Question

In auditing the auditor must understand that although ratios are easy to compute, they depend entirely on the reliability of the data on which they are based, e.g. estimates of historical costs. Discuss why or why not ratios may not be depended on.

Answer 1

Ratios signifies the relationship between two variables that when one variable is divided on the other variable the resultant figure helps in decision making. These ratios can be relied upon only when the data presented in the financial statement reflect a reliable value without any deviation from the original value.

Why a company can rely upon ratios is because

1. It helps in measuring operational efficiency , liquidity, profitability and stability of an organization with help of computation of various relevant ratios

2. It helps in assesing the company's strength

3. It facilitates the company in making intra and inter firm comparisons

Why ratios cannot be relied upon , it is because

1. Information used in ratios are historical information and it foes not necessarily represent the company's future performance

2. Inflationary effects are ignored

3. It does not consider non cash items and human resources which plays a significant role