Ratio analysis and the nature of ratio analysis.
The analysis of the financial statements & interpretations of financial results of a particular period of operations with the help of ‘ratio’ is termed as “ratio analysis.” Ratio analysis used to determine the financial soundness of a business concern.
An absolute figure does not convey much meaning. It, therefore, becomes necessary to study a certain figure in relation to some other relevant figure to arrive at certain conclusion. e.g., if we are given the figure of only gross profit earned by a certain firm, we cannot say whether the gross profit is heavy, reasonable or insufficient. For this purpose we must take into consideration the figure of sales. Thus, the gross profit is required to be studied in relation to the sales to decide the percentage of gross profit earned is reasonable or otherwise. Thus, the relationship between the two figures expressed mathematically is called ratio.
1) According to Robert Anthony ratio is “one number expressed in terms of another.”
2) According to J. Batty, Ratio can be defined as “the term accounting ratio is used to describe significant relationships which exist between figures shown in a balance sheet & profit & loss account in a budgetary control system or any other part of the accounting management.”
3) According to Accountant’s Handbook by Wixon, Kell & Bedford, a ratio is” an expression of the quantitative relationship between two numbers.”
• Nature of ratio analysis:-
Ratio analysis is a technique of analysis & interpretation of financial statements. It is the process of establishing & interpreting various ratios for helping in making certain decisions. However, ratio analysis is not an end in itself. It is only a means of better understanding of financial strengths & weaknesses of a firm. Calculation of mere ratios does not serve any purpose, unless several appropriate ratios are analyzed & interpreted. There are a number of ratios which can be calculated from the information given in the financial statements, but the analyst has to select the appropriate data & calculate only a few appropriate ratios from the same keeping in mind the objective of analysis. The ratios may be used as symptom like blood pressure. The pulse rate or the body temperature & their interpretation depend upon caliber & competence of the analyst. The following are the four steps involved in the ratio analysis:-
1) Selection of relevant data from the financial statements depends upon the objective of the analysis.
2) Calculation of appropriate ratios from the above data.
3) Comparison of the calculated ratios with the ratio of the same firm in the past, or the ratio developed from projected financial statements or the ratios of some other firms or the comparison with ratios of the industry to which the firm belongs.
4) Interpretation of the ratios.
Different categories of ratio and its classifications.
• Classification of ratio:-
1) Liquidity Ratio: – These are the ratios which measures the short term solvency or financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm’s ability to meet its current obligations. Liquidity ratios are also termed as short term solvency ratios. The term liquidity means the extent of quick convertibility of assets in to money for paying obligation of short term nature. According to liquidity ratios are useful in obtaining an indication of a firm’s ability to meet its current liabilities, but it does not reveal how effectively the cash resources can be managed. To measure the liquidity of a firm, the following ratios are commonly used.
a) Current ratio: – Current ratio establishes the relationship between current assets & current liabilities. It attempts to measure the ability of a firm to meet its current obligations. In order to compute this ratio, the following formula is used :
Current ratio = Current Assets / Current Liabilities
➢ Advantages of current ratio:-
1) It helps to measure the liquidity of a firm.
2) It represents general picture of the adequacy of the working capital position of a company.
3) It indicated liquidity of a company.
4) It represents a margin of safety.
5) It helps to measure the short term financial position of a company or short term solvency of a firm.
➢ Disadvantages of current ratio:-
1) Current ratio cannot be appropriate to all business it depends on many other factors.
2) Window dressing is another problem of current ratio for e.g. overvaluation of closing stock.
3) It is a crude measure of a firm’s liquidity only on the basis of quantity & not quality of current assets.
b) Quick ratio or Acid test ratio or Liquid ratio: – It is supplementary to the current ratio. The acid test ratio is more severe & stringent test of a firm’s ability to pay short term obligations as & when they become due. Quick ratio establishes the relationship between the quick assets & current liabilities. In order to compute this ratio, the following formula is used.
Liquid ratio = Liquid Assets / Current liabilities or Quick liabilities
Liquid assets = Current assets – (stock + Prepaid expenses)
Liquid liabilities = Current liabilities – (Bank overdraft + Outstanding expenses)
The ideal quick ratio of 1:1 is considered to be satisfactory. High acid test ratio is an indication that the firm has relatively better position to meet its current obligation in time. On the other hand, a low value of quick ratio exhibits that the firm’s liquidity position is not good.
➢ Advantages of quick ratio:-
1) Quick ratio helps to measure the liquidity position of a firm.
2) It is used as a supplementary to the current ratio.
3) It is used to remove inherent defects of current ratio.
c) Absolute liquid ratio: – Absolute liquid ratio is also called as cash position ratio or overdue liability ratio. This ratio established the relationship between the absolute liquid assets & current liabilities. Absolute liquid assets include cash in hand, cash at bank, & marketable securities or temporary investments. The optimum value for this ratio should be one, i.e., 1:2. It indicates that 50% worth absolute liquid assets are considered adequate to pay the 100% worth current liabilities in time. If the ratio is relatively lower than one, it represents that the company’s day to day cash management is poor. If the ratio considerably more than one, the absolute liquid ratio represents enough funds in the form of cash to meet its short term obligations in time. The absolute liquid ratio can be calculated by dividing the total of the absolute liquid assets by total current liabilities. Thus,
Absolute Liquid Ratio = Absolute Liquid Assets / Current Liabilities
Absolute Liquid Assets = Cash in hand + cash at bank +marketable securities
2) Profitability Ratio: – The term profitability means the profit earning capacity of any business activity. Thus, profit earning may be judged on the volume of profit margin of any activity & is calculated by subtracting costs from the total revenue accruing to firm during a particular period. Profitability ratio is used to measure the overall efficiency or performance of a business. Generally, a large number of ratios can also be used for determine the profitability as the same is related to sales or investment. Following are the important profitability ratios:-
a) Gross profit ratio: – Gross profit ratio establishes the relationship between gross profit & net sales. This ratio is calculated by dividing the gross profit by sales. It is usually indicated as percentage.
Gross profit ratio = Gross Profit / Net sales X 100
Gross profit = Net sales – cost of goods sold
Net sales = Gross sales – Sales return or return inwards
➢ Advantages of Gross profit ratio:-
1) It helps to measure the relationship between gross profit & net sales.
2) It reflects the efficiency with which a firm produces its product.
3) This ratio tells the management, that a low gross profit may indicate unfavourable purchasing & makeup policies.
4) A low gross profit ratio also indicates the inability of the management to increase sales.
b) Operating ratio: – Operating ratio is calculated to measure the relationship between total operating expenses & sales. The total operating expenses is the sum total of cost of goods sold, office & administrative expenses & selling & distribution expenses. In other words, this ratio indicates a firm’s ability to cover total operating expenses. In order to compute this ratio, the following formula is used:
Operating Ratio =Operating Cost / Net Sales X 100
Operating cost = Cost of goods sold + Office and Administrative expenses + Selling expense & Distribution expenses.
Net sales = Gross sales – Sales return or return inwards or
Net sales = Sales – Sales return or return inwards
c) Operating Profit Ratio: – Operating profit ratio indicates the operational efficiency of the firm & is a measure of the firm’s ability to cover the total operating expenses. Operating profit ratio can be calculated as
Operating profit ratio =Operating profit / Net sales X 100
Operating profit = Net sales – operating cost
d) Net profit ratio: – Net profit ratio is also termed as Sales margin ratio or Profit margin ratio or Net profit to sales ratio. This ratio reveals the firm’s overall efficiency in operating the business. Net profit ratio is used to measure the relationship between net profit (either before or after taxes) & sales. This ratio can be calculated by the following formula.
Net Profit Ratio = Net profit after tax /Net Sales X 100
Net profit includes non-operating incomes & profits. Non-operating incomes such as dividend received, interest on investment, profit on sales of fixed assets, commission received, and discount received, etc. profit or sales margin indicates margin available after deduction cost of production, other operating expenses & income tax from the sales revenue. Higher net profit ratio indicates the standard performance of the business concern.
➢ Advantages of Net profit ratio:-
1) This is the best measure of profitability & liquidity.
2) It helps to measure overall operational efficiency of the business concern.
3) It facilitates to make or buy decisions.
4) It helps to determine the managerial efficiency to use a firm’s resources to generate income on its invested capital.
5) Net profit ratio is very much useful as a tool of investment evaluation.
e) Return on investment ratio: – This ratio is also called as RIO. This ratio measures a return on the owner’s or shareholders’ investment. This ratio establishes the relationship between net profit after interest & taxes & the owner’s investment. Usually this is calculated in percentage. This ratio, thus can be calculated as
Return on Investment Ratio =Net profit (after interest & tax) /Shareholders’ fund or Investments X 100
Shareholders Investments = Equity share capital + Preference share capital + Reserve & surplus – Accumulated losses.
Net profit = Net profit – Interest & taxes
➢ Advantages of Return on Investment Ratio:-
1) This ratio highlights the success of the business from the owner’s point of view.
2) It helps to measure an income on the shareholders or proprietor’s investments.
3) This ratio helps to the management for important decisions making.
4) It facilitates in determining efficiently handling of owner’s investment.
f) Return on capital employed ratio: – Return on capital employed ratio measures a relationship between profit & capital employed. This ratio is called as Return on Investment Ratio. The term return means profits or net profits. The term capital employed refers to total investments made in the business. The concept of capital employed can be considered further into the following ways.
a) Gross Capital Employed = Fixed Assets + Current Assets
b) Net Capital Employed = Total Assets – current Liabilities
c) Average Capital Employed = Opening Capital Employed + Closing Capital Employed / 2
d) Proprietor’s Net Capital Employed = Fixed Assets + Current Assets – Outside Liabilities
g) Net Profit to Net worth Ratio: – This ratio measures the profit return on investment. This ratio indicates the established relationship between net profit & shareholders’ net worth. It is a reward for the assumption of ownership risk. This ratio is calculated as
Net Profit to Net Worth =Net profit after Taxes /Shareholder Net Worth X 100
Shareholder Net Worth = Total tangible net worth
Total tangible net worth = Company’s net assets – Long term liabilities or Shareholders fund + Profits retained in business
➢ Advantages of Net Profit to Net Worth Ratio:-
1) This ratio determines the incentive to owners.
2) This ratio helps to measure the profit as well as net worth.
3) This ratio indicates the overall performance & effectiveness of the firm.
4) This ratio measures the efficiency with which the resources of a firm have been employed.
3) Turnover Ratio: – Turnover ratios may be also termed as Efficiency Ratio or Performance Ratio or Activity Ratios. Turnover ratios highlight the different aspect of financial statement to satisfy the requirements of different parties interested in the business. It also indicates the effectiveness with which different assets are vitalized in a business. Turnover means the number of times assets are converted or turned over into sales. The activity ratios indicate the rate at which different assets are turned over.
a) Stock turnover ratio: – This ratio is also called as Inventory Ratio or Stock Velocity Ratio. Inventory means stock of raw materials, working in progress & finished goods. This ratio is used to measure whether the investment in stock in trade is effectively utilized or not. It reveals the relationship between sales & cost of goods sold or average inventory at cost price or average inventory at selling price. Stock turnover ratio indicated the number of times the stock has been turned over in business during a particular period. While using this ratio, care must be taken regarding season & condition, price trend, supply condition etc.
Stock Turnover Ratio = Cost of goods sold /Average Inventory at Cost
Cost of Goods Sold = Opening stock +Purchases + Direct Expenses – Closing stock
Cost of Goods Sold = Net Sales – Gross Profit
Average Stock = Opening Stock + Closing Stock / 2
➢ Advantages of Stock turnover Ratio:-
1) This ratio indicates whether investment in stock in trade is efficiently used or not.
2) This ratio is widely used as a measure of investment in stock is within proper limit or not.
3) This ratio highlights the operational efficiency of the business concern.
4) This ratio is helpful in evaluating the stock utilization.
5) It measures the relationship between the sales & stock in trade.
6) This ratio indicates the number of times the inventories have been turned over in business during a particular period.
b) Debtors Turnover Ratio: – Debtors Turnover Ratio is also termed as Receivable Turnover Ratio or Debtors’ Velocity. Receivables & debtors represent the uncollected portion of credit sales. Debtors’ velocity indicates the number of times the receivables are turned over in business during a particular period. In other words, it represents how quickly the debtors are converted into cash. It is used to measure the liquidity position of a concern. This ratio establishes the relationship between receivables & sales. Two kinds of ratios can be used to judge a firm’s liquidity position on the basis of efficiency of credit collection & credit policy. They are a) Debtor turnover ratio and b) Debt collection period. These ratios may be computed as
Debtors’ turnover ratio = Net Credit sales / Average receivables or Average account receivables
Net credit sales = Total sales – (cash sales + sales return)
Account receivable = Sundry debtors or trade debtors + bills receivables
Average Account receivable = Opening receivable + Closing receivable / 2
It is to be noted that opening & closing receivable & credit sales are not available, the ratio may be calculated as
Debtors turnover ratio = Total sales / Account receivable
Debt collection period ratio: – This ratio indicates the efficiency of the debt collection period & the extent to which the debt have been converted into cash. This ratio is complementary to the debtors’ turnover ratio. It is very helpful to the management because it represents the average debt collection period. The ratio can be calculated as follows.
Debt collection period ratio = Months or Days in a year / Debtors’ turnover ratio
➢ Advantages of Debtors turnover Ratio:-
1) This ratio indicates the efficiency of firm’s credit collection & efficiency of credit policy.
2) This ratio measures the quality of receivable.ie. Debtors.
3) It enables a firm to judge the adequacy of the liquidity position of a concern.
4) This ratio highlights the probability of bad debts lurking in the trade debtors.
5) This ratio measures the number of times the receivables are turned over in business during a particular period.
c) Creditors Turnover Ratio: – Creditors turnover ratio is also called as payable turnover ratio or creditors velocity. The credit purchases are recorded in the accounts of the buying companies as creditors to accounts payable. The term account payable or trade creditors include sundry creditors & bills payable. This ratio establishes the relationship between the net credit purchases & the average trade creditors. Creditor’s velocity ratio indicates the number of times with which the payment is made to the supplier in respect of credit purchases. Two kinds of ratios can be used for measuring the efficiency of payable of a business concern relating to credit purchases. They are 1) Creditors turnover ratio 2) Creditors payment period or average payment period. The ratio can be calculated by the following formulas :-
Creditors Turnover Ratio = Net Credit Purchases / Average Account Payable
Net credit purchases = Total purchases – Cash purchases
Average Account Payable = Opening Payable + Closing Payable / 2
Average payment period = Month or Days in a year / Creditors Turnover Ratio
➢ Significance of Creditors turnover Ratio:-
1) A high creditor’s turnover ratio signifies that the creditors are being paid promptly.
2) A lower ratio indicates that the payment of creditors is not paid in time.
3) A high average payment period highlight the unusual delay in payment & it affect the creditworthiness of the firm.
4) A low average payment period indicates enhancing the creditworthiness of the company.
d) Working Capital Turnover Ratio: – This ratio highlights the effective utilization of working capital with regard to sales. This ratio represents the firm’s liquidity position. It establishes relationship between cost of sales & networking capital. This ratio is calculated as follows :-
Working Capital Turnover Ratio = Net Sales / Working Capital
Net Sales = Gross Sales – Sales Return
Working Capital = Current Assets – Current Liabilities
➢ Significance of Working Capital turnover Ratio:-
1) It is an index to know whether the working capital has been effectively utilized or not in making sales.
2) A higher working capital turnover ratio indicates efficient utilization of working capital.
3) A lower working capital turnover ratio shows that firm has to face the shortage of working capital to meet its day to day business activities unsatisfactorily.
e) Fixed Assets Turnover Ratio: – This ratio indicates the efficiency of assets management. Fixed assets turnover ratio is used to measure the utilization of fixed assets. This ratio establishes the relationship between cost of goods sold & total fixed assets. Higher the ratio highlights a firm has successfully utilized the fixed assets. If the ratio is depressed, it indicates the under utilization of fixed assets. The ratio may also be calculated as
Fixed Assets Turnover Ratio = Cost of Goods Sold / Total fixed Assets
Sales / Net Fixed Assets
4) Solvency Ratio – The term Solvency generally refers to the capacity of the business to meet its short term & long term obligations. Short term obligations include creditors, bank loans & bills payable etc. long term obligations consists of debenture, long term loans & long term creditors etc. solvency ratio indicates the sound financial position of a concern to carry on its business smoothly & meet its all obligations.
a) Debt Equity Ratio: – This ratio also termed as External – Internal Equity Ratio. This ratio is calculated to ascertain the firm’s obligations to creditors in relation to funds invested by the owners. The ideal debt equity ratio is 1:1. This ratio also indicates all external liabilities to owner recorded claims. It may be calculated as
Debt- Equity Ratio = External Equities / Internal Equities
Outsider fund / Shareholders funds
➢ Significance of Debt Equity Ratio:-
1) This ratio indicates the proportion of owner’s stake in the business. Excessive liabilities tend to cause insolvency.
2) This ratio also tells the extent to which the firm depends upon outsiders for its existence.
b) Proprietary Ratio: – Proprietary Ratio is known as Capital Ratio or Net Worth to Total Assets Ratio. This is one of the variant of debt equity ratio. The term proprietary fund is called Net Worth. This ratio shows the relationship between shareholders fund & total assets. It may be calculated as
Proprietary Ratio = Shareholders fund / Total Assets
➢ Significance of Proprietary Ratio:-
1) This ratio is used to determine the financial stability of the concern in general.
2) It indicates the share of owners in the total assets of the company.
3) It serves as an indicator to the creditors who can find out the proportion of shareholders fund in the total assets employed in the business.
4) A higher proprietary ratio indicates relatively little secure position in the event of solvency of a concern.
5) A lower ratio indicates greater risk to the creditors.
6) A ratio below 0.5 is alarming for the creditors.
c) Capital gearing ratio: – this ratio also called as capitalization or leverage ratio. This is one of the solvency ratios. The term capital gearing refers to describe the relationship between fixed interest & fixed dividend bearing securities and the equity shareholders fund. It can be calculated as shown below:
Capital gearing ratio = Equity share capital / Fixed interest bearing funds
Equity share capital = Equity share capital + reserve & surplus
Fixed interest bearing funds = debentures + preference share capital + other long term loans.
➢ Significance of Capital gearing Ratio:-
1) A high capital gearing ratio indicates a company is having large funds bearing fixed interest & fixed dividend as compared to equity share capital.
2) A low capital gearing ratio represents preference share capital & other fixed interest bearing loans are less than equity share capital.
• ADVANTAGES / USES / UTILITY / SIGNIFICANCE / IMPORTANCE OF RATIO ANALYSIS:-
The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyze & interpret the financial health of enterprise. It helps to measure the financial condition of a firm & can point out whether the condition is strong, good, questionable or poor. The conclusion can also be drawn as to whether the performance of the firm is improving or deteriorating.
1) Helps in decision making: – Financial statements are prepared primarily for decision making. But the information provided in financial statements is not an end in itself & no meaningful conclusion can be drawn from these statements alone. Ratio analysis helps in making decisions from the information provided in these financial statements.
2) Helps in financial forecasting & planning: – Ratio analysis is of much help in financial forecasting & planning. Planning is looking ahead. The ratio calculated for a number of years work as a guide for the future. Meaningful conclusions can be drawn for future from these ratios. Thus, ratio analysis helps in forecasting & planning.
3) Helps in communicating: – The financial strength & weakness of a firm are communicated in a more easy & understandable manner by use of ratios. The information contained in the financial statements is conveyed in a meaningful manner to the one for whom it is meant. Thus, ratios help in communication & enhance the value of financial statements.
4) Helps in co-ordination:- Ratios even help in co-ordination which is of utmost importance in effective business management. Better communication of efficiency & weakness of an enterprise results in better co-ordination in the enterprise.
5) Helps in control: – Ratio analysis even helps in making effective control of the business. Standard ratios can be based upon pro-forma financial statements & variance or deviations, if any can be found by comparing the actual with the standards so as to take a corrective action at the right time. The weakness or otherwise, if any come to the knowledge of the management which helps in effective control of the business.
6) Other uses: – There are so many other uses of the ratio analysis. It is essential part of the budgetary control & standard costing. Ratios are of immense importance in the analysis & interpretation of financial statements as they bring the strength or weakness of a firm.
7) Utility to shareholders / Investors: – investors in the company will to assess the financial position of the concern where he is going to invest. His first interest will be the security of his investment & then a return in the form of dividend or interest. For the first purpose he will try to assess the value of fixed assets & the loans raised against them. The investor will feel satisfied only if the concern has sufficient amount of assets. Long term solvency ratio will help him in assessing financial position of the concern. Profitability ratios, on the other hand, will be useful to determine profitability position. Ratio analysis will be useful to the investor in making up his mind whether present financial position of the concern warrants further investment or not.
8) Utility to creditors: – the creditors or suppliers extend short term credit to the concern. They are interest to know whether financial position of the concern warrants their payment at a specified time or not. The concern pays short term creditors out of its current assets. If the current assets are quite sufficient to meet current liabilities then the creditors will not hesitate in extending credit facilities. Current & acid test ratio will give an idea about the current financial position of the concern.
9) Utility to Employees: – The employees are also interest in the financial position of the concern especially profitability. Their wage increases & amount of fringe benefits are related to the volume of profits earned by the concern. The employees make use of information available in financial statements. Various profitability ratios relating to gross profit, operating profit, net profit etc, enable employees to put forward their viewpoint for the increase of wages & other benefits.
10) Utility to Government: – Government is interested to know the overall strength of the industry. Various financial statements published by industrial units are used to calculate ratios for determining short term, long term & overall financial position of the concern. Profitability indexes can also be prepared with the help of ratios. Government may base its future policies on the basis of industrial information available from various units. The ratios may be used as indicators of overall financial strength of public as well as private sector. In the absence of the reliable economic information, government plans, & policies may not prove successful.