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Important Factors For Understanding Ratios Analysis:

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Quality of Financial Statements:

The reliability of ratios is linked with the quality of financial statements. Financial statements which have been prepared by faithful adherence to generally accepted accounting principles (GAAP). Generally accepted accounting principles are likely to contain reliable data. Calculation of ratios from such financial statements is bound to be more useful and trustworthy.

Purpose of Analysis:

Users of accounting information are different such as short-term and long-term creditors; owners and would be investors; trade unions; tax authorities; competitors etc., object of each group of interested parties is also different such as liquidity or solvency or profitability, etc. So, before undertaking the analysis, one should be clear about the object of analysis. It is the object of analysis which determines the area (liquidity, solvency, profitability, leverage, activity etc.) to be
studied, analyzed and interpreted.

Selection of Ratios:

There is no end to the number of ratios which can be calculated. In 1919, Alexander Wall developed an elaborated system of ratio analysis. The same has been extended and modified over the period of time. So the ratios to be calculated should be selected judiciously taking into consideration the object of analysis. The ratios selected should serve the purpose of analysis. For example, short term creditors 'purpose is liquidity whereas owners' purpose may be served by solvency.

Standards to be Applied:

Any ratio in itself i.e. in isolation is meaningless. It must be compared with some standard to arrive at any logical conclusion. The analyst can choose the comparing standard from (a) Rule of thumb (b) past ratios (c) projected standards or (d) industry standards. Selection of standards for the purpose of interpretation will also depend upon the object of the analysis and the capacity of the analyst. For example, management (being the insider) can opt. for project standards whereas any outsider's choice shall be limited to the published information of the unit.

Capability of the Analyst:

Analysis is a tool in the hands of the analyst. Knife (as a tool) in the hands of a criminal may take the life but the knife (as a tool) in the hands of a surgeon may give new life to a patient. Interpretation depends on the educational background; professional skill; experience and intuition of the professional conducting it.

Ratios to be used only as Guide:

Ratios can provide, at the best, the starting point. The analyst, before arriving at the conclusion, should take into consideration all other relevant factors financial and non-financial; macro and micro. For example, general condition of economy; values of society; priorities of the government etc., are the important factors.

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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