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RATIO ANALYSIS

MEANING OF RATIO
A ratio is a simple arithmetical expression of the relationship of one number to another. It may be
defined as the indicated quotient of two mathematical expressions. According to Accounts
Handbook by Wixon, Kell and Bedford, a ratio is an expression of the quantitative relationship
between two numbers`1 According to Kohler, a ratio is the relation, of the amount, a, to another, b,
expressed as the ratio of a to b; a: b (a is to b); or as a simple fraction, integer, decimal, fraction or
percentage2 In simple language ratio is one number expressed in terms of another and can be
worked out by dividing one number into the other.

INTERPRETATION OF THE RATIOS


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Single Absolute Ratio.


Group of Ratio.
Historical Comparison.
Projected Ratios.
Inter-firm Comparison.

GUIDELINES OR PRECATIONS FOR USE OF RATIOS.


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Accuracy of Financial Statements.


Objective or Purpose of Analysis.
Selection of Ratios.
Use of Standards.
Caliber of the Analyst.
Ratios Provide Only a Base.

USE AND SIGNIFICANCE OF RATIO ANALYSIS


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Managerial Uses of Ratio analysis


1) Helps in decision-making
2) Helps in financial forecasting and planning.
3) Helps in communicating.
4) Helps in co-ordination.
5) Helps in Control.
6) Other Uses.
Utility to Shareholders/Investors
Utility to Creditors
Utility to Employees.
Utility to Government
Tax Audit Requirements

LIMITATIONS OF RATIO ANALYSIS


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Limited Use of a Single Ratio.


Lack of Adequate Standards.
Inherent Limitations of Accounting.
Change of Accounting Procedure.
Window Dressing.
Personal Bias.
Incomparable.
Absolute Figures Decorative.
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9. Price Level Changes.


10. Ratios no Substitutes.
Financial Statements-The financial statements provide a summary of the accounts of a business
enterprise, the balance sheet reflecting the assets, liabilities, and capital as on a certain data and the
income statement showing the results of operations during a certain period.
Various Financial Statements
1. Income statement (or Profit and Loss Account. Income statement is prepared to determine
the operation position of the concern. It is a statement of revenues earned and the expenses
incurred for earning that revenue. The income statement is prepared for a particular,
generally a year.
2. Balance Sheet. The balance sheet shows all the assets owned by the concern and all the
liabi9lities and claims it owes to owners and outsiders. The balance sheet is prepared on a
particular date.
3. Cash flow statement. A statement of changes in the financial positions of an organization
on cash basis is called cash Flow Statement. It summaries the causes of changes in cash
position of a business enterprise between dates of two balance sheets.
Financial statement analysis is defined as the process of identifying financial
strengths and weaknesses of the firm by properly establishing relationship
between the items of the balance sheet and the profit and loss account.
There are various methods or techniques that are used in analyzing financial
statements, such as comparative statements, schedule of changes in working
capital, common size percentages, funds analysis, trend analysis, and ratios
analysis.

Financial Ratio Analysis:


A ratio is an arithmetical relationship between two figures. Financial ratio analysis is a study of
ratios between various items or groups of items in financial statements. Ratios can be classified
according to statements mainly they are profit and loss ratios or revenue or income statement ratios,
balance sheet ratios or projection statement ratios, corporate or mixed ratio or inter statement ratios
Balance sheet ratio deals with the relationship between two balance sheet items: these can be
mainly classified as liquidity ratio, long term solvency or leverage ratio, and proprietors funds ratio.
Liquidity refers to the ability of an organization to meet its obligations in the short run, usually one
year. The important liquidity ratios are current ratio an acid test ratio.
Leverage refers to the use of debt finance and helps in assessing the risk arising from the use of debt
capital. The commonly used leverage ratios are debt-equity ratio and Equity ratio.
Proprietor ratio shows how the proprietors funds used for assets; the main proprietors funds ratio
is the proprietor funds to fixed assets.
Profit and loss ratios deal with relationship between two profit and loss accounts items. This may
classified a profitability ratio, Leverage Ratios.
Profitability or Profit margins reflect the relationship between profits and sales. The common-used
profit margin ratios are gross profit margin, operating margin profit, and net profit margin.
Leveraged ratio also composed from the profit and loss items to determine the extent in which the
operating profits are efficient to cover the fixed charges. These are financial leverage, operating
leverage and combined leverage.

Mixed ratio or inter statement ratios deals with relationship between one profit and loss account
items and one balance items. This may classify as Coverage Ratios, Activities Ratio, and Return on
Investment
Coverage Ratios indicated that the firms ability to pay interest regularly on long-term borrowings,
repayment of principal amount at the maturity. The main coverage ratios are interest coverage ratio
and debt service coverage ratio.
Activity ratios also referred to as turnover ratio or asset management ratios, measure how efficiently
the assets are employed by the organization. The important turnover ratios are inventory turnover
ratio, receivable turnover ratio, average collection period, fixed assets turnover ratio, and total assets
turnover ratio.
Return on Investment Ratio reflecting the relationship between profit and investment. Return on
investment ratio measures the overall financial performance of the organization. The most important
return on investment ratios are net income to total assets ratio, earning per share, and return on
equity.
Common Size Financial Statements Analysis:
The common size statements, balance sheet and income statement are shown in analytical
percentage. The figures are shown as percentage of total assets, total liabilities, and total sales. In
common size analysis the items in the balances sheet are stated as percentages of total assets and the
items in the income statement are expressed as percentage of total sales. Such percentage statements
are called common size statements.

Trend Analysis:
The financial statement may be analyzed by computing trends of series of information. This method
determines the direction upwards or downwards and involves the computation of percentage
relationship that each statement items bears to the same item in the base year. The information for a
number of years is taken up and one year generally the first year is taken as a base year. The figures
of the base year are taken as 100 and trend ratios for other years are calculated on this base year.

ANALYSIS OF RATIO
Ratios can be classified according to the statements as profit and loss ratios or revenue or income
statement ratios and balance sheet ratios or projections statement ratios, corporate or mixed ratio or
inter statement ratios.
Balance sheet or position statements ratio
Balance sheet ratio deals with the relationship between two balance sheet items; these can be
classified as liquidity ratio, long-term solvency or leverage ratio, and proprietors fund ratio.
Liquidity Ratio
These ratios are calculated to comment upon the short term paying capacity of a firm or concerns
ability to meet its current obligation. The important liquidity ratios are current ratio and quick ratio.
Current Ratio is a measure of general liquidity and is used to make the analysis of a short-term
financial position or liquidity of an organization. It represents the margin of safety. Quick Ratio is
also known as acid test ratio or liquid ratio. It is fairly measure of liquidity. It is based on those
current assets those are highly Liquid. Inventories are excluded from the current assets.
Current Ratio= Current Assets/Current Liabilities
Quick Ratio= Quick Assets/Current Liabilities
Leverage Ratio
Liquidity ratio shows the short-term financial position of the firm. To judge the long-term financial
position leverage or capital structure ratios are calculated. Leverage ratios can calculate from the
balance sheet to determine the portion of debt in total financing. Debt Equity ratio is calculated to
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measure the relative claims of outsiders and the extent to which debt financing has been used in the
organization. In this ratio the debt has been taken as the long-term debt by deducting bank overdraft,
cash credit from banks, etc. from total debt, and net worth has been calculated by adding share
capital with reserves and surplus and deducting the intangibles.
Debt Equity=Debt/Net worth or Equity
Proprietors Funds Ratio
The main proprietor fund ratio is Fixed Assets to proprietors funds. The Fixed assets to proprietors
Funds ratio indicate owners fund invested in the fixed assets. This ratio shows how properly
investment of funds from the point of view of long terms financial position.
Proprietors Fund Ratio=Fixed Assets/Proprietors Funds
Profit and Loss ratio or Revenue or Income Statement Ratio.
These ratios deal with relationship between two profit and loss accounts items.
Profitability Ratio or Profit Margin Ratio
This ratio measures the results of business operations or overall performance and effectiveness of the
firm. The main profitability ratios are gross profit margin. Operating profit margin and net profit
margin etc. Gross profit margin measures the relationship of gross profit to net sales. The Gross
profit ratio indicates the margin left after meeting manufacturing costs. Operating profit margin
shows the relationship between operating and sales. Here operation profit is calculating by deducting
interest and depreciation from gross profit. Net profit margin establishes a relation ship between net
profit (profit after tax) and indicates the efficiency of the management in manufacturing, selling
administrative and other activities of the organization.
Gross Profit Margin=(Gross Profit/Net Sales)*100
Operating Profit Margin=(Operating Profit/Net Sales)*100
Net Profit Margin=(Net Profit/Net Sales)*100
Leverage Ratio
Leveraged ratio also can compose from the profit and loss items to determine the extent in which the
operating profits are efficient to cover the fixed charges. This is also known as Degree of Leverage.
Financial Leverage also known as capital leverage or capital structure leverage refers to the use of
funds obtained by fixed cost securities such as debentures, bonds preference shares etc., in the hope
of increasing the return to equity shareholders. It indicates the changes that take place in taxable
income as a result of changes in operating income.
Operating Leverage may be defined as the tendency of operating profit to vary proportionately with
sales.
Mixed ratio or inter statement ratios
These ratios exhibit the relationship between a profit and loss item and a balance sheet item.
Coverage Ratio
Leverage ratios fail to indicate the firms ability to meet interest obligation, the firms ability to pay
interest regularly on long-term borrowing, repayment or principal amount at the maturity and the
security of their loans. The coverage ratio shows the firms ability to pay interest and principals due
Interest coverage ratio properly measures the margin of safety; the organization enjoys with respect
to its interest burden. The interest coverage ratio does tell any thing about the ability of company to
make payment principal interest and also in time. Debt service coverage ratio gives picture of longterm liquidity position.
Interest coverage ratio=Profit Before Interest and Taxes/Interest
Debt service coverage=(Profit After Tax+ Depreciation+ Interest on Long Term Loans)/(Interest+
Long Term Loans)
Activity Ratio or Current Assets movement Ratio

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 speed at which the assets
are being turned over into sales. The important turnover ratios are debtors turnover ratio inventory
turnover, creditor turnover ratio and working capital turnover ratios, fixed assets turnover ratio, total
assets turnover ratio.
Debtor turnover ratio indicates the velocity of debt-collection of an organization. In simple words, it
indicates the number of times debtors (receivables) are turned over during a year Generally high
turnover ratio is the more efficiency is managements of debtors / sales or more liquid are at the
debtors.
Debtor Turnover Ratio=Net Credit Sales/Average Trade Debtor
Average Collection Period represent the average number of days in which its debtors converted in to
cash. The short collection period implies quick payment by the debtors.
Average Collection Period= Total Trade Debtor/Sales Per Day
Creditor Turnover Ratio- In course of business operations an organization has to make credit
purchases and incurred short-term liabilities. Suppliers of goods naturally interested in finding out
how much time the organization likely to take to repaying the creditors.
Creditors Turnover Ratio=Net Credit Purchase/Average Trade Creditor
Average payment period represent the average number of days the organization is top pay its
creditors.
Average payment period=Total Trade Creditors/Average Daily Purchases
Inventory Turnover Ratio- Organization has to maintain the inventory of finished goods so as to
able to meet the requirement of the business, but the level of inventories should either too high or too
long.
Inventory Turnover Ratio=Costs Of Goods Sold/ Average Inventory at costs
Profitability ratio in relation to Investment
Return on investment is one of the important ratios used to measuring the efficiency of the
organization, as the objective of the organization is to maximize its earning.
Return on investment =Profit Before Interest Tax/Capital Employed
Return on Equity is calculated to see the profitability of the owners investment. It is regarded as an
important measure, because it reflects the productivity of the ownership (risk) capital employed in
the organization. It is affected by several factors like earning power, debt equity ratio, and cost of
debt and tax rate.
Return on Equity=Profit After Tax/Net Worth
The profit after tax belongs to shareholders. But income, which they really received, is the amount
earning received as cash dividend. Therefore a large number of present and potential investors are
interested in the Dividend Per Share.
Dividend Per Share=Dividend Paid/Number of Shares
Earning Per Share is a small variation of equity capital and is calculated by dividing the net profit
after tax and preference dividend by the total number of equity shares. EPS calculated for a number
of years indicates the earning power of the company has increased or decreased.
Earning Per Share=Profit After Tax/Number of Shares