Ratio Analysis (Unit II) Introduction: Analysis and interpretation of financial statements with the help of ratio is termed

d as ratio analysis Ratio analysis, involves the process of computing, determining and presenting the relationship of items or groups of items of financial statements. Meaning: A ratio is a mathematical relationship between two items expressed in a quantitative form. Definition: 1.Relationships expressed in quantitative terms, between figures which have caused and effect relationships or which are connected

with each other in some manner or the other. 2. An quantitative relationship between two or more items of the financial statements connected with each other. 3. A comparison of the numerator with the denominator. Modes of Expression of Ratios 1. In Proportion: In this type of expression the amounts of two items are expressed in a common denominator. (example: 2:1) 2. In Rate or Times or Coefficient: Dividing one item by another is taken as unit or expression. (example: 5 times) 3. In Percentage: Dividing one item by another is multiplied by one hundred to show the relationship in terms of percentage. (example: 25%)

Steps in Ratio Analysis 1. Selection of relevant information 2. Comparison of Calculated Ratios 3. Interpretation and Reporting Advantages of Ratio Analysis 1. Forecasting (sales or profit) 2. Managerial control (cost and profit) 3. Facilitates Communication (convey) 4. Measuring Efficiency (operational) 5. Facilitating investment decisions (decision) 6. Useful in measuring financial solvency (liquidity position) 7. Inter firm comparisons (performance) Limitations of Ratio Analysis 1. Practical Knowledge (thorough) 2. Ratios are means (not an end) 3. Inter-relationship (cannot convey)

4. Non availability of standards or norms (lack) 5. Accuracy of financial information (inaccurate) 6. Consistency in preparation of financial statements (procedure) 7. Time log (delay) 8. Change in price level (fluctuations)

Classification by Statements

Balance Sheet Ratios Liquid Ratio Current Ratio Proprietary Ratio Debt Equity Ratio Fixed assets Ratio Capital gearing Ratio etc..

Profit & Loss A/c Ratio Gross Profit Ratio Operating Ratio Operating Profit Ratio Expense Ratios Net Profit Ratio etc

B/S and P& L A/c Ratios

Return on Investment Return on shareholders Funds Stock Turnover Debtors Turnover Creditors Turnover Fixed assets turnover Earnings per share etc.

Classification of Ratios by Purpose/ Function

Profitability Ratios

Turnover Ratios

Financial Ratios or Solvency Ratios Shortterm solvency Long-term solvency 1. Proprietary Ratio 2. Debt-Equity Ratio 3. Fixed Assets Ratio 4. Capital gearing etc.

1. Return on Investment 2. Net Profit Ratio 3. Gross Profit Ratio 4. Expense Ratio 5. Operating Profit Ratio etc..

1. Stock Turnover 2. Debtors Turnover 3. Creditors Turnover 4. Working capital Turnover 5. Fixed assets Turnover etc

1. Current Ratio 2. Liquidity Ratio 3. Cash position Ratio

I. Solvency Ratio Financial ratios include all ratios which express financial position of the concern. The term financial position generally refers to short term and long term solvency of the business concern, indicating safety of different interested parties 1. Overall solvency (or) Total debt (or) Debt ratio Relates the total tangible assets with the total borrowed funds Formula Total debts ratio = Total debt --------------------------Total Tangible assets Where: Total debts includes: both short-term and long term borrowings. A higher ratio indicates greater risk and lower safety to the owners. 2. Short-term solvency (or) Liquidity ratios (a) Current ratio The ratio of current assets to current liabilities

It indicates the ability of a concern to meet its current obligations. Formula Current ratio = Current assets -----------------Current liabilities Where: Current assets includes: debtors, stock, B/R, bank and cash balances, prepaid expenses, income due and short term investments Current liabilities includes: creditors, bank O/D, B/P, outstanding expenses, income received in advances etc. Standard ratio = 2 : 1 (b) Liquid ratio It is also called Quick ratio, Acid test ratio. Comparing the quick assets with current liabilities Formula Liquid ratio = Liquid assets ------------------Current liabilities

Where: Liquid assets refer to assets which are quickly convertible into cash (current assets other than stock and prepaid expenses) Standard ratio = 1 (c ) Cash position ratio It is also called Absolute liquidity ratio or Super quick ratio. It measures liquidity in terms of cash and near cash items. Formula Cash position ratio = Cash and bank balances + Marketable securities ------------------------------------------------------Current liabilities Standard ratio = 0.75:1 3. Long term solvency (a) Fixed assets ratio The relationship between fixed assets and longterm funds. To ascertain the proportion of long-term funds investment in fixed assets.

Formula Fixed assets ratio = Fixed assets ----------------Long term funds Where: Long term funds includes = Share capital + Reserves and surplus + Long-term loans Fictitious assets. Fixed assets means = Fixed assets Depreciation An ideal ratio is 0.67 (not more than 1) (b) Debt equity ratio To determine long-term solvency position of a company. It is also called external-internal equity ratio. Formula Debt equity ratio = Total long-term debt -------------------------Share holders funds (or) External equity --------------------Internal equities

Where: External equities refers total outsiders liabilities Internal equities refers to Shareholders funds or the tangible net worth (equity shareholders only) Ideal ratio is 1. (c ) Proprietary ratio Expresses the relationship between the proprietors funds and the total tangible assets. Formula Proprietary ratio = Shareholders funds -------------------------Total tangible assets A ratio below 0.5 is alarming for the creditors. (d) Capital gearing ratio It is also known as capitalization or leverage ratio. Establish the relationship between fixed interest and dividend bearing funds and equity shareholders funds Formula Capital gearing ratio= Longterm loans + Debentures + Preference share --------------------------------------------------------Equity share holders funds

A high geared capital structure is the indication for under capitalization.