15 Mins
Article Content

Financial statements contain financial information about a company’s financial situation. Furthermore, in order to make important financial decisions, business owners, analysts, and other stakeholders examine, compare, and interpret this financial data. However, such information is interpreted using financial statement analysis tools and methodologies. One such popularly used tool is accounting ratio analysis. In this article, we have covered each type of accounting ratios, their formula, and importance of each ratio.

## What are Accounting Ratios?

Accounting ratios are an important tool for analysing financial statements. It is a comparison of two or more financial data that is used to analyse a company’s financial statements. These depict a connection between two or more accounting numbers obtained from financial statements. It is a useful tool for shareholders, creditors, and other stakeholders to understand a company’s profitability, strength, and financial health. This is also known as financial ratios, which are used to track corporate performance and make key business choices.

All of these sorts of ratios are used to track business performance and compare results to those of competitors. Additionally, such ratios can be stated as a fraction, %, proportion, or number of times. The financial statements determine the correctness and efficiency of accounting ratios as a financial statement analysis tool. This is because the two or more accounting statistics used to calculate a financial ratio are obtained from such statements. As a result, if the financial statements contain incorrect data, the ratios will also portray an inaccurate analysis of the company’s financial results.

In addition, the accounting numbers used to calculate ratios should be related in some way. This is because a financial examination of the company’s financial outcomes would be meaningless if the statistics were unrelated.

## Types of Accounting Ratios

• Liquidity Ratios
• Profitability Ratios
• Solvency Ratios
• Activity or Efficiency Ratio

### Liquidity Ratios

The liquidity ratio is used to determine whether or not a company has enough cash on hand to pay down its short-term debts. A high liquidity ratio indicates that the corporation will be able to pay its creditors. It is allowed to have a liquid ratio of 2 or more.

### Profitability Ratio

Profitability ratios are a group of financial indicators that are used to evaluate a company’s ability to create earnings over time in relation to its revenue, operational costs, assets, or shareholders’ equity. The evaluation is done by utilising financial information from a certain point in time. Efficiency ratios assess how successfully a corporation uses its assets internally to generate income. These efficiency ratios can be compared to profitability ratios (as opposed to after-cost profits).

Higher ratio outcomes are often more beneficial. However, such a ratio outcome must be compared to

• The results of similar companies
• The company’s own previous performance
• Industry average

### Solvency Ratios

A solvency ratio is a crucial metric used by prospective business lenders to assess an organisation’s capacity to satisfy long-term debt obligations. A solvency ratio is a measure of a company’s financial health that determines if its cash flow is sufficient to cover its long-term liabilities. An unfavourable ratio can suggest that a corporation is at risk of defaulting on its debt obligations. Solvency ratios are frequently utilised by prospective lenders and bond investors when evaluating a company’s creditworthiness. Although both solvency and liquidity ratios are used to assess a company’s financial health, solvency ratios have a longer-term outlook than liquidity ratios.

### Activity or Efficiency Ratio

Activity ratio determines the efficiency by which a company is utilizing its assets to generate revenue and cash or bank balance. In other words, it calculates a company’s margin of safety for paying interest on its debt over a specific time period.

Analysts can use activity ratios to assess a company’s inventory management, which is critical to its operational flexibility and overall financial health. An activity ratio is a financial indicator that investors and research analysts use to determine how well a firm uses its assets to create revenue and cash.

Activity ratios can be used to compare two organizations in the same industry, or they can be used to track the financial health of a single company over time.

## Objectives of Accounting Ratio Analysis

All stakeholders in a business must be able to interpret financial statements and other financial data. As a result, ratio analysis becomes an important tool for financial analysis and management. The following are the objectives of performing financial ratio analysis of an organization:

### Measure the Profitability and Growth

Every company’s ultimate goal is to make money. So, if I tell you that ABC Company made a profit of 5 lakhs last year, how would you know whether it is a good or terrible figure? To quantify profitability, context is essential, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratios, and Expense Ratios, among others, provide a gauge of a company’s profitability. Such ratios can be used by management to identify and improve problem areas.

### Evaluate Operational Efficiency of an Organization

Certain ratios reflect a company’s level of efficiency in managing its assets and other resources. To avoid excessive expenditures, it is critical that assets and financial resources be allocated and used wisely. Turnover and efficiency ratios will highlight any asset mismanagement.

### Liquidity

Every company must ensure that part of its assets are liquid in case it needs money right now. As a result, ratios like the current ratio and the quick ratio are used to assess a company’s liquidity. These aid a company’s ability to sustain the necessary degree of short-term solvency.

### Financial Strength

Some ratios can be used to determine a company’s long-term solvency. They can tell if a company’s assets are being strained or if the company is over-leveraged. To avoid liquidation in the future, management will need to immediately correct the situation. Debt-Equity Ratios, Leverage Ratios, and other similar ratios are examples.

### Comparison with Industry Standards and Competitors

To acquire a better picture of the organisation’s financial health and fiscal situation, the ratios must be compared to industry standards. If the company fails to meet market criteria, the management can take corrective measures. The ratios can also be compared to past years’ ratios to evaluate how far the company has progressed. Trend analysis is the term for this.

## Advantages of Accounting Ratio Analysis

Ratio analysis will assist in validating or disproving the firm’s finance, investment, and operational decisions. They convert the financial statement into comparison statistics, allowing management to assess and evaluate the firm’s financial status and the outcomes of their decisions.

• Complex accounting statements and financial data are reduced to simple ratios of operating efficiency, financial efficiency, solvency, long-term positions, and so on.
• Ratio analysis assists in identifying issue areas and drawing management’s attention to them. Some information is lost in the complicated accounting statements, and ratios will aid in identifying these issues.
• Allows the company to compare itself to other companies, industry standards, and intra-firm comparisons, among other things. This will assist the firm in gaining a better understanding of its financial situation in the economy.

Explore Golden Rules of Accounting

## Limitations of Accounting Ratio Analysis

• The data utilised in the analysis is based on the company’s own published prior results. As a result, ratio analysis indicators are not always indicative of future firm performance.
• Because financial statements are released on a regular basis, there are time gaps between them. Real prices are not represented in the financial accounts if inflation has occurred between periods. As a result, until the figures are corrected for inflation, they are not comparable across time periods.
• If the company’s accounting standards and practices have changed, this could have a significant impact on financial reporting. The key financial indicators used in ratio analysis are changed in this scenario, and the financial outcomes reported after the change are not comparable to those recorded before the change. It is the analyst’s responsibility to keep up with changes in accounting policies. The notes to the financial statements section usually contain the changes made.
• A company’s operational structure, from its supply chain strategy to the product it sells, may undergo major changes. When a firm undergoes significant operational changes, comparing financial measures before and after the change might lead to inaccurate inferences about the company’s success and future prospects.
• Seasonal influences should be considered by analysts because they can lead to ratio analysis constraints. Due to the inability to alter the ratio analysis for seasonality effects, the results of the analysis may be misinterpreted.
• The information given by the corporation in its financial accounts is the basis for ratio analysis. This data could be modified by the company’s management to show a greater performance than it actually has. As a result, ratio analysis may not adequately reflect the underlying nature of the firm, because information misrepresentation is not detectable by basic analysis. It is critical for an analyst to be aware of these potential manipulations and to conduct thorough due diligence before drawing any conclusions.

Discover More