Accounting ratios - such ratios, which are created based on market data regarding the company and based on information contained in the company's financial statements, such as balance sheet, profit and loss account, and cash flow statement. They are used to analyze the condition of the company and help in making decisions in the future.
Ratio analysis is an essential element of financial analysis. When conducting index analysis, it should be remembered that it is based on historical data. Ratio analysis also has some advantages over other financial analyzes - it is simply simple. Thanks to the indicators, we can quickly and accurately determine the current trends and changes in financial condition.
Features of financial indicators
Financial indicators must have the following characteristics:
- Measurability - this feature is ensured by using measurable parameters (derived from the financial statements) for calculations.
- Comparability - allows comparing the financial indicator to a specific factor in time (changes over the years), planning (plan versus reality), spatial (between companies from the same industry but different economic markets), industry (between companies from the same industry).
- Interpretability - allows you to read the result and determine the situation, condition of the enterprise.
Basic distribution of financial indicators
The following financial indicators can be distinguished:
- Liquidity ratio - used to measure and monitor the company's ability to meet short-term liabilities. Maintaining financial liquidity is one of the basic tasks of any business entity that wants to maintain good conditions on the market.
- Return on investment - is one of the most important indicators and is used to assess the amount of profit achieved. When analyzing profitability, the following are distinguished: sales profitability, economic profitability, financial profitability.
- The activity indicator - or the efficiency indicator - gives information on how quickly the company has to pay its debts. It is divided into two groups: rotation and cycle indicators.
- Market value indicator - as the name implies, it is to assess the market value of an enterprise and does so based on the value of its shares on the stock exchange. It should be remembered here that when discussing this indicator, one should take into account the average for a given industry because it does not give an absolute result.
- Debt ratio - is an extension of the financial liquidity ratio and informs about the company's debt and repayment capacity. This ratio is important for credit institutions because the higher its value, the greater the risk that the borrower will not be able to repay the loans taken out.
Examples of Accounting ratios
- Current ratio: This is a liquidity ratio that measures a company’s ability to pay short-term obligations. It is calculated by dividing current assets by current liabilities. For example, if a company has $20,000 in current assets and $15,000 in current liabilities, the current ratio would be 1.33 (20,000/15,000).
- Debt-to-Equity Ratio: This is a solvency ratio that measures a company’s financial leverage. It is calculated by dividing total liabilities by total equity. For example, if a company has $100,000 in total liabilities and $200,000 in total equity, the debt-to-equity ratio would be 0.5 (100,000/200,000).
- Return on Assets (ROA): This is a profitability ratio that measures a company’s ability to generate profits from its assets. It is calculated by dividing net income by total assets. For example, if a company has a net income of $50,000 and total assets of $150,000, the ROA would be 0.33 (50,000/150,000).
- Operating Profit Margin: This is a profitability ratio that measures a company’s ability to generate profits from its operations. It is calculated by dividing operating profits by total revenue. For example, if a company has operating profits of $20,000 and total revenue of $100,000, the operating profit margin would be 0.2 (20,000/100,000).
Advantages of Accounting ratios
Accounting ratios provide a quick and relatively easy way to assess a company’s performance and financial health. There are many advantages to using accounting ratios, including:
- The ability to compare a company’s performance over time, as well as against competitors. This allows management to identify any potential problems and take corrective actions early on.
- Accounting ratios provide deeper insights into a company’s financial position and performance, enabling managers to make more informed decisions.
- It allows companies to evaluate the cost structure of the company and identify areas where costs can be reduced.
- Accounting ratios also help to identify areas where the company can improve its efficiency and productivity.
- Accounting ratios can be used to identify potential opportunities for growth, as well as areas where the company can reduce its risk.
- Accounting ratios are also useful for investors, as they can use the ratios to analyze a company’s financial position and make decisions about investing in the company.
Limitations of Accounting ratios
Accounting ratios have several limitations, which must be taken into consideration when assessing the financial health of a company. These limitations include:
- Accounting ratios are backward looking and do not take into account future projections and potential risks. They are also based on historical data, which may be outdated and not applicable to the current situation.
- Accounting ratios are limited by the quality and accuracy of the financial statements and data used. If there is any inaccuracy in the data, then the ratios can be unreliable.
- Accounting ratios are based solely on numbers and do not consider other important factors such as customer service, company culture, and other intangible assets.
- Accounting ratios are subject to manipulation by the management of the company, who may use accounting techniques to artificially increase or decrease certain ratios.
- Accounting ratios may be misinterpreted as they do not provide a full picture of the company's financial condition. They should be used in conjunction with other financial analyses in order to make a comprehensive assessment.
Apart from Accounting ratios, there are other approaches that can be used to analyze the condition and performance of a company.
- Benchmarking: It is the process of comparing the performance of a company to the performance of other companies in the same industry or sector. It helps to identify areas of strength and weaknesses and to learn from the best practices of other companies.
- Financial Statement Analysis: It is a method used to analyze a company’s financial statements to assess its performance, liquidity, and financial health. This helps to identify potential problems and opportunities.
- Ratio Analysis: It is the process of calculating and analyzing financial ratios to assess a company’s performance and financial health.
- Cost Analysis: It is the process of analyzing costs to identify areas where cost savings can be made or where cost overruns have occurred.
- Cash Flow Analysis: It is the process of analyzing the movement of cash in and out of a company in order to assess its liquidity and financial health.
- Trend Analysis: It is the process of analyzing historical data to identify trends in the financial performance of a company.
In conclusion, apart from Accounting ratios, there are other approaches such as Benchmarking, Financial Statement Analysis, Ratio Analysis, Cost Analysis, Cash Flow Analysis, and Trend Analysis that can be used to analyze the condition and performance of a company.
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Author: Julianna Lekarczyk