RATIO ANALYSIS The focus of financial analysis is on key figures in the financial statements and the significant relationship

that exists between them. The analysis of financial statements is a process of evaluating the relationship between the component parts of financial statements. To obtain a better understanding of the firms position and performance. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performances and current financial condition are determined. Ratio Analysis is a widely-used tool of financial analysis .It can be used to compare the risk and return relationships of firms of different sizes. Absolute Figures obtained in monetary terms in financial statements by themselves are meaningless. These figures often do not convey much meaning unless expressed in relation to other figures. For Example, one trader Mr. A. earns a profit of Rs. 1, 50,000 while another trader Mr. B. earns a profit of Rs. 1,80,000. Which of them is more efficient? Generally, we can say that Mr. B. is more efficient as he earns a higher quantum of profits. But in order to get the correct answer, we must find out, how much capital is employed by each of them. Suppose, Mr. A has employed a capital of Rs. 10, 00,000 and Mr. B. has employed a capital of Rs. 15,00,000 ,we can calculate the percentage of profit earned by each of them on the capital employed: Mr. A =
150000 100 15% 1000000

Mr. B. =

180000 100 = 12% 1500000

This shows that A earned Rs. 15 for every Rs.100 of capital whereas B earned Rs 12 for every Rs. 100 of capital. As such, A is using his capital more efficiently. . The above example shows that figures assume significance only when expressed in relation to other figures. Just as in the example given above, the absolute figure of profit was meaningless but when the figure of profit was expressed in relation to capital ,it assumed significance. Meaning of Ratio Relationship between two figures, expressed in arithmetical terms is called a Ratio. In the words of R. N. Anthony: A Ratio is simply one number expressed in terms of another . It is found by dividing one number into the other Ratios may be expressed in the following four ways: (1) Proportion or Pure Ratio or Simple Ratio:It is expressed by the simple division of one number by another. For Example, if the current assets of a business are Rs. 2,00,000 and its current liabilities are Rs. 1,00,000 ,the ratio of Current Assets to Current Liabilities will be 2:1.

(2) Rate or So Many Times:In this type , it is calculated by how many times a figure is ,in comparison to another figure. For Example, if a firms credit sales during the year are Rs. 2,00,000 and its debtors at the end of the year are Rs. 40,000 ,its Debtor Turnover Ratio=
200000 = 5 Times. 40000

It shows that credit sales are 5 times in comparison to debtors. (3) Percentage:In this type, the relation between the two figures is expressed in hundredth. For Example, if a firms capital is Rs. 10,00,000 and its profit is Rs. 2,00,000 ,the ratio of profit to capital ,in terms of percentage is Rs.
200000 100 =20%. 1000000

(4) Fraction:Say, net profit is one-fifth of capital.

Advantages or Uses of Accounting Ratios 1. Advantages of Ratio Analysis are: 2. Helpful in Analysis of Financial Statements 3. Simplification of Accounting Data 4. Helpful in Comparative Study 5. Helpful in locating weak spots of business 6. Helpful in Forecasting 7. Estimate about the trend of the business 8. Fixation of Ideal Standards 9. Effective Control Disadvantages or Limitations of Accounting Ratios 1. False Accounting Data gives false ratios.

2. Comparison not possible if different firms adopt different accounting policies. 3. Ratio Analysis becomes less effective due to price level changes. 4. Ratios may be misleading in the absence of absolute data. 5. Limited use of a single ratio. 6. Window-Dressing. 7. Lack of proper standards. 8. Ratios alone are not adequate for proper conclusions. 9. Effect of Personal Ability and Bias of the analyst.

Steps in Ratio Analysis 1. The first task of the financial analysis is to select the information relevant to the decision under consideration from the statements and calculates appropriate ratios. 2. To compare the calculated ratios with the ratios of the same firm relating to the past or with the industry ratios. It facilitates in assessing success or failure of the firm. 3. Third step is to interpretation, drawing of inferences and report writing conclusions are drawn after comparison in the shape of report or recommended courses of action.

Classification of Ratios: Users of financial statements, i.e. Short-term creditors ,long-term creditors ,shareholders ,etc are interested in knowing the liquidity ,solvency ,activity and profitability of the enterprise .On this basis ratios may be classified into the four categories as follows: A. Liquidity Ratios B. Solvency Ratios Activity or Turnover Ratios C. Profitability Ratios or Income Ratios Liquidity Ratios:Liquidity refers to the ability of the firm to meet its short-term or current liabilities. The liquidity ratios , therefore are also called the Short-Term Solvency Ratios. These ratios are used to assess the short-term financial position of the concern .They reflect the firms ability to meet its current obligations out of current resources. Short-term creditors of the firm are primarily interested in the liquidity ratios of the firm as they want to know how promptly or readily the firm can meet its current liabilities. If the firm wants to take a short-term loan from the bank ,the bankers have to study the liquidity ratios of the firm in order to assess the margin between current assets and current liabilities. Liquidity Ratios include two main ratios: 1. Current Ratio or Working Capital Ratio 2. Quick Ratio or Acid Test Ratio or Liquid Ratio 1-Current Ratio or Working Capital Ratio

The Current Ratio is the ratio of Current Assets and Current Liabilities. It is calculated by dividing Current Assets by Current Liabilities : Current Assets Current Ratio= Current Liabilities Current Assets of a firm represent those assets which can be ,in the ordinary course of business, converted into cash within a short period of time ,normally not exceeding one year and include cash and bank balances ,marketable securities(short-term investments) ,Bills Receivable, Prepaid Expenses, Stock ,Net Trade Debtors( Total Trade Debtors-Provisions) ,etc. Current Liabilities include liabilities which are short-term maturing obligations to be met, as originally contemplated, within a year and consists of trade creditors, Bills Payable, Bank Credit, Provisions for Taxation, etc. Significance: As a measure of short-term financial liquidity, it indicates the rupees of current assets available for each rupee of current liability/obligation payable. The higher the current ratio, the more is the firms ability to meet short-term obligations and the greater is the safety of the funds of short-term creditors. However, this rule is not always true. A much higher ratio may indicate that stock might be piling up because of poor sales or large amount of cash is locked up with debtors because of inefficient collection policy. Ideal Ratio: Although there is no hard and fast rule, conventionally, a current ratio of 2:1 is considered ideal. The logic underlying the conventional rule is that even with a drop of 50% (half) in the value of current assets, a firm can meet its obligations, that is, a 50% margin of safety is assumed to be sufficient to ward off the worst of situations.

2-Quick Ratio or Acid Test Ratio or Liquid Ratio As observed, one defect of the current ratio is that it fails to convey any information on the composition of the current assets of a firm. A rupee in cash is considered equivalent to a rupee of inventory receivable. This impairs the usefulness of the current ratio. The acid-test ratio is a measure of liquidity designed to overcome this defect of current ratio. Quick Ratio indicates whether a firm is in a position to pay its current liabilities within a month or immediately. Thus, it is a measure of quick or acid liquidity. The Quick Ratio is calculated by dividing quick assets by current liabilities. Quick Assets Quick Ratio= All Current Liabilities -Bank Overdraft

Quick Assets or Liquid Assets refers to current assets which can be converted into cash immediately or at a short notice without diminution of value. All current assets except stock and prepaid expenses are included in liquid assets. Stock is excluded from liquid assets as it has to be sold before being converted into cash while prepaid expenses are excluded as they are not expected to yield any cash benefit in future. Significance: The usefulness of the ratio lies in the fact that it is widely accepted as the best available test of liquidity of the firm. This ratio is a better test of short-term of financial position of the company than the current ratio as it considers only those assets which can be easily and readily converted into cash. Ideal Ratio:

Although there is no hard and fast rule, conventionally, a current ratio of 1:1 is considered ideal. Solvency Ratios/ Leverage Ratio / Capital Structure Ratio: The long-term lenders / creditors would judge the soundness of a firm on the basis of the long- term financial strength measured in terms of its ability to pay the interest regularly as well as repay the principal on due dates or in one lump sum at the time of maturity. The long-term solvency of the firm can be examined using leverage or capital structure or solvency ratios. The leverage or capital structure ratios may be defined as financial ratios which throw light on long-term solvency of a firm as reflected in its ability to assure the long-term lenders with regard to: i. ii. Periodic Payment of interest during the period of the loan and Repayment of principal on maturity or in predetermined installments on due date. There are three main types of leverage ratios: 1. Debt-Equity Ratio 2. Total Assets to Debt Ratio 3. Proprietary Ratio 1-Debt-Equity Ratio The relationship between borrowed funds and owners capital is a popular measure of the long-term financial solvency of the firm. This relationship is shown by the debt-equity ratio. This ratio reflects the relative claims of creditors and shareholders against the assets of the firm. Alternatively, this ratio indicates the relative proportions of debt and equity in financing the assets of the firm i.e., it indicates the proportions of assets which have been acquired by long-term debts

in comparison to shareholders funds. This ratio is calculated to ascertain the soundness of long-term financial policies of the firm. Debt Equity Ratio = Debt Long-Term Loans Equity or Shareholder's Funds

Long-Term Loans: These refer to long-term liabilities which mature after one year. These include Debentures, Mortgage Loan; bank Loan, Loan from Financial Institutions and Public Deposits, etc. Shareholders Funds: These include Equity Share Capital, Preference Share Capital ,Securities Premium ,General Reserve ,Capital Reserve ,Other Reserves and Credit balance of Profit and Loss Account. However, accumulated losses and fictitious assets remaining to be written off like preliminary expenses, underwriting commission, share issue expenses etc should be deduced. Significance: This ratio is calculated to assess the ability of the firm to meet its long-term liabilities. Ideal Ratio: Generally, debt-equity ratio of 2:1 is considered safe. If the debt-equity ratio is more than that, it shows a rather risky financial position from the long-term point of view as it indicates more and more funds invested in the business and provided by long-term lenders.

2-Total Assets to Debt Ratio: This ratio is a variation of debt equity ratio and gives the same indication as the debt equity ratio. .In this ratio, total assets are expressed in relation to long-term debts. It is calculated as under: Total Assets Total Assets to Debt Ratio= Debt/Long-term loan Total Assets include all fixed as well as current assets .However, these do not include the fictitious assets appearing on the assets side of the Balance Sheet such as Preliminary Expenses, Underwriting Commission ,Share Issue Expenses ,Discount on issue of shares ,etc and debit balance of Profit and Loss Account. Long-Term Loans These refer to long-term liabilities which mature after one year. These include all long-term debts such as Debentures, Mortgage Loan, bank. Loans from Financial Institutions and Public Deposits, etc. Significance: The ratio measures the extent to which long-term loans are covered by assets which indicates the margin of security available to providers of long-term loans. A higher total asset to debt ratio implies the use of lower debts in financing the assets which means a larger margin of safety for lenders. On the other hand, a low ratio represents risky financial position as it implies the use of higher debts in financing the assets of the business. 3-Proprietary Ratio: This ratio indicates the proportion of total assets funded by owners or shareholders .It is calculated as under: Equity Proprietary Ratio = Total Assets

Significance: A higher proprietary ratio is generally treated an indicator of sound financial position from long-term point of view because it means a large proportion of total assets is provided by equity and hence the firm is less dependent on external sources of finance. On the contrary a low proprietary ratio is a danger-signal for long-term lenders as it indicates a lower margin of safety available to them. The lower the ratio the less secured are the long-term loans and they face the risk of losing their money. Activity or Turnover Ratio: These ratios measure how well the facilities at the disposal of the concern are being utilized that is they are concerned with measuring the efficiency in asset management. These ratios are known as turnover ratios as they indicate the rapidity with which resources available to the concern are being used to produce sales. These ratios are also called Efficiency Ratios or Assets Utilization Ratios. The efficiency with which the assets are used would be reflected in the speed and rapidity with which assets are converted into sales. The greater the rate of turnover or conversion, the more efficient is the utilization of assets ,other things being equal. In other words, these ratios measure the efficiency and rapidity of the resources of the company, like stock, fixed assets, working capital, debtors, etc. These ratios are generally calculated on the basis of cost of sales. Some of the important activity ratios are: a) Inventory Turnover Ratio or Stock Turnover Ratio b) Debtors Turnover Ratio or Receivables Turnover Ratio c) Creditors Turnover Ratio or Payables Turnover Ratio d) Working Capital Turnover Ratio Inventory Turnover Ratio or Stock Turnover Ratio

This ratio indicates the number of times inventory is replaced during the year. It measures the relationship between the cost of goods sold and the average inventory level. It can be calculated in the following way: Inventory Turnover Ratio= Cost of Goods Sold Average Stock

(1) Cost of Goods Sold can be calculated in two ways: (i)Cost of Goods Sold=Opening Stock +Purchases +Carriage+ Wages +Other Direct Charges-Closing Stock (ii)Cost of Goods Sold=Net Sales-Gross Profit (2)Average Stock= Opening Stock+Closing Stock 2

Significance: This ratio indicates whether stock has been efficiently used or not. It shows the speed with which stock is rotated into sales or the number of times stock is turned into sales during the year .The higher the ratio, the better it is, since it indicates that stock is selling quickly. Ina business where stock turnover ratio is high, goods can be sold at a low margin of profit and even then the profitability may be quite high. A low stock turnover ratio indicates that stock does not sell quickly and remains lying in the warehouse for a quiet a long time. This results in increased storage costs, blocking of funds and losses on account of goods becoming obsolete or unsalable.

This ratio can be used for comparing the efficiency of sales policies of two firms doing the same type of business .The stock policies of the management of that firm whose stock turnover ratio is higher ,will be treated more efficient. Similarly, by comparing the stock turnover ratio of current year with the previous year, the management can assess whether stock has been more efficiently used or not. Debtors Turnover Ratio or Receivables Turnover Ratio: This ratio indicates the relationship between credit sales and average debtors during the year. It can be calculated as: Net Credit Sales Debtors Turnover Ratio= Average Debtors+Average Bills Receivable

Bills Receivables are added in debtors for the purpose of calculation of this ratio . Average Debtors is calculated by dividing the total of debtors at the beginning of the financial year and at the end of the financial year by 2. Similarly, Average Bills Receivable is calculated by dividing the total of Bills Receivables at the beginning of the financial year and at the end of the financial year by 2. While calculating this ratio, provision for bad and doubtful debts is not deducted from total debtors, so that it may not give a false impression that debtors are collected quickly. Significance: This ratio indicates the speed with which the amount is collected from debtors. The higher the ratio, the better it is, since it indicates that amount from debtors is being collected more quickly. The more quickly the debtors pay ,the less the risk

from bad debts ,and so the lower the expenses of collection and increase in the liquidity of the firm. A lower debtor turnover ratio will indicate the inefficient credit sales policy of the management. It means that credit sales have been, made to customers who are not creditworthy. It is difficult to set up a standard for this ratio. It depends upon the policy of the management and the nature of the industry. Creditors Turnover Ratio or Payables Turnover Ratio: This ratio indicates the relationship between credit purchases and average creditors during the year. It is expressed as: Net Credit Purchases Creditors Turnover Ratio =Average Creditors+Average Bills Payable

Significance: This ratio indicates the speed with which the amount is being paid to creditors. The higher the ratio, the better it is, since it will indicate that the creditors are being paid more quickly which increases the credit worthiness of the firm. Working Capital Turnover Ratio: It is a measurement comparing the depletion of working capital to the generation of sales over a given period. This provides some useful information as to how effectively a company is using its working capital to generate sales. It can be computed as follows: Net Sales Working Capital Turnover Ratio= Working Capital Working Capital=Current Assets-Current Liabilities

Significance: This ratio is of particular importance in non-manufacturing concerns where current assets play a major role in generating sales. This ratio reveals how efficiently working capital has been utilized in making sales. In other words, it shows the number of times working capital has been rotated in producing sales. A high working capital turnover ratio shows efficient use of working capital and quick turnover of current assets like stock and debtors .A low working capital turnover ratio indicates under-utilization of working capital . However ,a very high turnover ratio of working capital is also dangerous as it is a sign of over-trading ,i.e., doing business with too little working capital. It is an indicator of the shortage of working capital and may put the concern in financial difficulties. On the other hand , a very low turnover of working capital may be a sign of undertrading in comparison to working capital ,i.e. the working capital is in excess of the requirements of business. Profitability Ratios or Incomes Ratios: The main object of every business concern is to earn profits .A business must be able to earn adequate profits in relation to the capital invested in it. The efficiency and the success of a business can be measured with the help of profitability ratios. The management of a firm is eager in measuring its operating efficiency. The operating efficiency of a firm and its ability to ensure adequate returns to investors depends on the profits earned by it. Operating Efficiency can be measured with the help of profitability ratios. The following are the important profitability ratios: 1. Gross Profit Ratio 2. Operating Ratio 3. Net Profit Ratio Gross Profit Ratio

This ratio shows the relationship between gross profit and sales. The formula for computing this ratio is: Gross Proft Gross Profit Ratio = Net Sales 100 Net Sales =Total Sales-Sales Return Significance: This ratio measures the margin of profit available on sales .The higher the gross profit ratio, the better it is. No ideal or standard is fixed for this ratio, but the gross profit ratio should be adequate enough not only to cover the operating expenses but also to provide for depreciation, interest on loans, dividends and creation of reserves. This ratio is compared with earlier years ratio and important conclusions are drawn from such comparison .For instance, if there is a decline in gross profit ratio in comparison to the previous years, it may be concluded that :a) Prices of materials purchased, freight ,wages and other direct charges may have gone up but selling price may not have gone up in proportion to the increase in costs.; or b) The selling prices may have fallen but the prices of materials ,freight ,wages and other direct charges may not have fallen relatively.; or c) There may be misappropriation, theft or pilferage of stocks during the year. ; or d) There is a fall in the sale of more profitable variety of goods. ;or e) There is a fall in the prices of unsold goods, thereby reducing the value of closing stock. A high ratio of gross profit is a sign of good management as it implies that the cost of production if the firm is relatively low .On the contrary ,a relatively low

gross profit margin is a danger signal ,warranting a careful and detailed study of the factors responsible for it. Net Profit Ratio: This ratio measures the relationship between net profits and sales of the firm. It can be calculated as: Net Proft Net Profit Ratio = Net Sales 100 Net Profit= Gross Profit-Indirect Expenses Net Sales= Total Sales-Sales Return

Significance: The net profit margin is indicative of managements ability to operate the business with sufficient success not only to recover from revenues of the period ,the cost of merchandise or services ,the expenses of operating the business (including depreciation) and the cost of borrowed funds ,but also to leave a margin of reasonable compensation to the owners for providing their capital at risk. The ratio of net profit to sales effectively expresses the cost price effectiveness of operation. A high net profit margin would ensure adequate returns to the owners as well as enable a firm to withstand adverse economic condition when selling price is falling. A lower net profit margin has opposite implications. Operating Ratio:

This ratio measures the proportion of an enterprises cost of sales and operating expenses in comparison to its sales:Operating Ratio = Cost of Goods Sold+Operating Expenses 100, where Net Sales

Cost of Goods Sold =Opening Stock +Purchases +Direct Expenses Closing Stock Operating Expenses = Office and Administration Expenses +Selling and Distribution Expenses (including Depreciation) +Discount +Bad Debts + Interest on short term loans

However, while calculating Operating Ratio it must be remembered that nonoperating expenses such as loss on sale of fixed assets ,loss from fire ,income tax ,charities and donations ,finance charges relating to interest on long-term loans and interest on debentures ,etc are ignored while calculating this ratio. Similarly, non-operating incomes (such as income from investments) are also ignored. Significance: Operating Ratio is a measurement of the efficiency and profitability of the business enterprise .This ratio indicates the extent of sales that is absorbed by the cost of goods sold and operating expenses .Lower the operating ratio ,the better it is ,because it will leave a higher margin of profits on sale.