Accounting Ratios

Kenya Frazer, Khaneik King, Tori-Ann Williams

Uses of Accounting Ratios
❖ Comparing and Decision making - One of the uses of ratio analysis is to compare a company’s financial performance to
similar firms in the industry to understand the company’s position in the market. Obtaining financial ratios, such as
Price/Earnings, from known competitors and comparing it to the company’s ratios can help management identify market
gaps and examine its competitive advantages, strengths, and weaknesses. The management can then use the information to
formulate decisions that aim to improve the company’s position in the market.
❖ Predict Future performance - Companies can also use ratios to see if there is a trend in financial performance.
Established companies collect data from the financial statements over a large number of reporting periods. The trend
obtained can be used to predict the direction of future financial performance, and also identify any expected financial
turbulence that would not be possible to predict using ratios for a single reporting period.
❖ Determines Efficiency in Managing Assets and Liabilities - The management of a company can also use financial ratio
analysis to determine the degree of efficiency in the management of assets and liabilities. Inefficient use of assets such as
motor vehicles, land, and building results in unnecessary expenses that ought to be eliminated. Financial ratios can also
help to determine if the financial resources are over- or under-utilised.
Types of Accounting Ratios

❖ Profitability / performance ratios - these measure how well the business is doing in terms of profit, turnover or sales
and capital employed. They reflect the performance of the company and management
❖ Liquidity ratios - these show whether or not the company can effectively pay its debt. They also reflect the firm’s
short-term strength or solvency
❖ Investor’s / Shareholders’ ratios - these measure the returns on the capital invested by shareholders or other investors.
They also show the relationship of ordinary shares and their price to the profits, dividends and assets of the company
❖ Efficiency ratios - these measure how efficiently resources are utilised. They also determine the efficiency of the firm in
collecting its debts
❖ Financial / gearing ratios - they assess the financial structure of the business, including the proportion of its financing
that is obtained from debts capital
Advantages of Accounting Ratios

❖ Provides the framework and information to compare a business’s performance with other businesses in the same
industry or the same nature
❖ Can produce vital information about the performance of the firm
❖ Can be used as a guide in making investment decisions
❖ A good tool used to assess the financial position of the business
❖ It helps in determining both liquidity and long term solvency of the firm.
Disadvantages of Accounting Ratios

❖ Ratio analysis is predominantly quantitative and hardly focuses on quality. Customer service and the moral of
employees
❖ If the financial report is not credible, then the ration cannot be either
❖ If the ratios are not adjusted for inflation, they might be misleading
Limitations of Accounting Ratios

❖ Its usefulness is dependent on the user. It requires experience to interpret properly and place in context
❖ Ratio analysis focuses on historical data, with little emphasis on the future, though it can be used to make
projections
❖ Ratios can only be used to compare similar companies and present with previous data
❖ An accounting ratio is only an indicator of a problem; it is not a solution to a problem
References

● https://byjus.com/commerce/advantages-and-disadvantages-of-ratio-analysis/#:~:text=It%20helps%20i
n%20determining%20how,term%20solvency%20of%20the%20firm.
● https://learn.financestrategists.com/explanation/accounting-ratios/limitations-of-accounting-ratios/