Calculation of ratios is comparatively simple, routine clerical in nature but
interpretation of ratios is highly sophisticated and intricate phenomenon. The
benefit of ratio analysis depends a great deal upon the correct interpretation.
It needs skill, intelligence, training, farsightedness and intuition of high
order on the part of the analyst. The following are different ways in which ratios
may be interpreted:
Individual ratio may have significance of its own. For example, if the
current ratio unit continuously falls, it may indicate probable insolvency. But
generally single ratio may not convey any sense. However single ratio may be
studied with reference to certain popular rules of thumb which can only give
approximations. Care must be exercised because such comparison may be erroneous
Ratios may be interpreted by considering group of several related ratios.
Such interpretation may be more meaningful. For example, current ratio may be
studied along with liquid ratio. Similarly profitability ratios may be studied
along with return on investment.
Comparison with Past:
Ratios may be interpreted by making comparison over a period of time i.e. the
same ratio be studied over a period of years of the same unit. It will highlight
the significant trend revealing use, decline or stability of the phenomenon.
Average value of the ratio for the past number of years can serve as a standard
against which current performance may be measured. While interpreting ratios
from comparison over a period of time one should be careful about the changes
which might have taken place during the time. For example, price index; changes
in managerial policies or changes in accounting practices etc.
Comparison with Projections:
In a business unit where system of budgetary control and forecast is in
existence, projected financial statements are usually drawn. Ratios calculated
based on such projected financial statements shall act as the standards with
which the ratios calculated from the present financial statements shall be
compared. Variances shall be calculated and analyzed by reasons and persons. It
shall enable to take corrective action wherever required.
Inter-firm or Inter-Industry Comparison:
Ratios of one unit may be compared with the ratios of another identical unit
or with the
industry average at the same point of time. Such comparison is useful for
evaluating relative financial position of the unit vis-à-vis other units or
industry. While making such comparison, care must be taken regarding the
difference of accounting methods, policies, procedures and terminology being
followed by different units.