The progress of a company can be measured from its profitability. The figures of gross profit and net profit are not very significant unless expressed as a percentage of sales. The relation between gross and net profit can be used to determine how effectively the company’s management is controlling its operating costs. Moreover, return on capital employed determines the efficiency and effectiveness of the management in using its available resources. Return on capital employed is helps analyze better when used for comparing a company with industry averages instead of the analysis of a company over a period (www.
accaglobal. com/archives/sa_oldarticles). Liquidity Ratios Liquidity ratios assess the cash flow position of a company. For this purpose current ratio and acid test ratio is used. Current ratio tells how many current assets the company has to deal with its current liabilities and explains how liquid a company is. A higher current or acid test ratio is favorable for a company as the higher the ratio the more funds are available with the company to deal with its debts.
However, sometimes a very high ratio may be an indicator of the fact that most of the assets of the company are kept liquid therefore the company is not able to earn the best possible returns (www. accaglobal. com/archives/sa_oldarticles). Financial Ratios All the current and prospective stakeholders of a company are interested in its financial position. The debt equity ratio shows the relationship between the debts of the company and the equity of the company. The interest cover ratio shows how much more interest the company pay with the available profit.
The lower the interest cover ratio the higher the risk of default by the company. The company may have to face severe consequences if the interest payments and the principal payments are not made on timely basis. The earnings per share of a company shows how much profit the company has earned during the accounting period in relation to the number of shares issued to the ordinary share holders. The movement in earnings per share over time is used to analyze the investment potential of a company’s shares (Kaplan, 2007).
PROS AND CONS OF RATIOS Following are some of the benefits than can be derived from the use of accounting ratios. • Simplify financial statements: They make it easy to understand the financial statements. Although the financial statements give only the numerical aspect of the performance the company the ratios give the detailed insight on such figures. • Facilitate inter-company comparison: They provide basis for inter-company comparison. Ratios emphasize the factors related to the successful and unsuccessful companies.
They also reveal strong companies and weak companies, overvalued and undervalued companies. • Help in forecasting: They help in forecasting therefore, they can assist management, in its basic functions of planning. • Help in investment decisions: They help the bankers and the investors in making their investment and lending decisions. Following are some of the limitations of the accounting ratios. • Lack of comparative information: Appropriate data is very important for the comparison and detailed analysis.
Non availability of required data for comparison with similar company in the industry or with prior years’ performance of the same company will adversely affect the analysis; • Limitations of historical cost accounting: The financial statements on the basis of which ratios are calculated are prepared by using historical cost accounting. Therefore factors like inflation, impact of global recession and other similar factors may affect intercompany and over the period comparisons.
• Dependency on financial information: Ratio analysis may build a good or bad image of the company. The quality of the ratio analysis depends on the accuracy of the data on the basis of which ratios are calculated. If the accounts are poorly prepared, e. g. , poor accounting policy or poor estimates of the management, then the conclusions drawn from the accounting ratios may be misleading; • Comparison with past performance: Past performance of a company may not always be the best basis for the analysis of the company’s current and future performance.
In fact, when the financial statements of a company become available for analysis they had already been out dated by few months due to the time taken for their preparation (Financial Ratio: accounting for managment). CONCLUSION Accounting ratios are one of the key tools used by the stake holders of any company for interpreting its financial statements. However, care must be taken in drawing any conclusions; a change or difference in a ratio may be an indicator of various factors and not necessarily of the company’s good or bad performance.
Bibliography Financial Ratio: accounting for managment. (n. d. ). Retrieved July 17, 2010, from Accounting for management: http://ww. accountingformanagement/financial_statement_analysis_accounting_ratios. htm Kaplan. (2007). ACCA Paper P2: Corporate Reporting. London: BPP Learning Media Ltd. Lynch, F. &. (2009). CA Financial Reporting Study Text. Lahore: Business Publishers Pakistan. www. accaglobal. com/archives/sa_oldarticles. (n. d. ). Retrieved july 17, 2010, from ACCA official Website: http://www. accaglobal. com