Accounting Ratios: Importance and Limitations

Accounting Ratios: Importance and Limitations!

Importance of Accounting Ratios:

The importance of accounting ratios, that is, relationships worked out among various accounting data which are mutually interdependent and which influence each other in a significant manner, arises from the fact that often absolute figures standing alone convey no meaning. They become significant only when considered along with other figures.

A firm earns a profit of Rs 1,00,000. This information is meaningless unless either the figure of capital employed to earn it or of sales affected is available. Even if an absolute figure is considered significant, one may be subconsciously aware of the other relevant figures.

When we say that so and so is fat, what we are trying to say is that considering the age and height of the person, he is overweight. Ratio may be expressed as a rational figure or as a percentage. For example, the ratio of 3, 00,000 to 2, 00,000 may be expressed as 1.5 or 150%.

For purposes of analysis, accounting ratios are indispensable. Suppose, sales have increased but profit has fallen. One may be vaguely aware of the causes, but for precise knowledge it will be necessary to analyse ail the figures completely.

For example, one will have to ascertain the contribution to higher sales by change in prices and by increased or lower sales volume; the consumption of materials will also be analysed both for changes in prices and in quantities consumed. Such analysis is greatly facilitated by accounting ratios. In fact, a meaningful analysis of the financial situation and performance is the first great advantage of accounting ratios.

This requires ratios and their comparison which may be:

(i) For the same firm over a period of years, or

(ii) For one firm against another, or

(iii) For one firm against the industry as a whole or against predetermined standards, or

(iv) For one division or department of a firm against other divisions or departments of the same firm.

Inter-firm comparison and intra-firm comparison are, thus, both possible on the basis of accounting ratios; this can also be attempted in other ways but accounting ratios are indispensable in this respect. For example, to judge which firm has the best overall efficiency, one should compare the rate of profit on capital employed for the firms concerned—the size of the profit as such is not relevant.

Accounting ratios not only indicate the present position, they also indicate the causes leading up to the position to a large extent. For instance, accounting ratios may indicate not only that financial position is precarious but also the past policies or actions which have caused it.

Best results are obtained when ratios for a number of years are put in a tabular form so that the figures for one year can be easily compared with those of other years.

Accounting ratios tabulated for a number of years indicate the trend of the change. This helps in preparation of estimates for the future. Ratios also help in ascertaining other figures if one figure is available. Suppose it is known that the ratio of wages to sales is 15%; it is then easy to calculate the amount to be spent on wages if the amount of expected sales is known.

Limitations of Accounting Ratios:

Ratio analysis is very fashionable these days and is useful but one should be aware of its limitations also.

The following are the chief limitations of accounting ratios:

(i) Accounting ratios can be only as correct as the data on which they are based, For instance, if inventory values are inflated, not only will one have an exaggerated view of profitability of the concern, but also of its financial position. The basic data must be absolutely reliable, if the ratios worked out on its basis are to be relied upon.

(ii) When two firms’ results are being compared, it should be remembered that the firms may follow different accounting policies; for instance, one firm may charge depreciation on the straight line basis and the other on diminishing value. Such differences will not make some of the accounting ratios strictly comparable.

(iii) Changes in price levels often make comparison of figures for various years difficult. For instance, the ratio of sale to fixed assets in 2001 would be much higher than in 1984 due to rising prices, fixed assets being expressed still on the basis of cost,

(iv) Accounting ratios may be worked out for any two figures even if they are not significantly related. For example, a ratio may be worked out for sales and investments in government securities. Such ratios will only be misleading. Care should be exercised to work out ratios between only such figures as have a cause and effect relationship. One should also be reasonably clear as to what is cause and what is effect,

(v) Ratios sometimes give a misleading picture. One company produces 1,000 units in one year and 2,000 units next year; the progress is 100%. Another firm raises production from 6,000 units to 8,000 units—the progress is only 33⅓%.

The second firm will appear to be less active than the first firm if only the rate of increase is compared. It is, therefore, useful if, along with ratios, absolute figures are also studied—unless the firms being studied are equal in all respects.

In fact, one should be extremely careful while comparing the results of one firm with those of another if the two firms differ in any significant manner, say, in size, location, degree of automation or mechanisation, etc.

(vi) Accounting ratios are expressed in precise figures and that may be misleading unless one remembers that the figures on which they are based are often only estimates and that different figures could also have been worked out legitimately.

One should also remember that often the basis of accounting is changed; this will mean that ratios of one period and those of another may not be comparable. In a nutshell, before one works out the ratios, one should be sure of the figures leading to the ratios,

(vii) Another important point to keep in mind is that there is almost no single standard ratio against which the actual ratio is measurable. Circumstances differ from firm to firm and the nature of each industry is different.

Therefore, the standard will differ for each industry and the circumstances of each firm will have to be kept in mind. For instance, while comparing the rate of return of electricity companies with that in other industries, one must remember that, by law, electricity companies are precluded from making high profits.

One industry may have to invest heavily in fixed assets and another industry may have to keep large stocks of raw materials and finished goods. For these reasons, the performance of one industry may not be properly comparable with that of another.

For each industry, standard ratios will have to be worked out separately, mostly on the basis of actuals for a few representative companies which may be considered as reasonably sound and competent. The performance of firms in the industry may then be compared but still remembering the circumstances of each firm.