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.
