Accounting Ratio:

Without the accounting ratio the financial statment of any corporate entity is meaningless or unformative.With the help of accounting ratios companies annual records can be interpretated and help the users to collect the desire result.For Example if there are 2 companies both the companies dealing in the same type of business they are

Company A      Gross Profit  $200,000          sales $848,000

Company B      Gross Profit  $300,000          Sale  1,252,000   

Suppose if someone want to know which company gets the best profit. Simply by seeing above figure we cannot judge which company is making more profit then the other or which company performance is best then the other.For this we can use accounting ratio i.e. Grossprofit ratio. The grossprofit is the amount of grossprofit on sale as a percentage. When we apply the formula the result is below

Company A        23.58%

Company B        23.96%

In that case, company B with gross profit 23.96% is better than company A.

 

How to Use Ratios:

If you want to use the accounting ratio use it sensibly compare like for like. We can not compare gross profit percentage of a wholesale chemist with that of a restaurant.

Similarly, figures of two companies are only comparable if they have build up on a similar basis.For example the sales figure of company A, which treat items as sale only when cash is received, cannot be properly compared with those of company B,which treats item as sale as soon as they are invoiced.

Now lets compare two companies, company y and company z. Both the company are clothing business so would seem to be comparbale.Both the companies have annual sale revenue of $300,000.However, the average inventory of y is $40,000 and for z is $20,000.Cost of sales for both companies is $200,000.

 

                                      Y                Z

 =  Cost of sales                                                            200,000  =5                   200,000          =10

    Average Inventory                                                    40,000                             20,000

 

 Now lets imagine that Y had a financial year end of 30 November,just before the christmas, so the clothing inventory would be extremely high; that z had a year end of 31 January when following the christmas sales,its inventory had dropped to the year's lowest level;and that at 30 November both this year and last year z also had inventory valued at $40,000.So the difference in timing of year ending of both companies can affect the ratio significantly?

"Ratios therefore need very careful handling.They are extremely useful if used and interpreted appropriately,and very misleading otherwise."(Wood,Sangster:2000)

 

Users Of Ratios:

As we know that there are many parties interested in analysing financial statment, including shareholders,lenders,suppliers, creditors, employees,goernment agencies and competitors.

"Ratio analysis is a first step in financially assessing an entity.It removes some of the mystique surrounding the financial statements and makes it easier to pinpoint items which it would be interesting to investigate further."(Wood,Sangster:2000)

                      Ratio Category            Examples of Interested Groups                                                                            

                        Profitability                                Shareholders,Management,Employees,Creditors,Competitors,Investors

                        Liquidity                                     Shareholders,Suppliers,Creditors,Competitors,

                        Efficiency                                    Shareholders, Purchaser,Competitors, Potentials

                        Capital Structure                       Shareholders,Lenders,Creditors,investors

                        Shareholders                              Shareholders,Investors.