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Unit 2 D2 - Evaluate the adequacy of accounting ratios as a means of monitoring the state of a business in a selected organisation, using examples£3.49
D2 – Evaluate the adequacy of accounting ratios as a means of monitoring the state of a
business in a selected organisation, using examples
Accounting ratios are used to determine solvency, profitability and performance.
Accounting ratios can be used to compare how well a business is doing internally or can be
compared to other businesses, accounting ratios cannot be used to compare businesses in
different industries because what could be a good ratio in one industry may not be good in
another industry, they are generally useful for Tesco to see how well they are doing
compared to previous years.
Advantages of using accounting ratios
Accounting ratios are a universal way to compare companies, the basics of the ratios are all
calculated in the same way (using the same formula), they are designed to equate all the
raw figures into a ratio that could be compared to a ratio of a different business to see how
well they are doing. For example Tesco may make a lot more revenue than a smaller
business, this may be due to Tesco having a larger market share than the smaller company
due to historical reasons but using an accounting ratio such as return on equity they may
find out that the smaller business operates more efficiently than Tesco does, Tesco would
then use this data and try and find the areas where they are not being efficient and try to
improve.
Accounting ratios can be used within industries by smaller companies to compare how well
they are performing compared to bigger organisations, this is better than looking at
businesses as a whole without taking into account what product/service they provide, it
creates a standard that businesses should strive perform like. Tesco can use their ratios to
compare to a shop like Aldi (even though they are a smaller company than Tesco) this is
because the financial ratios will take it into account. The asset turnover ratio divides the
sales by the total assets, Tesco are going to look like a more successful company if you only
take the total sales. The shop’s figures can be made universal by diving the sales by the total
assets, if both shops are turning over their assets the same even with different inputs into
the equation (figures) the accounting ratios can be the same.
It creates a “common language” that anyone can use to understand the strengths and
weaknesses of a particular business, as there are many accounting ratios that can be used
by Tesco they can see the areas they are good at compared to businesses (that are in the
same industry) and they can also look at where they are not doing so well compared to
other businesses with their industry, they can also use them to look at how well they are
doing compared to a previous year.
Disadvantages
Accounting ratios are calculated using a balance sheet which has been created by the
business, the balance sheet doesn’t include all assets the company has, for example the
brand name of Tesco’s clothing (F&F) is not recorded as an asset, also assets that cannot be
calculated into monetary value are not recorded on the balance sheet, this means that any
ratios that are calculated using this data will not be completely comprehensive of all the
total assets that Tesco owns. Accounting is done differently within different business’ and
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