Ratio is one of the important tools of financial analysis to various end-users such as management executives, investors, creditors and banks to assess the performance of a company in terms of liquidity position, long term solvency, operating efficiency, and profitability.
The efficacy of a company is affected by several factors. Some of these factors are discussed as follows:
Type of business: A businessâ€™s ratio is affected directly by the type of business being run. This affects the business ratios and by extension, this affects their interpretation. For example, a high ratio of debt to net worth can be expected of a public utility company operating with large fixed assets with social benefit considerations and of corporate entity applying trading on equity. Inventory turnover ratios vary considerably among industries.
Seasonal character: A businessâ€™s seasonal character directly affects its ratios and how they are interpreted. For example, inventory to sales ratio for a woolen cloth merchant during the winter season has a different meaning and is supposed to be much higher than during other periods of the same year.
Quality of assets: A businessâ€™s ratio analysis is affected directly by their quality of assets; thus, leaving the interpretation ambiguous. The current assets to current liabilities ratio is generally 2:1 and is considered more satisfactory for a liquid position of the company, but if for some proportion of the assets, an acid test ratio is calculated, it may give a different result and may depict an unsatisfactory position in the availability of liquid funds within the company to meet its most urgent and pressing obligations.
Adequacy of data: The adequacy of data must be considered while comparing different accounting factors with one another. For example, the average collection period for the bill receivables for a certain month may differ from those in other months or the average of the year. Another consideration would be whether the bill receivables have been properly valued for a period as overvaluation may render the ratio incomparable.
Modification of ratios: The modification of ratios deals only with an organizationâ€™s performance in the past. These must be modified and adapted to extend the understanding of a businessâ€™s future trends.
Change in accounting policies & accounting estimates: With the change in accounting policies and accounting estimates, there may be vast changes in the financial position of a company in comparison to the previous years, which makes the ratios from before and after such a transition incomparable.
Interpretation of ratios: On their own, interpretation of ratios can be inaccurate without the other relevant accounting documents. Thus, these ratios must be interpreted only in the context of other accounting data associated with them, as they would provide a faulty picture, when considered alone.
Accuracy: Storing wrong information can be far worse than storing no information at all. It does not mean that ratios have to be calculated to four decimal places, but anyone using the figures should be able to rely on the fact that the numbers can tell a true story.
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