Ratio Analysis

The term Ratio refers to the quantitative relationship between two figures which is obtained by dividing the former by the latter. A ratio, thus is a comparison of the numerator with the denominator. Ratio Analysis is an important technique of Financial Analysis. It is a technique of calculating various ratios from figures available in the financial statements and comparing these ratios with those of previous years or with those of other concerns or with he standard ratios and drawing the conclusion. Nature of Ratio Analysis: Ratio Analysis is the process of establishing various ratios in order to help in making certain decisions. It involves four steps: i) Selection of relevant data from financial statements ii) Calculation of relevant ratios from the selected data iii) Comparison of these ratios with those of previous years or with those of other concerns or with the standard ratios iv) Drawing conclusions, based on interpretation of ratios. Importance of Ratio Analysis: Ratio analysis of the financial statements of an organization is of much importance to a number of persons such as shareholders, creditors, employees, customers, legal authorities & general public for decision making. Following are the relevant points revealing importance of Ratio Analysis: i) Measuring General Efficiency: Ratios enable the mass of accounting data to be summarized or simplified. They act as an index of efficiency of the enterprise. ii) Measuring Financial Solvency: Ratios are the useful tools in the hands of the management to evaluate the firms performance over a period of time. They point out the firms liquidity position to meet its short-term and long-term obligations. iii) Forecasting and Planning: Ratio Analysis is an important tool to the management. Ratios enable the management to prepare properly the budgets, to formulate scientific business policies and to prepare future plan of action. iv) Decision Making: Ratio Analysis throws light on the degree of efficiency of the management and extent of utilization of assets of the enterprise. Ratios help management in decision making. v) Taking Corrective Action: Ratio Analysis helps in making inter-firm comparison. If the comparison shows an unfavorable trend, the corrective action can conveniently be taken. The figures in financial statements in their absolute forms are neither significant nor able to be compared. In fact they are dump but ratios instill in them the power to speak. Limitation of Ratio Analysis: Ratio Analysis, is no doubt, an important tool of financial management. But the ratios must be used carefully. Because the ratio analysis suffers from following demerits: 1. Ill - defined ratios : The most important drawback of ratio analysis is that there is no consistency and uniformity in the definition of various ratios. E.g. In the case of debt-equity ratio some experts take into consideration only the long-term liabilities where as others take short -term liabilities also. 2. Inaccurate Financial Statements : Ratios are calculated from figures contained in the financial statements. If the data in financial statements happen to be inaccurate, the ratios calculated on the basis of such data turnout to be ineffective.
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3. Difficulty in establishment of Standard Ratios : Ratios convey proper meaning only when they are compared with standard ratios already developed. But it is very difficult set standard ratios under changing socio-economic environment. Further, even the standard ratio may have to be changed from time to time. 4. No proper basis for comparison : Ratios facilitate inter-firm comparison but it is difficult to evaluate differences in factors affecting one firms performance in relation to another. Several differences exist in them such as age of the plant, degree of mechanization, size of the firm etc. In fact no two firms can be identical in every respect. Thus ratios of one firm cannot be compared with those of the other firm accurately. 5. Ignores Quality Aspect : Ratios express the quantitative relationship between two variables to measure efficiency. But the quality plays a very important role in presenting overall efficiency of the enterprise, which is ignored in ratio analysis. However, the ratio analysis is an age-old and very effective technique of financial management. But the analyst must have comprehensive and practical knowledge and experience about the concern whose financial statements have been used in calculating the ratios. Ratios are not an end in themselves but are the means to achieve a particular end. Hence, while attempting to draw any conclusion on the basis of ratios, other management techniques should also be used. Types of Ratios Ratios, reflecting the quantitative relationship between two figures of normal accounting process can be divided into following four types: 1) Liquidity Ratios 2) Capital structure Ratios or Leverage Ratios 3) Profitability Ratios 4) Activity Ratios or Turnover Ratios I. Liquidity Ratios: These are the ratios which intend to measure the liquidity or short-term solvency (i.e., the short term financial position) of the enterprise. They indicate whether the enterprise has sufficient working capital or not. Ratios which indicate liquidity of the enterprise are: i) Net working Capital ii) Current Ratio iii) Liquid Ratio iv) Absolute Liquid Ratio i) Net working Capital : It represents excess of current assets over current liabilities and is used as a measure of companies liquidity. Net working Capital = Current Assets Current Liabilities Where, Current assets include cash and bank balances, marketable securities, net debtors, bills receivable, stock and prepared expenses and Current Liabilities include creditors, bills payable, bank credits (i.e., short term loans, cash credits, O.Ds and bills discounted), provisions for tax, dividend payable and other expenses. ii) Current Ratio : It is the ratio of total current assets to current liabilities. The current ratio measures the short-term solvency (i.e., the ability to meet short-term obligations) of the concern. A current ratio of 2:1 is considered satisfactory. Current Ratio = Current Assets Current Liabilities Higher the current ratio more is the firms ability to meet the current obligations and vice-versa.
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iii) Liquid Ratio (Quick Ratio or Acid Test Ratio) : It is the ratio which measures the firms ability to convert its current assets into cash in order to meet its current liabilities. Liquid Ratio = Liquid Assets Current Liabilities Where, Liquid Assets = Current Assets (Stock & Prepaid Exp.) Liquid Ratio of 1:1 is accepted as a standard ratio and this ratio indicates the firms capacity to meet its financial obligations immediately without having to wait for the realization of sales proceeds. iv) Absolute Liquid Ratio (Super Quick Ratio) : This Ratio indicates clearly whether the firm is liquid or not. Absolute Liquid Ratio = Absolute Liquid Assets Current Liabilities Where, Absolute Liquid Assets = Cash & Bank Balance and readily marketable securities II. Capital Structure Ratios or Leverage Ratios : Long-term solvency of the firm can be examined by using the capital structure ratios. Equity shareholders, Debenture Holders and the financial institutions are interested in knowing the financial conditions of the firm. Capital structure ratios express the relationship between the funds supplied by the owners and the funds supplied by the creditors. There are two different but inter-related types of leverage ratios. They are: (A) Ratios which can be calculated from Balance Sheet (B) Ratios which can be calculated from Profit & Loss Account (A) Balance Sheet Ratios: The Balance Sheet Ratios are : 1) Debt-Equity Ratio 2) Proprietory Ratio 3) Fixed Assets to Net Worth Ratio 4) Current Assets to Net Worth Ratio 5) Capital Gearing Ratio and 6) Fixed Assets Ratio 1) Debt-Equity Ratio : This ratio indicates the relationship between borrowed fund (the debt) and owners fund (the equity). Thus, this ratio reflects the relative claims of creditors and shareholders against the assets of the company. Debt Equity Ratio = Long Term Debts Share Holders Equity Where, Long-term Debts include Debentures, Bonds, Moorages and other long-term loans from banks and financial institutions. Share holders Equity (also known as Net worth or Owners Equity or Proprietors fund) includes Equity Share Capital + Pref. share capital + Reserves and Surplus Accumulated losses. Another approach is to relate the Total Debts to Share holders Equity. Debt-Equity Ratio = Total Debts Shareholders Equity Where, Total Debts include long-term Debts and short term Debts (i.e., Current Liabilities) Ideal Debt Equity Ratio is one which maximizes earnings per share (EPS) and minimizes cost of capital.

Financial structure of the company is considered to be sound, when the debt is less than 2 times the equity. The higher Debt-Equity Ratio indicates the increased financial risk of the company as the debt carries interest, to be paid at regular intervals. 2) Proprietory Ratio (Net Worth Ratio or Capital Ratio or Equity Ratio) : This ratio indicates the relationship between the net worth as proprietors fund on the total assets. Proprietory Ratio = Net Worth Total Assets Where, Net worth = Shareholders Equity Total Assets = All tangible assets + The intangible assets (like G.W., Patents etc.) The proprietory ratio 0.75 : 1 is considered to be ideal. A high proprietory ratio signifies a strong financial position and vice-versa. 3) Fixed Assets to Net Worth Ratio : This ratio indicates the relationship between the net fixed assets and the proprietors fund. Fixed Assets to Net Worth Ratio = Net Fixed Assets Net worth Where, Net Fixed Assets = Cost of fixed Assets Depreciation This ratio reveals the extent of investment of proprietors fund on fixed assets. 4) Current Assets to Net Worth Ratio : This ratio indicates the relationship between the curren t assets and the proprietors fund. Current Assets to Net Worth Ratio = Current Assets Net Worth This ratio reveals the extent of investment of Proprietors fund on current assents. 5) Capital Gearing Ratio : This ratio expresses the relationship between Equity Share Capital and Debt Capital. Capital Gearing Ratio = Fixed Cost Bearing Funds Equity Shareholders' Fund Where, Fixed Cost Bearing Funds = Pref. Share Capital + Debentures + Long-term loans from Banks and Financial institutions Equity Shareholders Fund = Equity Share Capital + Reserves and surplus Accumulated Losses Capital Gearing Ratio reveals the present earnings of Equity shareholders and also the kind of securities to be issued in future to meet the financial requirements in time. (B) P&L A/C Ratios (Coverage Ratios): The P&L A/c Ratios are : 1) Interest Coverage Ratio, and 2) Dividend Coverage Ratio 1) Interest Coverage Ratio : This ratio reveals the debt securing capacity of the firm. Interest Coverage Ratio = EBIT Interest Where, EBIT = Earnings before Interest & Tax on operating profit A low ratio of Interest coverage indicates the firms difficulty in payment of interest and it implies that the debt capital is not effectively used. A high ratio of interest Coverage signifies the regular payment of interest without any delay.
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2) Dividend Coverage Ratio : This ratio measures the firms ability to pay dividend on preference shares which carry a fixed rate of dividend. Dividend Coverage Ratio = Earnings after Tax Preference Dividend III. Profitability Ratio : The profitability ratio indicates the relationships between Profit & Net sales and Profit & Investments. These ratios are generally expressed in percentages. Important profitability Ratios on net sales are: a) Gross Profit Ratio, b) Net Profit Ratio, c) Cost of Goods Sold Ratio, d) Expenses Ratio, e) Operating Ratio and f) Operating Profit Ratio a) Gross Profit Ratio : This ratio reveals the general profitability of the concern. G/P Ratio = G/P x 100 Net Sales Where, G/P = Sales Cost of Goods sold Net Sales = Gross Sales Sales Returns A high G/P Ratio signifies low cost of production and high quality of management. b) Net Profit Ratio : This ratio reveals the Net Margin N/P Ratio = N/P x 100 Net Sales A high N/P ratio ensures adequate return to the owners of the concern. c) Cost of Goods Sold Ratio : Cost of Goods Sold Ratio = Cost of Goods Sold x 100 Net Sales Where, Cost of Goods Sold = Sales - G/P or Opening Stock + Purchase + Manufacturing Expenses Closing Stock d) Expenses Ratio : i) Selling Expense Ratio = Selling Expense x 100 Net Sales ii) Administration Expenses Ratio = Admn. Expenses x 100 Net Sales iii) Operating Expenses Ratio = Admn. Expenses + Selling Exp. x 100 Net Sales e) Operating Ratio : Operating Ratio = Cost of Goods Sold + Operating Exp. X 100 Net Sales f) Operating Profit Ratio : Operating Profit Ratio = Operating Profit x 100 Net Sales Where, Operating Profit = N/P + Non-operating Exp. Non-operating Income Note: Operating Ratio + Operating Profit Ratio = 100%

Following are the profitability ratios on the basis of investments : a) Return on Capital Employed b) Return on Assets Ratio c) Return on Shareholders Equity d) Earning per share e) Dividend per share f) Dividend payment Ratio g) Price Earning Ratio a) Return on Capital Employed = Net Profit after Tax x 100 Capital Employed N/P after Tax & Int. Tax Advance on Int. x 100 Capital Employed N/P after Tax and Int. x 100 Capital Employed Intangible Assets b) Return on Assets Ratio = N/P after Tax & Int. Tax Advance on Int. x 100 Total Tangible Assets c) Return on Shareholders Equity = N/P after Tax x 100 Shareholders Equity d) Earning per share = Net Earnings available to Equity Shareholder No. of Equity Shares e) Dividend per share = Dividend paid to Equity Shareholders No. of Equity Shares f) Dividend payment Ratio = Dividend per Share x 100 Earning per share g) Price Earning Ratio = Market Price per Share Earning per Share IV. Activity Ratios (Turnover Ratios) : These Ratios measure the level of efficiency in the utilization of assets of a firm. The various turn-over ratios are: 1) Stock Turnover Ratio 2) Debtors Turnover Ratio 3) Creditors Turnover Ratio 4) Total Assets Turnover Ratio 5) Fixed Assets Turnover Ratio 6) Current Assets Turnover Ratio 7) Net Working Capital Turnover Ratio 8) Capital Turnover Ratio 1) Stock (Inventory) T/O Ratio : This ratio indicates the efficiency in inventory management, expressing how fast the stock is sold. Stock T/O Ratio = Cost of Goods sold Average Stock Where, Cost of Goods Sold = Sales G/P and Average Stock = Op.Stock + Cl. Stock 2 From the Stock T/O Ratio the stock holding period is calculated as under:
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OR

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Stock Holding Period = No. of Days in a year Stock T/O Ratio If the Cost of Goods sold is not known, the Stock T/O Ratio is calculated as under: Stock T/O Ratio = Net Sales Closing Stock 2) Debtors Turnover Ratio (Receivable T/O Ratio) : Debtors T/O Ratio = Net Cr. Sales Average Debtors If net credit sales are not given, the Debtors T/O Ratio is calculated as under: Debtors T/O Ratio = Total Sales Closing Debtors From the Debtors T/O ratio, the Debt collection period is calculated as under: Debt Collection Period = No. of Days/Months in a year Debtors T/O Ratio 3) Creditors T/O Ratio : Creditors T/O Ratio = Net Credit Purchases Average Creditors If Credit Purchases are not given, the Creditors T/O Ratio is calculated as under: Creditors T/O Ratio = Total Purchases Closing Creditors From the Creditors T/O Ratio Creditors Payment Period is calculated as under : Creditors Payment Period = No. of Days/Months in a year Creditors T/O Ratio 4) Total Assets T/O Ratio = Cost of Goods Sold Total Assets 5) Fixed Assets T/O Ratio = Cost of Goods Sold Fixed Assets 6) Current Assets T/O Ratio = Cost of Goods Sold Current Assets 7) Net Working Capital T/O Ratio = Cost of Goods Sold Net Working Capital 8) Capital T/O Ratio = Cost of Goods Sold Capital Employed