2. 1.1 INTRODUCTION ON RATIO ANALYSIS
The term “ratio analysis” refers to the analysis of the financial
statements in conjunction with the interpretations of financial results of a
particular period of operations, derived with the help of ‘ratio’. Ratio
analysis is used to determine the financial soundness of a business
concern.
Ratio analysis is a conceptual technique which dates back to the
inception of accounting, as a concept.
Financial analysis as a scientific tool is used to carry out the calculations
in the area of accounting.
In order to appraise the valid and existent worth of an enterprise, the
financial tool comes handy, regularly. Besides, it also allows the firms to
observe the performance spanning across a long period of time along
with the impediments and shortcomings.
However, there’s been a complete paradigm shift in the structure.
Currently, lending is based on the evaluation of the actual need of the
firms. Financial viability of the proposal, as a base to grant loans, is now
been given precedence over security. Further, an element of risk is
imperative in every business decision. Credits, run a higher risk, as a
part of any decision making in business.
3. 1.2 OBJECTIVES OF RATIO ANALYSIS
Interpreting the financial statements and other financial data is essential
for all stakeholders of an entity. Ratio Analysis hence becomes a vital
tool for financial analysis and financial management. Let us take a look
at some objectives that ratio analysis fulfils.
Measure Of Profitability:
Profit is the ultimate aim of every organization. So, if I say that ABC
firm earned a profit of 5 lakhs last year, how will you determine if that is
a good or bad figure? Context is required to measure profitability, which
is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio,
Expense ratio etc. provide a measure of the profitability of a firm. The
management can use such ratios to find out problem areas and improve
upon them.
Evaluation of Operational Efficiency:
Certain ratios highlight the degree of efficiency of a company in the
management of its assets and other resources. It is important that assets
and financial resources be allocated and used efficiently to avoid
unnecessary expenses. Turnover Ratios and Efficiency Ratios will point
out any mismanagement of assets.
Ensure Suitable Liquidity:
Every firm has to ensure that some of its assets are liquid, in case it
requires cash immediately. So, the liquidity of a firm is measured by
ratios such as Current ratio and Quick Ratio. These help a firm maintain
the required level of short-term solvency.
4. Overall Financial Strength:
There are some ratios that help determine the firm’s long-term solvency.
They help determine if there is a strain on the assets of a firm or if the
firm is over-leveraged. The management will need to quickly rectify the
situation to avoid liquidation in the future. Examples of such ratios are
Debt-Equity Ratio, Leverage ratios etc.
Comparison:
The organizations’ ratios must be compared to the industry standards to
get a better understanding of its financial health and fiscal position. The
management can take corrective action if the standards of the market are
not met by the company. The ratios can also be compared to the
previous years’ ratios to see the progress of the company. This is known
as trend analysis.
1.3 ADVANTAGES OF RATIO ANALYSIS:
When employed correctly, ratio analysis throws light on many problems
of the firm and also highlights some positives. Ratios are essentially
whistleblowers; they draw the management's attention towards issues
needing attention. Let us take a look at some advantages of ratio
analysis.
Ratio analysis will help validate or disprove the financing,
investment and operating decisions of the firm. They summarize
the financial statement into comparative figures, thus helping the
management to compare and evaluate the financial position of the
firm and the results of their decisions.
5. It simplifies complex accounting statements and financial data into
simple ratios of operating efficiency, financial efficiency,
solvency, long-term positions etc.
Ratio analysis help identify problem areas and bring the attention
of the management to such areas. Some of the information is lost
in the complex accounting statements, and ratios will help pinpoint
such problems.
Allows the company to conduct comparisons with other firms,
industry standards, intra-firm comparisons etc. This will help the
organization better understand its fiscal position in the economy.
1.4 LIMITATIONS OF RATIO ANALYSIS:
While ratios are very important tools of financial analysis, they have
some limitations, such as
The firm can make some year-end changes to their financial
statements, to improve their ratios. Then the ratios end up being
nothing but window dressing.
Ratios ignore the price level changes due to inflation. Many ratios
are calculated using historical costs, and they overlook the changes
in price level between the periods. This does not reflect the correct
financial situation.
6. Accounting ratios completely ignore the qualitative aspects of the
firm. They only take into consideration the monetary aspects
(quantitative)
There are no standard definitions of the ratios. So, firms may be
using different formulas for the ratios. One such example is
Current Ratio, where some firms take into consideration all current
liabilities but others ignore bank overdrafts from current liabilities
while calculating current ratio
And finally, accounting ratios do not resolve any financial
problems of the company. They are a means to the end, not the
actual solution.
EXAMPLE:
When many year figures are kept side by side, they help a great deal in
exploring the ___ visible in the business.
A. Trends, B. System, C. Difference
The correct option is A. Ratio analysis can be used to compare
information taken from financial statements to gain a general
understanding of the results, financial positions, and cash flow of a
business. Ratio analysis is useful in exploring trends of the business.
7. 1.5 AREA OF STUDY
Financial statement ratio analysis focuses on three key aspects of a
business: liquidity, profitability, and solvency. The problems, which are
common to most of the public sectors under taking, are materials
scarcity. Capacity utilization and mainly working capital requirements
and Heritage Foods (India) Limited.
8. 1.6 CHAPTERIZATION
CHAPTER 1 INTRODUCTION 1.1 INTRODUCTION
ABOUT THE
PROJECT TITLE
1.2 OBJECTIVES
1.3 ADVANTAGES
1.4 LIMITATIONS
OF THE STUDY
1.5 AREA OF
STUDY
CHAPTER 2 THEORETICAL
OUTLOOK
CHAPTER 3 COMPANY
PROFILE
CHAPTER 4 DATA ANALYSIS &
INTERPRETATION
CHAPTER 5 FINDING,
SUGGESTION &
CONCLUSION
5.1 FINDING
5.2 SUGGESTION
5.3 CONCLUSION
REFERENCE BOOKS, BLOGS &
WEBSITES.
10. 2.1 THEORETICAL OUTLOOK OF RATIO ANALYSIS:
Ratio is an expression of one number in relation to another. Ratio
analysis is the process of determining and interpreting the numerical
relationship between figures of financial statements. A ratio is a
mathematical relationship between two items expressed in a quantitative
form. An absolute figure does not convey much meaning. Generally, with
the help of other related information the significance of the absolute
figure could be understood better.
2.2 DEFINITION OF RATIO ANALYSIS:
In the words of Kennedy and Mc Millan “the relationship of an item to
another expressed in simple mathematical form is known as a ratio”
EXPRESSIONS OF RATIO
1. TIME: In this type of expression one number is divided by
another number and the quotient is taken as number of times.
2. PERCENTAGE: It is expressed in Percentage. When the above
example is expressed as percentage.
3. PURE: It is expressed as a proportions.
The study of relationships between various items or groups of
items in financial statements is known as ‘Financial Ratio Analysis’
11. 2.3 ADVANTAGES OF RATIO ANALYSIS:
Ratio analysis is an important technique in financial analysis. It is a
means for judging the financial soundness of the concern. The
advantages of accounting ratios are as follows:
1. It is an useful device for analysing the financial statements.
2. It simplifies, summarizes the accounting figures to make it
understandable.
3. It helps in financial forecasting.
4. It facilitates interfirm and intrafirm comparisons.
Ratio analysis is useful in finding the strength and weakness of a
business concern. After identifying the weakness, the ratios are also
helpful in determining the causes of the weakness.
12. 2.4 CLASSIFICATION OF RATIOS:
1. LIQUIDITY RATIOS :
Liquidity Ratios measure the firms’ ability to pay off current dues
i.e.,repayable within a year. Liquidity ratios are otherwise called
as Short Term Solvency Ratios.
The important liquidity ratios are
1. Current Ratio
2. Liquid Ratio
3. Absolute Liquid Ratio
13. CURRENT RATIO:
This ratio is used to assess the firm’s ability to meet its current
liabilities. The relationship of current assets to current liabilities is
known as current ratio. The ratio is calculated as:
Current Assets are those assets, which are easily convertible into cash
within one year. This includes cash in hand, cash at bank, sundry
debtors, bills receivable, short term investment or marketable securities,
stock and prepaid expenses.
Current Liabilities are those liabilities which are payable within one
year. This includes bank overdraft, sundry creditors, bills payable and
outstanding expenses.
LIQUID RATIO:
This ratio is used to assess the firm’s short - term liquidity. The
relationship of liquid assets to current liabilities is known as liquid ratio.
It is otherwise called as Quick ratio or Acid Test ratio. The ratio is
calculated as:
Liquid assets means current assets less stock and prepaid expenses.
14. ABSOLUTE LIQUID RATIO :
It is a modified form of liquid ratio. The relationship of absolute
liquid assets to liquid liabilities is known as absolute liquid ratio.
This ratio is also called as ‘Super Quick Ratio’. The ratio is
calculated as:
Absolute liquid assets means cash, bank and short term
investments. Liquid liabilities means current liabilities less bank
overdraft.
15. 2. SOLVENCY RATIOS :
Solvency refers to the firms ability to meet its long term indebtedness.
Solvency ratio studies the firms ability to meet its long term obligations.
The following are the important solvency ratios:
1. Debt-Equity Ratio
2. Proprietory Ratio
DEBT EQUITY RATIO:
This ratio helps to ascertain the soundness of the long term financial
position of the concern. It indicates the proportion between total long
term debt and shareholders funds. This also indicates the extent to which
the firm depends upon outsiders for its existence. The ratio is calculated
as:
Total long term debt includes Debentures, long term loans from banks
and financial institutions.
Shareholders funds includes Equity share capital, Preference share
capital, Reserves and surplus.
16. PROPRIETORY RATIO:
This ratio shows the relationship between proprietors or shareholders
funds and total tangible assets. The ratio is calculated as:
Tangible assets will include all assets except goodwill, preliminary
expenses etc.
17. 3. PROFITABILITY RATIO:
Efficiency of a business is measured by profitability. Profitability ratio
measures the profit earning capacity of the business concern. The
mportant profitability ratios are discussed below:
1. Gross Profit Ratio
2. Net Profit Ratio
3. Operating Profit Ratio
4. Operating Ratio
GROSS PROFIT RATIO:
This ratio indicates the efficiency of trading activities. The relationship
of Gross profit to Sales is known as gross profit ratio. The ratio is
calculated as:
Gross profit is taken from the Trading Account of a business concern.
Otherwise Gross profit can be calculated by deducting cost of goods sold
from sales.
Sales means Net sales.
18. Gross Profit = Sales – Cost of goods sold
Cost of goods sold = Opening Stock + Purchases – Closing Stock
OR
Sales – Gross Profit
