Ratio Analysis

Topics: Generally Accepted Accounting Principles, Balance sheet, Financial ratios Pages: 22 (3094 words) Published: January 22, 2013

Ways of interpreting financial statements
-Using individual items contained in financial statement.
-Using ratios computed from items contained in Financial Statement (Ratio analysis)

Reasons for interpreting accounts

Accounts have to be analyzed and interpreted for the following logical points

(1)Evaluation of the trading performance of a firm in order to have a measure of the quality of management running it. (2)Appraisal and monitoring of the constituents of the Capital Structure and the cost associated with them (3)Whether or not an enterprise has solid liquidity base – a position of being able to meet contractual obligations as they are due is revealed. (4)Comparison of the operations of an enterprise for two or more years or between similar firms within the same industry could assist merger or ‘take-over considerations. (5)The ‘static’ or ‘historical cost’ nature of accounting information calls for more educative and concise indices for performance control.


(i)Financial statements are prepared on going concern basis while company may fold up few months after the financial statement date.

(ii)Application of accounting concept and convention may not be the same from organization to organization.

(iii)Financial statements are prepared to show true and fair view hence the actual figures may not be shown in financial statement.

(iv)Financial statement only discloses monetary facts. Non-monetary facts can only be disclosed in the notes to the financial statements.

(v)Financial statement of two or more companies may be difficult to compare unless the statement of accounting policies used for the preparation of the statement is known.


(1)The differences in the methods adopted by two enterprises may distort the result of analysis and therefore misinform judgment. An example of such difference being occasioned is ‘X’ company adopting ‘first-in-first-out stock valuation whereas ’Y’ company used ‘weighted average. The profit figures declared by the two companies may diverge, not as a result of varying levels of efficiency and effectiveness.

(2)There is inherent assumption that the historical data used for ratio analysis are inviolate, fixed and applicable under all situations. However, the dynamics of political and economic factors may prove such data as out-of-date’.

(3)Just as mathematics, which engages in ‘arm-chair’ reasoning and does not concern itself with what goes on in the empirical world, ratio analyses are not supposed to be ends in themselves. Useful as they are, ratio analyses should be considered along with other quantitative and indeed qualitative factors.

(4)The issues which crop up are:
(a)What is the suitable standard for comparison?
(b)What is the suitable industry standard?
There is no ‘ideal standard. Only guides exist.

(i)Accounting ratios only trigger off points for further investigation.

(ii)No fixed standard can be laid down for ideal ratio.


Ratio analysis may be carried out using any of the two approaches.

(1)TREND/TIME SERIES ANALYSIS: This involves computing ratios and comparing them with previous year ratios of the same coy to assess the performance of the company.

(2)CROSS-SECTIONAL ANALYSIS: This approach entails computing ratios of a company and comparing them with the average of the industry in which the company operates to asses the performance of the company.

Based on these two approaches, the reference point to which ratios of the coy may be compared include: (I)Previous years ratios (ii) The average of the industry (iii) inter-company analysis.

(1)PROFIT ABILITY RATIOS: These ratios assess or indicate the profitability of a company and some of them include

(a)Return on capital employed (ROCE):...
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