RATIOS
Ratio is an arithmetical expression of relationship between two interdependent or related items. It may be defined as indicated quotient of mathematical expression. Accounting ratios are numerical relationship between two accounting variables. It indicates a quantitative relationship which is used for analysis and decision making.
ACCORDING TO ACCOUNTANT’S HANDBOOK BY WIXON, KELL AND BEDFORD
“A ratio is an expression of the quantitative relationship between two numbers.”
ACCORDING TO KOHLER
“A ratio is relation of the amount a, to another, b, expressed as the ratio of a to b; a:b; or as a simple fraction, integer, decimal or percentage.”
ACCORDING TO J BETTY
“The term accounting ratio is used to describe significant relationships which exist between figures shown in Balance Sheet, in a statement of Profit and Loss, in a budgetary control system or in any part of the accounting organization.”
ACCORDING TO KENNEDY AND MC MULLAN
“The relationship of one term to another, expressed in simple mathematical form is known as ratio.”
ACCORDING TO RN ANTHONY
“Ratio is simply one number, expressed in terms of another. It is found by dividing one number by the other.”
Example: The ratio of current assets to current liabilities can be expressed as:
Current Ratio= Current Assets/ Current Liabilities.
EXPRESSING A RATIO
Accounting ratio can be expressed in any of the following form:
PURE OR PROPORTION OR SIMPLE RATIO
It is expressed by the simple division of one number by another. For Example: If the current assets of the business are Rs. 2,00,000 and its current liabilities are Rs. 1,00,000, the ratio of current assets to current liabilities will be 2:1.
RATE OR TIMES
In this type, it is calculated how many types a figure is, in comparison to another figure. For example: If a firm’s credit sales during the year are Rs. 2,00,000 and its trade receivables at the end of the year are Rs. 40,000, its trade receivables turnover ratio= 2,00,000/ 40,000= 5 times. It shows that the credit sales are 5 times in comparison to trade receivables.
PERCENTAGE FORM
In this form, the quotient obtained by dividing one item by another is multiplied by 100 and it becomes percentage form of expression. For example: the relationship between the sales and gross profit of the firm may be 40% i.e.
Gross profit ratio= Gross profit/ Net sales*100
Gross Profit Ratio= 4,00,000/10,00,000*100
Gross Profit Ratio= 40%.
FRACTION
Ratio can be expressed in fraction. Example: The ratio of fixed assets to current assets is 4/5.
TERMS OF DAYS
Ratio may sometimes be expressed in terms of days also. For Example: Average collection is 73 days.
INTERPRETATION OF RATIOS
The interpretation of ratios is an important factor. A single ratio in itself does not convey much of the sense. To make ratios more useful, they have to be interpreted properly. The ratios can be interpreted in following ways:
SINGLE ABSOLUTE RATIOS
Generally speaking one cannot draw any meaningful conclusion when a single ratio is considered in isolation. But single ratios may be studied in relation to certain rules of thumb which are based upon well proven conventions. For Example:
- 2:1 is the ideal standard for Current ratio.
- 1:1 is the ideal standard for Liquid ratio.
- 0.5:1 is the ideal standard for absolute liquid ratio.
- 2:1 is the ideal standard for debt-equity ratio.
GROUP OF RATIOS
Ratios may be interpreted by calculating a group of related ratios. A single ratio supported by other related additional ratios becomes more understandable and meaningful. For example, the ratio of current assets to current liabilities may be supported by the ratio of liquid assets to current liabilities to draw more dependable conclusions.
HISTORICAL COMPARISON
One of the easiest and most popular ways of evaluating the performance of the firm is to compare the present ratios with the past ratios known as comparison overtime. When financial ratios are compared over a period of time, it gives an indication of the direction of change and reflects whether the firm’s performance and financial position has improved, deteriorated or remained constant over a period of time. But while interpreting ratios from comparison over time, one has to be very careful about the changes in the price level, business conditions, accounting policies etc.
PROJECTED RATIOS
Ratios can also be calculated for the future standards based upon the projected or Proforma financial statements. These future ratios may be taken as a standard for comparison and the ratios calculated on actual financial statements can be compared with the standard ratios to find out the variances or deviations, if any there is. Such variance or deviations helps in interpreting and taking corrective action for improvement in future.
INTER-FIRM COMPARISON
Ratio of one firm can also be compared with the ratios of some other selected firms in the same industry at the same point of time. This comparison is also known as cross-sectional ratio analysis. This kind of comparison helps in evaluating relative financial position and performance of the firm. But while making use of such comparison one has to very careful regarding the different accounting methods, policies and procedures adopted by different firms.