RATIO ANALYSIS AS A TOOL FOR FINANCIAL ANALYSIS by : DR. T.K. JAIN AFTERSCHO ☺ OL centre for social entrepreneurship sivakamu veterinary hospital road bikaner 334001 rajasthan, india www.afterschoool.tk mobile : 91+9414430763
What types of ratios to use? Depending on your purpose, you may use different ratios. If you want to judge liquidity, use liquidity ratios, if you want to judge efficiency and performance, use operating ratios, if you are a creditor, look for solvency ratios.
Types of ratios... Solvency ratios (for example, debt equity ratio ) liquidity ratio (for example current ratio) profitability / operating ratios (for example turnover ratios)
How to undertake ratio analysis ? First of all make necessary adjustments in the balance sheet so that it can be compared. In ratio analysis we compare data from balance sheet and profit and loss accounts. We need data which can be compared. We have to find out the data which are comparable. Thus we need to make minor adjustments in these in order to make them comparable
Which ratio to use for evaluating inventory management Ratio analysis depends on your questions. If you want to judge inventory management, use inventory turnover ratios to find out the performance of the company.
What is inventory turnover? All turnover ratios have sales as numerator and the denominator is the item that you want to know. Instead of sales, you can also take cost of goods sold. Thus if you have sales and profit both the figure, you may use cost of goods sold (SALES – PROFIT) for this purpose. If sales is 100, and inventory is 10, inventory turnover ratio is 100/10=10, which is good (you dont have excess inventory)
Compare the ratio.... In order to derive any conclusion, compare the ratio that you have calculated with other ratios, and compare with other companies and other units. Ratio analysis can be misleading, if you dont have similar information to compare. For example, in wool industry of Bikaner, debtor turnover ratio of 4 is very good, but in a grocery store this will be very bad.
Ratio analysis is relative... Ratio analysis is relative as it depends on industry practices, business trends and many factors like this. Be careful to consider all those factors. Wool industry in Bikaner generally gives very long credit period – 6 months on an average. A grocery store cannot give such a long credit period, thus we have to understand the industry practices before taking any decision
Liquidity ratio... The purpose of these ratios is to find out availability of liquidity (cash or cash equivalent) in the company. Liquidity is necessary for smooth running of the business. We need to have high liquidity in a business to make it profitable. Liquidity ratio can be calculated by the following means : current ratio : comparison of current assets and current liability etc.
Current ratio Just devide current asset by current liability ideally you must have current assets at least 2 times the current liabilities. Thus if your current liabilities are 100, current assets must be at least 200. again you have to look at the type of current assets also. You have to look at the nature and composition of current assets before taking any decision.
Quick ratio Devide quick assets by current liabilities. Quick assets are those which can be converted into cash any time. These include cash, debtors, BR, etc. Thus if there is urgent demand from creditors, we can convert quick assets into cash and pay them. Thus quick assets should be at least equal to current liabilities. Inventories are generally not considered quick assets
Solvency ratio... Solvency ratios help you in identifying the solvency (capacity to meet liabilities in the long term) examples of these ratios are : debt equity ratio etc.
Debt equity ratio Devide your total long term debt by equity. Your long term debt should never be more than double the equity. However, in some industry (where there is some support by government / financial institution), you can have debt equity ratio of 3:1 or 4:1 also. Power sector in India is one such example, where you may have DE ratio of 4:1
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