In this article we will discuss about the standard of comparison of ratios and projection of future through ratios.
Standard of Comparison:
The ratio analysis involves comparison for useful interpretation of the financial statements. Interpretation of financial statements of a firm with the help of ratios becomes significant and meaningful. The ratios should be compared with some standard ratios. When actual ratios have been found out, they should be compared with some such ratios which may be termed as an ideal ratio.
These ideal ratios are called standard ratios. These standards may be of the following types, but selection of standards depends on the nature and circumstances of the firm and choice of management.
(1) Average Historical Ratios:
Ratios are calculated from the past financial statements of the same firm. The easiest way to evaluate the performance of a firm is to compare its present ratios with the past ratios. This standard can be used only in those cases where past data are available. These standard or normal ratios are suitable when there is no change in the accounting policies and procedures. It does not make room for changes.
(2) Ratios of Selected Firms:
Another way of comparison is to compare the ratios of one firm with some selected firms in the same industry at the same point of time. The financial ratios of the nearest competitor for the current period may be accepted as Standard or Normal Ratios. A firm can easily resort to such a comparison, as it is not difficult to get the published financial statements of the similar firms.
But these ratios, as Standards, have the hazards that nearest competing firm, from the financial statements of which, the standard ratios are to be derived, may not be a normal or comparable firm as it may differ with regard to product-mix, manufacturing process, age, size, location, customers, accounting system, financial policies etc.
(3) Ratios of the Industry to Which the Firm Belong:
To determine the financial condition and performance of a firm, its ratios may be compared with average ratios of the industry of which the firm is a member. Such ratios are important standards in view of the fact that each industry has its characteristic which influence the financial and operating relationships. The average ratios will be meaningless and the comparison futile, if the firms within the same industry widely differ in their accounting policies and practices.
(4) Absolute Standard Ratios:
Experts have laid down some standards after making numerous experiments in various companies and at various places. On the basis of such standards, ratios have been found out, and these ratios are called Standard Ratios or Absolute Ratios or Ideal Ratios. They are used all over the world, that is, such ratios are regarded as standard ratios everywhere. Due margin should be given for variations at the time of interpretation.
Projections through Ratios:
The ratio analysis can also be used in making future projections regarding various items of Income Statement and Balance Sheet. Proforma statements can be drawn which may help the management in evaluating the actual performance. For this purpose, past account data are used for the calculation of various accounting ratios, taking into account the expected changes.
Thus Standard ratios are prepared. These Standard Ratios are used in making forecasts in respect of several items of Income Statement and Balance Sheet. We have to find out various items by interpolations and extrapolations. At this stage, knowledge of ratio calculations and great skill of reasoning are needed.