the business future plan
  • To optimize the capital structure.
  • To compare inter and intra companies.
  • To measure the liquidity, solvency, profitability and managerial efficiency of an organization.
  • To properly utilize the assets of the company.
  • To prepare the budget.
  • To assess the solvency, bankruptcy position of the firm.

What are the advantages of Ratio Analysis?

Ratio Analysis is associated with the following advantages:

  • Short and long-term solvency of a company can be measured by Ratio Analysis.
  • Profitability and managerial efficiency of the company is measured by Ratio Analysis.
  • Operating activities of the business are measured.
  • The capital structure of the company is analyzed.
  • Ratio analysis enables to summarize large quantitative data.
  • The past accounting performance is related with the current performances.
  • Different functional machineries of a company are coordinated.
  • It helps the management in future decision-making.
  • A reasonable balance between sales and purchase is maintained and the working capital requirements are estimated.

What are the limitations of Ratio Analysis?

In spite of interpreting different accounting equations, Ratio analysis has its own limitations such as:

  • As the ratio analysis extracts the data from financial accounting, if the financial accounting data is incorrect, the ratio analysis data is not reliable.
  • Unauthenticated data may lead to misinterpretation of ratio analysis.
  • As ratio analysis is based on the past performance, the future predictions may not be always advisable.
  • A single ratio cannot conclude anything about the business rather a series of ratios have to be calculated.
  • As the result of the ratio is based on historical data, it is not mandatory that the ratio analysis provide the real present situation of the business.
  • The changes in the price levels can distort the ratios calculated and the Trend analysis done by using ratios may mislead.
  • Ratio analysis is effective only when other companies also follow the same accounting principles and policies. If not, a realistic picture of comparison is not possible.
  • Through ratio analysis, special events cannot be identified. For instance, ratio analysis cannot identify the maturity of debentures.
  • Practical experience and knowledge are essential for effective ratio analysis.
  • Ratio analysis is a useful tool only in the hands of an expert.

What are the different types of Ratios?

Ratios can be classified on the basis of financial statements or on the basis of functional aspects.

Classification of Ratios on the basis of financial statement

On the basis of financial statements ratios can be classified into:

Balance Sheet Ratios

Balance sheet ratios are calculated from taking the data from the balance sheet such as current ratio, liquid ratio, capital gearing ratio, debt equity ratio, and proprietary ratio, etc.

Revenue Statement Ratio

Revenue statement ratios are calculated from taking the data from trading account or the profit and loss account such as operating ratio, net profit ratio, gross profit ratio, and stock turnover ratio.

Mixed or Composite Ratio

For mixed or composite ratio the data is used from both balance sheet as well as revenue statements. For instance, working capital turnover ratio, inventory turnover ratio, accounts payable turnover ratio, fixed assets turnover ratio, return of net worth ratio, return on investment ratio.

Classification of Ratios on the Basis of Financial Statements
Balance Sheet Ratios
Profit and Loss A/c Ratios
Composite or Mixed Ratios
  • Current Ratio
  • Liquid Ratio
  • Absolute Liquid Ratio
  • Debt Equity Ratio
  • Proprietorship Ratio
  • Capita Gearing Ratio
  • Assets Proprietorship Ratio
  • Capital Inventory to Working Capital Ratio
  • Ratio of Current Assets to Fixed Assets
  • Gross Profit Ratio
  • Operating Ratio
  • Operating Profit Ratio
  • Net Profit Ratio
  • Cash Profit Ratio
  • Expenses Ratio
  • Interest Coverage Ratio
  • Stock Turnover Ratio
  • Receivable Turnover Ratio
  • Payable Turnover Ratio
  • Fixed Assets Turnover Ratio
  • Total Assets Turnover Ratio
  • Working Capital Turnover Ratio
  • Capital Turnover Ratio
  • Return on Capital Employed
  • Return on Equity Ratio
  • Return on Shareholders Fund
  • Capital Turnover Ratio

Classification of Ratios on the basis of financial aspects

On the basis of financial aspects ratios can be classified into:

Liquidity Ratios

The short-term paying capacity of the firm or to meet the current liabilities liquidity ratios is used. In similar fashion, the efficiency of liquid resources of the firm, Accounts Receivable (Debtors) Turnover Ratio and Accounts Payable (Creditors) are found by turnover ratios.

Long-Term Solvency and Leverage Ratios

In order to know the efficiency of the firm in paying long-term debts and to meet the interest costs, Debt equity ratio and interest coverage ratio are calculated. To know the proportion of debt and equity in the firm financing, Leverage ratios are used.

Activity Ratios

Activity ratios or the turnover ratios identify the efficiency with which the resources of a firm are employed.

Profitability Ratios

Profitability ratios are calculated for knowing the results of the business operations. The overall performance and the effectiveness of a firm can be known by these profitability ratios. Profitability ratios can be calculated in two types – with relation to sales and with relation to investments.

FUNCTIONAL CLASSIFICATION OF RATIOS
Liquidity Ratios
Long-Term Solvency and Leverage Ratios
Activity Ratios Asset Management Ratios
Profit Abilities Ratios
(A)
  • Current Ratio
  • Liquid Ratio
  • Absolute Liquid or Cash Ratios
  • Interval Measure
(B)
  • Debtors Turnover Ratio
  • Creditor Turnover Ratio
  • Inventory Turnover Ratio
  • Debt/Equity Ratio
  • Debt to total Capital Ratio
  • Interest Coverage Ratio
  • Cash Flow/ Debt
  • Capital Gearing
  • Inventory Turnover Ratio
  • Debtors Turnover Ratio
  • Fixed Assets Turnover Ratio
  • Total Assets Turnover Ratio
  • Working Capital Turnover Ratio
  • Payable Turnover Ratio
  • Capital Employed Turnover Ratio
(A) In relation to sales
  • Gross Profit Ratio
  • Operating Ratio
  • Operating Ratio
  • Operative Profit Ratio
  • Net Profit Ratio
  • Expenses Ratio
(B) In relation to Investments
  • Return on Investment
  • Return on Capital
  • Return on Equity
  • Return on Total
  • Resources
  • Earnings per Share
  • Price Earnings Ratio

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