8/13/2019 80941_49115_ratio_analysis

1/18

RATIO ANALYSIS

Meaning of Ratio:-A ratio is simple arithmeticalexpression of the relationship of one number to another. Itmay be defined as the indicated quotient of twomathematical expressions.

According to Accountants Handbook by Wixon, ell and!edford, "a ratio is an expression of the quantitati#erelationship between two numbers$.

Ratio Analysis:- %atio analysis is the process ofdetermining and presenting the relationship of items andgroup of items in the statements. According to !atty &.

'anagement Accounting "%atio can assist management inits basic functions of forecasting, planning coordination,control and communication$.

It is helpful to know about the liquidity, sol#ency, capitalstructure and profitability of an organi(ation. It is helpful toolto aid in applying )udgement, otherwise complex situations.

%atio analysis can represent following three methods.

%atio may be expressed in the following three ways *

+. Pure Ratio or Simple Ratio :-It is expressed by thesimple di#ision of one number by another. orexample , if the current assets of a business are %s.- and its current liabilities are %s. +, theratio of /0urrent assets to current liabilities will be -*+.

-. Rate or So Many Times :-In this type , it iscalculated how many times a figure is, in comparison to

another figure. or example , if a firms credit salesduring the year are %s. - and its debtors at theend of the year are %s. 1 , its 2ebtors 3urno#er%atio is -41 5 6 times. It shows that thecredit sales are 6 times in comparison to debtors.

8/13/2019 80941_49115_ratio_analysis

2/18

7. Perentage :- In this type, the relation between twofigures is expressed in hundredth. or example, if afirms capital is %s.+ and its profit is %s.-the ratio of profit capital, in term of percentage, is

-4+8+ 5 -9

A!"ANTA#$ O% RATIO ANALYSIS

+. Helpful in analysis of inancial :tatements.

-. Helpful in comparati#e :tudy.

7. Helpful in locating the weak spots of the

business.

1. Helpful in orecasting.

6. ;stimate about the trend of the business.

. :tudy of inancial :oundness.

LIMITATIONS O% RATIO ANALYSIS

+. 0omparison not possible if different firms adoptdifferent accounting policies.

-. %atio analysis becomes less effecti#e due toprice le#el changes.

7. %atio may be misleading in the absence ofabsolute data.

1. ?imited use of a single data.

6. ?ack of proper standards.

8/13/2019 80941_49115_ratio_analysis

3/18

. ;ffect of personal ability and bias of theanalyst.

&LASSI%I&ATION O% RATIO

%atio may be classified into the four categories as follows*

A' Li(ui)ity Ratio

a. 0urrent %atiob. @uick %atio or Acid 3est %atio

*' Le+erage or &apital Struture Ratio

a. 2ebt ;quity %atio

b. 2ebt to 3otal und %atio

c. roprietary %atiod. ixed Assets to roprietors und %atio

e. 0apital Bearing %atio

f. Interest 0o#erage %atio

&'Ati+ity Ratio or Turno+er Ratio

a.

:tock 3urno#er %atio

b. 2ebtors or %ecei#ables 3urno#er %atio

c. A#erage 0ollection eriod

d. 0reditors or ayables 3urno#er %atio

8/13/2019 80941_49115_ratio_analysis

4/18

8/13/2019 80941_49115_ratio_analysis

5/18

LI01I!ITY RATIO

(A. Li(ui)ity Ratio:-It refers to the ability of the firm tomeet its current liabilities. 3he liquidity ratio, therefore, arealso called /:hortGterm :ol#ency %atio. 3hese ratio are usedto assess the shortGterm financial position of the concern.

3hey indicate the firms ability to meet its current obligationout of current resources.

In the words of :aloman &. link, "?iquidity is the ability ofthe firms to meet its current obligations as they fall due$.

?iquidity ratio include two ratio *G

a.

0urrent %atio

b. @uick %atio or Acid 3est %atio

a. &urrent Ratio:-3his ratio explains the relationshipbetween current assets and current liabilities of a business.

ormula*

Current Assets:-/0urrent assets includes those assets which

can be con#erted into cash with in a years time.

0urrent Assets 5 0ash in Hand 0ash at !ank !4% :hort 3erm In#estment 2ebtorsE2ebtors ro#isionJ :tockE:tock of inished Boods :tock of %aw 'aterial Work in rogressJ repaid ;xpenses.

8/13/2019 80941_49115_ratio_analysis

6/18

&urrent Lia,ilities :-/0urrent liabilities include thoseliabilities which are repayable in a years time.

0urrent ?iabilities 5 !ank D#erdraft !4 0reditors ro#ision for 3axation roposed 2i#idend Knclaimed2i#idends Dutstanding ;xpenses ?oans ayable with ina Fear.

Signifiane :-According to accounting principles, acurrent ratio of -*+ is supposed to be an ideal ratio.

It means that current assets of a business should, at least ,be twice of its current liabilities. 3he higher ratio indicatesthe better liquidity position, the firm will be able to pay its

current liabilities more easily. If the ratio is less than -*+, itindicate lack of liquidity and shortage of working capital.

3he biggest drawback of the current ratio is that it issusceptible to "window dressing$. 3his ratio can be impro#edby an equal decrease in both current assets and currentliabilities.

,' 0ui2 Ratio:-@uick ratio indicates whether the firm is ina position to pay its current liabilities with in a month or

immediately.

ormula*

/?iquid Assets means those assets, which will yield cash#ery shortly.

?iquid Assets 5 0urrent Assets :tock repaid ;xpenses

8/13/2019 80941_49115_ratio_analysis

7/18

Signifiane :-An ideal quick ratio is said to be +*+. If it ismore, it is considered to be better. 3his ratio is a better testof shortGterm financial position of the company.

L$"$RA#$ OR &APITAL STR1&T1R$ RATIO

*. Le+erage or &apital Struture Ratio :-3his ratiodisclose the firms ability to meet the interest costs regularlyand ?ong term indebtedness at maturity.

3hese ratio include the following ratios *

a. !e,t $(uity Ratio:-3his ratio can be expressed intwo ways*

irst Approach * According to this approach, this ratioexpresses the relationship between long term debtsand shareholders fund.

ormula*

Long Term Loans:-3hese refer to long term liabilitieswhich mature after one year. 3hese include 2ebentures,'ortgage ?oan, !ank ?oan, ?oan from inancial institutionsand ublic 2eposits etc.

S/are/ol)ers %un)s :-3hese include ;quity :hare

0apital, reference :hare 0apital, :hare remium, Beneral%eser#e, 0apital %eser#e, Dther %eser#e and 0redit !alanceof rofit L ?oss Account.

Seon) Approa/ :According to this approach the ratio iscalculated as follows*G

8/13/2019 80941_49115_ratio_analysis

8/18

ormula*

2ebt equity ratio is calculated for using second approach.

Signifiane :-3his %atio is calculated to assess the abilityof the firm to meet its long term liabilities. Benerally, debtequity ratio of is considered safe.

If the debt equity ratio is more than that, it shows a ratherrisky financial position from the longGterm point of #iew, as itindicates that more and more funds in#ested in the businessare pro#ided by longGterm lenders.

3he lower this ratio, the better it is for longGterm lendersbecause they are more secure in that case. ?ower than -*+debt equity ratio pro#ides sufficient protection to longGtermlenders.

,' !e,t to Total %un)s Ratio :3his %atio is a #ariation ofthe debt equity ratio and gi#es the same indication as thedebt equity ratio. In the ratio, debt is expressed in relation tototal funds, i.e., both equity and debt.

ormula*

Signifiane :-Benerally, debt to total funds ratio of .

8/13/2019 80941_49115_ratio_analysis

9/18

8/13/2019 80941_49115_ratio_analysis

10/18

Signifiane :-3he ratio indicates the extent to whichproprietors E:hareholdersJ funds are sunk into fixed assets.Cormally , the purchase of fixed assets should be financedby proprietors funds. If this ratio is less than +9, it wouldmean that proprietors fund are more than fixed assets and apart of working capital is pro#ided by the proprietors. 3hiswill indicate the longGterm financial soundness of business.

e'&apital #earing Ratio:-3his ratio establishes arelationship between equity capital Eincluding all reser#esand undistributed profitsJ and fixed cost bearing capital.

ormula*

Whereas, ixed 0ost !earing 0apital 5 reference :hare0apital 2ebentures ?ong 3erm ?oan

Signifiane:-If the amount of fixed cost bearing capitalis more than the equity share capital including reser#esan undistributed profitsJ, it will be called high capital

gearing and if it is less, it will be called low capitalgearing.

3he high gearing will be beneficial to equity shareholderswhen the rate of interest4di#idend payable on fixed costbearing capital is lower than the rate of return onin#estment in business.

8/13/2019 80941_49115_ratio_analysis

11/18

3hus, the main ob)ecti#e of using fixed cost bearingcapital is to maximi(e the profits a#ailable to equityshareholders.

f' Interest &o+erage Ratio :-3his ratio is also termed as/2ebt :er#ice %atio. 3his ratio is calculated as follows*

ormula*

Signifiane :-3his ratio indicates how many times theinterest charges are co#ered by the profits a#ailable to payinterest charges.

3his ratio measures the margin of safety for longGtermlenders.

3his higher the ratio, more secure the lenders is in respectof payment of interest regularly. If profit )ust equals interest,it is an unsafe position for the lender as well as for thecompany also , as nothing will be left for shareholders.

An interest co#erage ratio of < or = times is consideredappropriate.

A&TI"ITY RATIO OR T1RNO"$R RATIO

&. Ati+ity Ratio or Turno+er Ratio :-3hese ratio arecalculated on the bases of /cost of sales or sales, therefore,these ratio are also called as /3urno#er %atio. 3urno#erindicates the speed or number of times the capital employedhas been rotated in the process of doing business. Higherturno#er ratio indicates the better use of capital or resourcesand in turn lead to higher profitability.

8/13/2019 80941_49115_ratio_analysis

12/18

It includes the following *

a' Sto2 Turno+er Ratio:-3his ratio indicates therelationship between the cost of goods during the yearand a#erage stock kept during that year.

ormula*

Here, 0ost of goods sold 5 Cet :ales Bross rofit

A#erage :tock 5 Dpening :tock 0losing :tock4-

Signifiane:-3his ratio indicates whether stock has beenused or not. It shows the speed with which the stock isrotated into sales or the number of times the stock isturned into sales during the year.

3he higher the ratio, the better it is, since it indicates that

stock is selling quickly. In a business where stock turno#erratio is high, goods can be sold at a low margin of profit ande#en than the profitability may be quit high.

,' !e,tors Turno+er Ratio :-3his ratio indicates therelationship between credit sales and a#erage debtorsduring the year *

ormula*

8/13/2019 80941_49115_ratio_analysis

13/18

While calculating this ratio, pro#ision for bad and doubtfuldebts is not deducted from the debtors, so that it may notgi#e a false impression that debtors are collected quickly.

Signifiane :-3his ratio indicates the speed with which theamount is collected from debtors. 3he higher the ratio, thebetter it is, since it indicates that amount from debtors isbeing collected more quickly. 3he more quickly the debtorspay, the less the risk from badG debts, and so the lower theexpenses of collection and increase in the liquidity of thefirm.

!y comparing the debtors turno#er ratio of the current yearwith the pre#ious year, it may be assessed whether the sales

policy of the management is efficient or not.

' A+erage &olletion Perio) :-3his ratio indicates thetime with in which the amount is collected from debtorsand bills recei#ables.

ormula*

Here, 0redit :ales per day 5 Cet 0redit :ales of the year 47

8/13/2019 80941_49115_ratio_analysis

14/18

A#erage collection period can also be calculated on thebases of /2ebtors 3urno#er %atio. 3he formula will be*

Signifiane :-3his ratio shows the time in which thecustomers are paying for credit sales. A higher debtcollection period is thus, an indicates of the inefficiency andnegligency on the part of management. Dn the other hand, if

there is decrease in debt collection period, it indicatesprompt payment by debtors which reduces the chance ofbad debts.

)' &re)itors Turno+er Ratio :-3his ratio indicates therelationship between credit purchases and a#erage creditorsduring the year .

ormula*G

Note :-If the amount of credit purchase is not gi#en in thequestion, the ratio may be calculated on the bases of totalpurchase.

Signifiane :-3his ratio indicates the speed with which theamount is being paid to creditors. 3he higher the ratio, thebetter it is, since it will indicate that the creditors are beingpaid more quickly which increases the credit worthiness ofthe firm.

8/13/2019 80941_49115_ratio_analysis

15/18

).A+erage Payment Perio) :-3his ratio indicates theperiod which is normally taken by the firm to make paymentto its creditors.

ormula*G

3his ratio may also be calculated as follows *

Signifiane :-3he lower the ratio, the better it is, becausea shorter payment period implies that the creditors are beingpaid rapidly.

)' %i3e) Assets Turno+er Ratio :-3his ratio re#eals howefficiently the fixed assets are being utili(ed.

ormula*G

Here, Cet ixed Assets 5 ixed Assets 2epreciation

Signifiane:-3his ratio is particular importance inmanufacturing concerns where the in#estment in fixed asset

8/13/2019 80941_49115_ratio_analysis

16/18

is quit high. 0ompared with the pre#ious year, if there isincrease in this ratio, it will indicate that there is betterutili(ation of fixed assets. If there is a fall in this ratio, it willshow that fixed assets ha#e not been used as efficiently, as

they had been used in the pre#ious year.

e' 4or2ing &apital Turno+er Ratio :-3his ratio re#ealshow efficiently working capital has been utili(ed inmaking sales.

ormula *G

Here, 0ost of Boods :old 5 Dpening :tock urchases 0arriage Wages Dther 2irect ;xpenses G 0losing :tock

Working 0apital 5 0urrent Assets 0urrent ?iabilities

Signifiane :-3his ratio is of particular importance in nonGmanufacturing concerns where current assets play a ma)orrole in generating sales. It shows the number of timesworking capital has been rotated in producing sales.

A high working capital turno#er ratio shows efficient use ofworking capital and quick turno#er of current assets likestock and debtors.

A low working capital turno#er ratio indicates underG

utilisation of working capital.

Profita,ility Ratios or Inome Ratios

!. Profita,ility Ratios or Inome Ratios:-3he mainob)ect ofe#ery business concern is to earn profits. Abusiness must be able to earn adequate profits in relation to

8/13/2019 80941_49115_ratio_analysis

17/18

the risk and capital in#ested in it. 3he efficiency and thesuccess of a business can be measured with the help ofprofitability ratio.

rofitability ratios are calculated to pro#ide answers to thefollowing questions*

i. Is the firm earning adequate profitsM

ii. What is the rate of gross profit and net profit on salesM

iii. What is the rate of return on capital employed in thefirmM

i#. What is the rate of return on proprietorsEshareholdersJ fundsM

#. What is the earning per shareM

rofitability ratio can be determined on the basis of eithersales or in#estment into business.

A. Profita,ility Ratio *ase) on Sales :

a. #ross Profit Ratio :3his ratio shows the relationship

between gross profit and sales.

ormula *

Here, Cet :ales 5 :ales :ales %eturn

Signifiane:-3his ratio measures the margin of profita#ailable on sales. 3he higher the gross profit ratio, thebetter it is. Co ideal standard is fixed for this ratio, but thegross profit ratio should be adequate enough not only to

8/13/2019 80941_49115_ratio_analysis

18/18

co#er the operating expenses but also to pro#ide fordeprecation, interest on loans, di#idends and creation ofreser#es.

,. Net Profit Ratio:-3his ratio shows the relationshipbetween net profit and sales. It may be calculated by twomethods*

ormula*