Accounting Ratios

While ratio analysis is useful, it also has several limitations. Since ratios are calculated from past financial statements, they reflect historical conditions and may not represent the current or future financial performance of the business. Moreover, ratios can become misleading if the underlying accounting data contains inaccuracies, manipulations or inconsistencies. Another limitation is that ratios do not consider qualitative factors such as management efficiency, economic conditions or market competition. Industry norms also vary widely, making comparisons difficult. Inflation can distort financial values as well, reducing the reliability of ratios over time. Overall, ratios should be used carefully along with other financial and non-financial information for accurate interpretation.

Solvency ratios determine the firm's long-term financial stability and ability to meet future obligations. They include debt-equity ratio, proprietary ratio and interest coverage ratio. Liquidity ratios indicate short-term ability, activity ratios measure efficiency and profitability ratios show earnings. Long-run survival depends on the firm's capacity to repay long-term debts, which is why solvency ratios provide the most critical information for long-term operations.

Profitability ratios measure a firm's ability to earn profits from its resources and operations. They include return on equity, net profit ratio and return on capital employed. Liquidity ratios measure short-term obligations, activity ratios measure efficiency and debt ratios measure long-term solvency. Because profitability ratios focus on returns, they are used to judge whether a company is generating adequate earnings relative to sales, assets or capital.

The old ratio of X, Y and Z is 3 : 2 : 1. Total share is 6 parts. X's share is 3/6. Y and Z take this share in the ratio of 3 : 2. Therefore, Y gets 3/5 of X's share which equals 3/6 × 3/5 = 9/30. Z gets 2/5 of X's share which equals 3/6 × 2/5 = 6/30. Their old shares were Y = 2/6 and Z = 1/6. Adding the gained shares, Y becomes 2/6 + 9/30 and Z becomes 1/6 + 6/30. After converting to a common denominator and simplifying, the new ratio of Y and Z becomes 19 : 11. This ratio represents how they will share profits after X's retirement.

Old ratio of Anu, Vanu and Tanu is 4 : 3 : 2. When Anu retires, her share is 4 parts out of 9 total parts. Vanu and Tanu's old shares are 3/9 and 2/9 respectively. Their new ratio is 5 : 3, which means Vanu receives 5/8 and Tanu receives 3/8. To calculate the gaining ratio, we find the difference between new share and old share. Vanu's gain is 5/8 minus 3/9 and Tanu's gain is 3/8 minus 2/9. After calculating the values, their gains simplify to 27/72 for Vanu and 13/72 for Tanu, giving a gaining ratio of 27 : 13. This ratio shows how much of Anu's share is gained individually by Vanu and Tanu.