Professional Documents
Culture Documents
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
Group ratio.
Historical comparision. Inter-firm comparision. Projected ratios.
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.
Quick ratio.
Absolute liquid ratio.
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.
Current liabilities
Ideal ratio: 1:1 Usually, a high acid test ratio is an indication that the firm is liquid and has ability to meet its current or liquid liabilities in time and on the other hand a low quick ratio represents that the firms liquidity position is not good.
organisation to repay the loan and interest. When an organization's assets are more than its liabilities is known as solvent organisation. Solvency indicates that position of an enterprise where it is capable of meeting long term obligations.
Debt-equity ratio. Proprietary ratio. Solvency ratio. Fixed assets to net worth ratio. Current assets to net worth ratio. Current liabilities to net worth ratio. Capital gearing ratio. Fixed assets ratio Debt servicing ratio. Dividend coverage ratio.
Shareholders funds
Ideal ratio: 2:1; It means for every 2 shares there is 1 debt. If the debt is less than 2 times the equity, it means the creditors are relatively less and the financial structure is sound. If the debt is more than 2 times the equity, the state of long term creditors are more and indicate weak financial structure.
Ideal ratio: 0.5:1 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 100-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.
sunk into assets with relatively low turnover. When the amount of proprietor's funds exceed the value of fixed assets, apart of the net working capital is provided by the shareholders, provided there are no other non-current assets, and when proprietors funds are less than the fixed assets, creditors obligation have been used to finance a part of fixed assets. The Yardstick for this measure is 65% for industrial undertakings.
A higher proportion of current assets to proprietors fund, as compared with the proportion of fixed assets to proprietors funds is advocated, as it is an indicator of the financial strength of the business, depending on the nature of the business there may be different ratios for different firms. This ratio must be read along with the results of fixed assets to proprietors funds ratio.
Net worth
Ideal ratio:1:3 This ratio indicates the relative contribution of short term creditors and owners to the capital of an enterprise. If the ratio is high, it means it is difficult to obtain long term funds by the business.
dividend bearing shares are higher than equity shareholders funds, the company is said to be highly geared. Where the fixed interest hearing securities and fixed dividend bearing shares share equal to equity share capital it is said to be evenly geared. When the fixed interest bearing securities and fixed dividend bearing shares are lower than equity share capital it is said to be low geared. If capital gearing is high, further raising of long term loans may be difficult and issue of equity shares may be attractive and vice-versa
Capital employed Ideal ratio: 0.67:1 This ratio enables to know how fixed assets are financed i.e. by use of short term funds or by long term funds. This ratio should not be more than 1.
of the organisation. Most of the ratio falling under this category is based on turnover and hence these ratios are called as turnover ratios.
reflect dull business, over investment in inventory, accumulation of stock and excessive quantities of certain inventory items in relation to immediate requirements. A high ratio may not be accompanied by a relatively high net income as, profits may be sacrificed in obtaining a large sales volume (unless accompanied by a larger total gross profit). It may indicate under investment in inventories. But generally, a high stock turnover ratio means that the concern is efficient and hence it sells its goods quickly.
36 days is considered ideal. A high debtor turnover ratio or low collection period is indicative of sound management policy. The amount of trade debtors at the end of period should not exceed a reasonable proportion of net sales. Larger the trade debtors greater the expenses of collection.
considered ideal. Very less creditors turnover ratio, or a high debt payment period may indicate the firms inability in meeting its obligation in time.
Cost of sales
Working capital turnover ratio= Average working capital
working capital and a low ratio indicates inefficient utilization of working capital. But a very high ratio is not a good situation for any firm and hence care must be taken while interpreting the ratio.
Ideal ratio: 5 times A high ratio indicates better utilisation of fixed assets. A low ratio indicates under utilisation of fixed assets.
a business. Profitability ratios are calculated either in relation to sales or in relation to investments. Profitability ratios can be classified into two categories. a) General Profitability Ratios. b) Overall Profitability Ratios.
Gross profit
Gross profit ratio= X 100 Net sales A low gross profit ratio may indicate unfavorable purchasing, the instability of management to develop sales volume thereby making it impossible to buy goods in large volume. Higher the gross profit ratio better the results.
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.
Operating profit
Operating profit ratio= Net sales X 100
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= X 100 Net sales
prospective shareholders as well as the management of the company. As this ratio reveals how well the resources of a firm are being used, higher the ratio, better are the results. The return on shareholders investment should be compared with the return of other similar firms in the same industry. The inter firm comparision of this ratio determines whether their investments in the firm are attractive or not as the investors would like to invest only where their return is higher. Similarly, trend ratios can also be calculated for a number of years to get5 an idea of the prosperity, growth of deterioration in the companys profitability and efficiency.
Net profit preference dividend Return on equity capital= Equity share capital (paid up)
Total assets
Ideal ratio: 2 times; i.e. for every Rs. 100 profits 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