An analyst irrespective of his cast and creed has; however, to bear in mind that, interpretation of Financial Statements of a firm with the help of ratios becomes significant and meaningful when the same is accomplished in the backdrop of some established Standard in this regard.
This Standard depends upon the own experience of the analyst or may be had from the reference of the past records of those firms whose performances had already been standardized or by having recourse to the data of the identical types of enterprises.
Besides, an analyst has also to take note of two other factors while attempting to interpret the Financial Statements of a firm or firms with the help of ratio analysis. One of them is that, a standard which is most significant today, may be less significant or less important at a future date under changed circumstances. That is to say, Standard is always changing.
The other one is that Standard varies from industry to industry, even from firm to firm under the same industry within the same span of time. For example, a current ratio of 1.50 to 1, may be found quite satisfactory in one industry, but hopelessly poor in another. Again, a current ratio of 1.25 to 1, may be found quite workable in firm ‘A’, but absolutely inadequate for another firm ‘B’ within the same industry, say, Jute.
In other words, it means that it is very difficult to find out a common Standard ratio which is universally applicable for all the industries under all the different time periods. Therefore, it may be suggested that each firm must build up its own standard ratio to suit its own requirements.
Selection of Standard or Normal Financial Ratio:
The possible approaches for the establishment of the standard or Normal ratios may be any one of the following:
(a) Average-Historical Ratios;
(b) Budgeted Financial Ratios;
(c) Financial Ratios of Nearest Competitor; and
(d) Industry Average Ratios.
(a) Average Historical Ratios:
With reference to a firm, it will be one that one may arrive at, on the basis of the average of ratios calculated from Financial Statements, relating to the past periods. This Standard can be used only in those cases where past dates are available. The main limitation of such ratios is that they are based on the past performances of the firms which might not have been satisfactory.
Moreover, it does not make room for changes that might have taken place in the current financial year in the internal and external environment of the firm. Further, it becomes difficult to locate the relative position of the firm in the industry on the basis of these ratios.
(b) Budgeted Financial Ratios:
When budgeting system is followed by a firm, it is possible to have predetermined financial ratios either at a particular volume of activity in case of fixed budget, or at different achievable volume of activity, in case of flexible budget.
These budgeted ratios are deemed better Standard than the aforesaid Average Historical Ratios owing to the fact that, although both these ratios are based on past data, it eliminates the snags in Average Historical Ratios, as it makes allowances for likely changes in the internal or external environment of firms.
A comparison of actual ratios calculated from Current Financial Statement with Standard Ratios calculated from the budget, is expected to focus light on the effectiveness of managerial policy. But the Budgeted Financial ratios are not also fool proof by themselves. They have also some limitations.
For example, Standard Ratios calculated from budgets are based on a number of forecasts, they, therefore, invariably suffer from the limitation inherent in forecasting. Moreover, the relative position of the firm is also not disclosed by a comparison with such ratios. Finally, the use of such Standard ratios is limited to the internal analysis only as budgets hardly form a part of published annual reports of firms.
(c) Financial Ratios of Nearest Competitor:
To overcome the limitations of Standard Ratios derived either under the Average Historical Ratios or under Budgeted Financial Ratios which do not provide a basis for measuring the relative position of firms, the Financial Ratios of the Nearest Competitor for the current period may be accepted as Standard or Normal Ratios.
These ratios being shorn off uncertainties associated with forecast are expected to gauge managerial efficiency better than it is possible under ratios discussed earlier. Further, these ratios have the advantages that they can be used both by internal and external analyst.
But, these ratios, as Standard, 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, production process, size age, location, customers, accounting system and financial policies, etc., perused during the current financial year.
Therefore, unless the competing firm in question is normal or comparable one, Standard Ratios based on the Financial Ratios of the Nearest Competitor will be of no use.
(d) Industry Average Ratios:
Under this method, the emphasis is 011 the derivation of Standard Ratios on the basis of data relating to a large number of units belonging to an industry. This is suggested with a view to avoid the problems associated with the same based on Financial Ratios of the Nearest Competitor.
These ratios have further the advantages that, they not only minimise the effect of external values but also derive the benefits of inertia of large numbers.
These ratios also go by the name of Industry norms and can be computed in any one of the following two ways:
(i) Average ratios based on consolidated or composite statements of the industry;
(ii) Average ratios based on ratios computed in different units of the industry.
Under the former, ratios are calculated on the basis of consolidated statements of the industry.
But though these ratios may be considered appropriate for studying the position of industry as a whole, doubts remain about the efficacy of the same for vertical comparison, as they suffer, first, from the limitation that these ratios merge together with financial items of different units in the industry as if they are interdependent and related to one another, whereas, in reality, these units are independent.
And secondly, from the fact, that, they do not allow for testing of ratios to see whether they are representative of the ratios of the units belonging to the industry.
Under the later method, (ii), Standard Industry Ratios are computed as average of ratios worked out for different units of an industry individually. These ratios are said to be free from the limitations found in the ratios calculated under the former method, viz. Average ratios based on consolidated statement of the industry.
Further, as these ratios represent the average relationship and, therefore, their validity can be evaluated on the basis of ratios computed for individual units. Moreover, to make these ratios more meaningful, it is possible under this method to prescribe the tolerance limit.
From what have hitherto been said regarding the establishment of Standard or Normal ratios, it appears that Industry Average ratios based on the ratios’ computed in different units of the industry, is probably the best one so far as the vertical comparison is concerned.