RATIO ANALYSIS

 Introduction
1. Ratio: It is an arithmetical expression of a relationship between two
related or interdependent items.
2. Accounting Ratios: It is a mathematical expression that shows the
relationship between various items or groups of items shown in
financial statements. When ratios are calculated on the basis of
accounting information, they are called accounting ratios.
3. Ratio Analysis: It is a technique that involves re-grouping of data by
application of arithmetical relationships.
Objectives of Ratio Analysis
(i) To know the areas of an enterprise that need more attention.
(ii) To know about the potential areas which can be improved on.
(iii) Helpful in comparative analysis of the performance.
(iv) Helpful in budgeting and forecasting.
(v) To provide analysis of the liquidity, solvency, activity, and profitability
of an enterprise.
(vi) To provide information useful for making estimates and preparing
the plans for the future.
Advantages of Ratio Analysis

(i) It is useful in the analysis of financial statements.

(ii) Helps in simplifying accounting figures.
(iii) Useful in judging the operating efficiency of the business.
(iv) Helps in the identification of problem areas.
(v) Helpful in comparative analysis.
Limitations of Ratio Analysis
(i) Accounting ratios ignore qualitative factors.
(ii) Absence of universally accepted terminology.
(iii) Ratios are affected by window-dressing.
(iv) Effects of inherent limitations of accounting.
(v) Misleading results in the absence of absolute data.
(vi) Price level changes ignored.
(vii) Affected by personal bias and ability of the analyst.
Liquidity Ratio
◦ A liquidity ratio is a type of financial ratio used to determine a
company’s ability to pay its short-term debt obligations. The metric
helps determine if a company can use its current, or liquid, assets to
cover its current liabilities.
• The three main liquidity ratios are the current ratio, quick ratio, and
cash ratio.
• When analyzing a company, investors and creditors want to see a
company with liquidity ratios above 1.0. A company with healthy
liquidity ratios is more likely to be approved for credit.
Solvency ratio
◦ A solvency ratio is a key metric used to measure an enterprise’s ability to
meet its long-term debt obligations and is used often by prospective
business lenders.
◦ A solvency ratio indicates whether a company’s cash flow is sufficient to
meet its long-term liabilities and thus is a measure of its financial health.
◦ An unfavorable ratio can indicate some likelihood that a company
will default on its debt obligations.
◦ Solvency ratios and liquidity ratios both measure a company's financial
health but solvency ratios have a longer-term outlook than liquidity ratios.
Profitability ratio
◦ Profitability ratios are a class of financial metrics that are used to assess a
business's ability to generate earnings relative to its revenue, operating
costs, balance sheet assets, or shareholders' equity over time, using data
from a specific point in time.
◦ Profitability ratios can be compared with efficiency ratios, which consider
how well a company uses its assets internally to generate income (as
opposed to after-cost profits).
KEY TAKEAWAYS
• Profitability ratios assess a company's ability to earn profits from its
sales or operations, balance sheet assets, or shareholders' equity.
• Profitability ratios indicate how efficiently a company generates profit
and value for shareholders.
• Higher ratio results are often more favorable, but these ratios provide
much more information when compared to results of similar
companies, the company's own historical performance, or the industry
average.
Activity ratio
◦ An activity ratio is a type of financial metric that indicates how efficiently a
company is leveraging the assets on its balance sheet, to generate
revenues and cash.
◦ Commonly referred to as efficiency ratios, activity ratios help analysts
gauge how a company handles inventory management, which is key to its
operational fluidity and overall fiscal health.
Key Takeaways
◦ An activity ratio broadly describes any type of financial metric that
helps investors and research analysts gauge how efficiently a company
uses its assets to generate revenues and cash.
• Activity ratios may be utilized to compare two different businesses
within the same sector, or they may be used to monitor a single
company's fiscal health over time.
• Activity ratios can be subdivided into merchandise inventory turnover
ratios, total assets turnover ratios, return on equity measurements, and
a spectrum of other metrics.
Causes of Depreciation
◦ i) Normal wear and tear
◦ (a) Due to usage - Every asset has a life for which it can run, produce
or give service. Thus, as we put the asset to use its worth decreases.
Like a decrease in the efficiency and functioning of a bicycle due to its
running and usage.
◦ (b) Due to passage of Time – As time goes by elements of nature,
wind, sun, rain etc., cause physical deterioration in the worth of an
asset. Like reduction in the worth of a piece of furniture due to passage
of time even when it is not used.
Contd…
◦ ii) Obsolescence:
◦ (a) Due to the development of improved or superior equipment: Sometimes fixed
assets are required to be discarded before they are actually worn out due to either of
the above reasons. The arrival of superior equipment and machines etc. allows the
production of goods at a lower cost. This makes older equipment worthless as the
production of goods with their use will be costlier and noncompetitive. For example,
Steam engines became obsolete with the arrival of diesel and electric locomotives.
◦ (b) Due to change in fashion, style, taste, or market conditions: Obsolescence may also
result due to a decline in demand for certain goods and services with a change in
fashion, style, taste, or market conditions. The goods and services that are no longer in
vogue lead to a decrease in the value of the assets which were engaged in their
production - like factories or machines meant for making old-fashioned hats, shoes,
furniture, etc.
Objectives
◦ i) To show the true financial position of the business
◦ ii) To retain funds in the business for replacement of the asset