Financial Ratios - Accounting Ratios

Short Financial Ratios Overview

Financial ratios are used to describe significant relationship between figures shown on a balance sheet, in a profit and loss account, in off-balance items, in a budgetary control system or in any other part of an accounting organization.

Ratios show how one number is related to another. It may be expressed in the form of co-efficient, percentage, proportion, or rate.

Advantages of Ratios Analysis:

*      Simplifies financial statements - It simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of the business;

*      Facilitates inter-firm comparison - It provides data for inter-firm comparison. Ratios highlight the factors associated with with successful and unsuccessful firm. They also reveal strong firms and weak firms, overvalued and undervalued firms;

*      Helps in planning - It helps in planning and forecasting. Ratios can assist management, in its basic functions of forecasting. Planning, co-ordination, control and communications;

*      Makes inter-firm comparison possible - Ratios analysis also makes possible comparison of the performance of different divisions/departments of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future;

*      Help in investment decisions - It helps in investment decisions in the case of investors and lending decisions in the case of bankers etc.


Limitations of Ratios Analysis:

*      Limitations of financial statements - Ratios are based only on the information which has been recorded in the financial statements. Financial statements themselves are subject to several limitations. Thus ratios derived, there from, are also subject to those limitations. For example, non-financial changes though important for the business are not relevant by the financial statements. Financial statements are affected to a very great extent by accounting conventions and concepts. Personal judgment plays a great part in determining the figures for financial statements;

*      Comparative study required - Ratios are useful in judging the efficiency of the business only when they are compared with past results of the business. However, such a comparison only provide glimpse of the past performance and forecasts for future may not prove correct since several other factors like market conditions, management policies, etc. may affect the future operations;

*      Ratios alone are not adequate - Ratios are only indicators, they cannot be taken as final regarding good or bad financial position of the business. Other things have also to be seen;

*      Problems of price level changes - A change in price level can affect the validity of ratios calculated for different time periods. In such a case the ratio analysis may not clearly indicate the trend in solvency and profitability of the company. The financial statements, therefore, be adjusted keeping in view the price level changes if a meaningful comparison is to be made through accounting ratios;

*      Lack of adequate standard - No fixed standard can be laid down for ideal ratios. There are no well accepted standards or rule of thumb for all ratios which can be accepted as norm. It renders interpretation of the ratios difficult;

*      Limited use of single ratios - A single ratio, usually, does not convey much of a sense. To make a better interpretation, a number of ratios have to be calculated which is likely to confuse the analyst than help him in making any good decision;

*      Personal bias - Ratios are only means of financial analysis and not an end in itself. Ratios have to interpreted and different people may interpret the same ratio in different way;

*      Incomparable - Not only industries differ in their nature, but also the firms of the similar business widely differ in their size and accounting procedures etc. It makes comparison of ratios difficult and misleading.


Classification of Financial Ratios

Traditional Classification or Statement Ratios

Functional Classification or Classification According to Tests

Significance Ratios or Ratios According to Importance

- Profit and loss account ratios or revenue/income statement ratios


- Balance sheet ratios or position statement ratios


- Composite/mixed ratios or inter statement ratios




- Profitability ratios


-  Liquidity ratios



-  Activity ratios


-  Leverage ratios or long term solvency ratios


-  Primary ratios


- Secondary ratios