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BAC 207: Fundamentals of Accounting II Notes on Ratio Analysis

Institution: University of Embu

Course: Bachelor of Education

Content Category: Lecture Notes

Posted By: 01115451xx

Document Type: PDF

Number of Pages: 7

Price: KES 100
 
    

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Summary

Ratio Analysis

Ratio

A ratio is a simple arithmetical expression of the relationship of one number to another. It is an expression of the quantitative relationship between two numbers

Managerial Uses of Ratio Analysis
The following are the important managerial uses of ratio analysis –
a. Helps in Financial Forecasting: Ratio analysis is very helpful in financial forecasting. Ratios relating to past sales, profits and financial position form the
basis for setting future trends.
b. Helps in Comparison: With the help of ratio analysis, ideal ratios can be composed and they can be used for comparing a firm's progress and performance.
Inter-firm comparison or comparison with industry averages is made possible by the ratio analysis.
c. Financial Solvency of the Firm: Ratio analysis indicates the trends in financial solvency of the firm. Solvency has two dimensions-long-term solvency and shortterm solvency. Long-term solvency refers to the financial viability of a firm and it is closely related with the existing financial structure. On the other hand, shortterm solvency is the liquidity position of the firm. With the help of ratio analysis conclusions can be drawn regarding the firm's liquidity and longterm solvency position.
d. Evaluation of Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets and resources. Various activity ratios measure this kind of operational efficiency and indicate the guidelines for economy in costs, operations and time.
e. Communication Value: Different financial ratios communicate the strength and financial standing of the firm to the internal and external parties. They indicate the over-all profitability of the firm.
f. Others Uses: Financial ratios are very helpful in the diagnosis of financial health of a firm. They highlight the liquidity, solvency, profitability and capital gearing etc. of the firm.

Draw Backs of Ratio Analysis
a. Limited use of a single ratio: Ratio can be useful only when they are computed in a sufficient large number. A single ratio would not be able to convey anything.
At the same time, if too many ratios are calculated, they are likely to confuse instead of revealing any meaningful conclusion.
b. Effect of inherent limitations of accounting: Because ratios are computed from historical accounting records, so they also possess those limitations and
weaknesses as accounting records possess.
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