Financial ratio is the relationship between twoaccounting figures expressed mathematically.Suppose there are two accounting figures of aconcern are sales Rs 100000 and profits Rs 15000.The ratio between these two figures will be
Need for Analysis Financial Statement• Earning capacity or Profitability• Comparative position in relation withother firms• Efficiency of management• Financial Strength• Solvency of the firm
Parties interested in Analysis of Financial Statement • Short term Creditor • Long term Creditor • Share holders • Management • Trade Union • Taxation Authority • Researchers • Employees
Significance of Ratio Analysis • Simplification of accounting data • Helpful in comparative Study • Focus in trends • Setting Standards • Study of financial Soundness
Broadly accounting ratios can be grouped intothe following categories : (a) Liquidity ratios (b) Activity ratios (c) Solvency ratios (d) profitability ratios (e) Leverage ratio
Liquidity RatiosThe important liquidity ratios(i) Current ratio(ii) Quick ratio (i) Current ratio The objective of computing this ratio is to measure the ability of the firm to meet its short term liability. It compares the current assets and current liabilities of the firm. This ratio is calculated as under :
SignificanceIt indicates the amount of current assets available forrepayment of current liabilities. Higher the ratio, thegreater is the short term solvency of a firm and vice aversa. However, a very high ratio or very low ratio is amatter of concern.Thus, the ideal current ratio of a company is 2 : 1 i.e. torepay current liabilities, there should be twice currentassets.
Quick ratioQuick ratio is also known as Acid test or Liquid ratio. It is anotherratio to test the liability of the concern. This ratio establishes arelationship between quick assets and current liabilities.. The mainpurpose of this ratio is to measure the ability of the firm to pay itscurrent liabilities.SignificanceQuick ratio is a measure of the instant debt paying capacity of thebusiness enterprise. It is a measure of the extent to which liquidresources are immediately available to meet current obligations. Aquick ratio of 1 : 1 is considered good for a company.
Activity Or Turnover RatioActivity ratios measure the efficiency or effectiveness withwhich a firm manages its resources. These ratios are alsocalled turnover ratios because they indicate the speed atwhich assets are converted or turned over in sales. Some of the important activity ratios are : (i) Stock turnover ratio (ii) Debtors turnover ratio (iii) Creditors turnover ratio (iv) Working capital turnover ratio
Stock turnover ratioStock turnover ratio is a ratio between cost of goods soldand the average stock or inventory. It evaluates theefficiency with which a firm is able to manage itsInventory. Cost of Goods SoldStock Turnover Ratio = ---------------------------------- Average StockCost of goods sold = Opening stock + Purchases + Direct expenses – Closing StockCost of goods sold = Sales – Gross ProfitAverage stock =
Inventory or Stock Conversion Period: Days in a yearInventory Conversion Period= --------------------------------- Inventory turnover ratioSignificanceThe ratio signifies the number of times on an average theinventory or stock is disposed off during the period. The highratio indicates efficiency and the low ratio indicates inefficiencyof stock management.
Debtors Turnover RatioThis ratio establishes a relationship between net credit salesand average account receivables. The objective of computingthis ratio is to determine the efficiency with which the tradedebtors are managed.
Debt Collection Period Significance Debtors turnover ratio is an indication of the speed with which a company collects its debts. The higher the ratio, the better it is.
Creditors Turnover Ratio Significance Creditors turnover ratio helps in judging the efficiency in getting the benefit of credit purchases offered by suppliers of goods. A high ratio indicates the shorter payment period and a low ratio indicates a longer payment period.
Working Capital Turnover Ratio Working capital = Current Assets – Current Liabilities Working Capital Turnover Ratio = Cost of Sales / Net Working CapitalNote:If the figure of cost of sales is not given, then the figure of sales can be used.On the other hand if opening working capital is not discussed then workingcapital at the year end will be used.
SOLVENCY RATIOSThe term ‘solvency’ refers to the ability of aconcern to meet its long term obligations. The following ratios serve the purpose of determining the solvency of the business firm. • Debt equity ratio • Proprietary ratio
Debt-equity ratio It is also otherwise known as external to internal equity ratio.• The outsiders’ funds include all debts/liabilities to outsiders i.e. debentures,long term loans from financial institutions, etc.• Shareholders’ funds mean preference share capital, equity share capital,reserves and surplus and fictitious assets like preliminary expenses.• In India, this ratio may be taken as acceptable if it is 2 : 1. If the debt-equityratio is more than that, it shows a rather risky financial position from the longterm point of view.
Proprietory ratioIt is also known as equity ratio.The shareholders’ fund is the sum of equity share capital,preference share capital, reserves and surpluses. Out ofthis amount, accumulated losses should be deducted.On the other hand, the total assets mean total resources ofthe concern.SignificanceA high ratio shows that there is safety for creditors of all types.Higher the ratio, the better it is for concerned.
From the following calculate the proprietary ratio :RsEquity share capital 1,00,000Preference share capital 50,000Reserves and surpluses 25,000Debentures 60,000Creditors 15,000Total 2,50,000Fixed assets 1,25,000Current Assets 50,000Investment 75,000Total 2,50,000
Net profit ratioIt indicates sales margin on sales. This is expressed as apercentage. The main objective of calculating this ratio is todetermine the overall profitability. Significance It indicates the extent to which management has been effective in reducing the operational expenses. Higher the net profit ratio, better it is for the business.
Operating profit ratio Operating profit is an indicator of operational efficiencies. Operating profit Ratio establishes relationship between operating profit and net sales.Operationg Profit = Gross Profit – (Administration expenses + selling expenses) Significance It helps in examining the overall efficiency of the business. It measures profitability and soundness of the business. Higher the ratio, the better is the profitability of the business.
Net Profit Before Interest = Net Profit + Interest
Return on investment ratio (ROI) Or Return on Capital Employed RatioThis ratio establishes relationship between net profit (beforeinterest, tax and dividend) and capital employed.SignificanceROI ratio judges the overall performance of the concern. Itmeasures how efficiently the sources of the business are beingused. Higher the ratio the more efficient is the managementand utilisation of capital employed.
LEVERAGE RATIO OR CAPITAL STRUCTURE RATIO• Leverage or capital structure ratios are calculated to testthe long term financial position of a firm.• Generally capital gearing ratio is mainly calculated toanalyse the leverage or capital structure of the firm.
Capital gearing ratioThe capital gearing ratio is described as the relationshipbetween equity share capital including reserves andsurpluses to preference share capital and other fixed interestbearing loans.
From the following information find out capitalgearing ratio. Source 2005 2006 Amount (Rs.) Amount (Rs.) Equity Share 5,00,000 4,00,000 Capital Reserve and 3,00,000 2,00,000 surplus 8% Preference 2,50,000 3,00,000 share capital 6% Debentures 2,50,000 4,00,000
LIMITATION OF ACCOUNTING RATIOS Ignorance of qualitative aspect Ignorance of price level changes No single concept Misleading results if based on incorrectaccounting data No single standard ratio for comparison Difficulties in forecasting