In this essay, we will see how accounting ratio analysis is useful in the analysis and interpretation of financial statements.

University Degree Business and Administrative studies

Introduction

In this essay, we will see how accounting ratio analysis is useful in the analysis and interpretation of financial statements. We shall also consider problems that are encountered when applying this technique. Accounting ratios can be used to examine various aspects of financial position and performance of a business. To start our analysis, we should know what is meant by an accounting ratio.

“An accounting ratio is an arithmetic relationship between two figures in a company’s balance sheet, income statement, and certain market data, often indicates something about the company’s activities.”( )

Ratios can be expressed in various forms, for example as a percentage, as a fraction or as a proportion. The way in which a particular ratio is presented will depend on the needs of those who will use the information. Although it is possible to calculate a large number of ratios, only a few, based on key relationships, are likely to be helpful to a user. Many ratios that could be calculated from the financial statements may not be considered because there is no clear or meaningful relationship between the items.

Accounting ratio classification

By calculating a relatively small number of ratios, it is often possible to build up a reasonably good picture of the position and performance of a business. Thus, it is not surprising that accounting ratio analysis is widely used by those who have an interest in businesses and business performance. Ratios can be grouped into certain categories, each of which reflects a particular aspect of financial performance or position. The following broad categories provide a useful basis for explaining the nature of the accounting ratios to be dealt with:

Profitability: this ratios provide and insight to the degree of success in achieving the purpose of creating wealth for the owners.

Efficiency: ratios may be used to measure the efficiency with which certain resources have been utilized within the business.

Liquidity: it is vital to the survival of a business that there be sufficient liquid resources available to meet maturing obligations. Certain ratios may be calculated that examine the relationship between liquid resources held and creditors due for payment in the near future.

Gearing: this is the relationship between the amount financed by the owners of the business and the amount contributed by outsiders, which has an important effect on the degree of risk associated with a business.

Investment: certain ratios are concerned with assessing the returns and performance of shares held in a particular business.

The strengths of accounting ratio analysis

Barry Elliott and Jamie Elliott mentioned accounting ratios are useful in their book: ‘Accounting ratios identify irregularities, anomalies and surprises that require further investigation to ascertain the current and future financial standing of a company’ (Barry Elliott and Jamie Elliott, 2002)

So far we know accounting ratios are useful, but we don’t know how useful they are. The next step we will discuss their usefulness at evaluating company’s performance.

Need of comparison

A ratio alone ...

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Investment: certain ratios are concerned with assessing the returns and performance of shares held in a particular business.

The strengths of accounting ratio analysis

So far we know accounting ratios are useful, but we don’t know how useful they are. The next step we will discuss their usefulness at evaluating company’s performance.

Need of comparison

A ratio alone will not tell very much about the position or performance of a business. For example, if a ratio reveals that a business was generating 100 pounds in sales per square metre of counter space, it would not be possible to deduce from this information alone whether this particular level of performance was good, bad or indifferent. It is only when compare this ratio with some ‘benchmark’ that the information can be interpreted and evaluated.

Past period

By comparing the ratio calculated with the ratio of a previous period, it is possible to detect whether there has been an improvement or deterioration in performance. Indeed, it is often useful to track particular ratios over time (say, five or ten years) in order to see whether it is possible to detect trends

Planned performance

Ratios may be compared with the targets that management developed before the commencement of the period under review. The comparison of planned performance with actual performance may therefore be a useful way of revealing the level of achievement attained.

Similar businesses

In a competitive environment, a business must consider its performance in relation to those of other businesses operating in the same industry. Survival may depend on the ability to achieve comparable levels of performance. Thus, a useful basis for comparing a particular ratio is the ratio achieved by similar businesses during the same periods.

Through the comparison, the users of financial statements are able to identify and highlight in which area a company is performing good or bad, in which area it has significant change.

User’s satisfaction

Although there are many users of financial statements, it is not necessarily everything they will ever need to know. Here we have listed the users of financial statements who want to know the sorts of things:

Different types of users of financial information are likely to have different information needs that will determine the ratios that they find useful. For example, shareholders are likely to be interested in their returns in relation to the level of risk associated with their investment. Thus, profitability, investment and gearing ratios will be of particular interest. Long-term lenders are concerned with the long-term viability of the business. In order to help them to assess this, the profitability ratios and gearing ratios of the business are also likely to be of particular interest. Short-term lenders, such as suppliers, may be interested in the ability of the business to repay the amounts owing in the short term. As a result, the liquidity ratios should be of interest.

Predicting financial distress

Accounting ratios, based on current or past performance, are often used to help predict the future. A number of methods and models employing ratios have now been developed that claim to predict future financial distress. Edward Altman (1968) in the USA was the first to develop a model that combine accounting ratios at a time in order to predict financial distress. His model containing five accounting ratios is called Z score:

Z = 0.012 R1 + 0.014 R2 + 0.033 R3 + 0.006 R4 + 0.010 R5

The five ratios were:

R1 = Working capital / total gross assets

R2 = Retained earnings / total gross assets

R3 = Earnings before interest and tax / total gross assets

R4 = Market values of equity / book value of debt

R5 = Sales total gross assets

Companies with a Z score greater than 2.99 were non-failed companies, whereas companies with a Z score below 1.81 were failed companies.

Problems when applying accounting ratio analysis

Although ratio analysis is useful in accessing business performance, it does have limitations, some of which are listed here.

Many large firms actually operate a number of different divisions in quite different industries, making it difficult to develop a meaningful set of industry averages for comparative purposes. This tends to make ratio analysis more useful for small than for large firms

Inflation has badly distorted firms’ balance sheets. Further, since inflation affects both depreciation charges and inventory costs, profits are also affected. Thus, a ratios analysis for one firm over time, or a comparative analysis of firms of different ages, must be interpreted with care and judgment.

Seasonal factors can also distort ratio analysis. For example, the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventory is the one just before versus just after the close of the canning season.

Different operating and accounting practices distort comparisons. For example, if one firm leases a substantial amount of its productive equipment, then its assets may be low relative to sales because leased assets may not appear on the balance sheet. At the same time, the lease liability is not shown as a debt. Thus, leasing can artificially improve the debt and turnover ratios.

“Window dressing” techniques imply that corporate management can manipulate the financial statements by making accounting choices that are available to them and still remain within the acceptable standards required by the generally accepted accounting principles (GAAP) in order to make a better face of financial statement.

Empirical finding

A recent study by Janne Lehtinen (1996) examined the validity and the reliability of financial ratios in an international comparison. In this research, financial ratio classifications for 16 ratios in 8 countries are carried out and compared to each other. The final empirical results show that following financial ratios are the most appropriate tools in the international context:

In the class of profitability the Return on Assets and the Operating Margin are safe choices.
The static liquidity ratio Quick Ratio and the dynamic liquidity ratio Defensive Interval is a very good pair in the evaluation of the liquidity.
The corresponding solvency indicators are the Equity to Capital and the Interest Coverage.

Based on these results it is reasonable to use all four efficiency ratios or select the most appropriate indicator depending on a purpose of the use.

Conclusion

In conclusion, usefulness of ratio analysis is to enable users of financial statement to evaluate a company’s performance and financial position over time, or in relation to other companies. All users’ needs for using financial statements are satisfied by a large number of accounting ratios. Using accounting ratios to access company’s performance and financial health, the only way is comparison with previous figures, competitor’s ratios or industry average. Accounting ratios is also a useful tool to predict company’s failure with Z score. However, this ratios analysis is not perfect since it has some shortcoming. The use of historical cost, different accounting policies, changes of economic condition, as well as different company structures, can distort comparisons. Furthermore, limited on disclosure and “window dressing” cause difficult for comparison. Therefore, ratios must be interpreted with caution.