Meaning and Definition:
Ratio analysis is one of the
techniques of financial analysis to evaluate the financial condition and
performance of a business concern. Simply, ratio means the comparison of one
figure to other relevant figure or figures.
According
to Myers, “Ratio analysis of financial statements is a study of relationship
among various financial factors in a business as disclosed by a single set of
statements and a study of trend of these factors as shown in a series of
statements."
Advantages and Uses of Ratio Analysis:
There
are various groups of people who are interested in analysis of financial
position of a company used the ratio analysis to workout a particular financial
characteristic of the company in which they are interested. Ratio analysis
helps the various groups in the following manner: -
a)
To workout the profitability: Accounting
ratio help to measure the profitability of the business by calculating the
various profitability ratios. It helps the management to know about the earning
capacity of the business concern.
b)
Helpful in analysis of financial statement:
Ratio analysis help the outsiders just like creditors, shareholders,
debenture-holders, bankers to know about the profitability and ability of the
company to pay them interest and dividend etc.
c)
Helpful in comparative analysis of the performance: With
the help of ratio analysis a company may have comparative study of its
performance to the previous years. In this way company comes to know about its
weak point and be able to improve them.
d)
To simplify the accounting information:
Accounting ratios are very useful as they briefly summaries the result of
detailed and complicated computations.
e)
To workout the operating efficiency:
Ratio analysis helps to workout the operating efficiency of the company with
the help of various turnover ratios. All turnover ratios are worked out to
evaluate the performance of the business in utilising the resources.
f)
To workout short-term financial position:
Ratio analysis helps to workout the short-term financial position of the
company with the help of liquidity ratios. In case short-term financial
position is not healthy efforts are made to improve it.
g)
Helpful for forecasting purposes: Accounting
ratios indicate the trend of the business. The trend is useful for estimating
future. With the help of previous years’ ratios, estimates for future can be
made.
Limitations of Ratio Analysis
In
spite of many advantages, there are certain limitations of the ratio analysis
techniques. The following are the main limitations of accounting ratios:
a)
Limited Comparability: Different
firms apply different accounting policies. Therefore the ratio of one firm can
not always be compared with the ratio of other firm.
b)
False Results: Accounting ratios are based on
data drawn from accounting records. In case that data is correct, then only the
ratios will be correct. For example, valuation of stock is based on very high
price, the profits of the concern will be inflated and it will indicate a wrong
financial position. The data therefore must be absolutely correct.
c)
Effect of Price Level Changes: Price
level changes often make the comparison of figures difficult over a period of
time. Changes in price affect the cost of production, sales and also the value
of assets. Therefore, it is necessary to make proper adjustment for price-level
changes before any comparison.
d)
Qualitative factors are ignored:
Ratio analysis is a technique of quantitative analysis and thus, ignores
qualitative factors, which may be important in decision making. For example,
average collection period may be equal to standard credit period, but some
debtors may be in the list of doubtful debts, which is not disclosed by ratio
analysis.
e)
Effect of window-dressing:
In order to cover up their bad financial position some companies resort to
window dressing. They may record the accounting data according to the
convenience to show the financial position of the company in a better way.
f)
Costly Technique: Ratio
analysis is a costly technique and can be used by big business houses. Small
business units are not able to afford it.
g)
Misleading Results: In the
absence of absolute data, the result may be misleading. For example, the gross
profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000
and sales are Rs. 20,000 and profit earned by the other one is Rs. 10, 00,000
and sales are Rs. 40, 00,000. Even the profitability of the two firms is same
but the magnitude of their business is quite different.
Types of accounting ratio
Ratio can be classified on the
basis of their functions in the following groups:
(A)
Liquidity Ratios:
(i)
Short term solvency ratio
(ii)
Long term solvency ratio
(B)
Profitability Ratios
(C)
Activity Ratios/ Turnover Ratios
(D)
Financial Ratios
The above groups are further classified
into following parts:
(i)
Short term solvency ratio:
a) Current
ratio
b) Liquid
ratio/Acid Test ratio
c) Absolute
liquid ratio
(ii)
Long term solvency ratio:
a)
Equity ratio
b)
Debt ratio
c)
Equity ratio
d)
Net income to debt service ratio
(iii)
Profitability ratio:
a)
Gross Profit Ratio
b)
Net Profit Ratio
c)
Operating Net Profit Ratio
d)
Operating Ratio
e)
Return on Investment or Return on
Capital Employed
f)
Return on Equity
g)
Earning Per Share
(iv)
Activity Ratios/ Turnover Ratios:
a)
Capital Turnover Ratio
b)
Fixed Assets Turnover Ratio
c)
Working Capital Turnover Ratio
d)
Stock Turnover Ratio
e)
Debtors Turnover Ratio
f)
Creditors turnover ratio
(v)
Financial Ratios:
a)
Debt-Equity Ratio
b)
Proprietary Ratio
c)
Capital Gearing Ratio
d)
Debt to Total Funds Ratio
e)
Fixed Assets Ratio
f)
Interest Coverage Ratio
Meaning, Objective and Method of Calculation of various types of
ratios:
a) Current Ratio: Current
ratio is calculated in order to work out firm’s ability to pay off its
short-term liabilities. This ratio is also called working capital ratio. This
ratio explains the relationship between current assets and current liabilities
of a business. It is calculated by applying the following formula :
Current Ratio = Current
Assets/Current Liabilities
Current Assets include
Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Stock of Goods,
Short-term Investments, Prepaid Expenses, Accrued Incomes etc.
Current Liabilities
includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses
etc.
Objective and Significance: Current
ratio shows the short-term financial position of the business. This ratio
measures the ability of the business to pay its current liabilities. The ideal
current ratio is supposed to be 2:1. In case, if this ratio is less than 2:1,
the short-term financial position is not supposed to be very sound and in case,
if it is more than 2:1, it indicates idleness of working capital.
b) Liquid Ratio: Liquid
ratio shows short-term solvency of a business. It is also called acid-test
ratio and quick ratio. It is calculated in order to know whether or not current
liabilities can be paid with the help of quick assets quickly. Quick assets
mean those assets, which are quickly convertible into cash.
Liquid Ratio = Liquid
Assets/Current Liabilities
Liquid assets include
Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Short-term
investments etc. In other words, all current assets are liquid assets except
stock and prepaid expenses.
Current liabilities
include Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses
etc.
Objective and Significance: Liquid
ratio is calculated to work out the liquidity of a business. This ratio
measures the ability of the business to pay its current liabilities in a real
way. The ideal liquid ratio is supposed to be 1:1. In case, this ratio is less
than 1:1, it shows a very weak short-term financial position and in case, it is
more than 1:1, it shows a better short-term financial position.
c) Gross Profit Ratio: Gross
Profit Ratio shows the relationship between Gross Profit of the concern and its
Net Sales. Gross Profit Ratio can be calculated in the following manner: -
Gross Profit Ratio = Gross Profit/Net
Sales x 100
Where Gross Profit = Net Sales – Cost of
Goods Sold
Cost of Goods Sold = Opening Stock + Net
Purchases + Direct Expenses – Closing Stock
And Net Sales = Total Sales – Sales
Return
Objective and Significance: Gross
Profit Ratio provides guidelines to the concern whether it is earning
sufficient profit to cover administration and marketing expenses and is able to
cover its fixed expenses. This ratio can also be used in stock-inventory
control. Maintenance of steady gross profit ratio is important .Any fall in
this ratio would put the management in difficulty in the realisation of fixed
overheads of the business.
d) Net Profit Ratio: Net
Profit Ratio shows the relationship between Net Profit of the concern and Its
Net Sales. Net Profit Ratio can be calculated in the following manner: -
Net Profit Ratio = Net Profit/Net Sales x
100
Where, Net Profit = Gross Profit –
Selling and Distribution Expenses – Office and Administration Expenses –
Financial Expenses – Non-Operating Expenses + Non Operating Incomes.
And Net Sales = Total Sales – Sales
Return
Objective and Significance: In order
to work out overall efficiency of the concern Net Profit ratio is calculated.
This ratio is helpful to determine the operational ability of the concern.
While comparing the ratio to previous years’ ratios, the increment shows the
efficiency of the concern.
e) Operating Profit Ratio: Operating
Profit Ratio shows the relationship between Operating Profit and Net Sales.
Operating Profit Ratio can be calculated in the following manner: -
Operating Profit Ratio = (Operating
Profit/Net Sales) x 100
Where Operating Profit = Gross Profit –
Operating Expenses
Or Operating Profit = Net Profit + Non
Operating Expenses – Non Operating Incomes
And Net Sales = Total Sales – Sales
Return
Objective and Significance: Operating
Profit Ratio indicates the earning capacity of the concern on the basis of its
business operations and not from earning from the other sources. It shows
whether the business is able to stand in the market or not.
f) Operating Ratio: Operating
Ratio matches the operating cost to the net sales of the business. Operating
Cost means Cost of goods sold plus Operating Expenses.
Operating Ratio = Operating Cost/Net
Sales x 100
Where Operating Cost = Cost of goods
sold + Operating Expenses
(Operating Expenses = Selling and
Distribution Expenses, Office and Administration Expenses, Repair and
Maintenance.)
Cost of Goods Sold = Opening Stock + Net
Purchases + Direct Expenses – Closing Stock
Or Cost of Goods Sold = Net sales –
Gross Profit
Objective and Significance: Operating
Ratio is calculated in order to calculate the operating efficiency of the
concern. As this ratio indicates about the percentage of operating cost to the
net sales, so it is better for a concern to have this ratio in less percentage.
The less percentage of cost means higher margin to earn profit.
g) Return on Investment
or Return on Capital Employed: This ratio shows the relationship
between the profit earned before interest and tax and the capital employed to
earn such profit.
Return on Capital Employed = Net Profit
before Interest, Tax and Dividend/Capital Employed x 100
Where Capital Employed = Share Capital
(Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious
Assets
Or
Capital Employed = Fixed Assets +
Current Assets – Current Liabilities
Objective and Significance: Return
on capital employed measures the profit, which a firm earns on investing a unit
of capital. The profit being the net result of all operations, the return on
capital expresses all efficiencies and inefficiencies of a business. This ratio
has a great importance to the shareholders and investors and also to
management. To shareholders it indicates how much their capital is earning and
to the management as to how efficiently it has been working. This ratio
influences the market price of the shares. The higher the ratio, the better it
is.
h) Return on Equity:
Return on equity is also known as return on shareholders’ investment. The ratio
establishes relationship between profits available to equity shareholders with
equity shareholders’ funds.
Return on Equity = Net Profit after
Interest, Tax and Preference Dividend/Equity Shareholders’ Funds x 100
Where Equity Shareholders’ Funds =
Equity Share Capital + Reserves and Surplus – Fictitious Assets
Objective and Significance: Return
on Equity judges the profitability from the point of view of equity
shareholders. This ratio has great interest to equity shareholders. The return
on equity measures the profitability of equity funds invested in the firm. The
investors favour the company with higher ROE.
i)
Earning Per Share: Earning per
share is calculated by dividing the net profit (after interest, tax and
preference dividend) by the number of equity shares.
Earning Per Share = Net Profit after
Interest, Tax and Preference Dividend/No. Of Equity Shares
Objective and Significance: Earning
per share helps in determining the market price of the equity share of the
company. It also helps to know whether the company is able to use its equity
share capital effectively with compare to other companies. It also tells about
the capacity of the company to pay dividends to its equity shareholders.
j)
Debt-Equity Ratio: Debt equity
ratio shows the relationship between long-term debts and shareholders funds’.
It is also known as ‘External-Internal’ equity ratio.
Debt Equity Ratio = Debt/Equity
Where Debt (long term loans) includes
Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial
institution etc.
Equity
(Shareholders’ Funds) = Share Capital (Equity + Preference) + Reserves and
Surplus – Fictitious Assets
Objective and Significance: This
ratio is a measure of owner’s stock in the business. Proprietors are always
keen to have more funds from borrowings because:
(i) Their stake in the business is
reduced and subsequently their risk too
(ii) Interest on loans or borrowings is
a deductible expenditure while computing taxable profits. Dividend on shares is
not so allowed by Income Tax Authorities.
The normally
acceptable debt-equity ratio is 2:1.
k) Debt to Total Funds
Ratio: This ratio gives same indication as the debt-equity ratio as this
is a variation of debt-equity ratio. This ratio is also known as solvency
ratio. This is a ratio between long-term debt and total long-term funds.
Debt to Total Funds Ratio = Debt/Total
Funds
Where Debt (long term loans) includes
Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial
institution etc.
Total Funds = Equity + Debt = Capital
Employed
Equity (Shareholders’ Funds) = Share
Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets
Objective and Significance: Debt to Total Funds Ratios shows the
proportion of long-term funds, which have been raised by way of loans. This
ratio measures the long-term financial position and soundness of long-term
financial policies. A higher proportion is not considered good and treated an
indicator of risky long-term financial position of the business.
l)
Fixed Assets Ratio: Fixed Assets
Ratio establishes the relationship of Fixed Assets to Long-term Funds.
Fixed Assets Ratio = Long-term Funds/Net
Fixed Assets
Where Long-term Funds = Share Capital
(Equity + Preference) + Reserves and Surplus + Long- term Loans – Fictitious
Assets
Net Fixed Assets means Fixed Assets at
cost less depreciation. It will also include trade investments.
Objective and Significance: This ratio indicates
as to what extent fixed assets are financed out of long-term funds. It is well
established that fixed assets should be financed only out of long-term funds.
This ratio workout the proportion of investment of funds from the point of view
of long-term financial soundness. This ratio should be equal to 1. If the ratio
is less than 1, it means the firm has adopted the impudent policy of using
short-term funds for acquiring fixed assets. On the other hand, a very high
ratio would indicate that long-term funds are being used for short-term
purposes, i.e. for financing working capital.
m) Proprietary Ratio:
Proprietary Ratio establishes the relationship between proprietors’ funds and
total tangible assets. This ratio is also termed as ‘Net Worth to Total Assets’
or ‘Equity-Assets Ratio’.
Proprietary Ratio = Proprietors’
Funds/Total Assets
Where Proprietors’ Funds = Shareholders’
Funds = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious
Assets
Total Assets include only Fixed Assets
and Current Assets. Any intangible assets without any market value and
fictitious assets are not included.
Objective and Significance: This
ratio indicates the general financial position of the business concern. This
ratio has a particular importance for the creditors who can ascertain the
proportion of shareholder’s funds in the total assets of the business. Higher
the ratio, greater the satisfaction for creditors of all types.
n) Interest Coverage
Ratio: Interest Coverage Ratio is a ratio between ‘net profit before
interest and tax’ and ‘interest on long-term loans’. This ratio is also termed
as ‘Debt Service Ratio’.
Interest Coverage Ratio = Net Profit
before Interest and Tax/Interest on Long-term Loans
Objective and Significance: This
ratio expresses the satisfaction to the lenders of the concern whether the
business will be able to earn sufficient profits to pay interest on long-term
loans. This ratio indicates that how many times the profit covers the interest.
It measures the margin of safety for the lenders. The higher the number, more
secure the lender is in respect of periodical interest.
o) Capital Turnover Ratio: Capital
turnover ratio establishes a relationship between net sales and capital
employed. The ratio indicates the times by which the capital employed is used
to generate sales. It is calculated as follows: -
Capital Turnover Ratio = Net
Sales/Capital Employed
Where Net Sales = Sales – Sales Return
Capital Employed = Share Capital (Equity
+ Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets.
Objective and Significance: The
objective of capital turnover ratio is to calculate how efficiently the capital
invested in the business is being used and how many times the capital is turned
into sales. Higher the ratio, better the efficiency of utilisation of capital
and it would lead to higher profitability.
p) Fixed Assets Turnover
Ratio: Fixed assets turnover ratio establishes a relationship between
net sales and net fixed assets. This ratio indicates how well the fixed assets
are being utilised.
Fixed Assets Turnover Ratio = Net
Sales/Net Fixed Assets
In case Net Sales are not given in the
question cost of goods sold may also be used in place of net sales. Net fixed
assets are considered cost less depreciation.
Objective and Significance: This
ratio expresses the number to times the fixed assets are being turned over in a
stated period. It measures the efficiency with which fixed assets are employed.
A high ratio means a high rate of efficiency of utilisation of fixed asset and
low ratio means improper use of the assets.
q) Working Capital
Turnover Ratio: Working capital turnover ratio establishes a relationship between
net sales and working capital. This ratio measures the efficiency of
utilisation of working capital.
Working Capital Turnover Ratio = Net
Sales or Cost of Goods Sold/Net Working Capital
Where Net Working Capital = Current
Assets – Current Liabilities
Objective and Significance: This
ratio indicates the number of times the utilisation of working capital in the
process of doing business. The higher is the ratio, the lower is the investment
in working capital and the greater are the profits. However, a very high
turnover indicates a sign of over-trading and puts the firm in financial
difficulties. A low working capital turnover ratio indicates that the working
capital has not been used efficiently.
r) Stock Turnover Ratio:
Stock turnover ratio is a ratio between costs of goods sold and average stock.
This ratio is also known as stock velocity or inventory turnover ratio.
Stock Turnover Ratio = Cost of Goods
Sold/Average Stock
Where Average Stock = [Opening Stock +
Closing Stock]/2
Cost of Goods Sold = Opening Stock + Net
Purchases + Direct Expenses – Closing Stock
Objective and Significance: Stock is
a most important component of working capital. This ratio provides guidelines
to the management while framing stock policy. It measures how fast the stock is
moving through the firm and generating sales. It helps to maintain a proper
amount of stock to fulfill the requirements of the concern. A proper inventory
turnover makes the business to earn a reasonable margin of profit.
s) Debtors’ Turnover
Ratio: Debtors turnover ratio indicates the relation between net credit
sales and average accounts receivables of the year. This ratio is also known as
Debtors’ Velocity.
Debtors Turnover Ratio = Net Credit
Sales/Average Accounts Receivables
Where Average Accounts Receivables =
[Opening Debtors and B/R + Closing Debtors and B/R]/2
Credit Sales = Total Sales – Cash
Sales-Return Inward
Objective and Significance: This
ratio indicates the efficiency of the concern to collect the amount due from
debtors. It determines the efficiency with which the trade debtors are managed.
Higher the ratio, better it is as it proves that the debts are being collected
very quickly.
t) Debt Collection
Period: Debt collection period is the period over which the debtors are
collected on an average basis. It indicates the rapidity or slowness with which
the money is collected from debtors.
Debt Collection Period = 12 Months or
365 Days/Debtors Turnover Ratio
Or
Debt Collection Period = Average Trade
Debtors/Average Net Credit Sales per day
Or
365 days or 12 months x Average
Debtors/Credit Sales (360 days can also be used instead of 365 days)
Objective and Significance: This
ratio indicates how quickly and efficiently the debts are collected. The
shorter the period the better it is and longer the period more the chances of
bad debts. Although no standard period is prescribed anywhere, it depends on
the nature of the industry.