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Ratio Analysis
Ratio Analysis
By Shilpa Arora
Assistant Professor
IITM
RATIO ANALYSIS
Ratio analysis is the process of determining and
interpreting numerical relationship based on
financial statements. It is the technique of
interpretation of financial statements with the help
of accounting ratios derived from the balance
sheet and profit and loss account.
Basis Of Comparision
Trend Analysis involves comparison of a firm over a
period of time, that is, present ratios are compared with
past ratios for the same firm. It indicates the direction of
change in the performance improvement, deterioration
or constancy over the years.
Interfirm Comparison involves comparing the ratios of a
firm with those of others in the same lines of business or
for the industry as a whole. It reflects the firms
performance in relation to its competitors.
Comparison with standards or industry average
Classification Of Ratios
Analysis of Short Term Financial Position
or Test of Liquidity. (LIQUIDITY RATIOS)
Analysis of Long Term Financial Position
or Test of Solvency.
Activity Ratios.
Profitability Ratios.
1.
2.
3.
4.
5.
LIQUIDITY
I. Test Of Liquidity
The liquidity ratios are used to test the short term
solvency or liquidity position of the business.
It enables to know whether short term liabilities can be
paid out of short term assets.
It indicates whether a firm has adequate working
capital to carry out routine business activity.
It is a valuable aid to management in checking the
efficiency with which working capital is being
employed.
It is also of importance to shareholders and long term
creditors in determining to some extent the prospects
of dividend and interest payment.
Current Ratio
It is the most widely used of all analytical devices based
on the balance sheet. It establishes relationship between
total current assets and current liabilities.
Current ratio=
Current assets
Current liabilities
Quick ratio=
Quick assets
Current liabilities
Proprietary funds
Total assets
or
Capital employed
Total liabilities
Solvency Ratio
It expresses the relationship between total assets and
total liabilities of a business. This ratio is a small variant
of equity ratio and can be simply calculated as
100-equity ratio
Solvency ratio=
Total assets
Total liabilities
Current assets
Proprietors fund
Current liabilities
Net worth
Ideal ratio:1:3
This ratio indicates the relative contribution of short term
creditors and owners to the capital of an enterprise. If
the ratio is high, it means it is difficult to obtain long term
funds by the business.
Fixed assets
Capital employed
Average stock
Cost of goods sold= sales-gross profit
= opening stock + purchases
closing
stock
Opening stock + Closing stock
Average stock=
Average Debtors
Opening balance + closing balance
2
2
Number of working days
Creditors turnover ratio
Cost of sales
Average working capital
Net sales
Fixed assets
Net sales
Total assets
Gross profit
Net sales
X 100
X 100
Operating Ratio
This ratio establishes a relationship between cost of
goods sold plus other operating expenses and net sales.
This ratio is calculated mainly to ascertain the
operational efficiency of the management in their
business operations.
Cost of goods sold + operating expenses
Operating ratio=
Net sales
Higher the ratio the less favorable it is because it would
leave a smaller margin to meet interest, dividend and
other corporate needs. For a manufacturing concern it is
expected to touch a percentage of 75% to 85%. This
ratio is partial index of over all profitability.
Operating profit
Net sales
X 100
Expenses Ratio
It establishes relationship between individual operation
expenses and net sales revenue.
X 100
Net sales
Office and admin exp
2. Admin. and office exp ratio=
X100
Net sales
Selling and dist. exp
3. Selling and distribution ratio=
X 100
Net sales
Non operating expense
4. Non-operating expense ratio=
X 100
Net sales
Return On Shareholders
Investment
Shareholders investment also called return on
proprietors funds is the ratio of net profit to proprietors
funds. It is calculated by the prospective investor in the
business to find out whether the investment would be
worth-making in terms of return as compared to the risk
involved in the business.
Net profit (After tax and int)
Return on shareholders investment=
Proprietors funds
Return On Shareholders
Investment
This ratio is of great importance to the present and
prospective shareholders as well as the management of
the company. As this ratio reveals how well the
resources of a firm are being used, higher the ratio,
better are the results. The return on shareholders
investment should be compared with the return of other
similar firms in the same industry. The inter firm
comparision of this ratio determines whether their
investments in the firm are attractive or not as the
investors would like to invest only where their return is
higher. Similarly, trend ratios can also be calculated for a
number of years to get5 an idea of the prosperity, growth
of deterioration in the companys profitability and
efficiency.
Net profit
Total assets
X 100
EXERCISE 1
LIABILITES
Capital
Reserves
ASSETS
180 Net Fixed Assets
20 Inventories
Term Loan
300 Cash
Bank C/C
200 Receivables
Trade Creditors
50 Goodwill
Provisions
50
800
a.
b.
c.
d.
e.
f.
400
150
50
150
50
800
EXERCISE 2
LIABILITIES
2005-06 2006-07
ASSETS
Capital
300
Reserves
140
160 Security
Electricity
320
Bank CC (Hyp)
200506
200607
730
750
30
30
280 Investments
110
110
490
150
170
Unsec. Long T L
150
170 S I P
20
30
Creditors (RM)
120
140
170
30
20
310
240
30
190
50
50
1600
1760
70 Finished Goods
Bills Payable
40
80 Cash
Expenses Payable
20
30 Receivables
Provisions
20
40 Loans/Advances
Goodwill
Total
1600
1760