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Financial Ratio Analysis

Ratio analysis is a process of determining and interpreting


relationships between the items of financial statements to provide a
meaningful understanding of the performance and financial
position of an enterprise. Ratio analysis is an accounting tool to
present accounting variables in a simple, concise, intelligible and
understandable form.
As per Myers Ratio analysis is a study of relationship among
various financial factors in a business


Objectives of Financial Ratio Analysis


The objective of ratio analysis is to judge the earning capacity,
financial soundness and operating efficiency of a business
organization. The use of ratio in accounting and financial
management analysis helps the management to know the
profitability, financial position and operating efficiency of an
enterprise.

Advantages of Ratio Analysis

The advantages derived by an enterprise by the use of accounting
ratios are:
1) Useful in analysis of financial statements:
Bankers, investors, creditors, etc analysis balance sheets and
profit and loss accounts by means of ratios.

2) Useful in simplifying accounting figures:
Accounting ratio simplifies summarizes and systematizes a
long array of accounting figures to make them
understandable. In the words of Biramn and Dribin,
Financial ratios are useful because they summarize briefly
the results of detailed and complicated computation

3) Useful in judging the operating efficiency of business:
Accounting Ratio are also useful for diagnosis of the
financial health of the enterprise. This is done by evaluating
liquidity, solvency, profitability etc. Such a evaluation
enables management to access financial requirements and the
capabilities of various business units.


4) Useful for forecasting:
Helpful in business planning, forecasting. What should be the
course of action in the immediate future is decided on the
basis of trend ratios, i.e., ratio calculated for number of years.

5) Useful in locating the weak spots:
Locating the weak spots in the business even though the
overall performance may quite good. Management cab then
pay attention to the weakness and take remedial action. For
example if the firm finds that the increase in distribution
expense is more than proportionate to the results achieved,
these can be examined in detail and depth to remove any
wastage that may be there.

6) Useful in Inter-firm and Intra-firm comparison:
A firm would 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, it is
called intra-firm comparison. Such comparison is almost
impossible without accounting ratios. Even the progress of a
firm from year to year cannot be measured without the help
of financial ratios. The accounting language simplified
through ratios are the best tool to compare the firms and
divisions of the firm.




Limitations of Financial Ratio Analysis:


1) False Results:
If Financial Statements are not correct Financial Ratio
Analysis will also be correct.

2) Different meanings are put on different terms:
Elements and sun-elements are not uniquely defined. An
enterprise may work out ratios on the basis of profit after Tax
and interest while others work on profit before interest and
Tax .So, the Ratios will also be different so cannot be
compared. But before comparison is to be done the basis for
calculation of ratio should be same.

3) Not comparable if different firms follow different
accounting Policies.
Two enterprises may follow different Policies like some
enterprises may charge depreciation at straight line basis
while others charge at diminishing value. Such differences
may adversely affect the comparison of the financial
statements.

4) Affect of Price level changes:
Normally no consideration is given to price level changes in
the accounting variables from which ratios are computed.
Changes in price level affects the comparability of Ratios.
This handicaps the utility of accounting ratios.

5) Ignores qualitative factors:
Financial Ratios are on the basis of quantitative analysis
only. But many times qualitative facts overrides quantitative
aspects .For Example: Loans are given on the basis of
accounting Ratios but credit ultimately depends on the
character and managerial ability of the borrower. Under such
circumstances, the conclusions derived from ratio analysis
would be misleading.

6) Ratios may be worked out for insignificant and unrelated
figures.
Example: A ratio may be worked out for sales and
investment in govt. securities. Such ratios will only be
misleading. Care should be exercised to work out ratios
between only such figures which have cause and effect
relationship. One should be reasonably clear as to what is the
cause and what is the effect.
7) Difficult to evolve a standard Ratio:
It is very difficult to evolve a standard ratio acceptable at all
times as financial and economic scenario are dynamic. Again
the underlying conditions for different firms and different
industries are not similar, so an acceptable standard ratio
cannot be evolved.
8) Window Dressing:
Financial Ratios will be affected by window dressing.
Manipulations and window dressings affect the financial
statements so they are going to affect the f. ratios also.
Therefore a particular ratio may not be a definite indicator of
good or bad management.
9) Personal Bias:
Ratios have to be interpreted, but different people may
interpret same ratios in different ways. Ratios are only tools
of financial analysis but personal judgment of the analyst is
more important. If he does not posses requisite qualifications
or is biased in interpreting the ratios, the conclusion drawn
prove misleading.


Classification or types of Ratios

1) Liquidity Ratio
2) Financial Structure Ratio
3) Activity Ratio
4) Profitability Ratio
5) Coverage Ratio


1) Liquidity Ratio(Short Term Solvency):
It measures the short-term solvency, i.e., the firms ability to
pay its current dues. They comprise of Current Ratio and
Liquid Ratio.
Current Ratio or Working Capital Ratio is a relationship
of current assets to current liabilities.
Current Assets are the assets that are either in the firm of
cash or cash equivalents or can be converted into cash or cash
equivalents in a short time (say, within a years time) and
Current Liabilities are repayable in a short time. It is
calculated as follows:

Current Ratio = Current Assets
Current Liabilities

Significance:
The objective of calculating Current Ratio is to assess the
ability of the enterprise to meet its short-term liabilities
promptly. It shows the number of times the current assets can
be converted into cash to meet current liabilities. As a normal
rule current assets should be twice the current liabilities.
Low ratio indicates inadequacy of the enterprise to meet its
current liabilities and inadequate working Capital.
High Ratio is an indication of inefficient utilization of funds.
An enterprise should have a reasonable current ratio.
Although there is no hard and fast rule yet a current ratio of
2:1 is considered satisfactory.
Current Ratio is calculated at a particular date and not for a
particular period.

The following items are included in current assets and
Current Liabilities:
Current Assets Current Liabilities

1.Cash and Bank Balance 1.Creditors
2.Debtors(after deducting provision) 2.Bills Payable
3.Bills Receivable (after deducting
provision) 3.Bank Overdraft
4.Stock 4.Short-term Loans
5. Marketable Securities 5.Outstanding Expenses
6.Prepaid Expenses 6.Provision for Tax
7.Advance Payments 7.Unclaimed Dividend
Dividend Payable
8.Accued Interest 8.Cash credit



Important Points:

1.Working Capital =Current Assts - Current Liabilities.
2.Total Debt =Total Outsider Liability =Long term
Liability+short term Liability (current Liability)
3.Total assets=fixed assets +investment +Current assets





Liquidity Ratio or Liquid Ratio or Quick Ratio or Acid
Test Ratio:


Liquidity Ratio is a relationship of liquid assets with current
liabilities and is computed to assess the short- term liquidity
of the enterprise in its correct form.
This is calculated as follows:

Liquidity Ratio =Liquid assets or quick assets
Current Liabilities
Quick assets=Current assets (stock +Prepaid Expenses)

Liquid assets are the assets, which are either in the form of
cash or cash equivalent or can be converted into cash within a
very short period. Liquid assets include cash, bills receivable,
marketable securities and debtors (excluding bad and
Doubtful debts), etc. Stock is excluded from liquid assets as
it may take some time before it is converted into cash.
Similarly prepaid expenses do not provide cash at all and are
thus excluded from liquid assets.

A quick ratio of 1:1 is usually considered favorable, since for
every rupee of current liabilities, there is a rupee of current
assets.
A high liquidity ratio compared to current ratio may indicate
under stocking while a low liquidity ratio while a low
liquidity ratio indicated overstocking.










Problem:

Following is the Balance sheet of XYZ Limited as on 31
st

March 2009:
Liabilities Rs. Assets Rs.
Equity Share Capital
2,400 shares of Rs.
10 each (fully paid)
Profit & Loss A/C
10% Debentures
Sundry Creditors
Provision for
Taxation
24,000


6,000
15,000
23,400
600

69,000
=====
Machinery and
Equipment
Stock
Sundry Debtors
Cash at bank
Prepaid Expenses

45,000
12,000
9,000
2,280
720


69,000
=====
Compute the following Ratios:
1) Current Ratio
2) Liquid Ratio
On the basis of these calculations write about the conclusions you
draw about the company.


Solution:

1)Current Ratio=Current assets
Current Liabilities

=Stock +Debtors +Bank +Prepaid Expenses
Creditors +Provision for Taxation

=Rs.12,000 +Rs.9000 +Rs.2,280 +Rs.720
Rs.23,400 +Rs.600

=Rs.24000 = 1:1
Rs.24000

Normally Current Assets should be twice the current
liabilities. in this case current assets are just equal to current
liabilities. Hence, the short term financial position of the
company cannot be said to be satisfactory.



2) Liquid Ratio =Liquid assets or quick assets
Current Liabilities


= Debtors +Cash at Bank
Creditors +Provision for Taxation

=Rs.9000 +Rs.2,280
Rs.23400 +Rs.600

= Rs.11,280
Rs.24,000
=0.47:1

For satisfactory position Liquid ratio is 1:1.In this case it is half
of its obligations and hence liquidity of the company is also
unsatisfactory




2) Financial Structure/Solvency Ratio

The term solvency implies ability of an enterprise to meet its
indebtedness and thus conveys an enterprises ability to meet its
long - term obligations. Important solvency ratios are:
Debt-Equity Ratio; Total assets to Debts Ratio and Proprietary
Ratio

Debt-Equity Ratio- It is computed to ascertain the soundness of
the long-term financial position of the firm. This ratio expresses
the relationship between debt (external equities) and the equity
(internal equities)
Debt means long term loans, i.e., debentures, long-term loans from
financial institution. Equity means shareholders funds, i.e.,
preference share capital, equity share capital, reserves less losses
and fictitious assets like preliminary expenses. The ratio is
ascertained as follows:

Debt- equity Ratio =Debt (long-term loans)
Equity (shareholders Funds)

Higher Ratio indicates risky financial position while lower ratio
indicates safe financial position. Acceptable Debt-Equity Ratio is
2:1 which means debt can be twice the equity.

Significance: This ratio is significant to access the soundness of
long term financial position. It also indicates the extent to which
firm depends upon outsiders for its existence. It portrays the
proportion of total funds acquired by a firm by way of loans.


Total Assets to Debt Ratio
Total Assets includes fixed as well as current assets. However, it
does not include fictitious assets like preliminary expenses,
underwriting commission, share issue expenses, discount on issue
of share etc and debt balance of profit and loss account.
Long term Debts refer to debts that will mature after one year. It
includes debentures, bonds, loans from financial institutions.

Total Assets to Debt Ratio = Total assets
Long Term Debts

Ideal Ratio is 2:1
It measures the safety margin available to the providers of long-
term debts.
A higher ratio represents higher security to lenders for extending
long-term loans to the business. On the other hand, a low ratio
represents a risky financial position as it means that the business
depends heavily on outside loans for its existence. In other words,
investment by the proprietors is low.


Proprietary Ratio:
It establishes the relationship between proprietors funds and total
assets. Proprietors fund means share capital +reserves +surplus,
Both of capital and revenue nature. Loss and fictitious assets are
deducted. This ratio shows the extent to which the shareholders
own the business. The difference between this ratio and 100
represents the ratio of total liabilities to total assets. It is computed
as follows:

Proprietary Ratio =Proprietors funds or share holders funds
Total assets (excluding fictitious assets)

Higher the ratio the better it is for all concerned.
Proprietary Ratio highlights the general financial position of the
enterprise. This ratio is of great importance to the creditors to
ascertain the proportion of shareholders funds in the total assets
employed in the firm.
A high ratio indicates adequate safety for creditors, but a very high
ratio indicates improper mix of proprietors fund and loan funds,
which results in lower return on investment. It is because on loans
funds, interest is deductible as an expense, thus the enterprise does
not pay income tax thereon.
A low ratio indicates inadequacy or low safety cover for the
creditors. It may lead to unwillingness of creditors to extend credit
to the enterprise.