The relationship of accounting ratios in Balance Sheet
It is said that Financial Management starts from the point, where Accountancy ends. In fact Accountancy forms the backbone of the financial management. According to the American Institute of Certified Public Accountants (AICPA), Accountancy is defined as
-the art of recording, classifying and summarising in a significant manner and in terms of money transactions and events which are, in part at least, of a financial character, and interpreting the results thereof-
If we interpret the definitions, we get some unique characteristics of accounting. The first one is the transactions, which are accounted for, must be of financial nature. That is Accountancy deals with quantitative data of the business transactions and not with the qualitative information. The second one is, Accountancy not only records the financial data but it also interprets data by finding out the profit/loss of the company as well as by giving the assets and liability status of the company at the end of the accounting period or the financial year. The Final accounts consists of the Income Statement and the Statement of Affairs of the company and provide valuable information about the operating profit/loss as well as the financial health of the organisation for the management and for the outsiders like shareholders, Government agencies, creditors and potential investors of the company. In fact the Balance Sheet of the company reflects the financial health of an organisation and, coupled with the Income Statement, forms the basis of almost all kinds of qualitative analysis on which the financial management of the company largely depends. One such tool for qualitative analysis is Ratio Analysis which gives an insight to a host of qualitative information for the management and plays a significant role in the deciding the future course of action of a company.
Before discussing the relationship of the accounting ratios and Balance Sheet, we will take a brief look at the roles played by the financial ratios in financial management.
The accounting data and the final accounts (Income Statement and the Balance Sheet) give only the quantitative figures about the various items of the Income Statement as well as the assets and liabilities. These data fail to convey the insight to the financial performance when act as standalone quantitative data. Ratio analysis helps to work out the relationship in between various items of the accounting data and reflect the interdependencies of those and the influence of one item on the other to affect the financial performance of the organisation. The financial ratios are really the first most significant tools in the hands of the strategic managers to take a stock of the financial situation of the organisation and to interpret the performance of the organisation in various fronts of the company activities. The financial ratios like the debtors’ turnover, the inventory turnover, the debt to equity ratio, the profitability ratios are all provide significant information to the management to identify the loopholes of the financial decisions and to decide on the financial strategies for the forthcoming years. The ratio analysis is also important tool for the inter-firm comparison in the same industry to have the idea how the organisation is performing in comparison to its competitors and what is the scope of development in various front of the operation of the company. Financial ratios depict the reasons for the precarious results of the organisation and when listed for several years, they also help the company for a trend analysis of the performance of the company indicating the changes in the financial performance and the reasons thereof over the years. This trend analysis helps a lot to predict and estimate the future performance of the company. However, financial ratios are not self sufficient to reflect all the cause and effect relationship in between the financial variables and it has its own limitations. The results that are reflected by the financial ratios should be corroborated by other analysis to get the best possible picture and to help the management to make the best possible financial strategy for the organisation.
The role played by the Balance Sheet in finding out the ratios is paramount. In fact most of the vital ratios are formed on the basis of the data given in the Balance Sheet of an organisation. As Balance Sheet reflects the financial health of the organisation, the financial ratios calculated using various figures of the Balance Sheet reflect provides most important information to the managers for proper analysis of the financial performance as well as for the future financial planning. To understand the relation between the financial ratios and the Balance Sheet it is better to look at the derivation of some ratios based on the Balance Sheet figures and their use in interpreting the financial situation of an organisation.
Debt to equity Ratio:defined as the ratio between the long term debts to total funds. Here total funds comprise of the shareholders’ fund plus the long term fund. This ratio shows how much of the total fund has been financed by debt. The financial leverage of the firm is very important in the sense that, it indicates the financial risk of the firm. The more the ratio, the more is the financial leverage and the more is the financial risk of the firm. In general, the debt capital should be used judiciously, and up to the extent it helps the management, to increase the wealth of the shareholders. Debt capital, if used beyond a certain limit, will act against the interest of the shareholders and will lead to an increase in the cost of equity as the shareholders will expect a higher return because of the increased financial risk of the company.
Ratio of long term funds to fixed assets:This one is calculated as the ratio of the long term funds to the fixed assets of the organisation. The long term fund means the shareholders’ fund plus the long term debt capital. This ratio indicates how much portion of the fixed asset has been financed by the long term funds. This is because of the fact that the fixed assets should preferably be financed by long term funds only. If the ratio is less than one the company is supposed to follow a faulty policy of using the short term funds to finance thefixed assets. However if the ratio is more than one, it reflects, the managementhas failed to use the longterm funds in a prudent manner as this means the long term funds have been acquired by the company and is being kept either idle or is unwisely using it to finance the working capital requirement of the company.
Current Asset ratio:One of the most important ratios to decide the short term solvency of the firm. It is calculated as the ratio of the current assets to current liabilities of the firm. If the current ratio is less than 2 (varies from industry to industry) then the company is said to be suffering from the short term solvency to honour its short term obligations. However, a higher current ratio, than is warranted by a particular industry, signify poor working capital management, as in that case the short term fund gets locked up in current assets thereby raising the cost of short term fund for the company. This ratio, therefore gives an insight to the management about how to deal with the various items of current assets and current liabilities, which have a direct bearing on the working capital management of the firm.
There are other ratios for which the various items of Balance Sheet are required. The ratios like Inventory turnover, debtors’ turnover, creditors’ turnover, fixed asset turn over, Return on capital employed are calculated on the basis of the information given in the Income Statement and the Balance Sheet of the firm. When the debtors’ turnover ratio gives an indication, how quickly the debtors of the company are being converted into cash and whether the credit policy of the receivables management of the company is at the best interest of the company, the return on capital employed indicates the performance of the company in generating the return as a percentage of the capital employed and whether the capital employed is being used efficiently to generate the best possible return for the company.
The above accounts of various financial ratios have been cited as an example to clarify how Balance Sheet items are used to find important ratios and why the ratios are found. Balance Sheet provides the platform wherefrom various accounting ratios are calculated and these ratios together with the quantitative information provide the management an insight to the performance of the company as well as the efficiency and effectiveness of various policies and the impact of those policies on the financial performance of the organisation. The result of the financial ratios when coupled with the Balance Sheet information provides the foundation, on which the entire financial analysis of the organisation starts and leads the way to form a sound financial planning for the company for the coming years.