Ratio Analysis

Ratio can be defined as the mathematical relationship between one number and another Ratio analysis can be defined as the analysis of two figures which have meaningful relation with each other eg.profit and sales, current assets and current liabilities

Advantages of Ratio Analysis

Useful in analysis of financial statements Helps in improving the future performance Useful in inter-firm and intra-firm comparison Helps in judging the efficiency of the business Useful in simplifying and presenting the accounting information

Limitations of Ratio Analysis

Reliability of ratios depends on the correctness of the basic data Ratios can be meaningful only when it is compared with other ratios Ratios does not give a correct picture all the time Ratios ignore the qualitative factors and focuses only on quantitative factors Ratios are based on past data and cannot be an indicator of future all the time

Liquidity Ratios
Current ratio=current assets/current liabilities Current assets include cash in hand, cash at bank, readily marketable securities, bills receivable, debtors, stock, prepaid expenses, any other asset which can be converted to cash within a year s time Current liabilities include sundry creditors, bills payable, bank overdraft, income tax payable, dividends payable, outstanding expenses, provision for taxation, unclaimed dividends Satisfactory current ratio=2:1

Quick Ratio
Quick, acid test or Liquid ratio: Quick ratio=Quick assets/Quick liabilities Quick assets include all the current assets except stock and prepaid expenses Quick liabilities include all the current liabilities except bank overdraft Satisfactory quick ratio is 1:1

Absolute Liquid Ratio

Also known as super quick ratio or cash ratio Absolute liquid ratio=cash in hand and bank+short term marketable securities/current liabilities Higher the ratio, higher is the cash liquidity

Capital Structure or Gearing Ratios

Also known as long term solvency ratios Debt equity ratio=External equities/Internal equities External equities include all outside liabilities such as debentures, sundry creditors, bills payable, bank overdraft, short and long term loans, outstanding expenses, taxation provision, proposed dividend Internal equities include share capital, accumulated profits , reserves and funds that belong to the shareholders

Proprietary Ratio
Proprietary ratio=shareholders funds/total assets Shareholders funds include equity share capital, preference capital, reserves and surplus which belongs to the shareholders Total assets include all tangible assets and the intangible assets which have a realisable value Higher proprietary ratio indicates long term stability of the company and greater protection to the creditors

Interest Coverage Ratio

Interest coverage ratio=EBIT/Fixed interest charges This ratio indicates the ability of the company to pay interest out of the profits The standard is that interest charges should be covered 6 to 7 times Fixed interest charges refers to the interest on debentures and long term loans

Debt to total funds ratio

Debt to total funds ratio=Debt/total funds This ratio indicates the proportion of funds supplied by outsiders Lower the ratio, it indicates that the creditors are safe and secure Debt includes long term loans and current liabilities Total funds include shareholders funds, long term loans and current liabilities

Capital Gearing Ratios

Capital Gearing ratio=Fixed income securities/Equity shareholder s funds Fixed income securities include debentures and preference share capital If the ratio is more than one, the company is highly geared

Turnover Ratios
Inventory turnover ratio=cost of goods sold/average stock Cost of goods sold=sales-gross profit Cost of goods sold=opening stock+purchases+carriage inwards and other direct expenses-closing stock Inventory turnover ratio=sales/average stock
Low ratio indicates dull business, accumulation of inventory etc. whereas high ratio indicates better position

Debtors turnover ratio

Debtors turnover ratio=credit sales/average debtors Debtors include trade debtors and bills receivables Sales per day=Net credit sales/No. of working days in a year Average collection period=Debtors/credit salesx365 days

Fixed assets turnover ratio

Fixed assets turnover ratio=Sales/net fixed assets High ratio indicates efficient utilisation of assets

Working capital turnover ratio

Working capital turnover ratio=Sales/Net working capital A higher ratio indicates efficient utilisation of working capital

Capital turnover ratio

Capital turnover ratio=Sales/total capital employed Totalcapitalemployed=equity+preference+rese rves+debentures+long term loans-fictitious assets-non-operating investments A higher turnover ratio indicates possibility of greater profit

Creditors turnover ratio

Creditors turnover ratio=Net credit purchases/average accounts payable

Profitability ratios
Gross profit ratio=GP/Net sales x100 Gross profit ratio=Net sales-cost of goods sold/net sales x100 Low ratio indicates higher cost of goods sold

 Net profit ratio=Net profit/net sales x100 Net operating profit ratio=net operating profit/net sales x100 Net operating profit is gross profit minus all operating expenses such as administrative expenses, selling and distribution expenses

 Operating ratio=cost of goods sold+operating expenses/netsalesx100 Expense ratio=Expenses/netsales x100

 Return on investment=PBIT/Capital employed x100 Capitalemployed=equitysharecapital+preferen ce sharecapital+reserves and other undistributed profit+long term loans and debentures-fictitious assets-non operating assets Higher the ROI, more efficient is the management

 Return on Proprietors equity=Net profit after taxes and interest/Shareholders fundsx100 Return on equity capital=Net profit after interest, tax and preference dividend/equity shareholders fund x100 EPS=Net profit after taxes-preference dividend/No. of equity shares

 Dividend pay out ratio=Dividend per share/EPS Dividend yield ratio=Dividend per equity share/market price per equity share Price earning ratio=Market price per equity share/EPS