Quality of Financial Statements:
The reliability of ratios is linked with the quality of financial statements.
Financial statements which have been prepared by faithful adherence to generally
accepted accounting principles (GAAP).
Generally accepted accounting principles are likely to contain reliable data.
Calculation of ratios from such financial statements is bound to be more useful
Purpose of Analysis:
Users of accounting information are different such as short-term and
long-term creditors; owners and would be investors; trade unions; tax
authorities; competitors etc., object of each group of interested parties is
also different such as liquidity or solvency or profitability, etc. So, before
undertaking the analysis, one should be clear about the object of analysis. It
is the object of
analysis which determines the area (liquidity, solvency, profitability,
leverage, activity etc.) to be
studied, analyzed and interpreted.
Selection of Ratios:
There is no end to the number of ratios which can be calculated. In 1919,
Alexander Wall developed an elaborated system of ratio analysis. The same has
been extended and modified over the period of time. So the ratios to be
calculated should be selected judiciously taking into consideration the object
of analysis. The ratios selected should serve the purpose of analysis. For
example, short term creditors 'purpose is liquidity whereas owners' purpose may
be served by solvency.
Standards to be Applied:
Any ratio in itself i.e. in isolation is meaningless. It must be compared
with some standard to arrive at any logical conclusion. The analyst can choose
the comparing standard from (a) Rule of thumb (b) past ratios (c) projected
standards or (d) industry standards. Selection of standards for the purpose of
interpretation will also depend upon the object of the analysis and the capacity
of the analyst. For example, management (being the insider) can opt. for
project standards whereas any outsider's choice shall be limited to the
published information of the unit.
Capability of the Analyst:
Analysis is a tool in the hands of the analyst. Knife (as a tool) in the
hands of a criminal may take the life but the knife (as a tool) in the hands of
a surgeon may give new life to a patient. Interpretation depends on the
educational background; professional skill; experience and intuition of the
professional conducting it.
Ratios to be used only as Guide:
Ratios can provide, at the best, the starting point. The analyst, before
arriving at the conclusion, should take into consideration all other relevant
factors financial and non-financial; macro and micro. For example, general
condition of economy; values of society; priorities of the government etc., are
the important factors.