Ratio Analysis CH 3C

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E5-E6 Finance Core

Module

Ratio Analysis


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RATIO ANALYSIS

FINANCIAL ANALYSIS : Is the process of identifying the

financial strengths and weakness of the firm by properly

establishing relationships between the items of BalanceSheet and Profit and Loss Account

RATIO ANALYSIS : is a tool of financial analysis.


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RATIO ANALYSIS

Ratio analysis is the analysis of the relationship betweenitems of financial data, or between financial and non

financial data.

Ratios sometimes prove themselves to be more

meaningful than the absolute figures


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Advantages of Ratio Analysis

I. Simplifies, Summarizes and Systematizes

accounting figures for easy understanding;

II. Ratios helps the management in measuring

things like Long-term Solvency, OperationalEfficiency, etc. of the firm

III. It can be used to compare the risk and return

relationships of firms of different sizes.


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Advantages of Ratio Analysis

IV. Facilitates inter-firm comparison showing

relat ive per formance of enterpr ise in theindustry;

V. Facilitates intra-firm comparison showing the

imp rovement/degradat ion in the performance

of the enterp rise;

VI. It provides a profile of a firm, its economic

characteristics and competitive strategies, and

its unique operating, financial and investment

characteristics.


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Standards of comparison:

A single ratio does not indicate any condition. It should

be compared with some standard. Standards of

comparison may consist of:

1) Ratios calculated from the past financial statements

of the same firm.

2) Ratios developed using the projected, or pro forma,

financial statements of the same firm.

3) Ratios of some selected firms, ( most progressive &successful,)

4) Ratios of the industry to which the firm belongs.



Limitations of Ratio Analysis

They are arithmetical expressions. Qualitative aspects

cannot be presenteddirectly.

They are calculated from accounting records which

have their own limitations.

Ratios are indicators only and must be supplemented by

a detailed analysis to discover the reality.

Strongly affected by man ipu lat ions o f f inanc ial

statements& this fact is not revealedby Ratio Analysis.

Factors like Inf lationalso dis tor tthe Ratio Analysis.



Precautions

Points to be borne in mind while using ratio analysistechnique

Only figures that have a mutual cause and effect

relationship should be considered

Particular characteristics of the industry should

always be kept in mind while a firm is being studied.

Ratios are only symptoms and not the real disease in

itself Good profits rather than good ratios is the objective of

the firm



RATIO ANALYSIS

Classification of Ratios:

Structural Classification

Functional Classification



ruc ura ass ca onof Ratios

This is the Conventional mode of classifying ratios wherethe ratios are classified on the basis of information given

in the financial statements.



u uof Ratios

S.N Type What it is Examples

1 Balance SheetRatios

Ratios for which the components forcomputation are drawn from the

Balance Sheet. (Financial Ratios.)

* Current Ratio * Liquid Ratio* Debt Equity Ratio

* Proprietary Ratio

* Capital Gearing Ratio

* Fixed Assets Ratio

2 P&L A/c Ratios Ratios for which the components are

drawn from the P&L Accoun t.

(Income Statement Ratios or Operating

Ratios )

* Gross Profit Ratio

* Net Profit Ratio

* Operating Ratio

* Stock Turnover Ratio

* Expenses Ratio

3 Inter-statement

Ratios orCombined Ratios

Ratios for which the components are

drawn both from the Balance Sheetand P&L Accoun t.

( Financial Ratios. )

* Return on Capital Employed [ROCE]

* Return on Investments [ROI]* Debtors Turnover Ratio

* Creditors Turnover Ratio

* Fixed Assets Turnover Ratio

* Working Capital Turnover Ratio


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Functional Classification Of Ratios:

Financial ratios are broadly categorized in four broadheads

Activity analysis

Liquidity analysis

Long term debt and solvency analysis

Profitability analysis



Activity analysis

Activity ratios describe the relationship between the firms

level of operations and the assets needed to sustain

operating activities.

Short term (operating) activity ratios

Inventory turnover Receivables turnover

Payable turnover

Working capital turnover

Long term (investment) activity ratios Fixed assets turnover

Total asset turnover



Liquidity analysis

Liquidity ratios helps in assessing the ability of a firm tomeet its current obligations.

This ability depends on the cash resources available as

on the balance sheet date.

Current ratio

Quick ratio

Cash ratio



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Long term debt and solvency analysis

Analysis of a firms capital structure is essential toevaluate its long term risk and return prospects.

Debt ratio

Debt to total capital

Debt to equity

Interest coverage ratio



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Profitability analysis

Investors are concerned with the firms ability togenerate, sustain and increase profits

Return on sales

Gross margin

Operating margin

Profit margin

Return on investments

Return on assets Return on equity



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EPS and P/E ratios

EPS is the most widely available and commonly usedperformance statistics for publicly traded firms

Calculation of EPS is governed and mandated by the

financial reporting standards

Earnings per share

Price earning ratio


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Ratio Analysis CH 3C

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