THEORETICAL FRAMEWORK

The ratio analysis is one of the most powerful tools of financial analyses. It is the
process of establishing and interpreting various ratios (quantitative relationship between
figures and group of figures). It is with the help of ratios that the financial statements can be
analyzed more clearly and decisions made from such analysis.

A ratio is a simple arithmetical expression of the relationship of one member to

another. It may be defined as the indicated quotient of two mathematical expressions.
According to accounts Hand Book Luxion, Kell and Badford, a ratio “is an expression of the
quantitative relationship between two numbers”. According to Kohler, ratio is the relation, of
the amount, a to another b, expressed as the ratio of a to b, a:b (a is to b) : or as a simple
fraction, integer, decimal, fraction or percentage.” In simple language ratio is one number
expressed in terms of another and can be worked out by dividing one number into another.

A financial ratio is the relationship between the accounting figures expressed

mathematically. A ratio analysis is a technique of analysis and interpretation of financial
statements to the process of establishing and interpretation of financial statements to the
process of establishing and interpreting various for helping in making decisions. However,
Ratio analysis is not and ends in itself. It is only a means of better understanding of financial
strengths and weaknesses of a firm. Calculation of mere ratios does not serve any purpose,
unless several appropriate ratios, which can be calculated from the information given in the
financial statements, but the analyst has to select the appropriate data and calculate in mind
the objective of analysis.

1. Selection of relevant data from the financial statement depending upon the objective
of the analysis.
2. Calculation of appropriate ratios from the above data.
3. Comparison of the calculated ratios with the ratios of the same firm in the past, or
the ratios developed for projected financial statements or the ratios developed for
projected financial statements or the ratios of some other firms or the comparison
with the ratios of industry to which the firm belongs.
Interpretation of the ratios.

The interpretation of ratios is an important factor limitations of ratio analysis

should be kept in mind while interpreting them. The impact of factors such as price level
changes, change in accounting policies, window dressing etc. should keep in mind when
attempting to interpret ratios.

A single ratio in itself does not convey much of the sense. To make ratios useful
for further interpret. The use of ratio is confined to financial managers. As discussed earlier
there are different parties interested in the ratio analysis for knowing the financial position of
a firm for different purposes. The suppliers of good on credit, banks, financial institutions,
investors, shareholders and mgt all make use of ratio analysis as a tool in evaluating the
financial position and performance of a firm for granting credit, providing loans or making
investments in the firm.

With the use of ratio, analysis one can measure the financial condition of a firm can
point out whether the condition is strong, good, questionable or poor. The conclusions can
also be drawn as to whether the performance of the firm is improving or deteriorating. Thus,
ratios have wide applications and are of immense use today

Managerial Uses of Ratio Analysis

1. Helps in decision-making

Financial statements are prepared primarily for decision-making. However, the

information provided in financial statements is not end in itself and no meaningful conclusion
can be drawn from these statements alone. Ratio analysis helps in making decisions from the
information provided in these financial statements.

2. Helps in forecasting and planning

Ratio analysis is of much help in financial forecasting and planning. Planning is

looking ahead and the ratios calculated for a number of year’s work as a guide for the future.
Meaningful conclusions can be drawn for future from these ratios. Thus, ratio analysis helps
in planning and forecasting.
3. Helps in Communicating

The financial strength and weakness of a firm are communicated in a more easy
and understandable manner by the use of ratios. The information contained in the financial
statements id conveyed in a meaningful manner to the one for meant. Thus, ratios help in
communication and enhance the value of the financial statements.

4. Helps in Co-ordination

Ratio evens help in co- ordination, which is of almost importance in

effective business mgt. better communication of efficiency and weakness of an enterprise
results in better co-ordination in the enterprise.

5. Helps in Control

Ratio analysis even helps in making effective control of the business.

Standard ratios can be based upon perform a financial statements variances or deviations of
any; can be found by comparing the actual with the standards to take a corrective action at the
right time. The weakness or otherwise it any come to the knowledge of the mgt which helps
in effective control of the business.

In view of requirements of the various users of ratios, we may classify them into the
following four important categories.

1. Liquidity ratios.

2. Leverage ratios.

3. Activity ratios.

4. Profitability ratios.

Liquidity ratios measure the firm ability to meet current obligations. Leverage
ratios show the proportions of debt and equity in financing the firm assets. Activity ratios
reflect the firms efficiency in utilizing its assets and Profitability ratios measure overall
performance and effectiveness of the firm.
1. Liquidity Ratios

The most common ratios, which indicate the extent of liquidity, are:

Current Ratio, Quick Ratio, other ratios include Cash Ratio, internal measure and Net
Working Capital Ratio.

Current Ratio: current assets

current liabilities

Quick Ratio: current assets-Inventories

current liabilities

Cash Ratio: cash + marketable securities

current liabilities

Net Working Capital Ratio: Net Working Capital

Net Assets

1. Leverage Ratios

Leverage ratios may be calculated from the balance sheet items to

determine the proportion of debt in total financing. Many variations of these ratios exist; but
all these ratios indicate the same thing – the extent to which the firm has relied on debt in
financing assets.
Debt Equity Ratio: Outsiders funds

Shareholders’ funds

Proprietor’s Ratio: Shareholders funds

Total Assets

Capital gearing ratio: Fixed interest bearing securities

Equity shareholders funds

(Fixed interest bearing securities= preference capital+ debentures+ loans)

Inventory Turnover Ratio: Cost Of Goods Sold

Average Inventory at cost

Return On Capital Employed: Net profit

Capital Employed

3. Activity Ratios

Activity ratios are employed to evaluate the efficiency with

which the firm manages and utilizes its assets. A proper balance between sales and assets
generally reflects that assets are managed well. Several activity ratios can be calculated to
judge the effectiveness of the asset utilization.
Debtors Turnover Ratio: Credit Sales

Average debtors

Collection Period: 360

Debtors Turnover

Net Assets Turnover Ratio: Sales

Net Sales

Total Assets Turnover Ratio: Sales

Total Assets

Fixed Assets Turnover Ratio: Sales

Net Fixed Assets

Current Assets Turnover Ratio: Sales

Current Sales

Working Capital Turnover Ratio: Sales

Net Current Asse

4. Profitability Ratios
 The profitability ratios are calculated to measure the operating
efficiency of the company in term of profits. Generally two major types of profitability ratios
are calculated.

 Profitability in relation to sales.

 Profitability in relation to investment.

Gross Profit Ratio: Gross Profit

Sales

Net Profit Ratio: Profit After Tax

Sales

Operating Expenses Ratio: Operating Profit

Sales

Operating Net Profit Ratio: Operating Profit

Net Sales

Operating profit = Gross profit –All operating expenses

Limitations of Ratio Analysis

The ratio analysis is one of the most powerful tools of financial management.
However, ratios are simple to calculate and easy to understand, they suffer from some serious
limitations.
1. Limited Use of a Single Ratio

A single ratio is usually, does not convey much of a sense. To make a better
interpretation a number of ratios have to be calculated which is likely to calculated which is
likely to confuse the analyst than help him in making any meaningful conclusion.

2. Lack of Adequate Standards

There are no well- accepted standards or rules of for all ratios that can be accepted
as norms. It renders interpretation of the ratios difficult.

3. Inherent limitations of Accounting

Like financial statement, ratios also suffer from the inherent weakness of
accounting records such as their historical nature. Ratios of the part are not necessarily true
indicators of the future.

4. Change of Accounting Procedure

Change in accounting procedure by a firm often makes ratio

analysis mislead e.g., a change in the valuation methods of inventories, FIFO to LIFO
increases the cost of sales and reduces considerably the value of closing stocks which makes
stock turnover ratio to be lucrative and an unfavorable gross profit ratio.

5. Window Dressing

Financial statement can easily be window dressing to

present a better picture of its financial and profitability position to outsiders. Hence, one has
to be very careful in making a decision from ratios calculated from such financial statements.
However, it may be very difficult for an outsider to know about the window dressing made
by a firm.

6. Personal Bias
 Ratio is only means of financial analysis and not an end in
itself. Ratios have to be interpreted and different people may interpret the same ratio in
different ways.

7. Absolute figures Distortive

Ratio devoid of absolute figures may prove distortive, as

ratio analysis is primarily a quantitative analysis and not a qualitative analysis.

8. Incomparable

Industries in their nature but also the firms of the similar business widely not only
differ in their size and accounting procedures, etc. it makes comparison of ratios difficult and
misleading. Moreover, comparisons are made difficult due to differences in definitions of
various financial terms used in the ratio analysis.

9. Price level changes

While making ratio analysis, no consideration is made to the changes in

price levels and this makes the interpretation of ratios invalid.

10. No substitutes

Ratio analysis is merely a tool financial statement. Hence, ratio becomes useless
if separated from the statements from which they are computed.