Ratio Analysis


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Ratio Analysis

  1. 1. RATIO ANALYSIS 1 RATIO ANALYSIS Analysis Meaning of Ratio Analysis Ratio analysis is a very important tool of financial analysis. It is the process of establishing the significant relationship between the items of financial statement to provide a meaningful understanding of the performance and financial position of a firm. Ratio when calculated on the basis of accounting information are called ‘Accounting Ratio’. Definitions: Kennedy and Mc Mulla. “The relationship of one to another, expressed in simple term of mathematical is know as ratio” According to Accountant’s Handbook by Wixon, kell and Bedford, a ratio “is an expression of the quantitative relationship between two numbers”. Analysis Nature of Ratio Analysis Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing and interpreting various ratios for helping in making certain decisions. However, ratio analysis is not an end in itself. It is only a means of better understanding of financial strengths and weakness of a firm. There are a number of ratios which can be calculated from the given information given in the financial statements, but the analyst has to select the appropriate data and calculate only a few appropriate ratios from the same keeping in mind the objectives of analysis. The following are the four steps involved in the ratio analysis: (i) Selection of relevant data from the financial statements depending upon the objective of the analysis. (ii) Calculation of appropriate from the above data. (iii) Comparison of the calculated ratios with the ratios of the same firm in the past, or the ratios developed from the projected financial statements or the ratios of some other firms or the comparison with ratios of the industry to which the firm belongs. (iv) Interpretation of the ratios. Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  2. 2. RATIO ANALYSIS 2 Uses/Significance/Objects Uses/Significance/Objects or importance of ratio analysis /Signif The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyse and interpret the financial health of the enterprise, just like a doctor examines the patient by recording his body temperature, blood pressure, etc. before making his conclusion regarding the illness and before giving his treatment, a financial analyst analyses the financial statements with various tools of analysis before commencing upon the health or weakness of an enterprise. ‘A ratio is known as a symptom like blood pressure, the pulse rate or the temperature of an individual.’ (A)Usefulness for short term creditors. Short term creditors are trade creditors, bills payables, creditors for expenses etc. The concern pays short term creditors out of its current assets. If the current assets are quit4e sufficient to meet current liabilities then the creditor will not hesitate in extending credit facilities. Current and acid-test ratios will give an idea about the current financial position of the concern. (B) Usefulness for long term creditors. Long term creditors are financial institutions, debenture holders, mortgage creditors etc. are interested in analysing the capacity of the unit of repay periodical interest, and repayment of loan on schedule. (C) Usefulness to Employees. The employees are also interested in the financial position of the concern. Their wages increases and amount of fringe benefits are related to the volume of profits earned by the concern. The employees make use of information available in financial statement. Various profitability ratios relating to gross profit, operating ratio, net profit, etc. enable employees to put forward their viewpoint for the increase of wages and other benefits. (D)Usefulness to the Government. Government is interested in the financial information of the units both at macro as well as micro levels. Individual unit’s information regarding production, sales and profit is required for exercise duty, sales tax and income tax purposes. Group information for the industry is required for formulating national policies and planning. In the absence of dependable information, govt. plans and policies may not achieve desired results. Government is interested to know the overall strength of the industry. The ration may be used as indicators of overall strength of public as well as private sector. In the absence if the reliable economic information, governmental plans policies may not prove successful. Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  3. 3. RATIO ANALYSIS 3 (E) Usefulness for investors. Investor’s first interest will be the security of his investment and then a return in the form of dividend or interest. The investors can determine the magnitude and direction of the movement in firm’s earnings with the help of profitability ratios such as earning per share, dividend yield, etc. After analyzing the relevant ratios the present investors can decide whether to hold, sell or purchase the shares and the prospective investor can decide whether or not to buy the shares. (F) Usefulness to the management (i) Decision-making: Financial statements are prepared primarily for decision making. Ratios help in high-lighting the areas of deserving attention and corrective action thus facilitating decision making. (ii) Financial forecasting and planning: Planning and forecasting can be done only by knowing the past and the present. Planning is looking ahead and the ratios calculated for a number of years work as a guide for the future. Meaningful conclusions can be drawn for future from these ratios. (iii) Communication: The financial strength and the weakness of a firm are communicated in a more easy and understandable manner by use of ratios. (iv) Co-ordination is facilitated: Ratio even help in co- ordination which is of outmost importance in effective business management. Better communication of efficiency and weakness of an enterprise results in better co-ordination in the enterprise. (v) Control is more effective: Ratio analysis even help in making effective control of the business. Standard ratio can be based upon proforma financial statements and variances or deviations, if any, can be found by comparing the actual with the standards so as to take a corrective action at the right time. The weakness or otherwise, if any, come to the knowledge of the management which helps in effective control of the business. (vi) Other Uses: There are so many uses of ratio analysis. It is an essential part of the budgetary control and standard costing. Ratios are of immense importance in the analysis Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  4. 4. RATIO ANALYSIS 4 and interpretation of financial statements as they bring the strength or weakness of a firm. Guidelines/Precautions/Factors considered while undertaking Ratio Analysis. 1. Quality/Accuracy of Financial Statement: The ratios are calculated from the data available in financial statements. The reliability of ratios is linked to the accuracy of information in these statements. Before calculating ratios one should see whether proper concepts and conventions have been used for preparing financial or not. 2. Objectives/purposes of Analysis: The type of ratios to be calculated will depend upon the purposes for which are required. The purpose of user is also important for the analysis of ratios. Creditors, a banker, an investor, a shareholder, all have different objects for studying ratios. The purpose or object for which ratios are required to be studied should always be kept in mind for studying various ratios. Different objects may require the study of different ratios. 3. Selection of Ratios: Another precaution in ratio analysis is the proper selection of appropriate ratios. The ratios should match the purpose for which these are required. Only those ratios should be selected which can throw proper light on the matter to be discussed. 4. Use of standards: The ratios will give an indication of financial position only when discussed with reference to certain standards. These standard may be rule of thumb as in case of current ratio (2:1) and acid-test ratio (1:1), may be industry standards, may be budgeted or projected ratios, etc. 5. Capability of the analyst: Analysis is a tool in the hands of analyst. Knife in the hands of criminal may take the life but the knife in the hands of a surgeon may give new life to a patient. Interpretation depends on the educational background; professional skill; experience and intuition of the professional conducting it. 6. Ratio to be used only as guide: Ratios can provide, at the best, the starting point. The analyst, before arriving at the conclusion, should take into consideration all other relevant factors financial and non- financial; macro and micro. Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  5. 5. RATIO ANALYSIS 5 Advantages of Ratio Analysis Following are some of the advantages of ratio analysis: 1. Simplifies financial statements. Ratio analysis simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of a business. 2. Facilitates inter firm comparison. Analysis provides data for inter firm comparison. Ratios high-light the factors associated with successful and unsuccessful firms. They also reveal strong firms and weak firms, overvalued and undervalued firms. 3. Makes inter-firm comparison possible. Ratio analysis also makes possible comparison of the performance of the different of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future. 4. Helps in planning. Ratio analysis helps in planning and forecasting. Over a period of time a firm or industry develops certain norms that may indicate future success or failure. Thus ratios can assist management in its basic function of forecasting, planning, co-ordination, control and communication. LIMITATIONS OF RATIO ANALYSIS The ratio analysis is one of the most powerful tools of the financial management. Ratio analysis is a widely used and useful technique to evaluate the financial position and performance of any business unit but it suffers from a number of limitations. These limitations must be kept in mind by the analyst while using this technique. 1. Limited use of a Single Ratio: A single ratio, usually, does not convey much of a sense. To make a better interpretation a number of ratios have to be calculated which is likely to confuse the analyst than help him to in making any meaningful conclusion. 2. Lack of adequate standards: There are no well accepted standards or rules of thumb for all ratios which can be accepted as norms. It renders interpretation of the ratios difficult. 3. Inherent Limitation of accounting: Like financial statements, ratios also suffer from the inherent weakness of accounting records Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  6. 6. RATIO ANALYSIS 6 such as their historical nature. Ratios of the past are not necessary true indicators of the future. 4. Change of accounting procedure: Change in accounting procedure by a firm often makes ratio analysis misleading, e.g., a change in the valuation of methods of inventories, from FIFO to LIFO increases the cost of sales and reduces considerably the value of closing stocks which makes stock turnover ratio to be lucrative and an unfavourable gross profit ratio. 5. Personal Bias: Ratios are only means of financial analysis and not an end in itself. Ratios have to be interpreted and different people may interpret the same ratio in different ways. 6. Uncomparable: Not only industries differ in their nature but also the firms of the similar business widely differ in their size and accounting procedures, etc. It makes comparison of ratios difficult and misleading. Moreover, comparisons are made difficult due to differences in definition of various financial terms used in the ratio analysis. 7. Absolute Figures Distortive: Ratio devoid of absolute figures may prove distortive as ratio analysis is primarily a quantitative analysis and not a qualitative analysis. 8. Price level Changes: While making ratio analysis, no consideration is made to the changes in price levels and this makes the interpretation of ratio invalid. 9. Ratios no Substitutes: Ratio analysis is merely a tool of financial statements. Hence, ratios become useless if separated from the statements from which they are computed. 10.Clues not Conclusions: Ratios provide only clues to analysts and not final conclusions. These ratios to be interpreted by these experts and there are no standard rules for interpretation. CLASSIFICATION OF RATIOS The use of ratio analysis is not confined to financial manager only. There are different parties interested in the ratio analysis for knowing the financial position of a firm for different purposes. Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  7. 7. RATIO ANALYSIS 7 Various accounting ratios can be classified as follows: RATIOS Traditional Classification Functional Classification Significance Ratios Or Or Or Statement Ratios Classification According To Tests Ratios According to Importance 1. Traditional Classification or statement Ratios Traditional Classification or classification according to the statement, from which these ratios are calculated, is as follows: Traditional Classification or Statement Ratios Balance Sheet Ratios Profit & Loss Account Ratio Composite /Mixed or or or Position Statement Ratios Revenue/Income Statement Ratios Inter-Statement ratios Current Ratio Gross Profit Ratio Stock Turnover Ratio Liquid Ratio Operating Ratio Debtors Turnover Ratio Absolute Liquidity Ratio Operating Profit Ratio Payable Turnover Ratio Debt Equity Ratio Net Profit Ratio Fixed Assets Turnover Ratio Proprietory Ratio Cash Profit Ratio Return on Equity Capital Gearing Ratio Expenses ratio Return on Shareholders’ Funds Assets-Proprietorship Ratio Interest Coverage Ratio Return on Capital Employed Capital Inventory to Capital Turnover Ratio Working Capital Ratio Working Capital Turnover Ratio Ratio of Current Assets to Return on Total Resources Fixed Assets Total Assets Turnover a) Balance Sheet or Position Statement Ratios: Balance Sheet Ratios deal with the relationship between two balance sheet items, e.g. the Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  8. 8. RATIO ANALYSIS 8 ratio of current assets to current liabilities, or the ratio of proprietors’ funds to fixed assets. b) Profit and Loss Account or Revenue/Income Statement Ratios: These ratios deals with the relationship between two profit and losses account items, e.g., the ratio of gross profit to sales, or the ratio of net profit to sales. c) Composite/mixed ratios or Inter Statement Ratios: These ratios exhibit the relation between a profit and loss account or income statement item and balance sheet item, e.g., stock turnover ratio, or the ratio of total assets to sales. The most commonly used inter-statement ratios are given in the chart exhibiting traditional classification or statement ratios. 2. Functional Classification or Classification According to Tests In view of the financial management or according to the tests satisfied, various ratios have been classified as below: Functional Classification in View of Financial Management or Classification According to Tests Liquidity Ratios Long-term Solvency Activity Ratios or Assets Profitability Ratios & Leverage Ratios Management Ratios Current Ratio Financing operating, Inventory Turnover In Relation to Sales Liquid Ratio Composite Ratio Gross Profit Ratio Or Debtors Turnover Operating Ratio Acid Test ratio Debt/Equity Ratio Fixed Assets Operating Profit Ratio Or Debt to Total Turnover Ratio Net Profit Ratio Quick ratio Capital Ratio Total Assets Expense Ratio Absolute Liquid Interest Coverage Turnover Ratio Ratio Cash Flow/Debt Working Capital In relation to Or Capital Gearing Turnover Ratio investments Cash ratio Payables Turnover Return on Investments Interval Measure Ratio Return on Capital Capital Employed Return on Equity Capital Debtors Turnover Turnover Return on Total Resources Ratio Earnings per share Creditors Turnover Price-Earning Ratio ratio Inventory Turnover Ratio. Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  9. 9. RATIO ANALYSIS 9 a) Liquidity Ratios: These are the ratios which measure the short-term solvency or financial position of a firm. These ratios are calculated to comment upon the short-term paying capacity of a concern or the firm’s ability to meet its current obligations. The various liquidity ratios are current ratio, liquidity ratio ad absolute liquid ratio. b) Long-term Solvency and Leverage Ratios: These are meant for testing long-term financial soundness of any unit. Primarily, these establish and study relationship between owned funds and loaned funds. For example, debt-equity ratio, capital gearing ratio etc., are covered under this group. The leverage ratios can further be classified as: (i) Financial leverage. (ii) Operating Leverage. (iii) Composite Leverage. c) Activity Ratios: Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales, e.g., debtors turnover ratio. The various activity or turnover ratios have been named in the chart classifying the ratios. d) Profitability Ratios: These ratios are measure the working results of the unit during the accounting period. Profits are compared with sales level and investment level. The various profitability ratio have been given in the chart exhibiting the classification of ratios according to test. Generally, two types of profitability ratios are calculated: (i) In relation to sales (ii) In relation to investments. 3. Classification According to Significance or Importance The ratios have also been classified according to their significance or importance. Some ratios are more important than others and the firm may classify them as primary and secondary ratios. The British Institute of Management has recommended the classification of ratio according to importance for inter-firm comparisons. For inter-firm comparisons, the ratios may be classified as Primary Ratios and Secondary Ratios. The primary ratio is one which is of the prime importance to a concern; thus return on capital employed is named as primary ratio. The other ratios which support or explain the primary ratio are called secondary ratios, e.g., the relationship of opening profit to sales or the relationship of sales to total assets of the firm. Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  10. 10. RATIO ANALYSIS 10 List of current assets and current liabilities. Current Assets Current Liabilities Cash-in-Hand Sundry Creditors Cash-at-Bank Bills Payable Bills Receivable Outstanding Expenses Sundry Debtors Bank Overdraft Less Provision for Bad debt Taxes Payable Marketable Securities Dividend Payable Temporary Investments Short-term advances Stock: Income received in advance Raw Materials Income tax Payable Work-in-Progress Finished Goods Short-term investments Recoverable Advances Prepaid Expenses Accrued Incomes Advance Taxes (I) LIQUIDITY RATIO: Current Ratio = Current Assets Current Liabilities Current Assets = Total assets Fixed assets Or = Working Capital + Current liabilities Liquidity Ratio/Quick Ratio/Acid Test Ratio = Liquid Assets/Quick Assets Current Liabilities Liquid assets/Quick Assets = Current assets Stock Prepaid Expenses (II) SOLVENCY RATIO/CAPITAL STRUCTURE RATIO/TEST OF LONG TERM SOLVENCY: Debt equity Ratio = Long Term Debts Total Shareholder’s Funds Long term debts = Debentures + other long term loans Shareholder’s Funds = Equity Share Capital + Preference Share Capital + Reserve & Surplus + Profit & Loss account Preliminary expenses Fictitious Assets Proprietary Ratio/Ratio of owner equity to total assets = Proprietor’s Funds Total Assets Total Assets to Debt Ratio = Total Assets Long Term debts Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  11. 11. RATIO ANALYSIS 11 (III) ACTIVITY RATIO/TURNOVER RATIO/PERFORMANCE RATIO/EFFICIENCY RATIO: Stock Turnover Ratio = Cost of Goods Sold Average Stock Debtors/Receivable turnover Ratio = Net Credit Sale Average debtors Creditors/Payable turnover Ratio = Net Credit Purchase Average Creditors Working Capital turnover Ratio = Cost of Goods sold/Net Sales Net Working Capital Fixed Assets turnover Ratio = Cost of Goods Sold/Net Sales Net Fixed Assets Current Assets turnover ratio = Cost of Goods Sold/Net Sales Current assets Cost of Goods sold = Net Sales Gross Profit Net Credit sales = Total sales Cash sale Sales return Net Credit Purchase = Total Purchase Cash purchase Returns Total Debtors = Sundry Debtors + B/R Provision for doubtful debts Total Creditors = Sundry creditors + Bills Payable Net Working Capital = Total Current assets Total Current Liabilities Net Fixed assets = Total Assets Current Assets Current Assets = Total Assets Fixed assets (IV) PROFITABILITY RATIO: Gross Profit Ratio/Gross Margin Ratio = Gross Profit Net Sales X 100 Net Profit Ratio = Net Profit(after tax) Net Sales X 100 Operating Ratio = Total Operating Cost X 100 Net Sales Operating Profit Ratio = Operating Profit Net Sales X 100 Return on Capital Employed/Return on Investment = = Net Profit before Tax & Dividend X 100 Capital Employed Earning Per Share(EPS) = Net Profit (after tax & Preference dividend) No. of Equity Shares X 100 Dividend Per Share(DPS) = Dividend paid to equity shareholder X 100 Number of equity shares Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666
  12. 12. RATIO ANALYSIS 12 Price Earning Ratio(PER) = Current Marketable Equity of Equity Share Earning Per Share X 100 Gross Profit = Net Sale Cost of Goods Sold Net profit = Net operating Profit + Non Operating Income Non operating Expenses Net Profit = Gross Profit + All other incomes All expenses Operating Cost = Cost of Goods Sold + Office & Administration Expenses + Selling & Distribution Expenses + Financial Expenses + Repair and Maintenance Operating Profit = Net Sales Operating Cost Operating Expenses = Administration + Selling Expenses Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets Or Capital Employed = Fixed Assets + Current Assets – Current Liabilities Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Fictitious Assets Fictitious Assets = Underwriting Commission + Preliminary Expenses + Discount or Loss on Issue of Shares/Debentures and miscellaneous Expenses Return on Investment or Return on Capital Employed: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit. Return on Equity: Return on equity is also known as return on shareholders’ investment. The ratio establishes relationship between profits available to equity shareholders with equity shareholders’ funds. Earning Per Share: Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares. THOUGHT Education is not the filling of a pail, but the lighting of Education a fire. Tutorial. School, National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu. 0191- Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666