The interpretation of ratios analysis important factor

The interpretation of ratios is an important factor. Though calculation of ratios is also important but it is only a clerical task whereas interpretation needs skill, intelligence and foresightedness. The inherent limitation of ratios analysis should be kept in mind while interpreting them. The impact of factors such as price level changes, Change in accounting policies, window dressing etc., should also be kept in mind when attempting to interpret. A single ratio in itself does not convey much of the sense. To make ratios useful, they have to be further interpreted. For example, say, the current ratio of 3:1 does not convey any sense unless it is interpreted and conclusion is drawn from it regarding the financial condition of the firm as to whether it is very strong, good, questionable or poor. 

The interpretation of the financial ratios can made

• Generally speaking one cannot draw any meaningful conclusion when a single ratio is considered in isolation. But single ratios may be studied in relation to certain rules of thumb which is based upon well proven conventions as for example 2:1 is considered to be a good ratio for current assets to current liabilities.

• Ratio may be interpreted be calculating a group of related ratios. A single ratio supported by other related additional ratios becomes more understandable and meaningful. For example, the ratio of current assets to current liabilities may be supported by the ratio of liquid assets to liquid liabilities to draw more dependable conclusions.

• One of the easiest and most popular ways of evaluating the performance of the firm is to compare its present ratios with the past ratios called comparison overtime. When financial ratios are compared over a period of time, it gives an indication of the direction of change and reflects whether the firm's performance and financial position has improved, deteriorated or remained constant over a period of time. But while interpreting ratios from comparison over time, one has to be careful about the changes, if any, in the firm's policies and accounting procedure.

• Ratios can also be calculated for future standards based upon the projected or proforma financial statements. These future Ratios may be taken as standard for comparison and the ratios calculated on actual financial statements can be compared with the standard ratios to find out variances, if any. Such variance help in interpreting and taking corrective action for improvement in future.

• Ratios of one firm can also be compared with the ratios of some other selected firms in the same industry at the same point of time. this kind of comparison helps in evaluating relative financial position and performance of the firm. But while making use of such comparison one has to be very careful regarding the different accounting methods, policies and procedures adopted by different firms.