RATIO ANALYSIS

           MODULE III

RATIO ANALYSIS

Ratio analysis is the analysis of financial statements with the help of ratios. It includes comparison and interpretation of these ratios and their use for future projection. It is one of the most powerful tools of analysis of financial statements. It aims at making use of quantitative information for decision making. These are widely used as they are simple to calculate and easy to understand. A ratio is an expression of relationship between two figures or two amounts. It is yardstick which measures relationship between two variables. Ratios are simply a means of highlighting in arithmetical terms the relationship between figures drawn from various financial statements. Robert Anthony defines a ratio as “simply one number expressed in terms of another”. A large number of ratios can be computed from the basic financial statements – Balance Sheet and Profit and Loss Account.

A ratio may be expressed in any of the following forms:

1.      Quotient or Pure Ratio (which is arrived at by the simple division of one number by another; for example, current asset to current liability ratio is 3:1)

2.      Percentage (which is a special type of ratio expressing the relationship in hundred. It is arrived at by multiplying the quotient by 100. For eg: The gross profit is 40% of sales)

3.      Rates (which is the ratio between the two numerical facts over a period of time. For example, stock turnover is five times a year)

Importance and uses (Advantages or Objectives) of Ratio Analysis

      Ratio analysis is an important and useful technique to check the efficiency with which working capital is being used in the enterprise. Some ratio indicates the trend or progress or downfall of the firm. The trade creditor, bank, lending institution and experienced investor all use ratio analysis as their initial tool in evaluating the firm as a desirable borrower or as potential investment outlet. The following are the important advantages of ratio analysis:

1.       It makes to easy to grasp the relationship between various items and helps in understanding the financial statements.

2.      Ratios indicate trends in important items and thus help in forecasting.

3.      Inter-firm comparisons can be made with the help of ratios, which may help management in evolving future ‘market strategies’.

4.      Standard ratios may be computed. Comparison of actual ratios with standard will help in control.

5.      Ratios can effectively ‘communicate’ what has happened between two accounting dates.

6.      It helps in a simple assessment of liquidity, profitability, solvency and efficiency of the firm.

7.      Ratios may be used as measures of efficiency.

8.      Ratios are very useful for measuring the performance and very useful in cost control.

9.      It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called surveyor of efficiency. They help management in decision making.

10.  It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called surveyor of efficiency. They help management in decision making.

Limitations of Ratio analysis

      Ratios never provide a definite answer to financial problems. There is always the questions of judgment as to what significant should be given to the figures. So one must rely upon one’s own good sense in making ratio analysis and analyst must use this technique keeping in mind the following short comings of this technique:

1.      Ratios can be useful only when they are computed in significantly large number. A single ratio would not be able to convey anything. At the same time, if too many ratios are calculated, they are likely to confuse instead of revealing any meaningful conclusion.

2.      Ratio analysis gives only a good basis for quantitative analysis of financial problems. But it suffers from quantitative aspects.

3.      Ratios are computed from historical accounting records. So they also posses those limitations of financial accounting.

4.      It is not possible to calculate exact and well accepted absolute slandered for comparison.

5.      In ratio analysis arithmetical window dressing is possible and firms may be successful in concealing the real position.

6.      Ratios are only means of financial analysis, but not an end in themselves. They can be affected with the personal ability and bias of the analyst.

7.       It should not also be remembered that ratio analysis helps in providing only a part of the information needed in the process of decision making. Any information drawn from the ratios must be used with the obtained from the other sources so as to ensure a balanced approach in solving the ticklish issues.

Classification of Ratios

      Ratios may be classified in a number of ways depending upon one or the other similarity. Some important classifications are given below:

1        Statement wise classification:

This classification is based on the statement from which items are taken.

a)      Balance sheet Ratios: these ratios deal with relationships between two items or groups of items which are both in the Balance Sheet. Eg: Current ratio, acid test ratio, debt-equity ratio, etc.

b)     Income statement ratios: These ratios focus on the relationship between the two items or group items. All of which are drawn from the revenue statement. These ratios are also known as “operating ratios”. Eg: gross profit ratio, stock turnover ratio, net profit ratio etc.

c)      Combined ratios: these ratios depict the relationship between two items, one of which is drawn from the Balance Sheet and the other from the revenue statement. Eg: Debtors’ turnover ratio, assets turnover ratio, returns on capital employed, etc.

2        Classification according to importance

It is evident that some ratios are more important than others. This classification has been recommended by the British Institute of Management.

a)      Primary ratios: As the success of any business undertaking is measured by the quantum of profit earned by it, the ratio which relates the profit to capital employed is turned as primary ratio. Eg: Return on capital employed, operating profit ratio, etc.

b)     Secondary ratio: This classification is effected to facilitate inter firm comparison and to focus on some factors responsible for the success of the unit. When such factors are isolated by means of ratios, they are called secondary ratios.

3        Classification according to nature

This mode of classification includes in its fold four different types of accounting ratios which are as follows:

a)      Liquidity ratios: These ratios portray the capacity of the business unit to meet its short-term obligations out of its short-term resource. Eg: Current ratio, acid test ratio, etc.

b)     Leverage ratios: These ratios are also called efficiency ratios. These ratios measure the owner’s stake in the business vis-à-vis that of outsiders. The long term solvency of the business can be examined by using leverage ratios. Eg: Debt-equity ratio, proprietary ratio, etc.

c)      Profitability ratios: The profitability of a business concern can be measured by the profitability ratios. These ratios highlight the end result of business activities by which alone the overall efficiency of a business unit can be judged. Eg: Return of capital employed, gross profit ratio, net profit ratio, etc.

d)     Activity ratios: These ratios evaluate the use of the total resource of the business concern along with the use of the components of total assets. More precisely, they are intended to measure the effectiveness of the assets management. The efficiency with which the assets are used would be reflected in the speed and rapidity with which the assets are converted into sales. The greater the rate of turnover, the more efficient the management would be. Eg: Stock turnover ratio, fixed assets turnover ratio, etc.

LIQUIDTY RATIOS / SHORT TERM LIQUIDTY RATIOS:

Liquidity is the ability of the firm to meet its current liabilities as they fall due. Since liquidity is basic to continuous operations of the firm it is necessary to determine the degree of liquidity of the firm. The financial manager analysis the following important ratios for this purpose:

1.   Current Ratio :-

Current ratio is the most common ratio for measure liquidity. It represents the ratio of current assets to current liabilities.

Current Ratio = Current Assets

                         Current liabilities

Current assets are those, the amount of which can be realized with in a period of one year. It includes cash in hand, cash at bank, bill receivable, sundry debtors, stock, prepaid expense, short-term investments, etc.

Current liabilities are those amounts which are payable with in a period of one year. It includes cash in hand, cash at bank, bills payable, bank overdraft, outstanding expense, income tax payable, proposed dividend, etc.

Significance:

The current ratio of firm measures its short-term solvency, i.e., its ability to meet short-term obligations. In a sound business a current ratio of 2:1 is considered an ideal one. It provides a margin of safety to the creditors. It is an index of the firm’s financial stability. A high ratio indicates sound solvency position and a low ratio indicates inadequate working capital.

2. Quick Ratio

This ratio is sometimes known as “acid Test Ratio” or “Liquidity Ratio”. It is the relation between quick assets to current liabilities. It is determined by dividing “quick assets” by current liabilities. 

 Quick ratio = Quick or Liquid Assets

            Current Liabilities

The term ‘quick assets’ refers to current assets which can be converted into cash immediately. It comprises all current assets except stock and prepaid expenses.

Significance:

An Acid Test Ratio of 1:1 is considered satisfactory as a firm can easily meet all its current liabilities. If the ratio is less than 1:1, then the financial position of the concern shall be deemed to be unsound. On the other hand, if the ratio is more than 1:1 then the financial position of the concern is sound financial position and vice-versa.           

3.      Absolute Liquidity Ratio

This ratio is obtained by dividing cash (of course cash in hand and cash at bank) and marketable securities by current liabilities. It is also known as cash position ratio.

Absolute liquidity ratio = Cash + Marketable securities

                                   Current liabilities

A ratio of 0.75:1 is recommended to ensure liquidity. This test is more vigorous measure of a firm’s liquidity position.

LONG TERM FINANCIAL RATIOS (LEVERAGE RATIOS)

Financial analysts are interested in the relative use of debt and equity in the firm. These ratios measure the long term solvency position of the firm. The following are the important leverage ratios:

1.      Debt-equity Ratio

The relationship between borrowed fund’s and owner’s capital is a popular measure of the long term financial solvency of a firm. This relationship is shown by the debt-equity ratio. This ratio indicates the relative proportion of debt and equity in financing the assets of a firm. This ratio is computed by dividing the total debt of the firm by its net worth.

Debt-equity ratio =      Debt

                                                            Equity

Or                    Debt-equity ratio =      Outsider’s fund

                                                            Shareholder’s fund

The term ‘debt’ refers to the total outside liabilities. It includes all current liabilities and other outside liabilities like loan, debentures, etc. the term equity refers to net worth or shareholder’s fund.

Equity or shareholder’s fund = Share capital (Equity + Preference) + Reserves and Surplus – Fictitious assets

Significance:

An acceptable norm for this ratio is considered to 2: 1. A high ratio shows that the claims of creditors are greater than those of owners. A very high ratio is unfavorable for the firm. High debt companies (highly geared or leveraged) are able to borrow funds on very restrictive term and conditions. A low debt-equity ratio implies greater claims of owners than creditors. From the point of view of creditors, it represents a satisfactory capital structure of the business.

2.      Proprietary Ratio

Proprietary ratio relates to the shareholders fund to total assets. This ratio shows the long term solvency of the business. It is calculated by dividing shareholder’s funds by the total assets.

Proprietary ratio = Shareholders funds

                                    Total assets

Shareholders fund = Equity share capital + Preference share capital + Reserves and Surplus – Fictitious assets

Total assets include all assets including goodwill (excluding fictitious assets). The acceptable norm of the ratio is 1:3 (i.e., 0:33).

3.      Solvency Ratio

Solvency ratio indicates the relationship between total outside liabilities to total assets. A total asset does not include fictitious assets.

Solvency ratio = Total liabilities to outsiders

                                    Total assets

Significance

Generally, lower the ratio of total liabilities to total assets, more satisfactory or stable is the long term solvency position of a firm.

4.      Fixed Asset Ratio

Fixed assets ratio of fixed assets after depreciation to long term funds. Here, the long term fund means shareholder’s fund including preference share capital + long term borrowings.

Fixed Asset Ratio = Fixed asset (after depreciation)

                                    Total Long-term funds

Significance:

The ratio indicates the extent to which the totals of fixed assets are financed by long term funds of the firm. It is better if the total of fixed assets is equal to long term fund. If it is more, it means that some of the fixed assets are financed from current liabilities, which is not a good financial policy.

5.      Debt Service Ratio (Interest Coverage Ratio)

This ratio expenses the relationship between Earnings Before Interest and Tax (EBIT) and fixed interest charges.

Debt service ratio =                 EBIT

                                    Fixed Interest Charges

Significance:

This ratio shows how many times the interest charges are covered by EBIT out of which they will be paid. Higher the ratio better is the position of long term creditors and vice-versa.

6.      Ratio Long Term Debt to Shareholders fund

This ratio shows are relationship between long term debt and shareholder’s fund.

Ratio of long term debt to shareholders fund =         long term debt

                                                                                    Shareholders fund

A high ratio is not a healthy sign of financial management.

7.      Fixed Assets to Net worth

This ratio shows the relationship between fixed assets and shareholders fund. The purpose of this ratio is to fund out the percentage of the owners fund invested in fixed assets.

Fixed assets to net worth =     fixed assets

                                    Net worth or shareholders fund

If the ratio is greater than one, it means that creditors’ funds have been used to acquire a part of the fixed assets.

8.      Capital Gearing Ratio

Capital gearing ratio is also known as Leverage Ratio. This ratio is mainly used to analyze the capital structure of a company. The term capital gearing normally refers to the proportion between fixed income bearing securities and non-fixed income bearing securities. The former includes preference share capital and debentures and the latter includes equity share capital and reserves and surplus. The capital gearing ratio shows the mix of finance employed in the business. If the ratio is high, the capital gearing is said to be high and if the ratio is low, the gearing is said to be low. Similarly, high gearing means trading on thin equity and low gearing means trading on thick equity.

Capital gearing ratio = fixed interest bearing funds

                                    Equity share capital + Reserve & surplus

Significance:-This ratio aids in regulating a balanced capital structure in a company. Similarly, it analyses the capital structure of the company. It is useful to ascertain whether the company is practicing trading on equity or not.

PROFITABILITY RATIOS

A business firm is basically a profit earning organization. The income statement of the firm shows the profit earned by the firm during the accounting period. Profitability is an indication of the efficiency with which the operations of the business are carried on. Poor operational performance may indicate poor sales and hence poor profits. The profit figure has, however, different meanings to different parties interested in financial analysis. The following are the important profitability ratios.

I.   General Profitability Ratios

1.   Gross Profit Ratio

The gross profit ratio plays an important role in two management areas. In the area of financial management, the ratio serves as a valuable indicator of the firm’s ability to utilize effectively outside sources of fund. Secondly, this ratio also serves as important tool in shaping the pricing policy of the firm. This ratio expresses the relationship between gross profit and sales. This ratio calculated by dividing gross profit by net sales.

                  Gross profit ratio =           Gross profit x 100

                                                             Net sales

Significance:

This ratio helps in ascertaining whether the average percentage of profit on the goods is maintained or not. An increase in the gross profit ratio may be due to an increase in the selling price without a corresponding increase in the cost of goods sold or due to a decrease in the cost of goods sold without a corresponding decrease in the selling price of goods.

Similarly, a decrease in the gross profit ratio may be due to a decrease in the selling price without a corresponding decrease in cost of goods sold or due to an increase in the cost of goods without a corresponding increase in the selling price of the goods sold.

2. Net Profit Ratio

This ratio is also called as the net profit to sales or net profit margin ratio. It is determined by dividing the net income after tax to the net sales for the period and measure the profit per rupee of sales.

Net profit ratio =   Net profit x 100

                                  Sales

In this context, the term net profit means “net profit after interest and tax but before dividend”.

Significance:

This ratio is used measure the overall profitability and hence it is very useful to proprietors. It is an index of efficiency and profitability of the business. Higher the ratio, better is the operational efficiency of the concern.

3. Operating Ratio

Operating ratio is an indicative of the proportion that the cost of sales bears to sales. ‘Cost of sales’ includes direct cost of goods sold as well as other operating expenses. It is an important ratio that is used to discuss the general profitability of the concern. It is calculated by dividing the total operating cost by net sales. Total operating expenses include all costs like administration, selling and distribution expenses, etc. but do not include financing cost and income tax.

Operating ratio =      Operating cost   X 100

                                         Net sales                                                       

Operating cost = Cost of goods sold + Operating expenses

Significance:

Lower the ratio; the more profitable are the operations indicating an efficient control over costs and an appropriate selling price. Reverse is the position when the ratio is higher. It is one of the most important efficiency ratios.

4. Operating profit ratio

Operating profit ratio = 100 – Operating ratio

                        OR       Operating ratio = Operating profit X 100

                                                Net sales                                               

Operating profit = Net sales – Operating cost

OR Operating profit = Net profit + Non operating expenses - Non operating income

5. Expenses Ratio

Expenses ratio indicates the relationship of each item of expenses to net sales. The ratio can be calculated for each item of expenses or group expenses like cost of sales ratio, administrative expense ratio, selling expense ratio etc.

Particular expense ratio = Particular expense X 100

                                                  Net sales                                                         

Significance:

  The lower the ratio, the greater is the profitability and higher the ratio, the lower is the profitability.

II.   Overall Profitability Ratios

1.      Return on Shareholder’s Fund

This ratio shows the rate of profit on shareholder’s fund. It relates the profit available for the share holders to their total investment. It is also known as ‘Profit on net worth’ ratio.

                        Return on shareholder’s fund = Net profit (after interest and tax) X 100

                                                                                    Shareholder’s fund

Where, shareholders fund = Equity share capital + Preference share capital + Reserves and surplus – Fictitious assets.

2.      Return on Equity Share Capital

This ratio indicates the return on the equity share capital. Owners are more interested with this ratio since it indicates the success of the company in generating earnings on their behalf. The higher the ratio, the better the owners like it. It is calculated as follows:

Return on E. S. C = Net profit (after interest, tax and preference dividend) X 100

                                                Equity share capital

3.      Return on Capital Employed

This ratio is also known as Return On Investment (ROI). The primary objective of making investment in any business is to obtain satisfactory return on capital invested. It indicates the return on capital employed in the business and it can be used to show the efficiency of the business as a whole.

Return of capital employed = Net profit (before interest, tax and dividend) X 100

                                                            Net capital employed

The tern net capital employed refers to long term funds supplied by the creditors and owners of the firm. Alternately, it is equivalent to net working capital plus fixed assets.

Net capital employed = (Share capital + Reserves & Surplus + Debentures) - Fictitious assets

Net capital employed = Fixed assets + Current assets – Current liabilities

              The higher the ratio, the more efficient is the use of the capital employed.

4.      Earnings Per Share (E. P. S)

This ratio helps in the assessment of the profitability of a firm from the stand point of equity shareholders. This measures of the profit available to the equity share holders per share. It is calculated by dividing the profit available to the equity share holders by the number of shares issued. The profits available to the equity shareholders are represented by the net profits after interest, tax and preference dividend.

E. P. S = Net profit available to the equity shareholders

                        Number of equity shares issued

Significance:

The earnings per share help in determining the market price of the equity shares of the company. A comparison of E. P. S of the company with another will also help in deciding whether the equity share capital is being effectively used or not. It also helps in estimating the company’s capacity to pay dividend on its equity share holders.

5.      Price Earnings Ratio (P. E. Ratio)

The price earnings ratio expenses the relationship between the market price of the share and the EPS. In other words, in indicates the number of times the EPs is covered by its market price. This ratio is calculated as follows:

                        P. E. Ratio = Market price per equity share

                                                Earning per share

Significance:

            The price-earnings ratio helps the investor in deciding whether to buy or not to buy the shares of a company at a particular market price. As a rule, the higher the P/E ratio, the better it is for the equity shareholders.

6.      Dividend Yield Ratio

This ratio is useful for those investors who are interested only in dividend income. This ratio is calculated by comparing the rate of dividend per share with its market value. The formula for its calculation is given below:

            Dividend yield ratio = Dividend per share X 100

                                                Market price per share     

The ratio helps an intending investor in knowing the effective return he is going to get on the proposed investment.

7.      Dividend Pay Out Ratio

This ratio is also known as (D/P ratio). It measures the relationship between the earning belonging to the equity share holders and dividend actually paid to them. This ratio is computed by dividing the total dividend paid to the equity shareholders by the total profits belonging to them.

D/P ratio =      Total dividend paid to equity shareholders X 100

                        Total net profit belonging to equity shareholders

                                                Or

D/P ratio=       Dividend per equity share

                        Earning per share

8.      Return o n Total Assets

Profitability can be measured in terms of relationship between net profit and total assets. This ratio is also known as return on gross capital employed. It measures the profitability of investment. The overall profitability can be known by applying this ratio.

           Return on total assets =          Net profit X 100

                                                           Total assets

The term “Net profit” stands for “Net profit before interest, tax and dividend”.

9.      Capital Turn Over Ratio

Capital turnover ratio is the relationship between cost of goods sold and capital employed. This ratio is calculated to measure the efficiency of effectiveness with which a firm utilizes its resources or its capital employed.

Capital turnover ratio = Cost of goods sold

                                         Capital employed             

                                  

Capital employed = Equity share capital + Preference share capital + Reserves and surplus + Long term borrowings – Fictitious assets.

TURN OVER RATIOS (ACTIVITY RATIOS)

            This published account of a firm also provides a useful data for the measurement of the company’s level of activities. These ratios are also called as “Turnover ratios”. This ratio highlights upon the activity and operational efficiency of the business concern. Activity ratios measure how efficiently the assets are employed by the firm. These ratios indicate the speed with which assets are being converted into sales. These ratios are also called as efficiency ratios.

1.      Inventory Turnover Ratio (Stock Turnover Ratio or Stock Velocity)

This ratio indicates whether investment in inventory is efficiency used or not. It, therefore, explains whether investment in inventories is within proper limits or not. It also measures the effectiveness of the firm’s sales efforts. The ratio is calculated as follows:

Inventory turnover ratio = Cost of goods sold

                                                Average stock

Where, Cost of goods sold = Sales – Gross profit     Or

 Cost of goods sold = (Opening stock + Purchase + Direct expenses) – Closing stock

            Average stock = Opening stock + Closing stock

                                                    2

If there is no opening stock, the closing itself may be taken as the average stock.

Significance:

The inventory turnover ratio signifies the liquidity of the inventory. A high inventory turnover ratio indicates brisk sales. The ratio is a measure to discover the possible trouble in the form of over stocking. A low inventory turnover ratio results in blocking of funds in inventory. There is no standard ratio for the inventory turnover. Each field and kind of business has its own standard.

2.      Fixed Asset Turnover Ratio

This ratio indicates the extent to which the investments in fixed assets contribute towards sales. If compared with a previous year, it indicate whether the investment in the fixed assets has been judicious or not. The ratio is calculated as follows:

Fixed assets turnover ratio = Net sales

                                             Fixed assets

3.      Working Capital Turnover Ratio

This ratio reflects the turnover of the firm’s net working capital in the course of the year. It is good measure of over-trading and under-trading. The ratio is calculated as follows:

Working capital turnover ratio =       Net sales

                                                    Net working capital

4.        Debtors Turnover Ratio (Debtor’s velocity)

The purpose of this ratio is to discuss the credit collection power and policy of the form. For this ratio a relationship is established between accounts receivables and net credit sales of the period. The debtors’ turnover ratio is calculated as follows.

            Debtors turnover ratio =         Net credit sales

                                                      Average accounts receivable

The term” Accounts Receivable” includes trade debtors and bills receivables. This ratio indicates the efficiency of the staff entrusted with collection of book debts. The higher the ratio, the better it is, since, it would indicate that debts are being collected promptly.

5.      Average Debt Collection Period

This figure shows the average number of days that elapsed between the receipt of the invoice by customers and the actual payment of the invoice. When measured against the credit term obtained from suppliers, the average collection period shows the length of time during which the firm is financing the account receivable either with its own funds or borrowed funds, an increase in the period will result in greater blockage of funds in debtors. The ratio may be calculated as follows:

Average debt collection period (in days) = Average Accounts Receivable X 365

                                                                                    Net credit sales

                                                (In month) = Average Accounts Receivable X 12

                                                                         Net credit sales or sales

Significance:

This ratio measures the quality of debtors. A shorter collection period implies prompt payment by debtors. It reduces the chance of bad debts. A longer collection period implies inefficient credit collection performance.

6.      Creditors Turnover Ratio (Creditor’s velocity)

Creditor’s turnover ratio indicates the number of times the accounts payable rotate in a year. It signifies the credit period enjoyed by the firm in paying its creditors. Accounts payable include trade creditors and bills payable. This ratio shows the relationship between net credit purchase for the whole year and accounts payable.

Creditors turnover ratio =      Net credit purchase

Average accounts payable

Average debt payment period = Average Accounts Payable X 365 (in days)

Net credit purchases              

                        Average debt payment period = Average Accounts Payable X 12   (in months)

                                                                                    Net credit purchases

Significance:

            Bothe the creditor’s turnover ratio and average debt payment period indicate about the promptness in making payment of credit purchases. The ratio signifies that the creditors are being paid promptly, thus enhancing the credit worthiness of the company.

If cash purchase is not specifically given, the given purchase may be taken as credit purchase.

If a bills payable amount is not given, the accounts payable means creditors.