Diagnostic Power of Ratios

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Use of clues, by Arthur Conan Doyle (a trained medical doctor himself) who created the immortal detective Sherlock Holmes captivates readers and television audience even today. Part of the explanation perhaps can be found in the apparent superhuman ability to smell out the trail left by the hapless criminal by examining seemingly trivial tit-bits of information garnered through an uncanny ability for observation. While the bits of clues are by themselves insignificant, the conclusions arrived at are dramatic.

journal of entrepreneurship and management

However, to the trained mind it is “elementary dear Dr. Watson!” The use of financial ratios can achieve similar dramatic results because of the inter-relationships that exist between the various parts of the three financial statements themselves and characteristics that must somehow accompany them. The absence or presence of certain characteristics can be therefore become indicators of distortions, that must be examined and cross-verified with other data to arrive at definitive conclusions. In this chapter we propose to introduce the reader to those clues and how to link them together to arrive at a conclusion as to the reliability of financial statements as representing the true financial position of a company.

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