Finance

The financial statements of any company provide quantitative insight of the performance of the company. Although all these figures are very important they do not give a detailed review of the companys overall performance. Therefore, the accounting ratios are used to do a detailed analysis of the performance of the company. For the purpose of analysis of companys performance such accounting ratios are compared with those of prior years or with industry averages.

USES OF RATIOS
Profitability Ratios
The progress of a company can be measured from its profitability. The figures of gross profit and net profit are not very significant unless expressed as a percentage of sales. The relation between gross and net profit can be used to determine how effectively the companys management is controlling its operating costs. Moreover, return on capital employed determines the efficiency and effectiveness of the management in using its available resources. Return on capital employed is helps analyze better when used for comparing a company with industry averages instead of the analysis of a company over a period (www.accaglobal.comarchivessa_oldarticles).

Liquidity Ratios
Liquidity ratios assess the cash flow position of a company. For this purpose current ratio and acid test ratio is used. Current ratio tells how many current assets the company has to deal with its current liabilities and explains how liquid a company is. A higher current or acid test ratio is favorable for a company as the higher the ratio the more funds are available with the company to deal with its debts. However, sometimes a very high ratio may be an indicator of the fact that most of the assets of the company are kept liquid therefore the company is not able to earn the best possible returns (www.accaglobal.comarchivessa_oldarticles).

Financial Ratios
All the current and prospective stakeholders of a company are interested in its financial position. Thedebt equity ratioshows the relationship between the debts of the company and the equity of the company. Theinterest cover ratioshows how much more interest the company pay with the available profit. The lower the interest cover ratio the higher the risk of default by the company. The company may have to face severe consequences if the interest payments and the principal payments are not made on timely basis. Theearnings per shareof a company shows how much profit the company has earned during the accounting period in relation to the number of shares issued to the ordinary share holders. The movement in earnings per share over time is used to analyze the investment potential of a companys shares (Kaplan, 2007).

PROS AND CONS OF RATIOS
Following are some of the benefits than can be derived from the use of accounting ratios.
Simplifyfinancial statementsThey make it easy to understand the financial statements. Although the financial statements give only the numerical aspect of the performance the company the ratios give the detailed insight on such figures.
Facilitate inter-company comparisonThey provide basis for inter-company comparison. Ratios emphasize the factors related to the successful and unsuccessful companies. They also reveal strong companies and weak companies, overvalued and undervalued companies.
Help in forecastingThey help in forecasting therefore, they can assist management, in its basic functions of planning.
Help in investment decisionsThey help the bankers and the investors in making their investment and lending decisions.
Following are some of the limitations of the accounting ratios.

Lack of comparative information Appropriate data is very important for the comparison and detailed analysis. Non availability of required data for comparison with similar company in the industry or with prior years performance of the same company will adversely affect the analysis
Limitations of historical cost accounting The financial statements on the basis of which ratios are calculated are prepared by using historical cost accounting. Therefore factors like inflation, impact of global recession and other similar factors may affect intercompany and over the period comparisons.
Dependency on financial information Ratio analysis may build a good or bad image of the company. The quality of the ratio analysis depends on the accuracy of the data on the basis of which ratios are calculated. If the accounts are poorly prepared, e.g., poor accounting policy or poor estimates of the management, then the conclusions drawn from the accounting ratios may be misleading
Comparison with past performance Past performance of a company may not always be the best basis for the analysis of the companys current and future performance. In fact, when the financial statements of a company become available for analysis they had already been out dated by few months due to the time taken for their preparation (Financial Ratio accounting for managment).

Accounting ratios are one of the key tools used by the stake holders of any company for interpreting its financial statements. However, care must be taken in drawing any conclusions a change or difference in a ratio may be an indicator of various factors and not necessarily of the companys good or bad performance.