The calculation of ratio is very easy. But, the interested party or analyst should be very cautious while analyzing and interpreting the ratios. The following guidelines or factors may be kept in mind while analyzing and interpreting various ratios.
Guidelines or precautions while analyzing and interpreting ratios
1. Accuracy of Financial Statements
The stronger of the building is based on its foundation. Likewise, the accuracy of financial statements is based on the contents of the accounting records. The ratios are calculated on the basis of the data of financial statements.
The reliability of ratios in these statements are directly associated with the accuracy of information. Hence, the analyst should see whether proper accounting concepts and conventions are used for preparing financial statements before calculating ratios. Such type of precautions enlarge the reliability of ratios.
2. Objectives or Purpose of Analysis
The purpose of ratio analysis decides the types of ratios calculated. The purpose is decided by the interested party or an analyst. If the purpose is knowing long term solvency of the business concern, the long term solvency ratios are calculated. Therefore, different objectives may require the calculation of different ratios.
3. Selection of Ratios
The selection of ratio should be matched with objectives of analysis. Sometimes. large number of ratios are calculated without considering the purpose of analysis and interpretation. In such a case, there is a possibility of getting confusion instead of achieving the objectives.
4. Use of Standards
The financial position, strength and weakness of a business concern is.determined if the calculated ratios are compared with standard ratios of the concerned industry. These standards may be rule of thumb as in the case of current ratio (2:1) and liquidity ratio (1:1) i.e. industry standards. If not so, an analyst cannot arrive at conclusion.
5. Skill of Analyst
The skill and experience of the analyst are highly required for proper analysis and interpretation of ratios. A wrong interpretation leads to wrong conclusion. Finally, the top management or interested party may take wrong decision. Hence, the utility of ratio is linked with expertise of the analyst.
6. Ratios provide a Base Only
The calculated ratios provide only a base to the analyst. He need not rely fully on the ratios. He should study other relevant information, situation in the business concern, policy of the government changes, changes in the customers’ expectation, general economic condition and the like before reaching final conclusions.