Unit – 9: Ratio Analysis
Q.N.1. what do you mean by ratio analysis? What are the objectives and advantages of such analysis? Also point out the limitations of ratio analysis. 2012, 2012
Answer: 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."
Objectives of Ratio analysis
1. To know the area of the business which need more attention.
2. To know about the potential areas which can be improved with the effort in the desired direction.
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business.
4. To provide information for decision making.
Advantages and Uses of Ratio Analysis
1. Helpful in analysis of financial situation: It helps the management to know about the earning capacity and financial strength and weakness of the business concern.
2. Helpful in intra-firm comparison: Ratio analysis also makes possible comparison of the performance of the different division of the firm.
3. Helpful in inter firm comparison: It provides data for inter firm comparison. Ratios reveal strong and weak firms, overvalued and undervalued firms, successful and unsuccessful firm.
4. Simplifies the accounting information: It simplifies the financial statements. It gives a brief idea about the whole story of changes in the financial condition of a business.
Limitations of Ratio Analysis
1. Limited Comparability due to difference in accounting policies in different firms.
2. False Results if accounting data are not correct.
3. Effects of Price Level Changes are ignored.
4. Qualitative factors are ignored.
5. Historical in nature.
Q.N.2. Explain the meaning and method of calculation of some specific ratios.
Ans: Some of the useful ratios are explained below:
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, and Accrued Incomes etc.
Current Liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
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.
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
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
Q.N.3. What is Earning per Share?
Ans: EPS = Profit available for Equity Shareholders / No. of Equity Shares
Q.N.4. What is Book Value per Share?
Ans: Book Value Per Share = Equity shareholders’ Funds / No. of Equity Shares
Q.N.5. What are the types of Ratios according to traditional classification? 2016
Ans: A) Types of ratio according to traditional classification:
1. Income Statement Ratio: A ratio of two variables from the income statement is known as Income Statement Ratio.
2. Balance Sheet Ratio: In case both variables are from balance sheet, it is classified as balance sheet ratio.
3. Composite Ratio: If a ratio is computed with one variable from income statement and another variable from balance sheet, it is called Composite Ratio.
B) Functional classification of ratio: Under this classification, ratios may be grouped in the following types:
a) Liquidity Ratios: Liquidity ratios are calculated to have indications about the short term solvency of the business, i.e. the firm’s ability to meet its current obligations. For example: Current ratio, liquid ratio and absolute liquid ratio falls under this group.
b) Solvency Ratios or leverage ratios: Solvency ratios are calculated to determine the ability of the business to service its debt in the long Run. For example: Debt-equity ratio, total asset to debt ratio, Proprietory ratio and capital gearing ratio are covered under this group.
c) Efficiency or turnover or activity Ratios: These ratios are calculated to study the efficiency with which the resources of the unit have been used. For example: Inventory turnover ratio, debtor’s turnover ratio, creditor’s turnover ratio and fixed assets turnover ratios are covered under this group.
d) Profitability Ratios: These ratios measure the operating efficiency i.e. the financial result of the unit during the accounting period. For example: gross profit ratio, net profit ratio, operating ratio, operating profit ratio and return on investment are covered under this group.