RATIO ANALYSIS

Accounting Ratios & Useful:A relationship between various accounting figures, which are connected with each other, expressed in mathematical terms, is called accounting ratios. According to Kennedy and Macmillan, "The relationship of one item to another expressed in simple mathematical form is known as ratio." Robert Anthony defines a ratio as "simply one number expressed in terms of another." Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations. Absolute figures are useful but they do not convey much meaning. In terms of accounting ratios, comparison of these related figures makes them meaningful. For example, profit shown by two-business concern is Rs. 50,000 and Rs. 1,00,000. It is difficult to say which business concern is more efficient unless figures of capital investment or sales are also available. Analysis and interpretation of various accounting ratio gives a better understanding of the financial condition and performance of a business concern.

Ratio Analysis
Ratio analysis is one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern. Simply, ratio means the comparison of one figure to other relevant figure or figures. According to Myers, " Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements." Advantages and Uses of Ratio Analysis There are various groups of people who are interested in analysis of financial position of a company. They use the ratio analysis to workout a particular financial characteristic of the company in which they are interested. Ratio

analysis helps the various groups in the following manner: -

1. To workout the profitability: Accounting ratio help to measure the

profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern. In this way profitability ratios show the actual performance of the business. To workout the solvency: With the help of solvency ratios, solvency of the company can be measured. These ratios show the relationship between the liabilities and assets. In case external liabilities are more than that of the assets of the company, it shows the unsound position of the business. In this case the business has to make it possible to repay its loans. Helpful in analysis of financial statement: Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc. Helpful in comparative analysis of the performance: With the help of ratio analysis a company may have comparative study of its performance to the previous years. In this way company comes to know about its weak point and be able to improve them. To simplify the accounting information: Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations. To workout the operating efficiency: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilising the resources. To workout short-term financial position: Ratio analysis helps to workout the short-term financial position of the company with the help of liquidity ratios. In case short-term financial position is not healthy efforts are made to improve it. Helpful for forecasting purposes: Accounting ratios indicate the trend of the business. The trend is useful for estimating future. With the help of previous years ratios, estimates for future can be made. In this way these ratios provide the basis for preparing budgets and also determine future line of action.

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Limitations of Ratio Analysis In spite of many advantages, there are certain limitations of the ratio analysis techniques and they should be kept in mind while using them

in interpreting financial statements. The following are the main limitations of accounting ratios:

1. Limited Comparability: Different firms apply different accounting

policies. Therefore the ratio of one firm can not always be compared with the ratio of other firm. Some firms may value the closing stock on LIFO basis while some other firms may value on FIFO basis. Similarly there may be difference in providing depreciation of fixed assets or certain of provision for doubtful debts etc. False Results: Accounting ratios are based on data drawn from accounting records. In case that data is correct, then only the ratios will be correct. For example, valuation of stock is based on very high price, the profits of the concern will be inflated and it will indicate a wrong financial position. The data therefore must be absolutely correct. Effect of Price Level Changes: Price level changes often make the comparison of figures difficult over a period of time. Changes in price affects the cost of production, sales and also the value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison. Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision making. For example, average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis. Effect of window-dressing: In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way. Costly Technique: Ratio analysis is a costly technique and can be used by big business houses. Small business units are not able to afford it. Misleading Results: In the absence of absolute data, the result may be misleading. For example, the gross profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000 and sales are Rs. 20,000 and profit earned by the other one is Rs. 10,00,000 and sales are Rs. 40,00,000. Even the profitability of the two firms is same but the magnitude of their business is quite different.

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8. Absence of standard university accepted terminology: There are

no standard ratios, which are universally accepted for comparison purposes. As such, the significance of ratio analysis technique is reduced.

Classification of various profitability ratios: -

a. b. c. d. e. f.

Gross Profit Ratio Net Profit Ratio Operating Net Profit Ratio Operating Ratio Return on Investment or Return on Capital Employed Return on Equity Earning Per Share

Meaning, Objective and Method of Calculation: -

a. Gross Profit Ratio: Gross Profit Ratio shows the relationship between
Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner: Gross Profit Ratio = Gross Profit/Net Sales x 100 Where Gross Profit = Net Sales Cost of Goods Sold Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses Closing Stock And Net Sales = Total Sales Sales Return Objective and Significance: Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. The gross profit ratio of current year is compared to previous years ratios or it is compared with the ratios of the other concerns. The minor change in the ratio from year to year may be ignored but in case there is big change, it must be investigated. This investigation will be helpful to know about any departure from the standard mark-up and would indicate losses on account of theft, damage, bad stock system, bad sales policies and other such reasons. However it is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realisation of fixed expenses of the business.

b. Net Profit Ratio: Net Profit Ratio shows the relationship between Net
Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner: Net Profit Ratio = Net Profit/Net Sales x 100 Where Net Profit = Gross Profit Selling and Distribution Expenses Office and Administration Expenses Financial Expenses Non

Operating Expenses + Non Operating Incomes. And Net Sales = Total Sales Sales Return Objective and Significance: In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years ratios, the increment shows the efficiency of the concern.

c. Operating Profit Ratio: Operating Profit means profit earned by the

concern from its business operation and not from the other sources. While calculating the net profit of the concern all incomes either they are not part of the business operation like Rent from tenants, Interest on Investment etc. are added and all non-operating expenses are deducted. So, while calculating operating profit these all are ignored and the concern comes to know about its business income from its business operations. Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner: Operating Profit Ratio = Operating Profit/Net Sales x 100 Where Operating Profit = Gross Profit Operating Expenses Or Operating Profit = Net Profit + Non Operating Expenses Non Operating Incomes And Net Sales = Total Sales Sales Return Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.

d. Operating Ratio: Operating Ratio matches the operating cost to the

net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses. Operating Ratio = Operating Cost/Net Sales x 100 Where Operating Cost = Cost of goods sold + Operating Expenses Cost of Goods Sold = Opening Stock + Net Purchases + Direct

Expenses Closing Stock Operating Expenses = Selling and Distribution Expenses, Office and Administration Expenses, Repair and Maintenance. Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit.

e. Return on Investment or Return on Capital Employed: This ratio

shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit. Return on Capital Employed = Net Profit before Employed x 100 Interest, Tax and Dividend/Capital

Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans Fictitious Assets Or Capital Employed = Fixed Assets + Current Assets Current Liabilities Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.

f. Return on Equity: Return on equity is also known as return on

shareholders investment. The ratio establishes relationship between profit available to equity shareholders with equity shareholders funds. Return on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders Funds x 100

Where Equity Shareholders Funds = Equity Share Capital + Reserves and Surplus Fictitious Assets Objective and Significance: Return on Equity judges the profitability from the point of view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of equity funds invested in the firm. The investors favour the company with higher ROE.

g. Earning Per Share: Earning per share is calculated by dividing the net
profit (after interest, tax and preference dividend) by the number of equity shares. Earning Per Share = Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares Objective and Significance: Earning per share helps in determining the market price of the equity share of the company. It also helps to know whether the company is able to use its equity share capital effectively with compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.

INTRODUCTION AND RATIO ANALYSIS

Introduction:Ratio analysis is the method or process by which the relationship of item or groups of items in the financial statements are computed, determined and presented. Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of a business enterprise. Ratio analysis can be used both in trend and static analysis.

Objectives
Recall the meaning of financial statement. Explain the meaning and need for analysis of financial statement. Identify the parties interested in analysis of financial statement. Enumerate the defferent techniques of analysis. State the meaning of the term Accounting Ratio. Describe the significance of Accounting Ratio.

Meaning Of Analysis And Financial Statement

Analysis means establishing a meaningful relationship between various items of the two financial statement with each other in such a way that a conclusion is drawn. By Financial Statement we mean two statement, 1. Profit And Loss A/C Or Income Statement 2. Balance Sheet Or Position Statement.

These are prepared at the end of a given period of time. They are indicators of Profitability and Financial soundness of the business concern. Thus, Analysis of Financial Statement means establishing meaningful relationship between various items of the two financial statement

Need For Analysis Of Financial Statement

Analysis of Financial Statement is an attempt to assess the efficiency and performance of an enterprise. For this purpose, it is necessary to know the1. Earning Capacity Or Profitability:- The overall objective of a business is to earn a satisfactory return on the funds invested in it. Financial Analysis helps in ascertaining whether adwequate profit are being earned on the capital invested in the business or not. It also help in knowing the capacity to pay the interest and dividend. 2 Comparative Position In Relation To Other Firms :- The purpose of financial statement analysis is to help to management to make a comparative study of the profitability of various firms engaged in similar business. Such comparison also help the management to study the position of their firm in respect of sales expenses, profitability, and using capital, etc.

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Efficiency Of Management :- The purpose of financial statement analysis is to know that the financial policies adopted by the management are efficient or not. Analysis also helps the management in preparing budgets by forecasting next years profit on the basis of past earnings. It also helps the management to find out the shortcomings of the business so that remedial measures can be taken to remove these shortcomings.

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Financial Strength :- The purpose of financial analysis is to assess the financial potential of the business. Analysis also help in taking decisions. a) Whether funds required for the purchase of new machinery and equipments are provided from internal resources of the business or not. b) How much funds have been raised from external sources.

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Solvency of the firm:- The different tools of analysis tell us whether the firm has sufficient fund to meet its short-term and long-term liabilities or not.

Parties Interested In Analysis Of Financial Statement

Analysis of Financial Statement has become very significant due to widespread interest of various parties in the financial result of a business unit. The various person interested in the analysis of financial statement are: Short-Term Creditors They are interested in knowing whether the amount owing to them will be paid as and when fall due for payment or not. Long-Term Creditor They are interested in knowing whether the principal amount and the interest thereon will be paid on time or not. Shareholders They are interested in profitability, return and capital appreciation. Management The management is interested in the financial position and performance of the enterprise as a whole and of its various division. Trade Unions They are interested in financial statements for negotiating the wages or salaries or bonus agreement with the management. Taxation Authorities These Authorities are interested in financial statement for determining the tax liability. Researchers They are interested in financial statements in undertaking research in business affairs and practices. Employees They are interested as it enable them to justify their demands for bonus and increase in remuneration.

You have seen that different parties are interested in the results reported in the financial statements. These results are reported by analysis financial statements through the use of different techniques like ratio analysis, Fund Flow Analysis, etc. Here, we will discuss Ratio Analysis only.

Meaning And Significance Of Ratio Analysis

Meaning of accounting ratio The ratio is an arithmetical relationship between two numerical. It is expressed as a proportion, or a fraction, or in percentage or in terms of number of items. For Example, expenses are 70% of sales, or sales of current year are 4 time then that of the last year, Net Profit are 1/10th (one tenth) of the capital employed, etc. Thus, accounting ratio are ratio formed out of figures taken from financial statement. These are calculated by placing two figure taken from financial statement in the form of ratio. They are tools in the hand of users and help the management in taking decisions. Significance Of Ratio Analysis Analysing financial statements from various aspect of a business through the techniques of Accounting Ratio is called Ratio Analysis. Ratio Analysis is an important technique of financial analysis. It is a mean for judging the financial health of a business enterprises. It determines and interprets liquidity, solvency, profitability, etc of a business enterprise. Let us see some uses of Accounting Ratio. I. Simplification of Accounting Data It become simple to understand various figures in the financial statements through the use of different ratios. For example, A profit of Rs. 20000/- may not sound very impressive but if it is earned with the help of a capital of Rs. 20000/- it becomes easy to say that the profit is reasonably good by stating that it is 100% of the capital. Accounting Ratio simplify, summaries, and systematize the accounting figures presented in financial statement. II. Helpful In Comparative Study

With the help of ratio analysis, comparison of profitability and financial soundness can be made between one firm and another in the same industries. Similarly, comparison of current year figures can also be mad with those of previous year with the help of ratio analysis and if some weak points are located, remedial measures are taken to correct them. III. Focus On Trends If accounting ratios are calculated for a number of years, they will reveal the trend of costs, sales, profit and other important facts. Such trends are useful for planning. For Example:If sales of the firm during this year are Rs. 10 Lakhs and average amount of stock kept during the year Rs. 3 Lakh i.e. 30% of sales and the firms wishes to increase sales next year to Rs. 15 Lakhs, it must be ready to keep a stock of Rs. 4.5 Lakh, i.e.30% of 15 lakhs. IV. Setting Standards Accounting Ratio, based on a desired level of activities, can be set as standards for judging actual performance of a business. For Example:If owners of a business aim at earning profit @ 25% on the capital which is the prevailing rate of return in the industry then this rate of 25% become the standard rate. The rate of profit of each year is compared with this standard and the actual performance of the business can be judged easily. V. Study of Financial Soundness Ratio Analysis discloses the position of business with different viewpoints. It discloses the position of business with the liquidity viewpoint, profitability viewpoint, etc with the help of such a study; we can draw conclusions regarding the financial health of the business enterprise.