Accounting Ratio

Meaning, Significance, Limitation & Classification

Shivam Verma
M.B.A 1st semester
Roll No: 41

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 Ratio
• A Ratio is simply one number expressed in
terms of another, it is an expression of relation
spelt out by dividing one figure by another.

• Wixon, Kell and Bedford in their book

“Accounting’s Handbook” define ratio, as
“an expression of the quantitative relationship
between two number.

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 Accounting ratio
• Accounting ratio is used to describe the significant
relationship which exists between figures shown in
a balance sheet and profit and loss account
• Ratio are indicators, sometimes they serve as
pointers but not in themselves powerful tools of
management. The ratio help to summarize the
large quantity of financial data and to make
qualitative judgment about the firm’s financial
performance.

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 Accounting ratio Contd.
• They can not be taken as the final result
regarding good or bad financial position of the
business.

• It may be an indication that a firm is strong or

weak in a particular area but it must never be
taken as a powerful tool of management.

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 Mode of expressing Accounting Ratios
• Pure ratio, say ratio of current assets to current
liabilities is 2:1. e.g. debt-equity ratio, current
ratio etc
• A rate, say current result is 2 times current
liabilities. e.g. stock turnover ratio, debtors
turnover ratio etc
• A percentage, say current assets are 200% of
current liabilities. e.g. gross profit ratio,
operating ratio etc
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 Interpretation of Ratios
• Single absolute ratio.

• Group ratios.

• Historical comparison.

• Inter-firm comparison.

• Projected ratios.
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 Significance of Accounting Ratios
• Utility to management.

• Utility to shareholders and investors.

• Utility to creditors.

• Utility to employees.

• Utility to government.
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 Limitations of Accounting Ratios
• Usefulness of ratios depends upon the abilities and intentions
of the persons who handle them.
• Ratios are worked out on the basis of money value only. They
do not take into account the real values of various involved.
• Historical values are considered in working out the ratios.
However, the effects of changes in the price levels of various
items are ignored and to that extant the comparison and
evaluation of proposals through ratios become unrealistic.
• Ratio analysis is only a technique for making judgment and
not a substitute for judgment.

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 Limitations Contd.
• Ratios are only symptoms, they may indicate
what is to be investigated, only a careful
investigation will bring out the correct
position.

• Ratios calculated on the basis of past

statements need not necessarily constitute
true indicator of future.

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 Classification of Accounting Ratio
• On the basis of statements.

• On the basis of time.

• On the basis of nature.

• On the basis of functions.

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 On the basis of statements
• Balance sheet or position ratios.

• Profit and loss account or revenue ratios.

• Position-cum-revenue ratios.

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 On the basis of time

• Structural ratios: ratios computed from data

referred to the same point of time.

• Trend ratios: ratios compared between the

items referred to different period of time.
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 On the basis of nature

• Primary ratios: It measures the size of profit in

relation to capital employed.
e.g. operating profit to capital employed

• Secondary ratios: e.g. stock velocity, debtors

velocity, expense ratios
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 On the basis of function
• Financial ratios: current ratio, quick ratio,
proprietor ratio

• Profitability ratios: It would cover gross profit

ratio, net profit ratio, return on capital employed

• Market test ratio: It comprise of dividend yield,

fixed dividend cover, price earning ratio, etc.

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You may through any
question you have

Thank You
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