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RATIO ANALYSIS
Ratio analysis is the process of determining and interpreting numerical relationship based on financial statements. It is the technique of interpretation of financial statements with the help of accounting ratios derived from the balance sheet and profit and loss account.
Basis Of Comparision
Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance improvement, deterioration or constancy over the years. Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firms performance in relation to its competitors. Comparison with standards or industry average
Classification Of Ratios
Analysis of Short Term Financial Position or Test of Liquidity. Analysis of Long Term Financial Position or Test of Solvency. Activity Ratios. Profitability Ratios.
I. Test Of Liquidity
The liquidity ratios are used to test the short term solvency or liquidity position of the business. It enables to know whether short term liabilities can be paid out of short term assets. It indicates whether a firm has adequate working capital to carry out routine business activity. It is a valuable aid to management in checking the efficiency with which working capital is being employed. It is also of importance to shareholders and long term creditors in determining to some extent the prospects of dividend and interest payment.
Current Ratio
It is the most widely used of all analytical devices based on the balance sheet. It establishes relationship between total current assets and current liabilities. Current assets Current ratio= Current liabilities Ideal ratio: 2:1 High ratio indicates under trading and over capitalization. Low ratio indicates over trading and under capitalization.
Ideal ratio: 0.5:1 ratio: Higher the ratio better the long term solvency (financial) position of the company. This ratio indicates the extent to which the assets of the company can be lost without affecting the interest of the creditors of the company
Solvency Ratio
It expresses the relationship between total assets and total liabilities of a business. This ratio is a small variant of equity ratio and can be simply calculated as 100100-equity ratio Total assets Solvency ratio= Total liabilities No standard ratio is fixed in this regard. It may be compared with similar, such organisations to evaluate the solvency position. Higher the solvency ratio, the stronger is its financial position and vice-versa. vice-
Operating Ratio
This ratio establishes a relationship between cost of goods sold plus other operating expenses and net sales. This ratio is calculated mainly to ascertain the operational efficiency of the management in their business operations. Cost of goods sold + operating expenses Operating ratio= Net sales Higher the ratio the less favorable it is because it would leave a smaller margin to meet interest, dividend and other corporate needs. For a manufacturing concern it is expected to touch a percentage of 75% to 85%. This ratio is partial index of over all profitability.
Expenses Ratio
It establishes relationship between individual operation expenses and net sales revenue. Cost of goods sold 1. Cost of goods sold ratio= X 100 Net sales Office and admin exp 2. Admin. and office exp ratio= X100 Net sales Selling and dist. exp 3. Selling and distribution ratio= X 100 Net sales Non operating expense 4. Non-operating expense ratio= NonX 100 Net sales
Net profit preference dividend Return on equity capital= Equity share capital (paid up)
Ideal ratio: 2 times; i.e. for every Rs. 100 profits ratio: available for dividend, Rs. 50 is retained in the business and Rs. 50 is distributed. Higher the ratio higher is extent of retained earnings and higher is the degree of certainty that dividend will be repeated in future
Net profit available for equity share holders Earning per share = Number of equity shares