Accounting ratios are a very powerful tool for evaluating the performance of a business unit. The most important uses and advantages of accounting ratios are given below:
(1). Basis for comparison of two or more entities
The principal advantage of ratios is that they provide a basis for comparison. It is impossible to compare two absolute figures (from different companies, or sources) and to draw a meaningful conclusion. But two similar ratios can be compared and a meaningful conclusion drawn. For example, it would be unwise to compare the net profit of a company with that of another company without taking the other pertinent factors like equity, or sales, into account. If we compare net profit as a percentage of equity (ROE) of a company and compare it with ROE of another company, a meaningful comparison can be made. Similarly, we can compare net profit as a percentage of sales of ‘A’ company with that of ‘B’ company and make a judgment of their respective pricing policies and operational efficiency. The reason: in both cases, there will be one element common, i.e. an equity unit of 100 in the first case and a sales unit of 100 in the latter case.
(2). Measurement of financial performance of entity
Ratios can be used as a tool for measuring financial performance. For example, if a business achieves a higher sales volume (than previous year, or than budgeted level), and also a higher net profit – one may tend to ignore certain aspect of the performance. It would be more prudent to calculate, say, the net profit as a percentage of sales and see if that has also been improved, or at least sustained at previous year (or budgeted level). If that is not so, that would mean that increased sales have not brought in the due increase in profits. Let us take an example. If budgeted sales were, say, Rs 2,000,000 and budgeted net profit was Rs 200,000, it means the budgeted net profit margin was 10%. Now let us assume that actual sales achieved were Rs 2,500,000 and actual net profit was Rs 220,000. This means both the sales and net profit were above the budgeted levels. This may in itself be adequate source of satisfaction for certain managers. But a truly experienced manager will go a little beyond the absolute figures of sales and net profit. He would calculate the actual net profit margin (8.8% in this case) and compare it with the budget net profit margin (which was 10%). Now it can be seen, that the management been vigilant and succeeded in sustaining the net profit margin level, they could have achieved a net profit of Rs 250,000 (i.e. 10% of actual sales).
(3). A tool for controlling operational performance
Accounting ratios provide a means of controlling operational performance. By declaring certain ratios as benchmarks, management can control the performance of employees. For example, sales staff can be told that they can negotiate special deals and offer special discounts to their respective clients provided the gross profit margin on their total sales does not fall below a stated percentage. In this way, the operational staff gets adequate flexibility in their dealings and at the same time the profitability of the business also remains unimpaired.
(4) Use of ratios as benchmarks
Bench marks are also used to control use of resources tied up in total stock carried, debtors, etc. If benchmarks are set and operational staff is required to report regularly (say every month) on the level of stock (say in terms of rate of stock turnover, or average stock retention period), it’ would become obvious as to how efficiently the stock is being managed. Similarly, benchmarks provide a tool for controlling credit. If a benchmark of say 2 months credit allowed is set, no further credit should be allowed to a customer with longer than two months outstanding bills.
(5). Analysis of trends:
Accounting ratios calculated over a series of periods can provide an excellent means of noticing and analyzing trends. For example, if gross profit margin is falling from say 45% in 1997, to 44% in 1998, 40% in 1999 and say 38% in 2000, it can be seen that there is pattern or trend. If this trend or pattern is common industry, or countrywide, there is a useful lesson to be learned, and to be kept in mind when drawing up a pricing policy.
(6). Helpful in future planning
Accounting ratios are a great help in drawing up plans for the future. Ratios express relationship between different figures in an income statement or balance sheet. If only the major figures are forecast, or planned, other figures can be arrived at by applying the prevailing ratios to the key figures. Thus a total plan can be drawn up by forecasting only the key figures and setting the key ratios.