Definition and Explanation of Accounting Ratio Analysis (Financial Ratio Analysis):
We have so far been concerned with the preparation of financial statements without any examination of those accounts and without asking ourselves what those accounts mean or what they are telling us.
“Accounting ratio or financial ratio need to be calculated and interpreted to evaluate the strengths and weaknesses embodying the financial performance and position of a business, which is known as accounting ratio analysis (financial ratio analysis)“.
Financial ratios are calculated to establish a relevant relationship between two numbers of financial statements and then its result is interpreted in order to derive meaningful conclusions. A very important aspect of this process is that the numerator and denominator must be logically related to each other. Otherwise, the ratio will not provide information needed for decision making.
At least two items are used in the calculation of ratios. One number is placed in the numerator and the second in the denominator. The items used in the ratios may be taken from the income statement or the balance sheet and incorporated in any number of combinations. In either case, there must be logical relationship between numerator and denominator in order to draw meaningful conclusions from the ratio.
Types of Financial Ratios Analysis:
Financial ratios may be used in two types of analysis:
(1) Trend or Time Series Analysis (Comparing One Year with Another) – Definition and Explanation:
The financial performance of a business for a given year and its financial position at the end of that year may be judged by calculating a set of ratios and comparing the results with the equivalent ratios for the same business in previous year. Any perceived trends may be categorized as favorable, adverse or stagnant.
(2) Cross Sectional Analysis (Comparing One Business With Another Business) – Definition and Explanation:
The ratios calculated for a business in a given accounting year may be compared with those calculated for another business (operating in the same industry in the same year) or with industry average. This comparison helps to evaluate that how efficiency the company is performing? Any perceived trends, like above, may be categorized as favorable, adverse or stagnant.
(3) Rule of Thumb – Definition:
Rule of thumb has evolved over a period of time. For example, rule of thumb for current ratio is 1.5:1 to 2:1, meaning thereby current assets should be one and half to two times the current liabilities. However, this rule of thumb is to be cautiously used, as this may vary from industry to industry.