The essence of Financial Management - Gayathri Subramaniam Shrinivas

RATIO ANALYSIS
Introduction

Financial figures can be gained as stated before from various financial statements e.g.
trading account, Profit and loss account etc. However, these figures are not completely
useful in isolation. For instance, to know that a firms gross profit is Rs. 200000/-is not
enough. It is important to know the amount of sales done to achieve this gross profit. Let
us see the following example -

Company Name A Ltd. B Ltd. C Ltd.

Gross Profit for the yr
Rs.500000 Rs.500000 Rs.500000
2015
Sales for the year Rs.2000000 Rs.2500000 Rs.1500000
Gross Profit Ratio ie.
(Gross Profit /
25% 20% 33.33%
Sales)*100

The gross profit of each of these companies is the same. However, when these are
correlated to sales made by each company, the results give us another picture
altogether. After inter relating the data of gross profit with sales, we are in a better
position to understand and compare the results.

We can thus say that we have to group the data in financial statements and correlate
them in such a manner that we get the answers to our questions about the
performance of the company be it solvency, profitability or liquidity.

Now this data in terms of percentage can be easily understood and compared. This is
the most significant aspect of ratio analysis.

To understand this concept better, let us first understand what Ratio and Analysis
mean:

A. RATIOS

A ratio refers to the numerical or quantitative relationship between two items or

variables, expressed in a simple mathematical form. We use ratios quite normally
in our day to day life , for instance, we add manure in our soil according to a
particular ratio, and also use ratios to measure ingredients in recipes e.g. to
make a sugar syrup we use 2 cups of sugar for 1 cup of water. We can express
this ratio as 2:1 for sugar and water respectfully.

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 The essence of Financial Management - Gayathri Subramaniam Shrinivas

We can thus say that a ratio is nothing but one number expressed in terms of
another number to show the relationship between two different variables.

Ratios can be expressed in 3 ways:

1. PERCENTAGE 2. FRACTIONS 3. TIMES OR PROPORTION

E.g. Net Profit of the firm is Eg. Net profit of the firm is Eg. Relationship between Net
25% of sales 1/4th of sales Profit and Sales is 1:4

B. RATIO ANALYSIS

The methods suggested above can be used to express the relationship between
related or interconnected items for the purpose of financial analysis.

Financial ratio analysis can be defined as-

A study of relationships between various items or groups of items in financial

statements.

It entails:
1. Computing ratios of interconnected items
2. Determining their interrelationship as per financial statements
3. Presenting the relationship in a clear and lucid manner so that it can be
understood clearly by investors, creditors and other parties interested in the
performance of the company.

SIGNIFICANCE OF RATIO ANALYSIS

The significance of ratio analysis can be explained in 2 ways:

1. Significance to the enterprise

2. Significance to investors and third parties

1 . SIGNIFICANCE TO THE ENTERPRISE

This can be summed up in the following points:-

a) Facilitates comparison with past performance

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 The essence of Financial Management - Gayathri Subramaniam Shrinivas

Through ratio analysis, it becomes possible for the enterprise to compare its
past performance with its present performance.

As an example, consider the past performance of ABC Ltd over 5 years:

Financial 2010-11 2011-12 2012-13 2013-14 2014-15

Year
NBIT Rs. 200,000/- Rs. 200000/- Rs.400,000/- Rs.500,000/- Rs.600,000
Net Profit
before
interest
and tax
Capital Rs.20,00,000/- Rs.30,00,000/- Rs.30,00,000/- Rs.30,00,000/- Rs.30,00,000/-
Employed
ROCE 0.1 0.06 0.13 0.17 0.20

As you can see, though in the FY 2010-11 and 2011-12 the NBIT is the same, the
capital employed in each case is different. Thus , any conclusion drawn on the
basis of figures alone would not be reliable. However, we can calculate the
ROCE by interrelating the figures of NBIT and Capital Employed. The ROCE ,
shown in the above table, not only gives an equitable picture in each scenario,
but also makes the data comparable and meaningful.

b) Comparison with competitors

Ratio Analysis also enables an enterprise to compare its financial

performance with those of its competitors that have a similar size and
structure. It helps the company analyze its SWOT better.

c) Helps to identify weak links

Ratio Analysis helps in indicating the weak links in an organization. It acts like
a warning signal for the enterprise to understand where it may falter and thus
indicates a fair financial position of the enterprise. Suppose firm A has current
assets worth Rs. 2,50,000/- in FY 2013-14 and current liabilities of Rs. 50,000/-. To
a layman, these figures may prove to be good enough since the current
assets are more than the liabilities. However, the current ratio of the firm
would give us a proportion of 5:1, as against 2:1 (the ideal current ratio). This
indicates that there are very few operations in the enterprise. Thus, it brings to
notice such facts which may not be observed while observing figures in the
financial statements.

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