Introduction
In times of rising inflation and increasing input costs, traditional ratio analysis can give a misleading picture of a company’s financial health.
Whether it’s raw material prices, wage hikes, or power costs, inflation affects every layer of business performance — from profitability to liquidity.
In this blog, we’ll explore how inflation distorts key financial ratios, and how inflation-adjusted ratio analysis can help accountants, auditors, and entrepreneurs get a more realistic view of business performance.
Understanding Ratio Analysis {#understanding-ratio-analysis}
Ratio analysis is a cornerstone of financial management. It helps measure profitability, liquidity, solvency, and efficiency using relationships between key financial statement figures.
Some common ratios include:
- Gross Profit Ratio = (Gross Profit ÷ Net Sales) × 100
- Current Ratio = Current Assets ÷ Current Liabilities
- Debt-Equity Ratio = Total Debt ÷ Shareholders’ Equity
- Return on Capital Employed (ROCE) = EBIT ÷ Capital Employed
However, these ratios assume that financial data reflects real values — and this assumption fails during inflation.
How Inflation Affects Financial Ratios
Inflation affects both numerator and denominator in most ratios — often in different ways — leading to distorted results.
Here’s how:
- Revenue rises due to higher prices, but input costs rise faster, reducing profit margins.
- Asset values (recorded at historical cost) become understated compared to replacement cost.
- Depreciation expense remains low (on old asset values), inflating profits artificially.
- Inventory valuation methods (FIFO/LIFO) affect cost of goods sold differently under inflation.
- Interest expenses may lag behind inflation if loans are fixed-rate — overstating profitability temporarily.
Thus, financial ratios based on historical costs may overstate profitability and understate capital employed, giving an inaccurate view of efficiency or solvency.
Key Ratios Distorted by Inflation
| Ratio | Impact of Inflation | Distortion Explanation |
|---|---|---|
| Gross Profit Ratio | May decline | Raw material and power costs rise faster than selling prices. |
| Operating Ratio | Increases | Operating costs inflate, reducing operating efficiency. |
| Return on Assets (ROA) | Overstated | Assets at historical cost understate true asset base. |
| Debt-Equity Ratio | Understated | Equity value (book value) does not reflect real replacement value of assets. |
| Current Ratio | Misleading | Inventory and receivables may inflate nominally, hiding real liquidity stress. |
| Fixed Asset Turnover | Overstated | Asset base undervalued, making turnover look stronger. |
Inflation skews both profitability and solvency indicators, especially for manufacturing and energy-intensive businesses.
Inflation-Adjusted Ratio Analysis Explained
Inflation-adjusted ratio analysis (also called constant price ratio analysis) adjusts financial statements to reflect current price levels before calculating ratios.
The goal is to ensure comparisons are based on real values, not inflated rupees.
Key methods include:
- Revaluation of fixed assets — Adjust book values to current replacement cost.
- Current Cost Accounting (CCA) — Restate assets, depreciation, and cost of goods sold using price indices.
- General Price Level Accounting (GPLA) — Adjust all balance sheet items by a general inflation index (e.g., WPI or CPI).
- Use of Deflators — Convert nominal revenue and expenses into real terms using inflation deflators.
Practical Steps to Adjust Ratios for Inflation
- Identify the inflation rate (CPI/WPI) for the relevant period.
- Restate assets to current cost using an appropriate index.
- Adjust depreciation on the restated value, not historical cost.
- Revalue inventory and cost of goods sold using current purchase costs.
- Adjust equity and retained earnings for inflationary erosion of capital.
- Recalculate ratios using the adjusted financial statements.
Example:
If machinery purchased in 2020 for ₹10 lakh now costs ₹15 lakh, asset value and depreciation must be restated accordingly. This will lower ROA and ROCE — reflecting a more realistic return on current capital.
Case Example: Comparing 2020 vs 2025 Results
| Particulars | 2020 (₹ lakh) | 2025 (₹ lakh, nominal) | 2025 (₹ lakh, inflation-adjusted) |
|---|---|---|---|
| Sales | 100 | 150 | 125 |
| Net Profit | 10 | 15 | 8 |
| Total Assets | 100 | 100 | 150 |
| ROA (Nominal) | 15% | — | — |
| ROA (Adjusted) | — | — | 5.3% |
👉 The company appears to have improved its return on assets (15% vs 10%), but after adjusting for inflation, the real ROA actually declined.
This demonstrates how ignoring inflation can mask declining efficiency or profitability.
Pros & Limitations of Adjusted Ratios
✅ Advantages
- Reflects true financial performance in real terms.
- Enables better comparison across years during inflationary periods.
- Helps management in pricing, budgeting, and capital allocation decisions.
- Aids investors and lenders in understanding real returns.
⚠️ Limitations
- Requires reliable inflation indices and valuation data.
- May not be comparable across industries with different inflation exposures.
- Adjustments can be complex and subjective, needing expert judgment.
Conclusion & Expert Guidance
Inflation may be an unavoidable economic reality — but distorted ratios don’t have to be.
By adopting inflation-adjusted ratio analysis, businesses can uncover the real profitability, liquidity, and efficiency behind the numbers.
At Verotus Finlegal Solutions LLP,
our accounting experts can help you:
- Prepare inflation-adjusted financial statements
- Conduct realistic ratio analysis and performance reviews
- Build cost control strategies for inflationary periods
📞 Contact Verotus LLP
for professional accounting and financial analysis support tailored to your business.
🌐 www.verotusllp.com | 📧 info@verotusllp.com
FAQs
Q1. Why does inflation distort financial ratios?
Because ratios are based on historical-cost data, which don’t reflect current purchasing power or replacement costs.
Q2. Which ratios are most affected by inflation?
Profitability ratios (like ROA, ROCE) and solvency ratios (Debt-Equity) are the most distorted during inflation.
Q3. How do accountants adjust for inflation?
By restating assets, depreciation, and costs using inflation indices or replacement cost methods.
Q4. Is inflation-adjusted ratio analysis mandatory under Indian GAAP?
No, but it’s recommended for internal management and investor reporting, especially in high-inflation periods.
Q5. Can inflation adjustment affect tax reporting?
Not directly — tax laws still follow historical cost accounting, but it helps in internal decision-making and valuations.
