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Ratio analysis

Is a method or process by which the

relationship of items or groups of items in the

financial statements are computed, and

presented.

Is an important tool of financial analysis.

Is used to interpret the financial statements so

that the strengths and weaknesses of a firm, its

historical performance and current financial

condition can be determined.

Ratio

A mathematical yardstick that measures

the relationship between two figures or

groups of figures which are related to

each other and are mutually inter-

dependent.

It can be expressed as a pure ratio,

percentage, or as a rate

Ratio Analysis

Ratio is a numerical relationship between one item and another. Ratios are

expressed in various forms stated below:

(a) Pure ratio: It is the simple division of one item by another, e.g., Ratio of

Current Assets to Current liabilities and is shown as : Current

Assets/Current Liabilities = 4,000/2,000, i.e., Current assets to

Current liabilities ratio is 2 to 1.

(b) Rate: The ratio between two numerical facts, e.g., stocks turnover is 6

times a year or current assets

are two times the current liabilities.

(c) Percentage: It is a special type of rate which expresses the relation in

hundredth, e.g., the return on equity capital is 15% or gross margin on sales

is 40 per cent of net sales.

In short, a particular ratio may be expressed as a common fraction, decimally

or in percentage form.

Advantages of Ratio Analysis

(i) Help in financial statements analysis: It is easy to understand the

financial position of a business enterprise in respect of short term

solvency, capital structure position etc., with the help of various

ratios. The users can also gain by knowing the profitability ratios of

the firm.

(ii) Help in simplifying accounting figures: The single figures in

terms of absolute amounts such Rs. 10 lakhs income, Rs. 50 lakhs

sales etc. are not of much use. But they become important when

relationships are established, say for example, between gross profit

and sales or net profits and capital employed and so on.

(iii) Help in calculating the operating efficiency of the business

enterprise: Ratios enable the users of financial information to

determine operating efficiency of a business firm by relating the

profit figure to the capital employed for a given period.

(iv)Helpful in knowing Liquidity position: The short-term creditors

are more interested in the liquidity position of the firm in the sense

that their money would be repaid on due dates. The ability of the

firm to pay short- term obligations like interest on short term loan or

the principal amount can be found by computing liquidity ratios,

e.g., current ratio and quick ratio.

(V) Helpful in knowing solvency: This is required by long-term

creditors, security analysts and the present and potential

shareholders of the company. These persons can know with the help

of capital structure ratios such as debt-equity ratio, leverage ratio,

profitability ratios, etc. what sources of long-terms

funds are employed, and what is their relative position, i.e.,

percentage of various sources of finance.

(vi) Help in locating weak points of the firm: Ratio

analysis would pin point the deficiency of various

departments, or branches of a business unit even though

the overall performance is satisfactory.

(vii) Help in inter-firm and inter-period comparisons:

A firm can compare its results not only with other firms

in the same industry but also its own performance over

a period of time with the help of

ratio analysis.

(viii) Help in forecasting: Accounting ratios calculated

and tabulated for a number of years enable the users of

financial information to determine the future results on

the basis of past trends.

LIMITATIONS OF RATIO ANALYSIS

Ratios ignore qualitative factors: The ratios are obtained from the figures

expressed in money. In this way, qualitative factors, which may be

important, are ignored. For instance, it is just possible that the financial

position of a firm may be quite satisfactory in terms of money, yet it may

not be desirable to extend credit because of inefficient management in the

matter of payments on due dates.

Trends and not the actual ratios: The different ratios calculated from the

financial statements of a business enterprise for one single year are of

limited value. It would be more useful to calculate the important figures in

respect of income, dividends, working capital etc. for a number of years.

Such trends are more useful than absolute ratios.

Defective accounting information : The ratios are calculated from the

accounting data in the financial statements. It means that defective

information would give wrong ratios. Thus, the deliberate omission such as

omitting purchases, would positively affect the ratios too.

Change in accounting procedures: A comparison of

results of two firms becomes difficult when we find that

these firms are using different procedures in respect of

certain items such as inventory valuation, treatment of

intangible items like goodwill, capitalisation of certain

expenditures like interest on the loan taken to buy an asset

etc ..

Variations in general operating conditions: While

interpreting the results based on ratio analysis, all business

enterprises have to work within given general economic

conditions, conditions of the industry in which the firms

operate and the position of individual companies within the

industry. For example, if the firm has been forced by the

Government to sell its products at- fixed prices, its

comparison with other firms would become impossible.

Ratios are sometimes misleading: Ratios must not be generally studied

separately from the absolute figures, otherwise the results may be

misleading. For example, if the output of one firm goes up from 4,000 units

to 8,000 units, the ratio would show a 100% increase. On the other hand, if

the second firm increases its output from 10,000 units to 15,000 units, the

ratio would reflect an increase of only 50%. On the basis of ratios, we find

that first firm is more active than second though in terms of absolute

figures, the contribution of second firm is more than the first.

Classification of Ratios

Ratios can be broadly classified into four groups

namely:

Liquidity ratios

Capital structure/leverage ratios

Profitability ratios

Turnover or Activity ratios

Liquidity ratios

These ratios analyse the short-term financial

position of a firm and indicate the ability of the firm

to meet its short-term commitments (current

liabilities) out of its short-term resources (current

assets).

These are also known as short termsolvency ratios.

The ratios which indicate the liquidity of a firm are:

Current ratio

Liquidity ratio or Quick ratio or acid test ratio

Absolute liquid ratio

Current ratio

It is calculated by dividing current assets by

current liabilities.

Current ratio = Current assets where

Current liabilities

Conventionally a current ratio of 2:1 is

considered satisfactory

CURRENT ASSETS

include

Inventories of raw material, WIP, finished goods,

stores and spares,

sundry debtors/receivables,

short term loans deposits and advances,

cash in hand and bank,

prepaid expenses,

incomes receivables and

marketable investments and short term securities.

CURRENT LIABILITIES

include

sundry creditors/bills payable,

outstanding expenses,

unclaimed dividend,

advances received,

incomes received in advance,

provision for taxation,

proposed dividend,

instalments of loans payable within 12 months,

bank overdraft and cash credit

Quick Ratio or Acid Test Ratio

This is a ratio between quick current assets and current

liabilities (alternatively quick liabilities).

It is calculated by dividing quick current assets by

current liabilities (quick current liabilities)

Quick ratio = quick assets where

Current liabilities/(quick liabilities)

Conventionally a quick ratio of 1:1 is considered

satisfactory.

QUICK ASSETS & QUICK

LIABILITIES

QUICK ASSETS are current assets (as stated

earlier)

less prepaid expenses and inventories.

QUICK LIABILITIES are current liabilities (as

stated earlier)

less bank overdraft and incomes received in

advance.

Absolute Liquid Ratio

Absolute liquid Ratio = Super Quick Assets

Quick Liabilities

Super Quick Assets = cash in hand+ cash at

bank+ marketable securities or short term

investments

Capital structure/ leverage

ratios/Solvency Ratios

These ratios indicate the long term solvency

of a firm and indicate the ability of the firm

to meet its long-term commitment with

respect to

(i) repayment of principal on maturity or in

predetermined instalments at due dates and

(ii) periodic payment of interest during the

period of the loan.

Solvency/Capital structure/ leverage

Ratios

The different ratios are:

Debt equity ratio

Proprietary ratio

Debt to total capital ratio

Interest coverage ratio

Debt service coverage ratio

Debt equity ratio

This ratio indicates the relative proportion of debt and

equity in financing the assets of the firm. It is

calculated by dividing long-term debt by shareholders

funds.

Debt equity ratio = Total debt where

Shareholders funds

Generally, financial institutions favour a ratio of 1:1.

However this standard should be applied having regard

to size and type and nature of business and the degree of

risk involved.

SHAREHOLDERS FUNDS are equity share

capital plus preference share capital plus reserves and

surplus minus fictitious assets (eg. Preliminary

expenses, past accumulated losses, discount on issue

of shares etc.)

Proprietary ratio

This ratio indicates the general financial strength of the

firm and the long- term solvency of the business.

This ratio is calculated by dividing proprietors funds by

total funds.

Proprietary ratio = Shareholders funds

Total Assets

As a rough guide a 65% to 75% proprietary ratio is

advisable

Total Assets are all fixed assets and all current

assets except the fictitious assets.

Long Term Debt to total capital

ratio

In this ratio the outside liabilities are related to

the total capitalisation of the firm. It indicates

what proportion of the permanent capital of the

firm is in the form of long-term debt.

Long Term Debt to total capital ratio

long term debt

Shareholders funds + long term debt

Conventionally a ratio of 2/3 is considered

satisfactory.

Interest coverage ratio

This ratio measures the debt servicing capacity of a firm

in so far as the fixed interest on long-term loan is

concerned. It shows how many times the interest

charges are covered by EBIT out of which they will be

paid.

Interest coverage

Ratio = Profit before interest on Debt and Tax

Interest on long term debt

A ratio of 6 to 7 times is considered satisfactory.

Higher the ratio greater the ability of the firm to pay

interest out of its profits. But too high a ratio may

imply lesser use of debt and/or very efficient operations

Profitability ratios

These ratios measure the operating efficiency of

the firm and its ability to ensure adequate returns

to its shareholders.

The profitability of a firm can be measured by its

profitability ratios.

Further the profitability ratios can be determined

(i) in relation to sales and

(ii) in relation to investments

Profitability ratios

Profitability ratios in relation to sales:

gross profit margin

Net profit margin

Expenses ratio

Profitability ratios

Profitability ratios in relation to investments

Return on assets (ROA)

Return on capital employed (ROCE)

Return on shareholders equity (ROE)

Earnings per share (EPS)

Gross profit margin

This ratio is calculated by dividing gross

profit by sales. It is expressed as a percentage.

Gross profit is the result of relationship

between prices, sales volume and costs.

Gross profit margin = gross profit x 100

Net sales

Gross profit margin

A firm should have a reasonable gross profit

margin to ensure coverage of its operating

expenses and ensure adequate return to the

owners of the business ie. the shareholders.

To judge whether the ratio is satisfactory or

not, it should be compared with the firms past

ratios or with the ratio of similar firms in the

same industry or with the industry average.

Net profit margin

This ratio is calculated by dividing net profit by

sales. It is expressed as a percentage.

This ratio is indicative of the firms ability to

leave a margin of reasonable compensation to

the owners for providing capital, after meeting

the cost of production, operating charges and the

cost of borrowed funds.

Net profit margin =

net profit after interest and tax x 100

Net sales

Net profit margin

Another variant of net profit margin is operating

profit margin which is calculated as:

Operating profit margin =

net profit before interest and tax x 100

Net sales

Higher the ratio, greater is the capacity of the

firm to withstand adverse economic conditions

and vice versa

Expenses ratio

These ratios are calculated by dividing the various expenses by

sales. The variants of expenses ratios are:

Material consumed ratio = Material consumed x 100

Net sales

Manufacturing expenses ratio = manufacturing expenses x

100

Net sales

Administration expenses ratio = administration expenses x 100

Net sales

Selling expenses ratio = Selling expenses x 100

Net sales

Operating ratio = cost of goods sold plus operating expenses x

100

Net sales

Financial expense ratio = financial expenses x 100

Net sales

Expenses ratio

The expenses ratios should be compared over a

period of time with the industry average as

well as with the ratios of firms of similar type.

A low expenses ratio is favourable.

The implication of a high ratio is that only a

small percentage share of sales is available for

meeting financial liabilities like interest, tax,

dividend etc.

Return on assets (ROA)

This ratio measures the profitability of the total funds of

a firm. It measures the relationship between net profits

and total assets. The objective is to find out how

efficiently the total assets have been used by the

management.

Return on assets =

net profit after taxes plus interest x 100

Average Total assets

Total assets exclude fictitious assets. As the total assets

at the beginning of the year and end of the year may not

be the same, average total assets may be used as the

denominator.

Return on capital employed (ROCE)

This ratio measures the relationship between net profit and capital

employed. It indicates how efficiently the long-term funds of

owners and creditors are being used.

Return on capital employed =

Net profit before Interest, tax and Dividend x 100

Capital employed

CAPITAL EMPLOYED denotes shareholders funds and long-

term borrowings.

To have a fair representation of the capital employed, average

capital employed may be used as the denominator.

Return on equity

This ratio measures the relationship of profits to

owners funds. Shareholders fall into two groups

i.e. preference shareholders and equity

shareholders. So the variants of return on

shareholders equity are

Return on total shareholders equity =

Net profits after taxes x 100

Total shareholders funds

.

Return on ordinary shareholders

equity

Return on ordinary shareholders equity =

net profit after taxes pref. dividend x 100

Ordinary shareholders equity or net worth

ORDINARY SHAREHOLDERS EQUITY

OR NET WORTH includes equity share capital

plus reserves and surplus minus fictitious assets.

Earnings per share (EPS)

This ratio measures the profit available to the

equity shareholders on a per share basis. This

ratio is calculated by dividing net profit available

to equity shareholders by the number of equity

shares.

Earnings per share =

net profit after tax preference dividend

Number of equity shares

Dividend per share (DPS)

This ratio shows the dividend paid to the

shareholder on a per share basis. This is a better

indicator than the EPS as it shows the amount of

dividend received by the ordinary shareholders,

while EPS merely shows theoretically how much

belongs to the ordinary shareholders

Dividend per share =

Dividend paid to ordinary shareholders

Number of equity shares

Price earning ratio (P/E)

This ratio is computed by dividing the market

price of the shares by the earnings per share. It

measures the expectations of the investors and

market appraisal of the performance of the firm.

Price earning ratio = market price per share

Earnings per share

Turnover or Activity ratios

These ratios are also called efficiency ratios / asset

utilization ratios or turnover ratios. These ratios

show the relationship between sales and various

assets of a firm. The various ratios under this group

are:

Inventory/stock turnover ratio

Debtors turnover ratio and average collection

period

Asset turnover ratio

Creditors turnover ratio and average credit

period

Inventory /stock turnover ratio

This ratio indicates the number of times inventory is

replaced during the year. It measures the relationship

between cost of goods sold and the inventory level.

There are two approaches for calculating this ratio,

namely:

Inventory turnover ratio = cost of goods sold

Average stock

AVERAGE STOCK can be calculated as

Opening stock + closing stock

2

Inventory /stock turnover ratio

A firm should have neither too high nor too

low inventory turnover ratio. Too high a ratio

may indicate very low level of inventory and a

danger of being out of stock and incurring high

stock out cost. On the contrary too low a

ratio is indicative of excessive inventory

entailing excessive carrying cost.

Stock Conversion Period

= Days/ Months in a year

Stock turnover Ratio

Debtors turnover ratio and average

collection period

This ratio is a test of the liquidity of the debtors

of a firm. It shows the relationship between

credit sales and debtors.

1. Debtors turnover ratio =

Credit sales

Average Debtors and bills receivables

2. Average collection period =

Months/days in a year

Debtors turnover

Debtors turnover ratio and average

collection period

These ratios are indicative of the efficiency of

the trade credit management. A high turnover

ratio and shorter collection period indicate

prompt payment by the debtor. On the

contrary low turnover ratio and longer

collection period indicates delayed payments

by the debtor.

I n general a high debtor turnover ratio and

short collection period is preferable.

Creditors turnover ratio and average

credit period

This ratio shows the speed with which payments

are made to the suppliers for purchases made

from them. It shows the relationship between

credit purchases and average creditors.

Creditors turnover ratio =

credit purchases

Average creditors & bills payables

Average credit period = months/days in a year

Creditors turnover ratio

Creditors turnover ratio and average

credit period

Higher creditors turnover ratio and short credit

period signifies that the creditors are being

paid promptly and it enhances the

creditworthiness of the firm.

Other turnover ratios

Depending on the different concepts of assets employed, there are

many variants of this ratio. These ratios measure the efficiency

of a firm in managing and utilising its assets.

Total asset turnover ratio = Net sales

Average total assets

Fixed asset turnover ratio = Net sales

Average fixed assets

Capital turnover ratio = Net sales

capital employed

Working capital turnover ratio = cost of goods sold

Net working capital

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