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FINANCIAL STATEMENTS ANALYSIS Ratio Analysis Common Size Statements Importance and Limitations of Ratio Analysis Mini Case 6-2 6-2
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Ratio AnalysisRatio analysis is a widely used tool of financialanalysis. It is defined as the systematic use ofratio to interpret the financial statements sothat the strengths and weaknesses of a firm aswell as its historical performance and currentfinancial condition can be determined. 6-3 6-3
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Basis of Comparison1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance – improvement, deterioration or constancy – over the years.2) Interfirm Comparison involves comparing the ratios of a 6-4 6-4
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Net Working Capital Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.Table 1: Net Working CapitalParticulars Company A Company BTotal current assets Rs 1,80,000 Rs 30,000Total current liabilities 1,20,000 10,000NWC 60,000 20,000Table 2: Change in Net Working CapitalParticulars Company A Company BCurrent assets Rs 1,00,000 Rs 2,00,000Current liabilities 25,000 1,00,000NWC 75,000 1,00,000 6-6 6-6
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Liquidity RatiosLiquidity ratios measure the ability of a firm tomeet its short-term obligations. 6-7 6-7
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Current RatioCurrent Ratio is a measure of liquidity calculated dividing the currentassets by the current liabilities Current Assets Current Ratio = Current LiabilitiesParticulars Firm A Firm BCurrent Assets Rs 1,80,000 Rs 30,000Current Liabilities Rs 1,20,000 Rs 10,000Current Ratio = 3:2 (1.5:1) 3:1 6-8 6-8
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Acid-Test RatioThe quick or acid test ratio takes into consideration thedifferences in the liquidity of the components of currentassets. Quick Assets Acid-test Ratio = Current Liabilities Quick Assets = Current assets – Stock – Pre-paid expenses 6-9 6-9
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Example 1: Acid-Test RatioCash Rs 2,000Debtors 2,000Inventory 12,000Total current assets 16,000Total current liabilities 8,000(1) Current Ratio 2:1(2) Acid-test Ratio 0.5 : 1 6 - 10 6 - 10
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Supplementary Ratios for LiquidityInventory Turnover RatioDebtors Turnover RatioCreditors Turnover Ratio 6 - 11 6 - 11
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Inventory Turnover RatioThe ratio indicates how fast inventory is sold. A high ratio is good fromthe viewpoint of liquidity and vice versa. A low ratiowould signify that inventory does not sell fast and stays on the shelf or inthe warehouse for a long time. Cost of goods sold Inventory turnover ratio = Average inventory The cost of goods sold means sales minus gross profit. The average inventory refers to the simple average of the opening and closing inventory. 6 - 12 6 - 12
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Example 2: Inventory Turnover RatioA firm has sold goods worth Rs 3,00,000 with a gross profitmargin of 20 per cent. The stock at the beginning and the end ofthe year was Rs 35,000 and Rs 45,000 respectively. What is theinventory turnover ratio? (Rs 3,00,000 – Rs 60,000) Inventory 6 (times per = =turnover ratio (Rs 35,000 + Rs 45,000) ÷ 2 year) 12 months Inventory = = 2 monthsholding period Inventory turnover ratio, (6) 6 - 13 6 - 13
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Debtors Turnover RatioThe ratio measures how rapidly receivables are collected. A highratio is indicative of shorter time-lag between credit sales andcash collection. A low ratio shows that debts are not beingcollected rapidly. Net credit sales Debtors turnover ratio = Average debtorsNet credit sales consist of gross credit sales minus returns, if any,from customers.Average debtors is the simple average of debtors (includingbills receivable) at the beginning and at the end of year. 6 - 14 6 - 14
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Example 3: Debtors Turnover RatioA firm has made credit sales of Rs 2,40,000 during the year.The outstanding amount of debtors at the beginning and atthe end of the year respectively was Rs 27,500 and Rs32,500. Determine the debtors turnover ratio. Rs 2,40,000 Debtors 8 (times per = =turnover ratio (Rs 27,500 + Rs 32,500) ÷ 2 year) 12 Months Debtors 1.5 = =collection period Debtors turnover ratio, (8) Months 6 - 15 6 - 15
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Creditors Turnover RatioA low turnover ratio reflects liberal credit terms granted bysuppliers, while a high ratio shows that accounts are to be settledrapidly. The creditors turnover ratio is an important tool ofanalysis as a firm can reduce its requirement of current assets byrelying on supplier’s credit. Net credit purchases Creditors turnover = ratio Average creditorsNet credit purchases = Gross credit purchases - Returns tosuppliers.Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year. 6 - 16 6 - 16
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Example 4: Creditors Turnover RatioThe firm in previous Examples has made credit purchases of Rs1,80,000. The amount payable to the creditors at the beginningand at the end of the year is Rs 42,500 and Rs 47,500 respectively.Find out the creditors turnover ratio. (Rs 1,80,000) Creditors 4 (times = =turnover ratio (Rs 42,500 Rs 47,500) ÷ 2 per year) 12 months Creditor’s = = 3 monthspayment period Creditors turnover ratio, (4) 6 - 17 6 - 17
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The summing up of the three turnover ratios (known as acash cycle) has a bearing on the liquidity of a firm. The cashcycle captures the interrelationship of sales, collectionsfrom debtors and payment to creditors. The combined effect of the three turnover ratios is summarised below:Inventory holding period 2 months Add: Debtor’s collection period + 1.5 months Less: Creditor’s payment period – 3 months 0.5 months As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa. 6 - 18 6 - 18
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DEFENSIVE INTERVAL RATIODefensive interval ratio is the ratio between quickassets and projected daily cash requirement. Liquid assets Defensive- = interval ratio Projected daily cash requirement Projected cash operating expenditure Projected daily =cash requirement Number of days in a year (365) 6 - 19 6 - 19
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Example 5: Defensive Interval RatioThe projected cash operating expenditure of a firm from thenext year is Rs 1,82,500. It has liquid current assetsamounting to Rs 40,000. Determine the defensive-intervalratio. Rs 1,82,500 Projected daily cash requirement = = Rs 500 365 Rs 40,000 Defensive-interval ratio = = 80 days Rs 500 6 - 20 6 - 20
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Cash-flow From Operations RatioCash-flow from operation ratio measures liquidity of afirm by comparing actual cash flows from operations(in lieu of current and potential cash inflows fromcurrent assets such as inventory and debtors)with current liability. Cash-flow from operations Cash-flow from = operations ratio Current liabilities 6 - 21 6 - 21
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Leverage Capital Structure RatioThere are two aspects of the long-term solvency of a firm:(i) Ability to repay the principal when due, and(ii) Regular payment of the interest . Capital structure or leverage ratios throw light on the long-term solvency of a firm. Accordingly, there are two different types of leverage ratios. First type: These ratios are Second type: These ratios are computed from the balance computed from the Income sheet Statement(a) Debt-equity ratio (a) Interest coverage ratio(b) Debt-assets ratio (b) Dividend coverage ratio(c) Equity-assets ratio 6 - 22 6 - 22
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I. Debt-equity ratio Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity. Long-term Debt + Short Debt-equity ratio measures the ratio of long-term debt + Other Current Total Debt Debt-equitytotal de3bt to shareholders equity Liabilities = Total external term or ratio = Shareholders’ equity ObligationsIf the D/E ratio is high, the owners are putting up relatively lessmoney of their own. It is danger signal for the lenders andcreditors. If the project should fail financially, the creditors wouldlose heavily.A low D/E ratio has just the opposite implications. To the creditors, arelatively high stake of the owners implies sufficient safetymargin and substantial protection against shrinkage in assets. 6 - 23 6 - 23
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For the company also, the servicing of debt isless burdensome and consequently its creditstanding is not adversely affected, itsoperational flexibility is not jeopardised and itwill be able to raise additional funds.The disadvantage of low debt-equity ratio isthat the shareholders of the firm are deprivedof the benefits of trading on equityor leverage. 6 - 24 6 - 24
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Trading on EquityTrading on equity (leverage) is the use of borrowed funds inexpectation of higher return to equity-holders.Trading on Equity (Amount in Rs thousand) Particular A B C D(a) Total assets 1,000 1,000 1,000 1,000 Financing pattern: Equity capital 1,000 800 600 200 15% Debt — 200 400 800(b)Operating profit (EBIT) 300 300 300 300 Less: Interest — 30 60 120Earnings before taxes 300 270 240 180Less: Taxes (0.35) 105 94.5 84 63Earnings after taxes 195 175.5 156 117Return on equity (per cent) 19.5 21.9 26 58.5 6 - 25 6 - 25
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II. Debt to Total CapitalThe relationship between creditors’ funds and owner’scapital can also be expressed using Debt to total capitalratio. Total debtDebt to total capital ratio = Permanent capitalPermanent Capital = Shareholders’ equity + Long-term debt. 6 - 26 6 - 26
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III. Debt to total assets ratio Total debtDebt to total assets ratio = Total assetsProprietary RatioProprietary ratio indicates the extent to which assetsare financed by owners funds. Proprietary fundsProprietary ratio = X 100 Total assetsCapital Gearing RatioCapital gearing ratio is used to know the relationship between equityfunds (net worth) and fixed income bearing funds (Preferenceshares, debentures and other borrowed funds. 6 - 27 6 - 27
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Coverage RatioInterest Coverage RatioInterest Coverage Ratio measures the firm’s ability to makecontractual interest payments. EBIT (Earning before interest and taxes)Interest coverage ratio = InterestDividend Coverage RatioDividend Coverage Ratio measures the firm’s ability to pay dividendon preference share which carry a stated rate of return. EAT (Earning after taxes)Dividend coverage ratio = Preference dividend 6 - 28 6 - 28
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Total fixed charge coverage ratioTotal fixed charge coverage ratio measures the firm’s ability to meet all fixedpayment obligations. Total fixed charge EBIT + Lease Payment coverage ratio = Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)Total Cashflow Coverage RatioHowever, coverage ratios mentioned above, suffer from one majorlimitation, that is, they relate the firm’s ability to meet its variousfinancial obligations to its earnings. Accordingly, it would bemore appropriate to relate cash resources of a firm to its various fixed financial obligations. EBIT + Lease Payments + Depreciation + Non-cash expensesTotal cashflow =coverage ratio (Principal repayment) (Preference dividend) Lease payment + + + Interest (1– t) (1 - t) 6 - 29 6 - 29
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Debt Service Coverage RatioDebt-service coverage ratio (DSCR) is considered a morecomprehensive and apt measure to compute debt service capacityof a business firm. n ∑ EATt + Interestt + Depreciationt + OAt t=1 DSCR = n ∑ Instalmentt t=1DEBT SERVICE CAPACITYDebt service capacity is the ability of a firm to make thecontractual payments required on a scheduled basis over the lifeof the debt. 6 - 30 6 - 30
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Profitability Ratio Profitability ratios can be computed either from sales or investment. Profitability Ratios Profitability Ratios Related to Sales Related to Investments(i) Profit Margin (i) Return on Investments(ii) Expenses Ratio (ii) Return on Shareholders’ Equity 6 - 33 6 - 33
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Profit Margin Gross Profit MarginGross profit margin measures the percentage of each salesrupee remaining after the firm has paid for its goods.Gross profit margin = Gross Profit X 100 Sales 6 - 34 6 - 34
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Net Profit MarginNet profit margin measures the percentage of each sales rupeeremaining after all costs and expense including interestand taxes have been deducted. Net profit margin can be computed in three ways Earning before interest and taxesi. Operating Profit Ratio = Net sales Earnings before taxes ii. Pre-tax Profit Ratio = Net sales Earning after interest and taxes iii. Net Profit Ratio = Net sales 6 - 35 6 - 35
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Example 7: From the following information of a firm,determine (i) Gross profit margin and (ii) Net profitmargin.1. Sales Rs 2,00,0002. Cost of goods sold 1,00,0003. Other operating expenses 50,000 Rs 1,00,000 (1) Gross profit margin = = 50 per cent Rs 2,00,000 Rs 50,000 (2) Net profit margin = = 25 per cent Rs 2,00,000 6 - 36 6 - 36
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Expenses Ratio Cost of goods soldi. Cost of goods sold = X 100 Net sales Administrative exp. + Selling exp.ii. Operating expenses = X 100 Net sales Administrative expensesiii. Administrative expenses = X 100 Net sales Selling expensesiv. Selling expenses ratio = X 100 Net sales Cost of goods sold + Operating expensesv. Operating ratio = X 100 Net sales Financial expensesvi. Financial expenses = X 100 Net sales 6 - 37 6 - 37
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Return on InvestmentReturn on Investments measures the overall effectivenessof management in generating profits with its availableassets.i. Return on Assets (ROA) EAT + (Interest – Tax advantage on interest)ROA = Average total assetsii. Return on Capital Employed (ROCE) EAT + (Interest – Tax advantage on interest)ROCE = Average total capital employed 6 - 38 6 - 38
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Return on Shareholders’ EquityReturn on shareholders equity measures the return on theowners (both preference and equity shareholders)investment in the firm.Return on total shareholders’ equity = Net profit after taxes X 100 Average total shareholders’ equityReturn on ordinary shareholders’ equity (Net worth) = Net profit after taxes – Preference dividend X 100 Average ordinary shareholders’ equity 6 - 39 6 - 39
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Efficiency RatioActivity ratios measure the speed with which variousaccounts/assets are converted into sales or cash.Inventory turnover measures the efficiency of various typesof inventories.i. Inventory Turnover measures theof goods soldInventory Turnover Ratio = Cost activity/liquidity of Average inventoryinventory of a firm; the speed with which inventory is soldi. Inventory Turnover measures the activity/liquidityusedRaw materials turnover = Cost of raw materials ofinventory of a firm; the speed with whichmaterial inventory Average raw inventory is soldi. Inventory Turnover measuresCost activity/liquidity of the of goods manufacturedWork-in-progress turnover =inventory of a firm; the speed with which inventory is sold Average work-in-progress inventory 6 - 40 6 - 40
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Debtors Turnover RatioLiquidity of a firm’s receivables can be examinedin two ways. Credit salesi. Debtors turnover = measures the activity/liquidity of inventory ofi. Inventory Turnovera firm; the speed with which inventoryAverage bills receivable (B/R) Average debtors + is sold Months (days) in a year2. Average collection period = Debtors turnoveri. Inventory Turnover(days) in a year activity/liquidity of inventory of aAlternatively = Months measures the (x) (Average Debtors + Average (B/R)firm; the speed with which inventory is credit sales Total soldAgeing Schedule enables analysis to identifyslow paying debtors. 6 - 41 6 - 41
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Assets Turnover RatioAssets turnover indicates the efficiency with which firmuses all its assets to generate sales. Inventory Turnover measures the of goods sold of inventory ofi. Total assets turnover =i. Cost activity/liquiditya firm; the speed with which inventory total assets Average is sold Cost of goods soldii. Fixed assets turnover = Average fixed assets Cost of goods soldi. Inventory Turnover measures the activity/liquidity of inventory ofiii. Capital turnover =a firm; the speed with which inventory is sold employed Average capital Cost of goods soldiv. Current assets turnover = Average current assetsi. Inventory capital turnover = Costactivity/liquidity of inventory ofv. Working Turnover measures the of goods sold Net working capitala firm; the speed with which inventory is sold 6 - 42 6 - 42
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1) Return on shareholders’ equity = EAT/Average total shareholders’ equity.2) Return on equity funds = (EAT – Preference dividend)/Average ordinary shareholders’ equity (net worth).3) Earnings per share (EPS) = Net profit available to equity shareholders’ (EAT – Dp)/Number of equity shares outstanding (N).4) Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N).5) Earnings yield = EPS/Market price per share.6) Dividend Yield = DPS/Market price per share.7) Dividend payment/payout (D/P) ratio = DPS/EPS.8) Price-earnings (P/E) ratio = Market price of a share/EPS.9) Book value per share = Ordinary shareholders’ equity/Number of equity shares outstanding. 6 - 43 6 - 43
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Integrated Analysis RatioIntegrated ratios provide better insight about financial andeconomic analysis of a firm.(1) Rate of return on assets (ROA) can be decomposed in to (i) Net profit margin (EAT/Sales) (ii) Assets turnover (Sales/Total assets)(2) Return on Equity (ROE) can be decomposed in to (i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity) (ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity) 6 - 44 6 - 44
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Rate of Return on Assets EAT as percentage of Assets sales turnoverEAT Divided by Sales Sales Divided by Total Assets Fixed assets Plus Current assetsGross profit = Sales less cost of goods sold Alternatively Minus Shareholder equity Expenses: Selling PlusAdministrative Interest Long-term borrowed Minus funds Income-tax Plus Current liabilities 6 - 45 6 - 45
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Return on AssetsEarning PowerEarning power is the overall profitability of a firm; is computedby multiplying net profit margin and assets turnover.Earning power = Net profit margin × Assets turnoverWhere, Net profit margin = Earning after taxes/SalesAsset turnover = Sales/Total assetsi. Inventory Turnover measurestaxes xEarning Power = Earning after the activity/liquidity of inventory of Sales x EATa firm; the speed with which inventory isTotal Assets Total assets Sales sold 6 - 46 6 - 46
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EXAMPLE: 8Assume that there are two firms, A and B, each having total assetsamounting to Rs 4,00,000, and average net profits aftertaxes of 10 per cent, that is, Rs 40,000, each.Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregateRs 40,00,000. Determine the ROA of firms A and B. Table 4 showsthe ROA based on two components.Table 4: Return on Assets (ROA) of Firms A and BParticulars Firm A Firm B1. Net sales Rs 4,00,000 Rs 40,00,0002. Net profit 40,000 40,0003. Total assets 4,00,000 4,00,0004. Profit margin (2 ÷ 1) (per cent) 10 15. Assets turnover (1 ÷ 3) (times) 1 106. ROA ratio (4 × 5) (per cent) 10 10 6 - 47 6 - 47
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Return on Equity (ROE)ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplierThree-component model of ROE can be broadened further toconsider the effect of interest and tax payments. EAT EBT EBIT Net Profiti. Inventory Turnover measures the activity/liquidity of x x =inventory of a firm; the EBIT SalesEarnings before taxes speed with which inventory is sold SalesAs a result of three sub-parts of net profit ratio, the ROEis composed of the following 5 components. EAT EBT EBIT Sales Assets x x x x EBT EBIT Sales Assets Equity 6 - 48 6 - 48
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A 5-way break-up of ROE enables the management of a firm to analyse the effect of interestpayments and tax payments separately from operating profitability. To illustrate further assume 8per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) andRs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the5 components) of Firms A and B.Table 5: ROE (Five-way Basis) of Firms A and BParticulars Firm A Firm BNet sales Rs 4,00,000 Rs 40,00,000 Less: Operating expenses 3,22,462 39,26,462Earnings before interest and taxes (EBIT) 77,538 73,538 Less: Interest (8%) 16,000 12,000Earnings before taxes (EBT) 61,538 61,538 Less: Taxes (35%) 21,538 21,538Earnings after taxes (EAT) 40,000 40,000Total assets 4,00,000 4,00,000Debt 2,00,000 2,50,000Equity 2,00,000 1,50,000EAT/EBT (times) 0.65 0.65EBT/EBIT (times) 0.79 0.84EBIT/Sales (per cent) 19.4 1.84Sales/Assets (times) 1 10Assets/Equity (times) 2 1.6ROE (per cent) 20 16 6 - 49 6 - 49
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Common Size StatementsPreparation of common-size financial statements is an extensionof ratio analysis. These statements convert absolute sums intomore easily understood percentages of some base amount. It issales in the case of income statement and totals of assets andliabilities in the case of the balance sheet. LimitationsRatio analysis in view of its several limitations should beconsidered only as a tool for analysis rather than as an end initself. The reliability and significance attached to ratios will largelyhinge upon the quality of data on which they are based. They areas good or as bad as the data itself. Nevertheless, they are animportant tool of financial analysis. 6 - 50 6 - 50
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