Chapter-1: Ratio Analysis

Introduction
Financial statement analysis is the process of analyzing financial statement
of a company of a company so as to obtain meaningful information about
its survival, stability, profitability, solvency and growth prospects. The
financial statement analysis can be performed by using a number of
techniques such as comparative statements, common size statements and
ratio analysis. Ratio analysis is the more popularly and widely used
technique of financial statement analysis.
 
Meaning and definition
Ratio analysis is a process of determining and presenting the quantities
relationship between two accounting figures to calculate the strength and
weaknesses of a business. In simple word, ratio analysis is quotient of two
numerical variables which shows the relationship between the two figures,
accordingly, accounting ratio us a relationship between two numerical
variable obtains from financial statements such as income statement and
the balance sheet. Accounting ratio are used as an important tool of
analysing the financial performance of the company over the years ans as
comparative position among other companies in the industry.
In other words, ratio analysis is the process of determining and
interpreting numerical relationship between figures of financial statement.
According to Kennedy and McMullan, the relationship of one term to
another expressed in simple mathematical form is known as ratio.
% of profit = ProfitCapitalProfitCapital * 100
Ratio can be expressed in the following terms:
Ratio method: This method shows the relationship between two figures in
ratio or proportion. It is expressed by simple division of one item by
another i.e 2:8:1, 0:8:1 and so on.
Rate method: This method shows relationship in rate or times, like 4 times
or 5 times and so on.
Precentage method: The relationship between two figures can be presented
in percentage like 20%, 30% and so on.
 
IMPORTANCE AND ADVANTAGES OF RATIO ANALYSIS
Ratio analysis is an important tool for analysising the company’s financial
performance. The following are the important advantages of the
accounting ratios.
Analysing financial statement: Ratio analysis an important technique of
financial statement analysis. Accounting ratios are useful for
understanding the financial position of the company. Different users such
as investors, management, bankers and creditors use the ratios to analyse
the financial statement of the company for their decision-making purpose.
Judging efficiency: Accounting ratios are important for judging the
company's efficiency in terms of its operations and management. They help
judge how well the company has been able to utilize its assets and earn
profits.
Locating weakness: Accounting ratios can also be used in locating
weakness of the company's operations even though its overall performance
may be quite good. Management can then pay attention to the weaknesses
and take remedial measures to overcome them.
Formulating plans: Although accounting ratios are used to analyse the
company's past financial performance, they can also be used to establish
future trends of its financial performance. As a result, they help formulate
the company's future plans.
Comparing performance: It is essential for a company to know how well it
is performing over the years and as compared to the other firms of the
similar nature. Besides, it is also important to know how well its different
divisions are performing among themselves indifferent years.
Inter-intra firm comparison: A firm may like to compare its performance
with that of other firms and of industry in general. The comparison is
called 'inter-firm comparison'. If the performance of different units
belonging to the same firm is to be compared, then it is called 'intra-firm
comparison'. Such comparison is almost impossible without proper
accounting ratios.
 
Classification of ratios
Accounting ratio can be classified from different point of view. Ratio may
be used to evaluate the company’s liquidity, efficiency, leverage,
profitability. The ratio may be classified as following;
Liquidity ratio: Liquidity represents one's ability to pay its current
obligations or short-term debts within a period less then a year. Liquidity
ratios, therefore, measure a a company's liquidity positions. The ratios are
important from the viewpoint of its creditors as well as management. The
liquidity position of the company can be measured mainly by using two
liquidity such as follows:
a)Current ratio
b)Quick ratio
Current ratio
Current ratio is also known as short-term solvency ratio or working capital
ratio. This ratio is used to assets the short-term financial position of the
business. In other words, it is an indicator of the firm's ability to meet its
short-term obligations;
it is calculated by;
Current ratio
= CurrentassetsCurrentliabilitiesCurrentassetsCurrentliabilities
 
Quick ratio
Quick ratio is another measure of a company's liquidity. It is also known as
liquid ratio or acid test ratio. However, although it is used to test the short-
term solvency or liquidity position of the firm, it is a more stringent
measure of liquidity than the current ratio. This ratio is calculated by
dividing liquid assets by current liabilities. liquid assets asset cash and
other assets which ate either equivalent to cash or convertible into cash
within a very short period of time. Thus liquid assets are also called
monetary current assets.
Quick ratio = LiquidassetscurrentliabilitiesLiquidassetscurrentliabilities
 
Fixed assets Turnover ratio
Fixed assets turnover ratio is termed as the ratio of sales to fixed assets.
Fixed turnover ratio indicates how efficiently the fixed assets are used. It
measures the efficiency with which the firm has been its fixed assets to
generate sales.
Fixed assets turnover  ratio= SalesNetfixedassetsSalesNetfixedassets
 
Total fixed turnover ratio
The ratio shows the relationship between total assets and sales. Total assets
turnover ratio indicates how well the firm's total assets are being used to
generate its sales.
Total assets turnover ratio = NetsalesTotalassetsNetsalesTotalassets
 
Capital employed turnover ratio
Capital employed turnover ratio establishes the relationship between the
amount of sales ad capital employed, it shown how efficiently capital
employed in the company has been utilized in generating sales revenue.
Capital employed turnover ratio
= SalesCapitalemployedSalesCapitalemployed
 
Leverage ratios
Leverage ratios are also called long-term solvency ratios or capital
structure ratios. The term solvency implies the ability of a company to meet
the payments associated with its long-term debts. Thus, solvency ratios are
the measure of the company's ability to meet its long-term obligations.
Generally, these ratios are expressed in proportions.
The following are the major types of leverage ratios:
a)Debt-equity ratio
b)Debt to total capital ratio
 
Debt-equity ratio
The debt-equity ratio is calculated to ascertain the soundness of the
company's long-term financial position. It indicates the extent to which it
depends upon borrowed funds for its existence. It portrays the proportion
if its total funds acquired by way of external financing.
Debt-equity ratio
= Long−termdebtShareholdersfundLong−termdebtShareholdersfund
Alternatively,
Debt-equity ratio
=  TotaldebtTotalshareholdersfundTotaldebtTotalshareholdersfund
Long-term debt: The debt which is payable after current year is called long
term-debt. Long-term debt refers to borrowed funds. Long-term debts
include term loans, debentures, bonds, mortgage loans and secured loans.
Total debt: it includes both short-term debt as well as long-term debt.
Short-term debts are the current liablilities.
 
Shareholder's fund: Shareholders fund is also called as net worth or
shareholders' equity. Shareholders fund is the amount, which belongs to
the company's shareholders or owners. It includes equity share capital,
preference share capital, reserve and surplus, accumulated profits, reserve
funds, general reserves, capital reserve, share premium, share forfeiture,
retained earnings, reserve for contingency, sinking fund for renewal of
fixed  assets and fixed assets and redemption of debenture. The fictitious
assets such as preliminary expenses, underwriting commissions, discount
on issue of shares, or debentures are deducted while determining
shareholders' fund.
 
Turnover ratios
Turnover ratios are also known as activity or efficiency ratios. The total
funds raised by the company are invested in acquiring various assets for its
operations. The assets are acquired to generate the sales revenue and the
position of profit depends upon the value of sales. These ratios establish the
relationship sale with various assets. Ratio and express in integrates or
times rather then percentage or proportion. The turnover ratios are mostly
computed to measure the efficiency.
The following are the types of turnover ratio;
 
Inventory turnover ratio
This ratio is also called stock turnover ratio. This ratio shows the
relationship between the cost of goods sold and the average inventory. This
ratio measures how frequently the company's inventory turn into sales. It,
therefore, shows the efficiency with which the company's inventory has
been converted into sales.
It is calculated by,
Inventory turnover ratio =  SalesClosinginventorySalesClosinginventory  
 
Debtor  turnover ratio     
It is also termed as receivable turnover ratio. This ratio establishes the
relationship between net credit sales and average debtor for the year. It
shows how quickly the credit (debtor or receivables) of the company has
been converted into cash. This ratio is calculated by using the following
formula
Debtor turnover
ratio= NetcreditsalesAverageaccountreceivableNetcreditsalesAverageaccou
ntreceivable
 
Average collection period           
It is also called debt collection period or average age of debtors and
receivables.it indicates how long it takes to realize the credit sales. It also
measures the average creditor period enjoyed by the customers. It indicates
the average time lag between credit sales and their conversion into cash.
 
Profitability ratios
The main objective of a company is to earn profit is both a means and an
end to the company. Therefore, profitability shows the overall efficiency of
the company. Profitability ratios are the measure of its overall efficiency.
Generally, profitability ratio can be calculated in term of the company's
sales, investments, and earning and dividends. The following are the main
types of profitability ratios:
1. Profitability in relation to sales
Gross profit margin
Net profit margin
 
2. Profitability in relation to investment
Return on assets
Return on shareholder equity
Return on shareholder find
Return on capital employed
 
3. Profitability in terms of earning and dividend
Earning per share
Dividend per share
 

Gross profit ratio

Gross profit ratio is also termed as gross profit margin. This ratio shows
the relationship between gross profit and net sales and it measures the
overall profitability of the company in terms of sales. It is generally
expressed in percentage.
It is calculated by,
Gross profit = GrossprofitNetSalesGrossprofitNetSales * 100  
 
Net profit ratio
This ratio is also called net profit margin. This ratio measures the overall
profitability of a business by establishing the relationship between net
profit and net sales. This ratio is calculated by dividing net profit tax by net
sales and multiplying by 100.
 
Return of assets
This ratio measure the relationship between the total assets and net profit
after tax plus interest. It measures the productivity of the assets and
determines how effectively the total assets have been used by the company.
Return of assets
=Netprofitaftertax+InterestTotalassetsNetprofitaftertax+InterestTotalasset
s
 
Return on shareholders' equity
This ratio expresses the profitability of a business in relation to the owners
fund.
It is calculated by,
Return on shareholders' equity =   NetprofitaftertaxTotalshareholder
′sequityNetprofitaftertaxTotalshareholder′sequity * 100
 
Return on capital employed
The net result of operation of a business is either profit or loss. The funds
used by the company to generate profit consist of both properties fund and
borrowed funds. Therefore, the company's overall performance can be
judged in terms of capital employed.
Return on capital employed
= Netprofitaftertax+InterestCapitalEmployedNetprofitaftertax+InterestCa
pitalEmployed * 100
 
Earning per share
Earning per share measures the profit available to equity shareholder on
per share basis. This ratio express the earning power of the company in
terms of a share held by the equity shareholders. This ratio computed by
dividing the net profits after preference dividend by the number of equity
shares outstanding.
Earning per share
= Netprofitaftertax−PreferencedividendNo.ofequitysharesoutstandingNetp
rofitaftertax−PreferencedividendNo.ofequitysharesoutstanding
 
Dividend per share
The profits earned by the company finally belong to the equity shareholder.
Therefore,  all or some of them are distributed to them which are known as
dividends. This ratio shows how much share of stock held by them is paid
out as dividend. The amount of earning distributed and paid as cash
dividend is considered for calculating the dividend per share.
Dividend per share
= DividendavailabletoshareholdersNo.ofequityshareoutstandingDividendav
ailabletoshareholdersNo.ofequityshareoutstanding