RATIO ANALYSIS

DEFINATION
Analytical review is the study of significant ratios, trends and statistics. ratio analysis is the systematic use of ratios for interpretation of financial statements in regard to operating results and financial position of a business.

VARIOUS BASES
TREND ANALYSIS INTER FIRM COMPARISON INDUSTRY ANALYSIS STANDARD ANALYSIS GROUP ANALYSIS

TREND ANALYSIS
This analysis is made on the basis of performance of the past years compared with performance of current year. This exactly shows in which direction the performance of the organization is going. It deflects with the change in ratio in preceding years.

INTER FIRM COMPARISON

This comparison is made on the basis of ratio between two or more firms carrying on the same business. It shows the financial position & performance of business of a individual firm. This type of comparison is generally seen in the competitive market. Only same type of business can be compared.

INDUSTRY ANALYSIS
In this type of analysis ratios of a firm with the relating industry is being made. This gives the personal standing of a firm in an organization. This analysis is generally made by outsiders to know the efficiency of a individual firm with the industry. Such a firm gets a better scope in the industry.

STANDARD ANALYSIS
In this type of analysis there is a standard already set by the firm itself. This kind of analysis is effective in the case of a going concern business. It may not hold good with a new comer of the market. This may also lay down the enthusiasm of new comers of the market.

GROUP ANALYSIS
This type of analysis is different from other analysis we have studied earlier. Here a group of ratios is studied together to form an opinion regarding a particular activity like profit, solvency, etc.

SIGNIFICANCE
It is the significant tool of financial analysis. This makes the user to draw a relevant information from the comparisons. This kind of analysis gives a consumer (particularly share holders) a great deal of work done for them in guiding them to invest their money. As a financial tool it provides financial analysis using various methods.

Advantages of Ratio analysis

Important technique of financial analysis Helps in judging financial health of a firm Helps in decision-making Useful in simplifying accounting figures Useful in judging operating efficiency Useful in forecasting & planning Useful in locating weak areas Useful in in comparison of performance Useful to all stakeholders

Disadvantages of Ratio analysis

Limited comparability False results Effect of price level changes Qualitative factors are ignored Effect of window dressing Costly techniques Misleading results Absence of standard university accepted technology

CLASIFICATION OF RATIOS

Traditional Classification

Functional Classification

Significance Ratios

a.

Balance sheet Ratios P & L A/C Ratios Composite Ratios

a. b. c. d.

Liquidity Ratios Leverage Ratios Profitability Ratios Turnover Ratios

a. b.

Primary Ratios Secondary Ratios

b. c.

Functional Classification
Ratios can be broadly classified into four groups namely: Liquidity ratios Capital structure/leverage ratios Profitability ratios Activity ratios

Liquidity ratios
These ratios analyse the short-term financial position of a firm and indicate the ability of the firm to meet its short-term commitments (current liabilities) out of its short-term resources (current assets). These are also known as solvency ratios.

1. Current Ratio or Working Capital Ratio

Current ratio may be defined as the relationship between current assets and current liabilities. It is also known as working capital ratio. Formula
Current ratio = Current Assets Current Liabilities

The following items are included in current assets and current liabilities:

Current Liabilities Creditors Bills Payable Bank Over Draft Short-term Loans Outstanding Expenses Income Tax Payable Unclaimed Dividend Provision for Tax Proposed Dividend

Current Assets Cash and Bank Balance Debtors Bills receivable Stock/Inventory Short-term Investments or Marketable securities Prepaid expenses Advanced Payment

Interpretation
Current ratio of a firm measures its short-term solvency and reflects its ability to meet short-term obligations when they are due. If the current ratio is higher, it is good from the creditors point of view but extremely high current ratio is not good from the managements point of view. a low and declining current ratio would indicate : (i) an inadequate margin of safety to the creditors, i.e. firm has no sufficient cash to pay its liabilities; (ii) shortage of working capital in the business i.e firm is trading out of its resources. Ideal Current Ratio: 2:1

2. Liquidity or Quick Ratio or Acid Test Ratio

This ratio establishes the relationship between quick/liquid current assets and current liabilities. Formula Liquid Ratio = Liquid or Quick Assets Current liabilities = Current Assets (Stock + Prepaid Exp.) Current Liabilities

INTERPRETATION
Liquid ratio is considered to be superior to current ratio in evaluating the liquidity position of the firm. Thus, liquidity ratio is an indication of a firms ability to meet unexpected demand for working capital. Ideal Ratio: A quick ratio of 1:1 is considered as an ideal ratio.

3. Absolute Liquid Ratio or Cash Position Ratio or Super-Quick Ratio

The absolute liquid ratio is the relationship between the absolute liquid or super quick assets to liquid or quick liabilities. It is a more rigorous test of liquidity of a firm. formula:
Absolute Liquid Ratio

= Absolute Liquid Assets Quick/Liquid Liabilities

Interpretation
This ratio pays more significance to liquidity when used in conjunction with current and quick ratio. It is considered to be a conservative test and is not widely used in practice. Ideal Ratio: A super quick ratio of 0.5:1 is considered as an ideal ratio.

Net Working Capital Ratio

Relation between sales and Net Working Capital. formula:
Net Working Capital Ratio

= Net Working Capital Total Assets where, NWC = Current Assets Current Liabilities

INTERPRETATION
Net working capital is used for the cash conversion cycle (aka earnings cycle) of a business, which uses cash for raw materials, converts into the finished product, sells the product, then receives payment for it. This conversion cycle may vary depending on the type of business, but net working capital is essentially the cash needed to run the business.

II. Test Of Solvency

Long term solvency ratios denote the ability of the organisation to repay the loan and interest. When an organization's assets are more than its liabilities is known as solvent organisation. Solvency indicates that position of an enterprise where it is capable of meeting long term obligations.

Important Ratios In Test Of Solvency

Debt-equity ratio. Proprietary ratio. Solvency ratio. Fixed assets to net worth ratio. Current assets to net worth ratio. Current liabilities to net worth ratio. Capital gearing ratio. Fixed assets ratio Debt servicing ratio. Dividend coverage ratio.

Debt Equity Ratio

It Is calculated to measure the relative claims of outsiders and the owners against the firms assets. This ratio indicates the relationship between the outsiders funds and the shareholders funds. Outsiders funds Debt equity ratio= Shareholders funds Ideal ratio: 2:1; It means for every 2 shares there is 1 debt. If the debt is less than 2 times the equity, it means the creditors are relatively less and the financial structure is sound. If the debt is more than 2 times the equity, the state of long term creditors are more and indicate weak financial structure.

Proprietary Ratio or Net Worth Ratio

It establishes relationship between the proprietors fund or shareholders funds and the total assets Proprietary funds Proprietary ratio= Total assets or Total liabilities Capital employed

Ideal ratio: 0.5:1 Higher the ratio better the long term solvency (financial) position of the company. This ratio indicates the extent to which the assets of the company can be lost without affecting the interest of the creditors of the company

Solvency Ratio
It expresses the relationship between total assets and total liabilities of a business. This ratio is a small variant of equity ratio and can be simply calculated as 100-equity ratio Total assets Solvency ratio= Total liabilities No standard ratio is fixed in this regard. It may be compared with similar, such organisations to evaluate the solvency position. Higher the solvency ratio, the stronger is its financial position and vice-versa.

Fixed Assets To Net Worth

It is obtained by dividing the depreciated book value of fixed assets by the amount of proprietors funds. Net fixed assets Fixed assets to net worth ratio= Net worth Ideal ratio: 0.75:1 A higher ratio, say, 100% means that there are no outside liabilities and all the funds employed are those of shareholders. In such a case the return to shareholders would be lower rate of dividend and this is also a sign of over capitalization.

Fixed Assets To Net Worth

This ratio shows the extent to which ownership funds are sunk into assets with relatively low turnover. When the amount of proprietor's funds exceed the value of fixed assets, apart of the net working capital is provided by the shareholders, provided there are no other noncurrent assets, and when proprietors funds are less than the fixed assets, creditors obligation have been used to finance a part of fixed assets. The Yardstick for this measure is 65% for industrial undertakings.

Current Assets To Net Worth Ratio

It is obtained by dividing the value of current assets by the amount of proprietors funds. The purpose of this ratio is to show the percentage of proprietors fund investment in current assets. Current assets Current assets to net worth ratio= Proprietors fund A higher proportion of current assets to proprietors fund, as compared with the proportion of fixed assets to proprietors funds is advocated, as it is an indicator of the financial strength of the business, depending on the nature of the business there may be different ratios for different firms. This ratio must be read along with the results of fixed assets to proprietors funds ratio.

Current Liabilities To Net Worth

It is expressed as a proportion and is obtained by dividing current liabilities by proprietor's fund. Current liabilities Current liabilities to net worth ratio= Net worth Ideal ratio:1:3 This ratio indicates the relative contribution of short term creditors and owners to the capital of an enterprise. If the ratio is high, it means it is difficult to obtain long term funds by the business.

Capital Gearing Ratio

It expresses the relationship between equity capital and fixed interest bearing securities and fixed dividend bearing shares. Fixed interest bearing securities + fixed dividend bearing shares CGR= Equity shareholders funds Components of fixed interest bearing securities Debentures Long-term loans Long-term fixed deposits Components of equity shareholders funds Equity share capital Accumulated reserves & profits Less losses and fictitious assets

When fixed interest bearing securities and fixed dividend bearing shares are higher than equity shareholders funds, the company is said to be highly geared. Where the fixed interest hearing securities and fixed dividend bearing shares share equal to equity share capital it is said to be evenly geared. When the fixed interest bearing securities and fixed dividend bearing shares are lower than equity share capital it is said to be low geared. If capital gearing is high, further raising of long term loans may be difficult and issue of equity shares may be attractive and vice-versa

Interpretation Of Capital Gearing Ratio

Fixed Assets Ratio

It establishes the relationship between fixed assets and capital employed Fixed assets Fixed assets ratio= Capital employed Ideal ratio: 0.67:1 This ratio enables to know how fixed assets are financed i.e. by use of short term funds or by long term funds. This ratio should not be more than 1.

Fixed Charges cover or Debt Service Ratio

This ratio is determined by dividing net profit by fixed interest charges. Net profit before deduction of interest and income tax Debt service ratio= Fixed interest charges Ideal ratio: 6 or 7 times; if the ratio is high it means there is higher margin of safety for the long term lenders and as such it is not difficult for the business to obtain further long term funds and vice-versa. This ratio indicates the financial ability of the enterprise to meet interest payment out of current earnings

Dividend Cover Ratio

It is the ratio between disposable profit and dividend. Disposable profit refers to profit left over after paying interest on long term borrowing and income tax. Net profit after interest and tax Dividend cover ratio= Dividend declared This ratio indicates the ability of the business to maintain the dividend on shares in future. If this ratio is higher is indicates that there is sufficient amount of retained profit. Even if there is slight decrease in profit in the future it will not affect payment of dividend in future

Profitability Ratio
(A)

Based on Sales/General Profitability Ratio:-

Gross Profit Ratio/Average mark up ratio = Gross Profit x 100 Net Sales

Operating Ratio = Operating cost x 100 Net Sales lower Good *operating cost = Cost of goods sold +operating expenses **operating expenses includes administrative, selling and distribution expenses.

Operating Profit Ratio :- The operating profit refers to the pure operating profit of the firm i.e. the profit generated by the operation of the firm and hence is calculated before considering any financial charge (such as interest payment), non-operating income/loss and tax liability etc. The operating profit is also termed as the Earnings Before Interest and Taxes (EBIT). OP Ratio = Operating Profit x 100 Net Sales

*operating profit = Gross Profit Operating Expenses High Good ** Operating Profit Ratio = 100 Operating Ratio

Expenses Ratio:- The expenses ratios are the measure of cost control and are computed by establishing the relationship between difference expense items and the sales. In other words, it is calculated to show relationship of each item of manufacturing cost and operating expenses to net sales. These ratios help in analysing the causes of variation of the operating ratio. Expenses Ratio = Different Expenses x 100 Net Sales Lower the ratio, the greater is the profitability.

Net Profit ratio :- It measures the efficiency of the management in generating additional revenue over and above the total cost of operations. The net profit ratio shows the overall efficiency in manufacturing, administrative, selling and distributing the product. This ratio also shows the net contributions made by every 1 rupee of sales to the owner funds. The NP Ratio indicates the proportion of sales revenue available to the owners of the firm and the extent to which the sales revenue can decrease or the cost can increase without inflicting a loss on the owners. So, the NP Ratio shows the firms capacity to face the adverse economic situations.

NP Ratio = NP ( after tax) x 100 Net Sales Or = NP ( before tax) x 100 Net Sales The higher the ratio, the better is the profitability of the firm.

(B) Based on capital :Return on Capital Employed:- The profitability of the firm can also be analyzed from the point of view of the total funds employed in the firm. The term funds employed or the capital employed refers to the total long term sources of funds. It means that the capital employed comprises of shareholders funds plus long term debts. Alternatively, it can also be defined as fixed assets plus net working capital.

Return on Capital Employed = Net Profit (PBIT) x 100 Capital Employed Some Equations: Gross capital employed = Total Assets Fictitious Assets Net Capital Employed = Total Assets Fictitious Assets Current Liabilities Average Capital Employed =
Opening Capital Employed + Closing Capital Employed 2

Return on Net Worth/Shareholders Funds/ Shareholders Investment/Proprietors Funds/ Equity : This ratio measures the profitability of a concern in relation to total investments made by the shareholders or proprietors in the business. The excess of total assets over total outside liabilities of an enterprise is known as shareholders funds or proprietors funds or net worth.
Return on Net Worth = Net Profit (PAIT) Shareholders fund x 100

Return on Equity Shareholders Fund :It examines profitability from the perspective of the equity investors by relating profits available for the equity shareholders with the book value of the equity investment. The return from the point of view of equity shareholders may be calculated by comparing the net profit less preference dividend with their total contribution in the firm.

Return on Equity Shareholders Fund =

Net Profit after Tax Preference Dividend x 100 Equity Shareholders Funds *Equity Shareholders Funds = Share Capital+Reserves Credit balance of P/l

Return on Total Assets = Net profit after tax x 100 Total Assets Or Net profit after tax + Interest x 100 Total Assets

Return on assets (ROA)

Return on assets = net profit after taxes plus interest x 100 Total assets Total assets exclude fictitious assets. As the total assets at the beginning of the year and end of the year may not be the same, average total assets may be used as the denominator.

Activity ratios
These ratios are also called efficiency ratios / asset utilization ratios or turnover ratios. These ratios show the relationship between sales and various assets of a firm. These ratios enables the management to measure the effectiveness of the resources at the command of the firm. Also called Turnover Ratios or Performance Ratios or Assets management ratio. The various ratios under this group are:

An activity ratio is the relationship between sales or cost of goods sold and investment in various assets of the firm. And calculated in turnover or in number of times. Ques. Why Activity Ratio is calculated? Ans. A turnover ratio is a measure of movement and thus indicates as to how frequently an account has moved/turned over during a period. It shows as to how efficiently and effectively the assets of the firm are being utilized. In simple words, for measuring the efficiency of the firm.

Inventory Turnover Ratio or Stock Turnover Ratio

This ratio is calculated to consider the justification of amount of capital employed in stock. Under it, rate of conversion of stock into sales (i.e., stock velocity) is known by establishing relationship of investment in inventory. It is calculated as follows:
Inventory Turnover ratio = Cost of goods sold or Net sales Average Inventory at cost

where,
Average inventory = Opening Stock + Closing stock 2
Cost of goods sold = Opening stock + Purchase Closing Stock = Net Sales Gross Profit

Note: Inventory, here will mean inventory of finished goods only because it only is capable of being sold. In departmental stores, where inventory is usually valued at sale price, this ratio is calculated on this basis : Net Sales Average Inventory at Selling Price

Inventory /stock turnover ratio

A firm should have neither too high nor too low inventory turnover ratio. Too high a ratio may indicate very low level of inventory and a danger of being out of stock and incurring high stock out cost. On the contrary too low a ratio is indicative of excessive inventory entailing excessive carrying cost.

Debtors or Receivable Turnover Ratio or Receivable Turnover Ratio

This ratio is a qualitative analysis of a firms marketing and credit policy and debtors realisations. In other words, if the firm sells goods on credit, the realisation of sells revenue is delayed and the receivables ( both debtors and/or bills) are created. It is calculated to know the uncollected portion of credit sales in the form of debtors by establishing relationship between trade debtors & net credit sales of the business.

Formula: Debtors/Receivable Turnover Ratio = Net credit Sales Average (Debtors+B/R) Note: Higher the value of debtors turnover, the more efficient is the management of debtors. An increase in this ratio is an indication of firms marketing superiority and efficiency in credit realization.

Creditors/Payable Turnover Ratio or P/T Ratio

The shot-term creditors (i.e., suppliers of goods and bankers) are very much interested in this ratio, as it shows the firms trend of payment to its short-term creditors. This ratio shows the velocity of the debt payment by the firm. This ratio shows the relationship of credit purchases and the average payables (creditors & bills) as follows:

Creditors Turnover Ratio =

Net Credit Purchases Average (Creditors+ B/P)

Note: Lower the ratio, the better is the liquidity position of the firm. Higher creditors turnover ratio indicates weak liquid position. A continuous increase in this ratio shows delay in payments.
Average Payment Period = No. of Days/Months Creditors Turnover Ratio

Note: Higher the creditors velocity, better it is.

Average collection period or Average Age of Receivables

Trade Receivables = Trade Receivables x No. of Working Days Sales per day Or Or Net credit Sales = No. of working Days Debtors Turnover = Trade Receivables x No. of Working Days Net credit Sales

Total Assets Turnover Ratio = Net Sales/ Cost of goods Sold Total Assets This ratio measures the per rupee sales generated by per rupee of tangible assets being maintained by the firm. It may be noted that (i) intangible assets such as goodwill etc. are not considered and (ii) that the tangible assets are taken at their written down values. In time series analysis of ratios, if the Total Assets Turnover ratio increases over a period, it means that more sales have been generated per rupee of tangible assets. This ratio must be analysed together with some other ratio/information.

Fixed Assets Turnover Ratio = Net Sales/Cost of goods sold Fixed Assets (less Dep.) Where the average fixed assets is equal to the average of the opening and closing balances of the fixed assets. High Good

Current Assets Turnover ratio = Net Sales/Cost of goods sold Current Assets Capital Turnover Ratio = Sales/Cost of goods sold Capital employed *capital employed = Fixed Assets + Current Assets Current Liabilities The higher the current ratio, the greater is the sales made per rupee of capital employed in the firm & hence higher is the profit.

Working Capital Turnover Ratio = Net Sales/ Cost of Goods Sold Working Capital The higher the working capital turnover ratio, the lower is the investment in the working capital and higher would be the profitability. A high working capital turnover ratio reflects the better utilization of the working capital of the firm. However, a working capital turnover ratio also implies a low net working capital in relation to its net working capital. This may be a risky proposition for the firm.