Question

Discuss how to choose, use, and interpret ratios.

Answer 1

Accounting ratios play a very important part to understand the financial position of any organisation. The investors in the stock market use the accounting ratios to determine and calculate the risk involved and the return to be expected out of their investments. The organisations and their analysts use these ratios to predict the organisations future and also to have an idea of the future profitability positions.

Some of the basic accounting ratios, their use and interpretations is mentioned in the table below:

Ratio Name	Fomula	Interpretation
Gross Profit Ratio	Gross profit / Sales	It is the most basic ratio to gain an understanding about company's profitability and to undestand what portion of sales are we saving as profits. It can be used with projected values to determine company's expected future profitability. Higher the better.
Current Ratio	Current Assets / Current Liabilities	This is also known as the acid test ratio. This ratio gives us the basic idea about the liquidity of any company. It basically shows the ability of company's assets to cover it's liabilities. An ideal ratio is considered to be 2:1 that is, the assets of the company are twice it's liabilities. Higher the better.
Debt- Equity Ratio (Gearing Ratio)	Total Liabilities / Shareholder's Equity	The debt equity ratio gives an idea about the company's financial leverage, that is the amount of debt the company is taking to increase it's value by using the borrowed money to finance it's projects. Generally a higher debt equity ratio is not considered good because the outside debt is generally provided at a higher cost and the company taking more outside debts would lose it's major earnings to pay of the debt costs and resulting in lower income to stakeholders. Therefore, a higher debts outweighs the company's ability to perform better.
Payout Ratios (Dividend payout ratio)	(Dividend per share / Earning per share) * 100 or (Dividends paid / Net income) * 100	This ratio basically gives us and idea as to what portion of net income earned is being paid out to the investors and stakeholders as dividends. A higher ratio is generally not considered good as it shows that the company has higher amounts of dividends to pay as compared to the net income earned. a general ratio of 0.5 is considered adequate.
Valuation Ratios (Earnings ratio)	Net Income / Total No. of shares	This ratio basically tells us the net earning that each share of the organisation is going to provide us. This is the net income of each part of your investment. The higher is considered better from point of view of the investor as well as the company.

There are many advantages derived from ratio analysis, such as :

1. Helps to understand efficacy of decisions: The ratio analysis helps you to understand whether the business firm has taken the right kind of operating, investing and financing decisions. It indicates how far they have helped in improving the performance.

2. Simplify complex figures and establish relationships: Ratios help in simplifying the complex accounting figures and bring out their relationships. They help summarise the financial information effectively and assess the managerial efficiency, firm’s credit worthiness, earning capacity, etc.

3. Helpful in comparative analysis: The ratios are not be calculated for one year only. When many year figures are kept side by side, they help a great deal in exploring the trends visible in the business. The knowledge of trend helps in making projections about the business which is a very useful feature.

4. Identification of problem areas: Ratios help business in identifying the problem areas as well as the bright areas of the business. Problem areas would need more attention and bright areas will need polishing to have still better results.

5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring in the business. The information of change helps the management a great deal in understanding the current threats and opportunities and allows business to do its own SWOT (StrengthWeakness-Opportunity-Threat) analysis.