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Ratio Analysis for Decision Making

This discussion is centred on the purpose of ratios in management accounting. Ratios play a pivotal role in the management accounting function of any organization. The main objective of ratio analysis is to use the results for decision making purposes. However, it is to be noted that ratios have no meaning unless the figures are interpreted. In each instance the user should attempt to explain exactly why an account reveals this behaviour. Accounting ratios identify and highlights the areas of poor performance and areas of satisfactory performance.

Ratios used in management accounting illustrate the relationship between financial statements. The usefulness of a ratio depends on what aspects of the company’s business affairs are being investigated. Financial ratios should be used correctly for it to be effective; when it comes to comparing the company’s financial ratio it must be compared with identical basis. In management accounting, ratio is comparing two values, any changes in each of these values over time would be shown in the final ratio figure.

The annual financial statement of an organisation can provide a lot of financial information that is difficult to interpret. A layman will be able to judge whether the company has made a profit or loss by generally looking at the income statement. However, deeper analysis of the management accounting information needs to be undertaken in order to ensure whether the company is making efficient use of all its resources.

In general ratio analysis has the following uses:

• It helps to review the performance of the organisation over time.
• It makes it possible to compare the performance of an organisation with its competitors.
• It makes it possible to compare the performance of an organisation with the industry average.
• It enables any problems within a company to be rectified by taking corrective actions.

Ratio analysis is a useful tool for any of the stakeholders in an organisation. For example, a supplier may want to ensure that any new customer will be able to pay for goods and services. The liquidity of the business will be important in this context. The efficiency of an organisation in generating profit will be of interest to potential shareholders. Lenders will be interested in the risk of the organisation, to ensure that the business is not overexposed to long-term debt and can afford to meet any interest payments when they become due. Management of the business will be interested in those ratios that highlight the efficiency of the business.

This comparison of ratios done by management accountants will direct attention to key areas requiring analysis, and identify areas of good and bad performance. The ratios may highlight areas of significant change, and provide an indication of the profitability and cash position of the company. By highlighting areas of good and bad performance, ratios can assist management to identify where their strengths and weaknesses are and where further effort should be directed. Ratios help in identifying the success or otherwise of particular choice of action as comparison can be made of the pre- and post-action results.

Some important management accounting ratios are given below

ROCE (Return on Capital Employed)

This can be thought as a way of measuring the capability of organization’s assets in generating profit.

ROCE = Profit before interest and tax / Capital employed (net assets) * 100

Profit Margin

This shows the margin that an organization keeps in terms of their sales. A low margin usually indicates high direct costs or a low selling price.

Profit Margin = Profit before Interest and Tax / Turnover * 100

Stock Turnover Ratio

Stock turnover ratio demonstrates the number of days the business takes to sell its entire stock.

Stock Turnover Ratio = Average Stock / Cost of Sale *365

Debt Collection Period

The number of days for the business to fully recover the debts of its debtors.

Debt Collection Period = Debtors / Turnovers *365

Gearing Ratio

This shows the extent to which the business if financed by debt. High gearing is considered as high risk and vice versa.

Gearing Ratio = Debt capital / Total Capital Employed * 100

Conclusion

Only calculating the ratios are of little benefit, ratio analysis as a technique should not be used in isolation either. It is essential that the findings are incorporated in to an overall analysis. It is necessary to establish why there has been a change and not simply identify that there has been a change. Any interpretation or analysis in management accounting must be taken in context with all the other available information about the company and its environment.

To make decisions in your business, you need solid management accounting data. Ration analysis is one major part of your management accounting pack. Thus, you need the help of an accountant to prepare your management accounts. Hammersmith accountants will help you to find an accountant that can help you with management accounts. Hammersmith Accountants will find you accountants in Hammersmith, West Kensington, Earls Court, Fulham, Chelsea, Richmond and Wandsworth