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# Interpretation of Accounting Ratios:

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Calculation of ratios is comparatively simple, routine clerical in nature but interpretation of ratios is highly sophisticated and intricate phenomenon. The benefit of ratio analysis depends a great deal upon the correct interpretation. It needs skill, intelligence, training, farsightedness and intuition of high order on the part of the analyst. The following are different ways in which ratios may be interpreted:

## Individual Ratio:

Individual ratio may have significance of its own. For example, if the current ratio unit continuously falls, it may indicate probable insolvency. But generally single ratio may not convey any sense. However single ratio may be studied with reference to certain popular rules of thumb which can only give approximations. Care must be exercised because such comparison may be erroneous or unrealistic.

## Group Ratios:

Ratios may be interpreted by considering group of several related ratios. Such interpretation may be more meaningful. For example, current ratio may be studied along with liquid ratio. Similarly profitability ratios may be studied along with return on investment.

## Comparison with Past:

Ratios may be interpreted by making comparison over a period of time i.e. the same ratio be studied over a period of years of the same unit. It will highlight the significant trend revealing use, decline or stability of the phenomenon. Average value of the ratio for the past number of years can serve as a standard against which current performance may be measured. While interpreting ratios from comparison over a period of time one should be careful about the changes which might have taken place during the time. For example, price index; changes in managerial policies or changes in accounting practices etc.

## Comparison with Projections:

In a business unit where system of budgetary control and forecast is in existence, projected financial statements are usually drawn. Ratios calculated based on such projected financial statements shall act as the standards with which the ratios calculated from the present financial statements shall be compared. Variances shall be calculated and analyzed by reasons and persons. It shall enable to take corrective action wherever required.

## Inter-firm or Inter-Industry Comparison:

Ratios of one unit may be compared with the ratios of another identical unit or with the industry average at the same point of time. Such comparison is useful for evaluating relative financial position of the unit vis-à-vis other units or industry. While making such comparison, care must be taken regarding the difference of accounting methods, policies, procedures and terminology being followed by different units.

More study material from this to

## More study material from this topic: Meanings, Nature and Usefulness of Ratios Analysis Interpretation of Ratios Important Factors for Understanding Ratios Analysis Significance and Usefulness Ratios Analysis Classification of Ratios Analysis of Short Term Financial Position or Test of Liquidity Current Ratio Quick/Acid Test/Liquid Ratio Absolute Liquid Ratio Inventory/Stock Turnover Ratio Debtors / Receivable Turnover Ratio Creditors / Payables Turnover Ratio Working Capital Turnover Ratio Profitability Ratios Gross Profit Ratio (GP Ratio) Operating Profit Ratio Net profit ratio (NP ratio) Earnings Per Share Ratio Operating ratio Expense ratio Solvency ratios - Test of Long Term Solvency Debt-equity Ratio Debt Service Ratio or Interest Coverage Ratio Fixed Assets Ratio Debts to Total Funds or Solvency Ratio Reserves to Capital Ratio Capital Gearing Ratio Proprietary Ratio Accounting Ratios Formulas Limitations of Ratios Analysis

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