by Michael Nnopu

Created on: October 04, 2010   Last Updated: October 05, 2010

In the life of every business organization, there comes a time when it actually needs to know how it stands and it does this by taking a step further from the preparation of the financial statements to better understand how it is performing vis-à-vis other similar businesses in the industry. Even creditors, suppliers, and potential lenders of short and long-term funds all, want to determine the ability of the firm to pay back with interest as at when due. Potential shareholders also want to know about the profitability of the organization. This is where ratios come in.

Accounting ratios or financial ratios help to evaluate the financial position of a company from its published financial statements. It is used to describe the relationship between the figures shown on the financial statements. In very simple words, Profitability is the ability of a firm to increase its capital after a trading period; or the excess of income over expenses. While liquidity is the ability to meet its short term expenditures as the fall due.

In accounting several types of ratios are used such as liquidity ratios, profitability ratios, leverage ratios, activity ratios, debt ratios, market ratios, etc. but of all these, the most often used is the liquidity and profitability ratios.

Ratios are usually expressed as a percentage or a fraction or decimal. Using ratios has the following advantages and disadvantages. It makes the understanding of financial statements easy. Ratios tell the whole story in just a figure. It enables oranges to be compared with oranges instead of apples. It facilitates inter firm and intra firm comparison. Ratios also assist management in planning, as the reveal things hitherto unknown which help management take corrective and preventive actions before things get bad. It also helps investment decisions of users. A high profitability ratio tells users that the firm is highly profitable and good to invest in.

Ratios also have drawbacks. First, Ratios are based on financial statements alone, and financial statements do not tell the complete story. For instance, financial statements do not directly reveal the exceptional leadership abilities of the directors. There is also  subjectivity in its interpretations. While ¼ may be acceptable to be Mr. A as a good value, Mr. B might consider it as a danger zone.  While using ratios, it is important to understand their limitations as an interpreter of financial statements, so that overly optimistic or pessimistic relevance are not given to their values.

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