Ratio analysis:-

Financial ratio is a relationship that indicates something about the company such as ratio
between current assets and current liabilities or between the debtors and its turnover.

The basic source of this ratio is with the help of balance sheet, profit and loss account and
balance sheet which contains all the important information about the company.

It is important to compare ratios between two companies which is shows the growth of the
companies.

Financial ratios must be used by mangers within a firm, by current and potential
shareholders and by creditors.

The financial ratios are taken from the balance sheet, income statements of cash flows and
the statements of retained earnings.

Used of ratio:-
Financial ratios are useful indicators of a firm’s performance and financial situation. Most
ratios can be calculated from information provided by the financial statements.

It is useful to consider the financial strength of the company, it is indicated the future
financial performance of a company.

Ratio can be used to evaluate a performance compare to previous year and competitors as
well.

It can be used to set standard for financial performance.

It shows the companies performance where they have to improve and how to make it useful
for future potential.

It is used to enable external users which are investors, Lander when they want to invest
their money at that time they looked at the financial statement first.

Limitations:-
Ratio analysis is based on accounting data not an economic data.

Ratio analysis don’t capture significant off balance sheet items.

Many large companies operate different divisions in different industries. For these
companies it is difficult to find a meaningful set of industry average ratios.

Ratios are enable to where the multinational companies which having different segments so
investors are unable to identify the comparable competitors.
Ratios show the quantitative factors it doesn’t shows the qualitative factor like political,
economic issues and HRM in their financial statements.

There is always time delay between accounting reporting period and actual publication of
the company quarterly or annual statements.

Many ratios are calculated on the basis of the balance sheet figures. These figures are as on
the balance sheet date only and may not be indicative of the year round positions.

Ratios give current and past trends but not future trends.

Limited use of single ratio is also the limitations of ratios.

Types of ratios:-

1] Liquidity ratio

2] Profitability ratio

3] Efficiency ratio

4] Capital structure ratio

5] Investment ratio

1]. Liquidity ratio:- it shows the ability of company to pay off its short terms debts
obligations. It represents availability of cash by which they can pay liabilities.

Liquidity ratio includes two ratios:

1. Current ratio
2. Liquid/ acid test/ quick ratio

1]. Current ratio:- current ratio may be defines as teh relationship between current assets
and current liabilities.

This ratio is also known as working capital ratio.

Current ratio measures the ability to pay its short term obligation which has to pay within a
short term.

This ratio should be at least 2:1 means it should be two assts in order to one liability so if a
company paying 1 liability with the rest one asset.

The lower current ratio shows company’s inability of that they cannot pay their short term
debt.

If the value is greater than 1.00 it means fully covered.

The higher current ratio shows that company can use investment in better way where
investment remains same.

Formulation:-

Current ratio = current assets/ current liability

Example:- if a company A having £20000 and they borrowed £10000 then the total
investment become £30000 so what is current rati?

Current ratio= £20000/£10000 = 2:1

In order to above example, company A borrowed £20000 and invest £10000 so there is risk
for a company.

Limitations of current ratio:

It is simple ratio because it measures only the quantity and not the quality of current assets.

Even if the ratio is positive the company may be in financial trouble because of more stock
and work force in process so it is not easy to convert in to cash so the company has less cash
to pay off current liabilities.

2].Quick ratio: - A quick ratio is an indicator of a company’s ability to pay short term
liabilities.

This ratio should 1:1.

It is also known as acid test and liquid ratio.

If it is higher it means company is having too much cash on hand or it can be poor collection
for period for debts / account receivable.

Formula:

Quick ratio= quick assets/ current liabilities

Quick assets= current assets – inventory (stock)

This ratio has the limitations same as the currents ratios.

3]. Profitability ratio: profitability ratios are performance indicators; they show how well
business is performing. It provides information about management performance.

For examples:-

If a small company sell goods for £100 and profit is £10. It means 10/100*100=10%. So 10%
is profit it means £10 comes in the business and £90 goes out from business. Here 10% gives
significance profit.
It is constructed four ratios.

1. Profit margin
2. Gross profit margin
3. Return on capital employee ROCE
4. Earning per share ratio EPS

1]. Profit margin:-

Profit margin measures the overall profitability of the company which shows the
effectiveness of the management.

The profit margin shows the relationship between net incomes (profit) and sales.

Profit margin is very useful when comparing companies in similar industries. A higher profit
margin indicates a more profitable company that has better control over its costs compared
to its competitors.

Formula:-

Profit margin = profit before interest and tax PBIT * 100 / sales

Profit margin displays as a percentage.

2]. Gross profit ratio:-

Gross profit ratio is the ratio of gross profit to net sales expressed as percentage.

This ratio measures sales margin of the company. It indicates the selling price of goods per
unit.

This ratio is different from business to business.

Gross profit should be earned as sufficient as to recover all expenses and to build up
reserves (savings) after paying charges invest and dividends and taxes.

Reasons of increase or decrease in gross profit:-

Reasons for increase in GP:-

1] It increases when there should be increase in selling price of goods sold without
increasing the cost of goods sold.

2] It should be decrease in cost of goods without decreasing selling price.

3] Under valuation of stock or overvaluation of closing stock.

Reasons for decreasing in GP:-

1] Decrease in selling price of goods without decreasing in cost of goods.

2] Increase in cost of goods without increase in selling price.

3] Overvaluation of opening stock or undervaluation of closing stock.

Formula:-

Gross profit margin= gross profit * 100 / sales

Where gross profit = sales - cost of sales

Cost of sales = opening stock + purchases – closing stock

3]. ROCE (RETURN ON CAPITAL EMPLOYEE) :-