{"id":3109,"date":"2019-12-21T09:18:03","date_gmt":"2019-12-21T09:18:03","guid":{"rendered":"https:\/\/commerceiets.com\/?p=3109"},"modified":"2019-12-21T09:18:03","modified_gmt":"2019-12-21T09:18:03","slug":"financial-ratio-analysis","status":"publish","type":"post","link":"https:\/\/commerceiets.com\/financial-ratio-analysis\/","title":{"rendered":"FINANCIAL RATIO ANALYSIS"},"content":{"rendered":"\n<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_65 counter-hierarchy ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title \" >Table of Contents<\/p>\n<span class=\"ez-toc-title-toggle\"><a href=\"#\" class=\"ez-toc-pull-right ez-toc-btn ez-toc-btn-xs ez-toc-btn-default ez-toc-toggle\" aria-label=\"Toggle Table of Content\"><span class=\"ez-toc-js-icon-con\"><span class=\"\"><span class=\"eztoc-hide\" style=\"display:none;\">Toggle<\/span><span class=\"ez-toc-icon-toggle-span\"><svg style=\"fill: #999;color:#999\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" class=\"list-377408\" width=\"20px\" height=\"20px\" viewBox=\"0 0 24 24\" fill=\"none\"><path d=\"M6 6H4v2h2V6zm14 0H8v2h12V6zM4 11h2v2H4v-2zm16 0H8v2h12v-2zM4 16h2v2H4v-2zm16 0H8v2h12v-2z\" fill=\"currentColor\"><\/path><\/svg><svg style=\"fill: #999;color:#999\" class=\"arrow-unsorted-368013\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" width=\"10px\" height=\"10px\" viewBox=\"0 0 24 24\" version=\"1.2\" baseProfile=\"tiny\"><path d=\"M18.2 9.3l-6.2-6.3-6.2 6.3c-.2.2-.3.4-.3.7s.1.5.3.7c.2.2.4.3.7.3h11c.3 0 .5-.1.7-.3.2-.2.3-.5.3-.7s-.1-.5-.3-.7zM5.8 14.7l6.2 6.3 6.2-6.3c.2-.2.3-.5.3-.7s-.1-.5-.3-.7c-.2-.2-.4-.3-.7-.3h-11c-.3 0-.5.1-.7.3-.2.2-.3.5-.3.7s.1.5.3.7z\"\/><\/svg><\/span><\/span><\/span><\/a><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1 ez-toc-heading-level-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/commerceiets.com\/financial-ratio-analysis\/#FINANCIAL_RATIO_ANALYSIS\" title=\"FINANCIAL RATIO ANALYSIS\">FINANCIAL RATIO ANALYSIS<\/a><ul class='ez-toc-list-level-2' ><li class='ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/commerceiets.com\/financial-ratio-analysis\/#BENCHMARKS_FOR_RATIO_ANALYSIS\" title=\"BENCHMARKS FOR RATIO ANALYSIS\">BENCHMARKS FOR RATIO ANALYSIS<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/commerceiets.com\/financial-ratio-analysis\/#OBJECTIVES_OF_FINANCIAL_RATIO_ANALYSIS\" title=\"OBJECTIVES OF FINANCIAL RATIO ANALYSIS\">OBJECTIVES OF FINANCIAL RATIO ANALYSIS<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/commerceiets.com\/financial-ratio-analysis\/#GUIDELINES_OR_PRECAUTIONS_FOR_THE_USE_OF_THE_RATIOS_FACTORS_CONSIDERED_IN_RATIO_ANALYSIS\" title=\"GUIDELINES OR PRECAUTIONS FOR THE USE OF THE RATIOS\/ FACTORS\nCONSIDERED IN RATIO ANALYSIS\">GUIDELINES OR PRECAUTIONS FOR THE USE OF THE RATIOS\/ FACTORS\nCONSIDERED IN RATIO ANALYSIS<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/commerceiets.com\/financial-ratio-analysis\/#ADVANTAGES_USES_SIGNIFICANCE_OF_RATIO_ANALYSIS\" title=\"ADVANTAGES\/ USES\/ SIGNIFICANCE OF RATIO ANALYSIS\">ADVANTAGES\/ USES\/ SIGNIFICANCE OF RATIO ANALYSIS<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-6\" href=\"https:\/\/commerceiets.com\/financial-ratio-analysis\/#LIMITATIONS_OF_RATIO_ANALYSIS\" title=\"LIMITATIONS OF RATIO ANALYSIS\">LIMITATIONS OF RATIO ANALYSIS<\/a><\/li><\/ul><\/li><\/ul><\/nav><\/div>\n<h1 class=\"has-text-align-center wp-block-heading\"><span class=\"ez-toc-section\" id=\"FINANCIAL_RATIO_ANALYSIS\"><\/span><strong>FINANCIAL RATIO ANALYSIS<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h1>\n\n\n\n<p>Financial Ratio Analysis is the process of determining and interpreting relationships between the items of financial statements to provide a meaningful understanding of the performance and financial position of an enterprise. Ratio analysis is basically a technique of:<\/p>\n\n\n\n<ul><li>Establishing meaningful relationship between\nsignificant variables of financial statements<\/li><li>And interpreting the relationship to form\njudgment regarding the financial affairs of the unit.<\/li><\/ul>\n\n\n\n<p class=\"has-coral-tree-background-color has-background\"><strong>&nbsp;ACCORDING TO JOHN N MYERS<\/strong><\/p>\n\n\n\n<p>\u201cRatio analysis is a study of relationship among various\nfinancial factors in a business.\u201d<\/p>\n\n\n\n<p>Financial Ratio analysis can be used for two types of analysis which are as follows:<\/p>\n\n\n\n<p><strong>CROSS-SECTIONAL ANALYSIS<\/strong><\/p>\n\n\n\n<p>The cross-sectional analysis involves comparison of one firm\nwith the other firm. This analysis is used to provide the conclusive evidence\nof the existence of the problem which in turn helps to take the corrective\nactions.<\/p>\n\n\n\n<p><strong>TIME SERIES ANALYSIS<\/strong><\/p>\n\n\n\n<p>In time series analysis, the current ratios of the firm are\ncompared with the past ratios of the same firm. This is also known as trend\nanalysis. Such an analysis gives an indication of direction of change or\ndeveloping trends. These changes show whether the position of firm has\nimproved, remained constant or deteriorated. While conducting such analysis,\nfollowing points should be considered such as changes in government policy,\nchange in accounting policy, technological development and competition over the\nperiod of time.<\/p>\n\n\n\n<h2 class=\"has-text-align-center wp-block-heading\"><span class=\"ez-toc-section\" id=\"BENCHMARKS_FOR_RATIO_ANALYSIS\"><\/span>BENCHMARKS FOR RATIO ANALYSIS<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>A single ratio conveys no meaning in itself. It should be compared with another to get some useful results. The benchmarks to compare the financial ratio analysis are as follows:<\/p>\n\n\n\n<p><strong>PAST RATIO:<\/strong> A ratio could be compared with the last year\u2019s ratio. It is also known as time series analysis.<\/p>\n\n\n\n<p><strong>RATIO OF SIMILAR FIRMS:<\/strong> A ratio could be compared with the ratios of similar firms in the same industry at the point of time. It is also known as the cross-sectional analysis.<\/p>\n\n\n\n<p><strong>RULE OF THUMB:<\/strong> Certain \u2018rule of thumbs\u2019 based upon well proven conventions have evolved over a period of time. For example: current ratio has 2:1 rule of thumb, liquid ratio has 1:1 rule of thumb, absolute liquid ratio has 0.5:1 rule of thumb.<\/p>\n\n\n\n<h2 class=\"has-text-align-center wp-block-heading\"><span class=\"ez-toc-section\" id=\"OBJECTIVES_OF_FINANCIAL_RATIO_ANALYSIS\"><\/span>OBJECTIVES OF FINANCIAL RATIO ANALYSIS<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The objectives of Ratio Analysis\nare as follows:<\/p>\n\n\n\n<p><strong>ANALYSIS OF FINANCIAL STATEMENTS<\/strong><\/p>\n\n\n\n<p>The main aim of ratio analysis is to facilitate the analysis of the financial statements. The financial statements include <a href=\"https:\/\/commerceiets.com\/profit-and-loss-account\/\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\"statement of profit and loss  (opens in a new tab)\">statement of profit and loss <\/a>and position statement i.e. <a href=\"https:\/\/commerceiets.com\/balance-sheet\/\" target=\"_blank\" rel=\"noreferrer noopener\" aria-label=\"balance sheet (opens in a new tab)\">balance sheet<\/a>. It helps the bankers, trade payables, investors, shareholders etc. in acquiring enough knowledge about the profitability and financial health of the business. In the light of the knowledge so acquired by them, they can take necessary decisions about their relationships with the concern.<\/p>\n\n\n\n<p><strong>SIMPLIFICATION OF ACCOUNTING DATA<\/strong><\/p>\n\n\n\n<p>Accounting ratio simplifies and summarizes a long array of\naccounting data and makes them understandable. It discloses the relationship\nbetween two such figures which have a cause and effect relationship with each\nother.<\/p>\n\n\n\n<p class=\"has-coral-tree-background-color has-background\"><strong>ACCORDING TO BIRAMN AND DRIBIN<\/strong><\/p>\n\n\n\n<p>\u201cFinancial ratios are useful because they summarize briefly the\nresults of detailed and complicated computation.\u201d<\/p>\n\n\n\n<p><strong>COMPARISON<\/strong><\/p>\n\n\n\n<p>With the help of ratio analysis two types of analysis can be\nmade: cross-sectional analysis and time series analysis. The accountant can\ngenerate useful results by comparing the current ratios of the firm with\nanother firm. Also the ratios can be compared with the past ratios of the same\nconcern to find out the development, deterioration in the working or performance\nof the concern.<\/p>\n\n\n\n<p><strong>LOCATION OF WEAK SPOTS IN THE BUSINESS<\/strong><\/p>\n\n\n\n<p>Time series analysis by the ratio analysis helps in locating\nthe weak spots of the business. The current ratios are compared with the past\nratios and areas of deficiency are found out. This helps in taking the remedial\nactions in the areas of need.<\/p>\n\n\n\n<p><strong>TO FORECAST THE FUTURE<\/strong><\/p>\n\n\n\n<p>Accounting ratios are very helpful in preparing the plans\nabout the future. For example: If sales or revenue of operations of the firm\nduring the year was Rs. 10 lakhs and average amount of inventory during this\nyear was Rs.2 lakhs i.e. 20% of the revenue from operations. If the firm wants\nto increase its sales from Rs. 10 lakhs to Rs. 15 lakhs, the firm will plan to\ninvest in the inventory Rs. 3,00,000 i.e. (20% of 15 lakhs). <\/p>\n\n\n\n<p>Similar other estimates for future can be worked out by\nestablishing a relationship between capital and revenue from operations; trade\nreceivables and revenue from operations; expenses and revenue from operations\netc.<\/p>\n\n\n\n<p><strong>ESTIMATE ABOUT THE TREND OF THE BUSINESS<\/strong><\/p>\n\n\n\n<p>If accounting ratios are prepared for a number of years,\nthey will reveal the trend of costs, revenue from operations, profits and other\nimportant facts.<\/p>\n\n\n\n<p><strong>FIXATION OF IDEAL STANDARDS<\/strong><\/p>\n\n\n\n<p>Ratios help us in establishing standards of the different\nitems of the business. By comparing the actual ratios calculated at the end of\nthe year with the ideal ratios, the efficiency of business can be easily\nmeasured.<\/p>\n\n\n\n<p><strong>EFFECTIVE CONTROL<\/strong><\/p>\n\n\n\n<p>Ratio analysis discloses the liquidity, solvency and\nprofitability of the business enterprise. Such information enables management\nto assess the changes that have taken place over a period of time in the\nfinancial activities of the business. It helps them in discharging their\nmanagerial functions of planning, organising, directing, communicating and\ncontrolling very effectively.<\/p>\n\n\n\n<p><strong>STUDY OF FINANCIAL SOUNDNESS<\/strong><\/p>\n\n\n\n<p>Ratio analysis discloses the position of business with\ndifferent view-points. It discloses the position of the business with the\nliquidity point of view, solvency viewpoint, profitability point of view etc.\nWith the help of such a study we can draw conclusions regarding the financial\nhealth of the business enterprise.<\/p>\n\n\n\n<h2 class=\"has-text-align-center wp-block-heading\"><span class=\"ez-toc-section\" id=\"GUIDELINES_OR_PRECAUTIONS_FOR_THE_USE_OF_THE_RATIOS_FACTORS_CONSIDERED_IN_RATIO_ANALYSIS\"><\/span>GUIDELINES OR PRECAUTIONS FOR THE USE OF THE RATIOS\/ FACTORS\nCONSIDERED IN RATIO ANALYSIS<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The calculation of ratios may not be a difficult task but\ntheir use is not easy. There are many factors that influence the use of the\nratios which are as follows:<\/p>\n\n\n\n<p><strong>ACCURACY OF FINANCIAL STATEMENTS<\/strong><\/p>\n\n\n\n<p>The ratios are calculated from the data available in the\nfinancial statements. If the data provided in financial statements is true and\nbest to the knowledge, then the ratios calculated from the data given will also\ngenerate accurate results. For this an accountant must ensure:<\/p>\n\n\n\n<ul><li>Proper following of accounting concepts and\nconventions.<\/li><li>Proper auditing of the accounts.<\/li><li>Proper internal check system.<\/li><\/ul>\n\n\n\n<p>All this will ensure that the financial statements are\naccurate and data contained in it is accurate.<\/p>\n\n\n\n<p><strong>OBJECTIVES OR PURPOSE OF ANALYSIS<\/strong><\/p>\n\n\n\n<p>The types of ratios to be used depend upon the purpose of\nthe analysis. The purpose is usually based on the nature of information needed\nand type of the user. Different ratios have been developed for different types\nof users. These are as follows:<\/p>\n\n\n\n<p><strong>Liquidity ratios<\/strong>\nlike current ratio, liquid ratio and absolute liquid ratio is studies with a\nview to get information about the liquidity position of the firm.<\/p>\n\n\n\n<p><strong>Activity or\nEfficiency ratios<\/strong> like debtor\u2019s turnover ratio, creditors turnover ratio,\nstock turnover ratio etc are studied with a view to get the information about\nthe efficiency of the operations of the firm.<\/p>\n\n\n\n<p><strong>Profitability Ratios<\/strong>\nlike gross profit ratio, operating ratio, net profit ratio, operating profit\nratio is calculated to know about the profitability position of the firm.<\/p>\n\n\n\n<p><strong>Solvency ratios<\/strong> like\nproprietary ratio, debt-equity ratio, total assets to debt ratio are calculated\nto know about the long term as well as short term solvency position of the\nfirm.<\/p>\n\n\n\n<p>So the analyst must know the purpose of analysis beforehand\nbefore selecting the type of ratio to be calculated.<\/p>\n\n\n\n<p><strong>SELECTION OF RATIOS<\/strong><\/p>\n\n\n\n<p>Another precaution in ratio analysis is the proper selection\nof appropriate ratios. The ratios should match the purpose for which these are\nrequired. Calculation of large number of ratios without determining their need\nin the present context may confuse the things instead of solving them. Only those\nratios should be selected which can throw proper light on the matter to be\ndiscussed.<\/p>\n\n\n\n<p><strong>USE OF STANDARDS<\/strong><\/p>\n\n\n\n<p>The ratios will give an indication of financial position\nonly when discussed with reference to certain standards. The standards for\ncomparing the ratios can be:<\/p>\n\n\n\n<p><em>PAST RATIO:<\/em> A ratio could be compared with the last year\u2019s ratio. It is also known as time series analysis.<\/p>\n\n\n\n<p><em>RATIO OF SIMILAR FIRMS: <\/em>A ratio could be compared with the ratios of similar firms in the same industry at the point of time. It is also known as the cross-sectional analysis.<\/p>\n\n\n\n<p><em>RULE OF THUMB:<\/em> Certain \u2018rule of thumbs\u2019 based upon well proven conventions have evolved over a period of time. For example: current ratio has 2:1 rule of thumb, liquid ratio has 1:1 rule of thumb, absolute liquid ratio has 0.5:1 rule of thumb.<\/p>\n\n\n\n<p>The comparison of calculated ratios with the standards will\nhelp the analyst in forming his opinion about financial situation of the\nconcern.<\/p>\n\n\n\n<p><strong>CALIBRE OF THE ANALYST<\/strong><\/p>\n\n\n\n<p>The ratios are the only tools of analysis and their interpretation\nwill depend upon the caliber and competence of the analyst. He should be\nfamiliar with the various financial statements and the significance of changes\netc. A wrong interpretation may create havoc for the concern since wrong\nconclusions may lead to wrong decisions. The utility of ratios is linked to the\nexpertise of the analyst.<\/p>\n\n\n\n<p><strong>RATIOS PROVIDE ONLY A BASE<\/strong><\/p>\n\n\n\n<p>The ratios are only guidelines for the analyst. These are not\nthe entire base for taking the decision. The ratio analysis can be a support to\nthe decision taken. Also other information like<\/p>\n\n\n\n<ul><li>Changes in business environment<\/li><li>Policy of management<\/li><li>Situation in the concern<\/li><li>Competition in the market<\/li><li>Government regulation etc. &nbsp;<\/li><\/ul>\n\n\n\n<p>should be taken into consideration before taking any\ndecision. The interpreter should use the ratios as a guide and may try to\nsolicit any other relevant information which helps in reaching a correct\ndecision.<\/p>\n\n\n\n<h2 class=\"has-text-align-center wp-block-heading\"><span class=\"ez-toc-section\" id=\"ADVANTAGES_USES_SIGNIFICANCE_OF_RATIO_ANALYSIS\"><\/span>ADVANTAGES\/ USES\/ SIGNIFICANCE OF RATIO ANALYSIS<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The advantages or uses or significance of ratio analysis is\nnot only confined to the financial managers only. It helps all other parties\nthat are interested for knowing the financial position of a firm. The uses of\nratio analysis are as follows:<\/p>\n\n\n\n<p><strong>UTILITY TO MANAGEMENT<\/strong><\/p>\n\n\n\n<p>Ratio analysis is of utmost use for the management. This can\nbe made clear with the help of following points:<\/p>\n\n\n\n<p><strong>HELPS IN DECISION MAKING:<\/strong> The financial statements prepared by the accountants do not convey any result unless these are properly analyzed. The ratio analysis is a tool to analyze the financial statements and draw out the results which are helpful for the management in taking the decisions for the business firm.<\/p>\n\n\n\n<p><strong>HELPS IN FINANCIAL FORECASTING AND PLANNING:<\/strong> Ratio analysis is of much help in financial forecasting and planning. Planning is looking ahead and the ratios calculated for a number of years work as a guide for the future. Meaningful conclusions can be drawn for the future from these ratios. Thus, ratio analysis helps in forecasting and planning.<\/p>\n\n\n\n<p><strong>HELPS IN COMMUNICATING:<\/strong> Ratio analysis helps in communicating the financial strengths and weaknesses of the business firm in more easy and understandable form. There are various user of the accounting information such as:<\/p>\n\n\n\n<ul><li>Creditors<\/li><li>Suppliers<\/li><li>Banks and financial institutions<\/li><li>Lenders<\/li><li>Employees<\/li><li>Owners\/ shareholders<\/li><li>Tax authorities, etc.<\/li><\/ul>\n\n\n\n<p>All these parties depends upon the ratio analysis to get\ninformation about the solvency, liquidity and profitability position of the\nbusiness.<\/p>\n\n\n\n<p><strong>HELPS IN COORDINATION: <\/strong>Ratios even help in coordination which is of utmost importance in effective business management. Better communication of efficiency and weakness of an enterprise results in better coordination of the enterprise.<\/p>\n\n\n\n<p><strong>HELPS IN CONTROL:<\/strong> Ratio analysis helps in exercising effective control over the business. Ratios are calculated and then compared with the standards. Any deviation found can be rectified by taking proper corrective measures.<\/p>\n\n\n\n<p><strong>OTHER USES:<\/strong> Ratio analysis has also many other uses as it is of utmost importance in budgetary control and standard costing.<\/p>\n\n\n\n<p><strong>UTILITY TO SHAREHOLDERS\/INVESTORS<\/strong><\/p>\n\n\n\n<p>Shareholders or investors are the persons who have invested\ntheir funds in the business. The shareholders are interested in knowing the<\/p>\n\n\n\n<ul><li>Security of the amount invested by them in the\nbusiness<\/li><li>Return to generated on the invested funds.<\/li><\/ul>\n\n\n\n<p>For this they want to know about the profitability and\nsolvency ratios like net profit ratio, earnings per share ratio, proprietary\nratio etc. Ratio analysis will be useful to the investor in making up his mind\nwhether present financial position of the firm warrants further investment or\nnot.<\/p>\n\n\n\n<p><strong>UTILITY TO CREDITORS<\/strong><\/p>\n\n\n\n<p>Creditors are the persons to whom business owes. Creditors are\ninterested to know about the short term liquidity of the business. Creditor will\ndeal with the business only if the creditworthiness of the business is strong\nand sound. For this purpose liquidity ratios such as liquid ratio, current\nratio, absolute liquid ratio is calculated. <\/p>\n\n\n\n<p><strong>UTILITY TO EMPLOYEES<\/strong><\/p>\n\n\n\n<p>The employees are interested in the profitability position\nof the firm. The increase in their wages, payment of bonuses and benefits are\ndirectly related to the amount of profits earned by the business. Various profitability\nratios like gross profit ratio, net profit ratio, operating ratio, operating\nprofit ratio enable the employees to put forward their viewpoints for the\nincrease in their wages.<\/p>\n\n\n\n<p><strong>UTILITY TO GOVERNMENT<\/strong><\/p>\n\n\n\n<p>Government is interested to know the overall strength of the\nindustry. Various financial statements published by the industrial units are\nused to calculate ratios for determining the long term and short term and\noverall financial positions of the concerns. Profitability indexes can also be\nprepared with the help of the ratios. The ratios may be used as indicators of\noverall strength of public as well as private sector. In the absence of the\nreliable economic information, governmental plans and policies may not prove\nsuccessful.<\/p>\n\n\n\n<p><strong>UTILITY FOR TAX AUDIT REQUIREMENTS<\/strong><\/p>\n\n\n\n<p>Section 44 AB inserted by the Finance Act 1984 in the Income\nTax Act 1961. Under this section every Assessee engaged in any business and\nhaving turnover or gross receipts exceeding Rs. 40 lakhs is required to get the\naccounts audited by the chartered accountant and submit the tax audit report\nbefore the due date for filing the return of income under section 139 (1). In\ncase of a professional, a similar report is required if the gross receipts\nexceed Rs. 10 lakh. Clause 32 of the Income Tax Act 1961 requires that the\nfollowing accounting ratios should be given:<\/p>\n\n\n\n<ul><li>Gross profit\/ turnover ratio<\/li><li>Net profit\/ turnover ratio<\/li><li>Stock in trade ratio<\/li><li>Material consumed .<\/li><\/ul>\n\n\n\n<p>Further, it is advisable to compare the accounting ratios\nfor the year under consideration with the accounting ratios for the earlier two\nyears so that the auditor can make necessary enquiries, if there is any major\nvariation in the accounting ratios. &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; &nbsp;<\/p>\n\n\n\n<h2 class=\"has-text-align-center wp-block-heading\"><span class=\"ez-toc-section\" id=\"LIMITATIONS_OF_RATIO_ANALYSIS\"><\/span>LIMITATIONS OF RATIO ANALYSIS<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>Accounting ratios are very important tool for financial\nanalysis. But despite its being indispensable, the ratios suffer from a number\nof limitations. These limitations should be kept in mind while making use of\naccounting ratios:<\/p>\n\n\n\n<p><strong>FALSE ACCOUNTING DATA GIVES FALSE RATIOS<\/strong><\/p>\n\n\n\n<p>Accounting ratios are calculated on the basis of data given\nin Profit and Loss statement and balance sheet. Therefore, they will be only as\ncorrect as the accounting data on which they are based. For example: If the\nclosing inventory is overvalued, not only the profitability is overstated but\nalso the financial position appears to be better. Therefore, unless the profit\nand loss statement and balance sheet are reliable, the ratios based on them\nwill not be reliable.<\/p>\n\n\n\n<p><strong>COMPARISON NOT POSSIBLE <\/strong><\/p>\n\n\n\n<p>There are many different accounting policies adopted by\ndifferent firms with regard to providing depreciation, creation of provision\nfor doubtful debts, method of valuation of stock etc. For instance, one firm\nmay adopt the policy of charging depreciation on straight line basis while\nother may charge on written down value basis. Such differences make the\naccounting ratios incomparable.<\/p>\n\n\n\n<p><strong>PRICE LEVEL CHANGES<\/strong><\/p>\n\n\n\n<p>Price level over the years goes on changing, therefore the\nratios of various years cannot be compared. For example: one firm sells 1,000\nmachines for Rs. 10 lakhs during 2018. It again sells 1,000 machines of same\ntypes in 2019 but owing to rising price in sales price was Rs. 15 lakhs. On the\nbasis of the ratios it will be concluded that the sales have increased by 50% whereas\nin actual, sales have not increased at all. Hence, the figures of the past\nyears must be adjusted in the light of the price level changes before the\nratios for these years are compared.<\/p>\n\n\n\n<p><strong>GIVES MISLEADING RESULTS<\/strong><\/p>\n\n\n\n<p>Ratio analysis may give misleading results if the comparison\nis made between the firms which are different from each other. For example: X\ncompany produces 10 lakh meters of cloth in 2018 and 15 lakh meters of cloth in\n2019, the progress is 50%. Y company raises its production from 10 thousand\nmeters in 2018 to 20 thousand meters in 2019; the progress is 100%. Comparison of\nthese two firms made on the basis of ratio is quite misleading because if the\ndifference in the size of the two firms. It is therefore, essential to study\nthe ratios along with the absolute data on which they are based.<\/p>\n\n\n\n<p><strong>LIMITED USE OF A SINGLE RATIO<\/strong><\/p>\n\n\n\n<p>The analyst should not merely rely on a single ratio. He should\nstudy several connected ratios before reaching a conclusion. For example, the\ncurrent ratio of a firm may be quite satisfactory, whereas the quick ratio may\nbe unsatisfactory.<\/p>\n\n\n\n<p><strong>WINDOW DRESSING<\/strong><\/p>\n\n\n\n<p>Some companies in order to cover up their bad financial position\nresorts to window dressing i.e. showing a better position than the one which really\nexists. They change their balance sheet in such a way that the important facts\nand truth may be concealed. For example: the current assets of a company are\nRs. 2,00,000 and its current liabilities are Rs. 1,00,000, so the current ratio\nis 2:1. After that, it purchased the goods for Rs. 1,00,000 for credit in the\nmonth of March. If it records the purchases, the current assets will increase\nto Rs.3,00,000 and current liabilities will increase to Rs. 2,00,000. As a\nresult, the current ratio will be reduced to 3:2 to 1.5:1. The company may pass\nthe entry for purchase in the beginning of next year or may postpone the\npurchase itself for a few days more.<\/p>\n\n\n\n<p><strong>LACK OF PROPER STANDARDS<\/strong><\/p>\n\n\n\n<p>Circumstances differ from firm to firm hence no single\nstandard ratio can be fixed for all the firms against which the actual ratio\nmay be compared. For example: the current ratio of 2:1 is generally accepted as\nan ideal ratio, which means that the current assets should be at least twice in\ncomparison to the current liabilities. But if a firm has such type of\narrangement with its bankers that the bankers will provide necessary credit to\nthe firm in case of need, the ideal current ratio for such firm may be less\nthan 2:1.<\/p>\n\n\n\n<p><strong>IGNORES QUALITATIVE FACTORS<\/strong><\/p>\n\n\n\n<p>Financial Ratio analysis is a quantitative measurement of the performance of the business. It ignores qualitative factors which are essential for interpretation. For example: credit may be granted to a customer on the basis of certain ratios of his business but&nbsp; the character and managerial ability of the customer must also be taken into consideration.<\/p>\n\n\n\n<p><strong>RATIOS ALONE ARE NOT ADEQUATE FOR PROPER CONCLUSIONS<\/strong><\/p>\n\n\n\n<p>Ratios derived from analysis of statements are not sure\nindicators of good or bad financial position and profitability of the firm. They\nmerely indicate the profitability of favorable or unfavorable position. The analyst\nhas to carry out further investigations and exercise his judgment in arriving\nat a correct diagnosis. This is for this reason that an analyst has to use\nother tools of financial analysis in addition to the tool of ratio analysis.<\/p>\n\n\n\n<p><strong>EFFECT OF PERSONAL ABILITY AND BIAS OF THE ANALYST<\/strong><\/p>\n\n\n\n<p>Another important point is to be kept in mind is that the different persons draw different meanings of different terms. One analyst may calculate ratios on the basis of profit after interest and tax, whereas other analyst may consider profits before interest and tax, a third may consider profits after interest but before tax. Therefore, before making comparisons, one must be sure that the ratios have been calculated from the same basis. &nbsp;<\/p>\n\n\n\n<div class=\"wp-block-buttons is-layout-flex wp-block-buttons-is-layout-flex\">\n<div class=\"wp-block-button\"><a class=\"wp-block-button__link\" href=\"https:\/\/www.linkedin.com\/in\/kajal-mahajan-7549b2197\/\" target=\"_blank\" rel=\"noreferrer noopener\">CONNECT ON LINKEDIN<\/a><\/div>\n<\/div>\n\n\n\n<figure class=\"wp-block-table\"><table><tbody><tr><td><strong>Also Study<\/strong><\/td><td><strong>Also Study<\/strong><\/td><td><strong>Also Study<\/strong><\/td><td><strong>Also Study<\/strong><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/accounting\/\"><strong>Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/non-profit-organisation\/\"><strong>Non profit organisation<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/depreciation\/\"><strong>Depreciation<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/liquidity-ratios-types\/\"><strong>Liquidity ratios<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/nature-of-accounting\/\"><strong>Nature of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/receipt-and-payment-account-pdf\/\"><strong>Receipts and Payments Account<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/depreciation-accounting\/\"><strong>Depreciation Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/acid-test-ratio-formula\/\"><strong>Acid Test Ratio<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/benefits-of-accounting\/\"><strong>Benefits of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/scope-of-accounting\/\"><strong>Scope of accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/hire-purchase-accounting-notes-pdf\/\"><strong>Hire Purchase Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/cash-ratio\/\"><strong>Cash Ratio<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/difference-between-cost-accounting-and-financial-accounting\/\"><strong>Difference between cost accounting and financial accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-financial-accounting-management-accounting-and-cost-accounting\/\"><strong>Financial accounting, cost accounting and management accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-hire-purchase-and-instalment\/\"><strong>Difference between hire purchase and instalment system<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/financial-ratio-analysis\/\"><strong>Financial ratio analysis<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/difference-between-transaction-and-event\/\"><strong>Difference between transaction and event<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/transactions\/\"><strong>Transactions<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/users-of-accounting\/\"><strong>Users of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/current-ratio-formula\/\"><strong>Ratio analysis<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/limitations-of-accounting-2\/\"><strong>Limitation of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/capital-expenditure\/\"><strong>Capital Expenditure<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/instalment-system\/\"><strong>Instalment System<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-consignment-and-sale\/\"><strong>Difference between consignment and sale<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/book-keeping\/\"><strong>Book Keeping<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/revenue-expenditure\/\"><strong>Revenue Expenditure<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/reserves-accounting\/\"><strong>Reserves Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-normal-and-abnormal-loss\/\"><strong>Abnormal loss vs normal loss in consignment<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/accountancy\/\"><strong>Accountancy<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-capital-expenditure-and-revenue-expenditure\/\"><strong>Difference between capital and revenue expenditure<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/reserves-accounting\/\"><strong>Provisions&nbsp;<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/treatment-of-loss-on-consignment\/\"><strong>Treatment of loss on consignment<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/accounting-is-an-art-or-science\/\"><strong>Accounting as science or an art<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/accounting-equation\/\"><strong>Accounting Equation<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/single-entry-system-in-accounting\/\"><strong>Single entry system<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/accounting-treatment-of-consignment\/\"><strong>Accounting treatment of consignment<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/accounting-is-an-art-or-science\/\"><strong>Book Keeping vs accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/deferred-revenue-expenditure\/\"><strong>Deferred Revenue Expenditure<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/statement-of-affairs-and-balance-sheet-difference\/\"><strong>Difference between statement of affairs and balance sheet<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-joint-venture-and-consignment\/\"><strong>Joint venture vs consignment<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/accounting-is-an-art-or-science\/\"><strong>Book keeping vs accountancy<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/capital-receipt\/\"><strong>Capital receipt<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/ifrs\/\"><strong>IFRS<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/departmental-accounting\/\"><strong>Departmental Accounting<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/accounting-is-an-art-or-science\/\"><strong>Accounting vs accountancy<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/revenue-receipt\/\"><strong>Revenue receipt<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/balance-sheet\/\"><strong>Balance Sheet<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/methods-of-departmental-accounting\/\"><strong>Methods of departmental accounting<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/basis-of-accounting\/\"><strong>Basis of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-capital-and-revenue-receipt\/\"><strong>Difference between capital and revenue receipt<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/profit-and-loss-account\/\"><strong>Profit and loss Account<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/allocation-of-expenses-in-departmental-accounting\/\"><strong>Allocation of expenses in departmental accounting<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/branches-of-accounting\/\"><strong>Branches of accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-accounting-concepts-and-conventions\/\"><strong>Difference between accounting concepts and conventions<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/trading-account\/\"><strong>Trading Account<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/inter-departmental-transfers\/\"><strong>Inter-departmental transfers<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/cash-and-mercantile-system-of-accounting\/\"><strong>Cash and mercantile system of accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/accounting-standards\/\"><strong>Accounting Standards<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/voyage-account\/\"><strong>Voyage Account<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/different-types-of-branches\/\"><strong>Different types of branches<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/accounting-principles\/\"><strong>Accounting Principles<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/objectives-of-accounting\/\"><strong>Objectives of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/accounting-for-incomplete-voyage\/\"><strong>Accounting for Incomplete Voyage<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-departmental-and-branch-accounting\/\"><strong>Departmental vs Branch accounting<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/golden-rules-of-accounting\/\"><strong>Golden ru\nles of accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/process-of-accounting\/\"><strong>Process of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/joint-venture\/\"><strong>Joint venture<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/methods-of-branch-accounting\/\"><strong>Methods of branch accounting<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/double-entry-system-of-accounting\/\"><strong>Double entry system of book keeping<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/scope-of-accounting\/\"><strong>Scope of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-joint-venture-and-partnership\/\"><strong>Joint Venture Vs Partnership<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/incorporation-of-branch-trial-balance\/\"><strong>Incorporation of branch trial balance<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/difference-between-double-single-entry-system\/\"><strong>Double entry vs Single entry system<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-accounting-concepts-and-conventions\/\"><strong>Accounting Concepts vs Accounting conventions<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/methods-of-recording-transactions-in-joint-venture\/\"><strong>Methods of recording transactions in Joint Venture<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/garner-vs-murray-rule\/\"><strong>Garner VS Murray Rule<\/strong><\/a><\/td><\/tr><tr><td><a href=\"https:\/\/commerceiets.com\/history-of-accounting-pdf\/\"><strong>History of Accounting<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/difference-between-provisions-and-reserves\/\"><strong>Difference between provisions and reserves<\/strong><\/a><\/td><td><a href=\"https:\/\/commerceiets.com\/consignment\/\"><strong>Consignment<\/strong><\/a><\/td><td><\/td><\/tr><\/tbody><\/table><\/figure>\n","protected":false},"excerpt":{"rendered":"<p>FINANCIAL RATIO ANALYSIS Financial Ratio Analysis is the process of determining and interpreting relationships between the items of financial statements to provide a meaningful understanding of the performance and financial position of an enterprise. Ratio analysis is basically a technique of: Establishing meaningful relationship between significant variables of financial statements And interpreting the relationship to&#8230;<\/p>\n<p class=\"more-link-wrap\"><a href=\"https:\/\/commerceiets.com\/financial-ratio-analysis\/\" class=\"more-link\">Read More<span class=\"screen-reader-text\"> &ldquo;FINANCIAL RATIO ANALYSIS&rdquo;<\/span> &raquo;<\/a><\/p>\n","protected":false},"author":2,"featured_media":3111,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[19,11],"tags":[],"_links":{"self":[{"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/posts\/3109"}],"collection":[{"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/comments?post=3109"}],"version-history":[{"count":0,"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/posts\/3109\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/media\/3111"}],"wp:attachment":[{"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/media?parent=3109"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/categories?post=3109"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/commerceiets.com\/wp-json\/wp\/v2\/tags?post=3109"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}