RATIO ANALYSIS

ADVANTAGES OF RATIO ANALYSIS

Important technique of financial analysis Helps in judging financial health of a firm Helps in decision-making Useful in simplifying accounting figures Useful in judging operating efficiency Useful in forecasting & planning Useful in locating weak areas Useful in comparison of performance Useful to all stakeholders

DISADVANTAGES OF RATIO ANALYSIS

Limited comparability False results Effect of price level changes Qualitative factors are ignored Effect of window dressing Costly techniques Misleading results Absence of standard university accepted technology

CLASIFICATION OF RATIOS

Traditional Classification

Functional Classification

Significance Ratios

a.

Balance sheet Ratios P & L A/C Ratios Composite Ratios

a. b. c. d.

Liquidity Ratios Leverage Ratios Profitability Ratios Turnover Ratios

a. b.

Primary Ratios Secondary Ratios

b. c.

FUNCTIONAL CLASSIFICATION
Ratios can be broadly classified into four groups namely: Liquidity ratios Capital structure/leverage ratios Profitability ratios Activity ratios

LIQUIDITY RATIOS

These ratios analyse the short-term financial position of a firm and indicate the ability of the firm to meet its short-term commitments (current liabilities) out of its short-term resources (current assets).

1. CURRENT RATIO
Current ratio may be defined as the relationship between current assets and current liabilities. Formula

Current ratio = Current Assets Current Liabilities

INTERPRETATION
Current ratio of a firm measures its short-term solvency and reflects its ability to meet short-term obligations when they are due.

If the current ratio is higher, it is good from the creditors point of view but extremely high current ratio is not good from the managements point of view. a low and declining current ratio would indicate : (i) an inadequate margin of safety to the creditors, i.e. firm has no sufficient cash to pay its liabilities; (ii) shortage of working capital in the business i.e firm is trading out of its resources. Ideal Current Ratio: 2:1

2. LIQUIDITY OR QUICK RATIO OR ACID TEST RATIO

This ratio establishes the relationship between quick/liquid current assets and current liabilities. Formula Liquid Ratio = Liquid or Quick Assets Current liabilities = Current Assets (Stock + Prepaid Exp.) Current Liabilities

INTERPRETATION

Liquid ratio is considered to be superior to current ratio in evaluating the liquidity position of the firm. Thus, liquidity ratio is an indication of a firms ability to meet unexpected demand for working capital. Ideal Ratio: A quick ratio of 1:1 is considered as an ideal ratio.

3. ABSOLUTE LIQUID RATIO OR CASH POSITION RATIO OR SUPER-QUICK RATIO

The absolute liquid ratio is the relationship between the absolute liquid or super quick assets to liquid or quick liabilities. It is a more rigorous test of liquidity of a firm. formula:

Absolute Liquid Ratio

= Absolute Liquid Assets Quick/Liquid Liabilities

INTERPRETATION

This ratio pays more significance to liquidity when used in conjunction with current and quick ratio. It is considered to be a conservative test and is not widely used in practice. Ideal Ratio: A super quick ratio of 0.5:1 is considered as an ideal ratio.

II. TEST OF SOLVENCY

Long term solvency ratios denote the ability of the organisation to repay the loan and interest. When an organization's assets are more than its liabilities is known as solvent organisation. Solvency indicates that position of an enterprise where it is capable of meeting long term obligations.

IMPORTANT RATIOS IN TEST OF SOLVENCY

Debt Ratio Debt-equity ratio. Solvency ratio. Fixed assets to net worth ratio. Current assets to net worth ratio. Fixed assets ratio

DEBT RATIO

A ratio that indicates what proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load.

Debt Ratio =

Total Debt Total Assets

Interpretation: A debt ratio of greater than 1 indicates that a company has more debt than assets, meanwhile, a debt ratio of less than 1 indicates that a company has more assets than debt.

DEBT EQUITY RATIO

It Is calculated to measure the relative claims of outsiders and the owners against the firms assets. This ratio indicates the relationship between the outsiders funds and the shareholders funds.

Debt equity ratio =

Total Debt Total Equity

Interpretation: It indicates what proportion of equity and debt the company is using to finance its assets. A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt.

SOLVENCY RATIO

It expresses the relationship between total assets and total liabilities of a business. Net assets Solvency ratio = Total liabilities Interpretation: Acceptable solvency ratios will vary from industry to industry, no standard ratio is fixed in this regard. Generally speaking, the lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.

FIXED ASSETS TO NET WORTH

It is obtained by dividing the depreciated book value of fixed assets by the amount of proprietors funds.

Net fixed assets Fixed assets to net worth ratio= Net worth
Interpretation: A higher ratio, say, 100% means that there are no outside liabilities and all the funds employed are those of shareholders. In such a case the return to shareholders would be lower rate of dividend and this is also a sign of over capitalization.

CURRENT ASSETS TO NET WORTH RATIO

It is obtained by dividing the value of current assets by the amount of proprietors funds. The purpose of this ratio is to show the percentage of proprietors fund investment in current assets.

Current assets Current assets to net worth ratio= Proprietors fund

Interpretation: A higher proportion of current assets to proprietors fund, as compared with the proportion of fixed assets to proprietors funds is advocated, as it is an indicator of the financial strength of the business, depending on the nature of the business there may be different ratios for different firms. This ratio must be read along with the results of fixed assets to proprietors funds ratio.

FIXED ASSETS RATIO

It establishes the relationship between fixed assets and capital employed Fixed assets Fixed assets ratio= Capital employed Interpretation: This ratio enables to know how fixed assets are financed i.e. by use of short term funds or by long term funds. This ratio should not be more than 1.

AIM FOR HIGHER PROFITS

PROFITABILITY

RATIO

(A)

Based on Sales/General Profitability Ratio:Gross Profit Ratio = Gross Profit x 100 Net Sales

Gross Profit Margin Ratio :- The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. Gross Profit Margin = Sales - Cost of Goods Sold Sales x 100

Gross profit is a company's residual profit after selling a product or service and deducting the cost associated with its production and sale.

Operating Profit Ratio :- The operating profit refers to the pure operating profit of the firm i.e. the profit generated by the operation of the firm and hence is calculated before considering any financial charge (such as interest payment), non-operating income/loss and tax liability etc. The operating profit is also termed as the Earnings Before Interest and Taxes (EBIT). OP Ratio = Operating Profit x 100 Net Sales *operating profit = Gross Profit Operating Expenses High Good

Expenses Ratio:- The expenses ratios are the measure of cost control and are computed by establishing the relationship between difference expense items and the sales. In other words, it is calculated to show relationship of each item of manufacturing cost and operating expenses to net sales. These ratios help in analysing the causes of variation of the operating ratio. Expenses Ratio = Different Expenses x 100 Net Sales Lower the ratio, the greater is the profitability.

Net Profit ratio :- It measures the efficiency of the management in generating additional revenue over and above the total cost of operations.

NP Ratio = NP ( after tax) Net Sales

x 100

The higher the ratio, the better is the profitability of the firm. This ratio also shows the net contributions made by every 1 rupee of sales to the owner funds. The NP Ratio indicates the proportion of sales revenue available to the owners of the firm and the extent to which the sales revenue can decrease or the cost can increase without inflicting a loss on the owners.

Return on Capital Employed = Net Profit (PBIT) x 100 Capital Employed Some Equations: Gross capital employed = Total Assets Fictitious Assets Net Capital Employed = Total Assets Fictitious Assets Current Liabilities Average Capital Employed = Opening Capital Employed + Closing Capital
Employed 2

Return on Net Worth/Proprietors Funds: This ratio measures the profitability of a concern in relation to total investments made by the shareholders or proprietors in the business. The excess of total assets over total outside liabilities of an enterprise is known as shareholders funds or proprietors funds or net worth.

Return on Net Worth = Net Profit (PAIT) x 100 Shareholders fund

Return on Equity Shareholders Fund :It examines profitability from the perspective of the equity investors by relating profits available for the equity shareholders with the book value of the equity investment. The return from the point of view of equity shareholders may be calculated by comparing the net profit less preference dividend with their total contribution in the firm. Return on Equity Shareholders Fund = Net Profit after Tax Preference Dividend x 100 Equity Shareholders Funds *Equity Shareholders Funds = Share Capital + Reserves Credit balance of P/l

RETURN ON ASSETS (ROA)

Return on assets = net profit after taxes plus interest x 100 Total assets Total assets exclude fictitious assets. As the total assets at the beginning of the year and end of the year may not be the same, average total assets may be used as the denominator.

ACTIVITY RATIOS

These ratios are also called efficiency ratios / asset utilization ratios or turnover ratios. These ratios show the relationship between sales and various assets of a firm.
These ratios enables the management to measure the effectiveness of the resources at the command of the firm.

Also called Turnover Ratios or Performance Ratios or Assets management ratio.

INVENTORY TURNOVER RATIO OR STOCK TURNOVER RATIO

This ratio is calculated to consider the justification of amount of capital employed in stock. Under it, rate of conversion of stock into sales (i.e., stock velocity) is known by establishing relationship of investment in inventory. It is calculated as follows:

Inventory Turnover ratio = Cost of goods sold or Net sales Average Inventory at cost

where,

Average inventory = Opening Stock + Closing stock 2

Cost of goods sold = Opening stock + Purchase Closing Stock = Net Sales Gross Profit

Note: Inventory, here will mean inventory of finished goods only because it only is capable of being sold. In departmental stores, where inventory is usually valued at sale price, this ratio is calculated on this basis : Net Sales Average Inventory at Selling Price

Formula: Debtors/Receivable Turnover Ratio = Net credit Sales Average (Debtors + B/R) Note: Higher the value of debtors turnover, the more efficient is the management of debtors. An increase in this ratio is an indication of firms marketing superiority and efficiency in credit realization.

CREDITORS/PAYABLE TURNOVER RATIO OR P/T RATIO

The shot-term creditors (i.e., suppliers of goods and bankers) are very much interested in this ratio, as it shows the firms trend of payment to its short-term creditors. This ratio shows the velocity of the debt payment by the firm. This ratio shows the relationship of credit purchases and the average payables (creditors & bills) as follows:

Creditors Turnover Ratio =

Net Credit Purchases Average (Creditors+ B/P)

Note: Lower the ratio, the better is the liquidity position of the firm. Higher creditors turnover ratio indicates weak liquid position. A continuous increase in this ratio shows delay in payments.
Average Payment Period = No. of Days/Months Creditors Turnover Ratio

Total Assets Turnover Ratio = Net Sales/ Cost of goods Sold Total Assets
This ratio measures the per rupee sales generated by per rupee of tangible assets being maintained by the firm. It may be noted that (i) intangible assets such as goodwill etc. are not considered and (ii) that the tangible assets are taken at their written down values. In time series analysis of ratios, if the Total Assets Turnover ratio increases over a period, it means that more sales have been generated per rupee of tangible assets. This ratio must be analysed together with some other ratio/information.

Fixed Assets Turnover Ratio = Net Sales/Cost of goods sold Fixed Assets (less Dep.) Where the average fixed assets is equal to the average of the opening and closing balances of the fixed assets. High Good

Current Assets Turnover ratio = Net Sales/Cost of goods sold Current Assets Capital Turnover Ratio = Sales/Cost of goods sold Capital employed *capital employed = Fixed Assets + Current Assets Current Liabilities The higher the current ratio, the greater is the sales made per rupee of capital employed in the firm & hence higher is the profit.

Working Capital Turnover Ratio

Working Capital Turnover Ratio = Net Sales/ Cost of Goods Sold Working Capital The higher the working capital turnover ratio, the lower is the investment in the working capital and higher would be the profitability. A high working capital turnover ratio reflects the better utilization of the working capital of the firm. However, a working capital turnover ratio also implies a low net working capital in relation to its net working capital. This may be a risky proposition for the firm.