ATIO ANALYSIS Introduction A financial statement depicts the financial position of the concern on a given date. To understand the financial position one should have Accounting knowledge. And also many accounting statements on the apparent look do not reveal the actual solvency or profitability position of the concern. For instance the profitability of the concern cannot just be understood by looking at the net profit. It will be more meaning full if it is said in relation to the sales or capital employed in terms of percentages. Similarly operating expenses when it is expressed in relation to sales it gives more clarity for making decisions like cost control. Hence financial statements independently cannot serve the purpose of the needy people like Creditors, Bankers, Investors, and others. So the concept of ratio is more important in the modern financial transactions and managerial decisions. Ratio is considered as one of the effective tool of financial analysis. It facilitates for interpretation of the profitability and solvency position of a concern. The term ratio, is understood as one number expressed in terms of another. It is an expression of relationship between two numbers by dividing one figure by another. Meaning of Ratio Analysis Ratio is the relationship between two accounting numbers by dividing one number by another. It is one of the effective tools of financial analysis. It indicates the relationship of accounting aspects like profit and sales, income and expenses, current assets and liabilities etc. with each other and reflects the soundness of the concern. Ratio analysis is the technique of the computation of number of accounting ratios from the data derived from the financial statements, and comparing those with the ideal or standard ratios or the previous year’s ratios or the ratios of other similar concerns. It is a technique of comparative analysis in which current year ratios are compared with the past or other organisations which are in similar line of operation so as to ascertain the financial soundness of the concern. Expression of Ratios Ratio can be espressed (i) Time Current Assets _ 50,000 _9 i nog Example: Current Liabilities | 25,000 — -— Scanned with CamScanner(i Percentage Current Assets 50,099 ple: Current Liabilitios ~ pegee * 100 = 2099 Beam Current Liabilities ~ 25,999 “100 = 200% Gii) Proportion Current Assets 7 50,000 sxample: Current Liabilities 22.000 | 25,000 0 It is better to express turnover ratio in “I ry @ Profitability ratio in percentage, Lan TT CRete, i) Profital m Lete, ji) Liquidity and solvency ratio botter to i i Gi Lag expressed in proportion, Example: CR, LR, RR There is no hard and fast rule expressing +4, SSI ict il romiligratis onacten ate pI Ing ratio in Particular form it is convenient to ime’. Example: § Example: GPR, NPR, RO) Significance of Ratio Ratio analysis has been identified as a very i __ Ra as beer ry important tool f fecitating several things, in the issues of simplifying fre tooo studying the financial health, helping inter-firm ana'inee a i ying ancia » helping comparisons and abow helping in co-ordination, communication and control whar are the three C’s of any-bucinaes, 1. Ratio analysis is an important and useful technique to check upon the efficiency with used in the enterprise. It helps the financial ol fi agement. accountant, # financial information, measuring and 3, It is a medium of communication of financial position of @ concern. Financial ratios communicate the strength and financial standing of the firm to the internal and external parties. Ratio analysis is very helpful in financial forecasting. A ratio relating to past sales, Profits and financial position is the base for future trends, 5. _ Ratio facilitates for comparison. With the help of ratio analysis ideal ratios can be composed and they can be used for comparison of a particular firm's progress and performance. Financial ratios are very helpful in the diagnosis and financial health of a firm. They highlight the liquidity, solvency, profitability and capital gearing, etc. of the firm. They are a useful tool of analysis of financial performance. Uses of Ratio Ratio analysis is one of the important tools of analyzing the financial statements, It helps in understanding the financial health and trend of a business. The utility of ratio analysis may be explained under the following heads: Scanned with CamScanner1. Utility to Management Ratio analysis helps the management in; a) Formulating the policies, b) Forecasting and planning. 9 Decision making. @ Knowing the trends of business. ©) Measuring efficiency. ) Communicating. 2 Controlling. 2. Utility to Shareholders and Investors An investor would normally assess the financial position of a business before he invests his money in it. He is interested in the safety, security and profitability of his investment, Accounting ratios help the prospective investors in selecting best companies to invest their funds. Ratios enable the shareholders to evaluate the performance and future prospects of the company. On the basis of some ratios, they are able to calculate the price of their shares, 3. Utility to Creditors The creditors or suppliers are those who supply goods to the firm on credit basis. They are interested in the liquidity position of the firm. To know the liquidity position or short term financial position, they use liquidity ratios. 4, Utility to Employees The employees are interested in the profitability of the company. Their wages, fringe benefits, working conditions etc. are related to the profits earned by the company. They want to ascertain the profitability for demanding wage increase and other benefits. For understanding the profitability of the company, profitability ratios come to their help. 5. Utility to Government The government uses ratio analysis for studying the cost structure of the industries. On the basis of this study, the government can formulate various policies. It can implement the price control measures to protect the interest of consumers. Classification of Ratio Ratio can be classified as per the need and requirement of the users. Ratio are not only useful for internal users but also to many others like investors, bankers, ereditors and government. In this view point, ratios can be classified as follows. On the basis of nature and significance of ratios it can be classified as follows: Scanned with CamScannerTYrEs Or Ratio fa 1p To lp pau RATIO (Caprrat Structure Acuviry Rats feo ey / «10 Current Ratio Debt Equity Ratio Stock tumover Gr ee c 088 Quick Ratio Networth Ratio Ratio Profit Ratio Absolute liquid Fixed Assets to peal eee Ratio Networth Ratio amen Ratio Creditor i Current Assets to ic eee ae Tumover Ratio Ratio . . FATumover i Capital Gearing Ratio i pea : Ratio Profit Ratio Solvency Ratio . a Cash Tumover P/E Ratio Ratio Detailed understanding of ratio’s are as follows: A) Liquidity Ratio It is the ratio which Measures the short-term solvency position of an organisation. It brings out the ability of an organisation to meet it’s immediate or short term financial commitments with it’s short term or liquid resources. Such ratio’s are highly needful for partis like creditors, Banker's and other private lender's It enables the lender's to know the repayment ability of an organisation with in short period. Liquidity ratio can be broadly classified as follows: i) Current Ratio ii) Acid test Ratio or Quick Ratio/Liquid Ratio iii) Absolute Liquid Ratio Cash position Ratio. the short-term financial Capacity of an enterprise and clearly Liquidity ratio signifies ay creditors, Banker's etc. detailed reflects the short term solvency position for investors, explanation of each of the liquidity ratio are as follows: i) Current Ratio It is the ratio which is computed by taking into consi current liabilities of an organisation. Current assets and c following: deration the current assets and urrent liabilities included the Scanned with CamScanneres B COM 3 CURRENT LIABILITIES coMPONES=3 Cash in hand bank Bills payable | Sundry Debtors Creditors Bills Receivables Bank overdraft Stock Provision for Prepaid expenses | O's Incomes Fee een | Shortterm Investments Outstanding expenses Income received in advance It is computed with the help of the following equation: Current Asset ~ Current Ratio= Gurrent Liability * Ideal Ratio = 2:1 Interpretation of Current ratio: The generally accepted current ratio or Ideal ratio is 2:1, It mean's for every one rupee of current liability, there should be Two rupee of current assets to ensure better solvency position. An organisation which has current ratio as 2 or more reflects the sufficient liquidity and enough working capital. Illustration - 1 Calculate: Current assets Current ratio = 2.6:1 and Current liability = 40,000 Solution: _ _ Current Assets Current ratio Current 26 _ Current Assets = 7 *~~40,000 = Current assets = 2.6 x 40,000 =. Current assets = 1,04,000 Illustration - 2 From the following calculate current ratio. Fixed assets 5,00,000, Total assets of the company 8,00,000, Current liabilities 200,000, Scanned with CamScannernot satisfacto} ii) Aci seriou! 2 practical, possible jiguidity ratio i: entel prise. It establish r Current Assets = 8,00,000 — 5,00,000 current Assets = 3,00,000. Current liability given in the caso ¢2,00,000 Current Assets ! 3,00,000 Gurrent Liabilities 00, oa ae t the Company short term solvency positio t assets position. Current Rati since the ideal ratio is 2:1, it is clear that ry. Necessary steps should be taken to improve current 7 d Test Ratio or Quick or Liquid Ratio t ratio reflects the liquidity position of includes aspects like stock and prepai term without financial loss. id or quick solvency position mediate solvency position of an dd quick liabilities. It is computed the concern, it suffer’s from Earnings available to equity share holder’s means net profit after tax and ag dividend to preference share holder's. ae ‘Total Equity Capital Face Value per Share = Number of equity share viii) Price-Earning Ratio ; he number of times the earning per share is covered by its market ‘This ratio indicates wv u the market price per share and earning per share, price. It is the ratio between Market Price per Equity Share PIE ratio = —fearning per Equity Share Interpretation of profitability ratio: Profitability ratios are the measurement of operational efficiency of an org” isation in a given financial year. It indicates the use of organisational resources in generating better revenues and achieving organisational goals. Profitability ratios like, gross profit ratio, net profit ratio, operating profit ratio, price earning ratio, earning per share ratio, when it is more it is said it is favourable to the crganisation. Similarly when expenses ratio are less itis said it is favourable to the concern. ‘As such there is no ideal or standard profitability ratio, in general. Dividend Payout Ratio ‘The Dividend Payout Ratio (DPR) is the amount of dividends paid to shareholders in relation to the total amount of net income the company generates. In other words, the dividend avout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends. Dividend Payout Ratio Formula There are several formulas for calculating DPR: . DPR = Total dividends / Net income 2. DPR=1-Retention ratio (the retention ratio, which measures the percentage of net income that is kept by the company as retained earnings, is the opposite, or inverse, of the dividend payout ratio 3. DPR=Dividends per share / Earnings per share Dividend Yield Ratio ‘The dividend yield is a financial ratio that measures the amount of cash dividends distributed to common shareholders relative to the market value per share, The dividend yield is used by investors to show how their investment in stock is generating either cash flows in the form of dividends or increases in asset value by stock appreciation. ia Scanned with CamScannerois calculated using the following formula: yield rat vidend Per Share/Market Valuo Por Sharo ‘The divide =D yield Ratio = form of calculation, you can take the amount of dividend per share and * it In the simples’ vt valuo per share to get tho dividend yield ratio. Dividend divide it with the ma" Limitations of . Ratio analysis is no doubt, useful in many respects to different parties like, Creditors, tat Banker's and Government. Since ratio’s are not independent and computed based on data, its reliability can be questioned because, if the basic data itself is manipulated, then ratio’s will also reflect the manipulated information. Following are some of The important draw back’s of ratio's. 1) It is based on financial statement: Ratios aro computed based on the financial statement of an organisation. Hence the ratio’s may not reflect the true and fair financial position if there are manipulation or window dressing in the basic data itself. 2) Does not reflect the qualitative aspects: Some times it is necessary to evaluate, the qualitative aspects like, managerial abilities, nature of customers, employees ete., for making effective decisions. Ratios since deals with quantitative aspects, does not reflect these in its reports. Ratios will not give decisions: It is just an information to make effective decisions. Ratio Investors, B the financial 3 4) Ratio’s alone are not adequate for judging the financial position of a business. 5) There is no standardization in ratios: Ratios are interpreted in different ways based on the situation, requirement and view point of the persons. Hence it cannot give the same meaning to all. 6) Ratios are based on many assumptions and hence these may mislead the decision makers. 7) _ Ratios are meaningful only when they are studied with other ratios. A ratio alone cannot be meaningless by itself. 8) Understanding of ratios needs professional knowledge. Hence, it cannot be used by ‘common people. Mlustration - 5 il is 7 3,57,500. Calculate the amount of current Current ratio is 3.75:1 Working capi assets and current liabilities. Solution: Let, Current liabilities = x . Current assets Current ratio = Current liabilities fm Scanned with CamScannerSES . Operating Ratio = iv) Calculation of Net Profit Ratio Net Profit 199 = 84.000 _, 199 = 10.8% Net Sales 6,00,000 v) Operating Profit Ratio Net Profit = is jo = Operating Profit 199 Operating profit Ratio= er Gatog —* Operating profit = Net Sales - Operating Cost = 6,00,000 — 4,20,000 (as computed above) = % 80,000 80,000 --Opening profit ratio = x100 = 16% 5,00,000 vi) Calculation of Stock Turnover Ratio . _ Cost of Goods Sold Stock Turnover Ratio = “Average Stock 5,0 ,000 : STR = 76250+98500 STR = 3.43 times 2 Summary of Ratio’s Ratio | Equation /Formula ‘Standard 4) Current Solvency Ratio's . Current Assets ; ae Current Liabilities a oa Quick Assets ee Current Liabilities Quick assets = CA — (Stock + Prepaid expenses) 1 . Absolute Liquid Assets Absol Absolute Liquid Assets to Liu Current Liabilities LL Ratio Absolute liquid assets = QA — (Debtors + B/R) 05:1 Scanned with CamScannerB) Long Term Solvency Ratio's Debtiequity Ratio Debt iabititi, Bquity Debt = Long term Liabilities + Short term liabilities Equity = Share capital + Liability + Reserves + P & L A/c Credit balance, | . Net worth Proprietary Ratio | Total Asseta Bal Net worth = Capital + Reserves + P&L Cr. Bal — Preliminary exp + Accumulate losses) Net Fixed Assets Fixed Assets Networth 223 of ‘to networth Ratio networth Current Assets wo Current assets Net worth a . higher the to networth Ratio . ratio higher the solvency, 7 a Fixed Committment Securities . . Capital gearing ~"Wauity share bol Fun higher the ratio Ratio higher of = ‘capital gearing C) Turnover Ratio] : —|-= ~ Cost of Goods Sold : ' Stock turn ‘Avg. Stock higher the ratio over Ratio CGS = Sales ~ G/P 0 . more favorable . il arr Average stock = OPening Stock Clearing stock Net Annual Credit Sales ©)" 509 | Act Annual Credit Sales Debtors turnover Average Tr. Debtors De Plreu Bin higher the Ratio Credit sales = Total sales ~ Cash sales ratio more Average Tr. debtors = 205. debtors Clg, Debtory favorable. irr Scanned with CamScanneret Annual Credit Purchases Net Anne tom vg. Trade Creditors Higher the Creditor? : e ratio fumover Rat? | Credit purchase = Total purchases ~ Cash purchase} favourable. Avg.Trereditors = Soe Cer Oh Geetiars pant calecton 30 days or eel 1 month No. of days or month in a year Average payment Creditor turn over Ratio 30 days or period o 1 month : Net Sales Working capital ‘Working Capital higher the Ratio . ratio, higher efficiency Net Sales ; ‘Total assets Total Assets 2 Times turn over Ratio " ~ | _Net Sales : Fixed assets: ‘Fixed Assets 5 times turnover Ratio or more Net Sales ; 5 Current assets CaeaRvAaets higher the ratio turn over Ratio higher efficiency D) Profitability Ratio | Gross Profit - ‘ : , Gross profit Ratio “Net Sales «100 higher the ratio, oss profit = Opening stock + Purchase + Direct | higher efficiency penses ~ (Sales + Closing stock) Net Profit Ratio Net Profit. 199 higher the ratio, Net Sales higher efficiency. Scanned with CamScannerOperating Cost sng Rati Operating Cost , 199 Operating Ratio Net Sales Operating cost = CGS + Operating expenses, Operating Profit 14, Operating Profit Net Sales Ratio Operating profit = Net profit + Non operating expenses - Non-operating incomes. Specific Expenses i ———_——— «x 100 Expenses Ratio Net Sales - Return On Capital Employed Return on Capital Capital Employed Employed Ratio Capital employed = owner's fund + long term borrowing — fictitious assets. Earning per | More the rats ait ., Harning available to Equity Shareholder —— No. of Equity Shares more is the (*= Net profit after tax - Preference Dividend) efficiency : . | Market price per equityshares Price Earning Ratio Turning perehave iE Scanned with CamScanner