RATIO ANALYSIS

J.K.OKE
RATIO ANALYSIS
 A RATIO IS A RELATIONSHIP BETWEEN TWO
RELATED FIGURES.
 RATIO ANALYSIS AS A TECHNIQUE OF
INTERPRETING THE FINANCIAL STATEMENTS
INDICATES THE CALCULATION AND
INTERPRETATION OF VARIOUS RATIOS
CALCULATED ON THE BASIS OF THE FIGURES,
WHICH ALREADY APPEAR ON THE FINANCIAL
STATEMENTS, EITHER BY USING THE SAID
FIGURES AS IT IS OR BY GROUPING OR
REGROUPING THOSE FIGURES.
RATIO ANALYSIS
 HOWEVER, IT IS NOT ONLY SUFFICIENT TO CALCULATE
THE RATIOS. FOR THE RATIOS TO CONVEY SOME
MEANINGFUL IMPLICATIONS NEED TO BE COMPARED
WITH SOME YARDSTICKS.
 THESE YARDSTICKS MAY BE IN THREE FORMS.
 “INTRA-FIRM COMPARISON.”
 “INTER-FIRM COMPARISON.”
 RATIOS OF AN ORGANIZATION CAN BE COMPARED

WITH SOME STANDARD RATIOS THAT CAN BE

CONSIDERED TO BE THE THUMB RULE FOR THE
EVALUATION OF THE PERFORMANCE.
 
RATIO ANALYSIS:
INTRA-FIRM RATIOS
 RATIOS OF THE SAME ORGANIZATION MAY BE
COMPARED WITH EACH OTHER ON YEAR TO
YEAR BASIS TO EVALUATE THE PERFORMANCE
OF THE ORGANIZATION ON YEAR TO BASIS.
FIGURES OF THE PREVIOUS YEARS MAY BE
CONSIDERED ON ACTUAL BASIS, WHEREAS THE
FIGURES FOR THE FUTURE YEAR CAN BE
CONSIDERED ON PROJECTED BASIS. THIS
COMPARISON IS CALLED AS “INTRA-FIRM
COMPARISON.”
  
RATIO ANALYSIS :
INTER-FIRM RATIOS
 RATIOS OF ONE ORGANIZATION CAN BE COMPARED
WITH THE RATIOS OF ANOTHER ORGANIZATION TO
EVALUATE THE PERFORMANCE OF ONE
ORGANIZATION IN THE LIGHT OF PERFORMANCE OF
ANOTHER ORGANIZATION. HOWEVER, THE
PREREQUISITE WILL BE THAT THE CONSTITUENT
ORGANIZATIONS NEED TO BE COMPARABLE WITH
EACH IN TERMS OF NATURE OF INDUSTRY, AGE,
EXTENT OF TURNOVER ETC. THIS COMPARISON IS
CALLED AS “INTER-FIRM COMPARISON.”
  
RATIO ANALYSIS:
STANDARD RATIOS COMPARISON
 RATIOS OF AN ORGANIZATION CAN BE
COMPARED WITH SOME STANDARD RATIOS
THAT CAN BE CONSIDERED TO BE THE
THUMB RULE FOR THE EVALUATION OF THE
PERFORMANCE.
 
CLASSIFICATION OF RATIOS
 FOR CONVENIENCE PURPOSE,
 LET US CLASSIFY THE VARIOUS RATIOS IN THE

FOLLOWING CATEGORIES.
◦ LIQUIDITY RATIOS
◦ ACTIVITY OR TURNOVER RATIOS
◦ CAPITAL STRUCTURE OR LEVERAGE RATIOS
◦ PROFITABILITY RATIOS
◦ MISCELLANEOUS RATIOS
 
CLASSIFICATION OF RATIOS
 1. Liquidity Ratios
 2. Solvency Ratios
 3. Profitability Ratios
 4. Efficiency Ratios
 5. Coverage Ratios
 6. Market Prospect Ratios
 1. Liquidity Ratios
 Liquidity ratios measure a company's ability to pay off its

short-term debts as they come due using the company's

current or quick assets. Liquidity ratios include the current
ratio, quick ratio, and working capital ratio.
 2. Solvency Ratios

 Also called financial leverage ratios, solvency ratios

compare a company's debt levels with its assets, equity, and

earnings to evaluate whether a company can stay afloat in
the long-term by paying its long-term debt and interest on
the debt. Examples of solvency ratios include debt-equity
ratio, debt-assets ratio, and interest coverage ratio.
 3. Profitability Ratios
 These ratios show how well a company can generate

profits from its operations. Profit margin, return on

assets, return on equity, return on capital employed,
and gross margin ratio are all examples of
profitability ratios.
 4. Efficiency Ratios
 Also called activity ratios, efficiency ratios evaluate

how well a company uses its assets and liabilities to

generate sales and maximize profits. Key efficiency
ratios are the asset turnover ratio, inventory turnover,
and days' sales in inventory.
 5. Coverage Ratios
 These ratios measure a company's ability to make the

interest payments and other obligations associated with

its debts. The times interest earned ratio and the debt-
service coverage ratio are both examples of coverage
ratios.
 6. Market Prospect Ratios

 These are the most commonly used ratios in fundamental

analysis and include dividend yield, P/E ratio, earnings per

share, and dividend payout ratio. Investors use these
ratios to determine what they may receive in earnings
from their investments and to predict what the trend of a
stock will be in the future.
LIQUIDITY RATIO

 LIQUIDITY RATIOS MEASURE A COMPANY'S

ABILITY TO PAY OFF ITS SHORT-TERM DEBTS
AS THEY COME DUE USING THE COMPANY'S
CURRENT OR QUICK ASSETS.
 LIQUIDITY RATIOS INCLUDE THE CURRENT

RATIO, QUICK RATIO, AND WORKING CAPITAL

RATIO.
LIQUIDITY RATIOS
 INTENTION OF CALCULATING THE LIQUIDITY RATIOS IS
TO INDICATE THE SHORT TERMS POSITION OF THE
ORGANIZATION. COMMERCIAL BANKS AND SHORT-TERM
CREDITORS OF THE ORGANIZATION MAY BE INTERESTED
IN THE RATIOS FALLING UNDER THIS CLASSIFICATION.
 UNDER THIS CLASSIFICATION, TWO IMPORTANT RATIOS

ARE CALCULATED VERY FREQUENTLY.

 CURRENT RATIO :
 LIQUID RATIO OR QUICK RATIO OR ACID TEST RATIO:

 
ACTIVITY OR TURNOVER RATIOS:
 RATIOS UNDER THIS CLASSIFICATION INDICATE
CAPACITY OF THE ORGANIZATION TO USE ITS
INVESTMENT IN VARIOUS KINDS OF ASSETS
MORE AND MORE EFFECTIVELY WHILE DOING
THE BUSINESS.
 ACTIVITY RATIOS ARE MIXED CLASSIFICATION

OF RATIOS I.E. NUMERATOR COMES FROM

PROFITABILITY STATEMENT VIZ. SALES, BOTH
CASH SALES AS WELL AS CREDIT SALES AND
DENOMINATOR COMES FROM BALANCE SHEET
VIZ. ASSETS.
ACTIVITY OR TURNOVER RATIOS:
 HIGHER TURNOVER RATIOS INDICATE THAT
THE ORGANIZATION IS EFFICIENT IN USING
ITS INVESTMENTS IN ASSETS MORE AND
MORE EFFECTIVELY WHILE DOING THE
BUSINESS.
 AS SUCH, HIGHER THE TURNOVER RATIOS,

BETTER THE SITUATION. DEPENDING UPON

THE NATURE OF ASSETS, THE ACTIVITY
RATIOS MAY GET CLASSIFIED IN THE
FOLLOWING CATEGORIES.
CAPITAL STRUCTURE OR
LEVERAGE RATIOS
 THE RATIOS CALCULATED UNDER THIS
GROUP INDICATE THE LONG TERM FINANCIAL
STABILITY OF THE ORGANIZATION. THE
INVESTORS AND LENDERS OF LONG TERM
FUNDS MAY BE BASICALLY INTERESTED IN THE
RATIOS CALCULATED UNDER THIS
CLASSIFICATION. FOLLOWING RATIOS MAY BE
CALCULATED UNDER THIS GROUP.
PROFITABILITY RATIOS:
 RATIOS CALCULATED UNDER THIS
CLASSIFICATION INDICATE PROFITABILITY OF
THE ORGANIZATION. AS SUCH, HIGHER THE
PROFITABILITY RATIOS, ALWAYS BETTER THE
SITUATION. FOLLOWING RATIOS MAY BE
CALCULATED UNDER THIS CLASSIFICATION.
MISCELLANEOUS RATIOS

 FOLLOWING RATIOS MAY BE CALCULATED

UNDER THIS CLASSIFICATION OF RATIOS –
 EARNINGS PER SHARE (EPS)
 PRICE EARNING RATIO (P/E RATIO)
 DIVIDEND PAYOUT RATIO (D/P RATIO)
LIMITATIONS OF RATIO ANALYSIS
 RATIOS ARE CALCULATED ON THE BASIS OF
FINANCIAL STATEMENTS.
 AS SUCH, THE LIMITATIONS APPLICABLE TO

THE FINANCIAL STATEMENTS EQUALLY APPLY

TO RATIO ANALYSIS.
LIMITATIONS OF RATIO ANALYSIS
◦ CONSTITUENT ORGANIZATIONS MAY NOT
BE COMPARABLE WITH EACH OTHER IN
TERMS OF AGE, LOCATION, EXTENT OF
AUTOMATION, EXTENT OF TURNOVER ETC.
◦ DIFFERENT ACCOUNTING POLICIES
FOLLOWED BY THE ORGANIZATIONS MAY
RENDER THE FINANCIAL STATEMENTS OF
THESE ORGANIZATIONS NON-COMPARABLE
WITH EACH OTHER.
LIMITATIONS OF RATIO ANALYSIS
◦ THE ACCOUNTING POLICIES MAY DIFFER IN
THE AREAS OF VALUATION OF STOCK AND
PROVISION FOR DEPRECIATION.
◦ RATIO ANALYSIS IGNORES NON-FINANCIAL
FIGURES.
◦ RATIO ANALYSIS IGNORES EFFECTS OF
CHANGES IN THE PRICE LEVELS.
LIMITATIONS OF RATIO ANALYSIS
 RATIO ANALYSIS ONLY HIGHLIGHTS THE
STRONG OR PROBLEM AREAS. FOR PROPER
DECISION MAKING THESE STRONG OR PROBLEM
AREAS ARE REQUIRED TO BE INVESTIGATED
FURTHER.
 FOR THE PURPOSE OF CALCULATION OF
RATIOS, THE FINANCIAL STATEMENTS ARE
CONSIDERED IN ISOLATION I.E. FINANCIAL
STATEMENTS FOR THE YEARS ENDING ON 31ST
MARCH 2018 AND 31ST MARCH 2019 ARE
CONSIDERED INDIVIDUALLY.
LIMITATIONS OF RATIO ANALYSIS
 RATIO ANALYSIS FAILS TO REALIZE THAT
INSTEAD OF CONSIDERING THESE FINANCIAL
STATEMENTS IN ISOLATION, IF THEY ARE
CONSIDERED TOGETHER, IT MAY HIGHLIGHT
THE FINANCIAL POLICIES AND STRATEGIES
FOLLOWED BY THE ORGANIZATION DURING THE
INTERVENING PERIOD.
 THIS LIMITATION OF RATIO ANALYSIS IS
OVERCOME BY FUNDS FLOW ANALYSIS WHICH
CONSIDERS THE FINANCIAL STATEMENTS ON
TWO CONSECUTIVE DATES.
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