RATIO ANALYSIS

We will first explain why we are discussing ratios? The ratio analysis is one of the most powerful tools of financial analysis. Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. It is with the help of ratios that the financial statements can be analyzed more clearly and decision made from such analysis.

INTRODUCTION:
A company is incorporated for running a business with certain objectives with the ultimate aim to maximize the wealth of the shareholders; the survival of the business etc., Finance is the common threat that runs across all areas of a business. A modern business enterprise has to meet the aspiration of various interest groups such as shareholders, employees, customers, creditors, government and society in general.

RATIO ANALYSIS:
A Ratio is an arithmetical expression of relationship between two related or interrelated items. Ratios when calculated on the basis of accounting information are called Accounting Ratios. A ratio is a statistical yardstick that provides a measure of relationship between two accounting figures, and which two figures should be compared with each other depending upon the purpose of comparison. The purposes may be as under: To examine the ability of existing assets to generate additional funds; To examine the adequacy of profitability; To assess the ability of the business to meet its current obligations; To evaluate debt-raising capacity

The following users require an analytical view of financial statements: The shareholders including existing and potential shareholders - to examine, to buy, sell or to hold the existing shares; Creditors - to assess the economic condition of the business; Business contact groups - customers, trade creditors, supplier to appraise the future of the enterprise to assess the reliability of the business; Government - for taxation, information etc. Employees - for collective bargaining and for assessment of job security; Financial analysis.

EXPRESSION OF RATIOS:
They are expressed in any one of the following forms: PURE: It is expressed as a quotient. For example, current ratio which expresses the relationship between current assets and current liabilities Current Ratio = (Current Asset Current Liabilities ) = = It may also be expressed as 2:1 Rs. 2, 00,000 Rs. 1,00,000 2

 PERCENTAGE: It is expressed in percentage. For example, gross profit ratio which relates gross profit to net sales Gross Profit Ratio = (Gross Profit Net Sales) 100 = [(Sales Cost of Goods Sold) Net Sales] 100

A ratio of 25% to 30% may be considered good. TIMES: It is expressed in a number of times a particular figure is compared to another figure. For example, stock turnover ratios which studies relationship between cost of good sold and average stock say 4 times FRACTION: It is expressed in fraction. For example, ratio to fixed asset to share capital is (0.75) Ratio, sometimes may be expressed in terms of days only. For example average collection period is 73 days

USES OF ACCOUNTING RATIOS:

The performance and financial position can be easily judged by working out of the accounting ratios, which may be done through comparison: For the same form over a period of years; or For one firm against another; or For one firm against the industry as a whole or against pre determined standards; or For one department or departments of a firm against the other divisions or departments of the same firm. The Accounting Ratios not only indicate the present position, but also indicate the causes leading into the position to a large extent; Accounting ratios tabulated for a number of years indicate the trend of change; Accounting ratios help in preparation of estimates for the future; Accounting ratios help in forewarning corporate sickness and helps the management to take corrective action; It helps in investment decisions in the case of investors and lending decisions in the case of bankers and financial institutions.

LIMITATIONS:
Accounting ratios can be only as correct as the data on which they are based; When two firms are compared difficulties may arise due to the adoption of different accounting policies etc. Changes in price levels often make comparison of figures for various years, difficult; Accounting rations may be worked out for any two figures even if they are not significantly related. Such ratios will only be misleading. So care should be there to work out only significant ratios; Ratios some times give a misleading picture. It is, therefore, useful if, along with ratios absolute figures are also to be studied; unless the firms being studied are equal in all respects.

STANDARDS FOR COMPARISON:

There must be some standard ratios with which the actual ratios can be compared, to have an effective ratio analysis. There are four types of standards which are as follows: HISTORICAL STANDARDS - They are the past ratios of the firm. Present performance of the firm can be compared with that of the past ratios and inference can be drawn on the improvement or of a particular aspect. These standards are not satisfactory. If we take operative ratios of the past as the standard, the present inefficiency is merely compared with the past inefficiency;

 ABSOLUTE STANDARDS - They are decided by the rule of thumb. For example, the case of current ratio 2:1 is desired for a firm. The actual is compared with such standard. There are also limitations of such standards. As such this standard is not an ideal one; HORIZANTAL STANDARDS - These are the average ratios calculated for the entire industry or the ratios of some other firm engaged in the same line. In using this standard there is a difficulty. No two firms are similar in size, having the accounting policies and corporate objectives. So there will be significant differences between the standard adopted and the actual ratio; BUDGETED STANDARD - These standards are based on budgeted figures. The actual ratios are compared with budgeted ratios.

CLASSIFICATION OF RATIOS:
There are three ways of classification of Accounting Ratios. One way is the classification based on the statement which the ratios are calculated which areBalance sheet ratios based on balance sheet figures; Profit and loss account ratios based on profit and loss accounts; Balance sheet and profit and loss ratios based on both statements. The second way of classification is from the angle of users such as shareholders, creditors etc. The third way of classification is based on their functions such as profitability ratios, solvency ratios etc. Ratios are also classified differently on different bases. The mostly used one is the financial classification under which the ratios are broadly divided into the following five classes: Liquidity ratios concerned with the short term solvency of the concern or its ability to meet financial obligation on their due dates. Activity ratios concerning efficiency of management of various assets by the concern. Leverage ratios concerning stake of the owners in the business in relation to outside borrowings or long term solvency. Coverage ratios concerned with the ability of the company to meet fixed commitments such as interest on term loans and dividend on preference shares and Profitability ratios concerned with the profitability of the concern.

Ratios

(A) Traditional Classification Ratios Or Statement Ratios Importance

(B) Functional Classification Or Classification According to Tests

(C) Significance Or Ratios According to

1. Balance Sheet Ratios Or Position Statement Ratios 2. Profit and Loss Account Ratios Or Revenue/Income Statement Ratios 3. Composite/Mixed Ratios Or

1. Liquidity Ratios 2. Leverage Ratios 3. Activity Ratios 4. Profitability Ratios

1. Primary Ratios 2. Secondary Ratios

Inter Statement Ratios

Liquidity Ratio Liquidity Ratio 1.Current Ratio 2. Acid Test or Liquidity or quick ratio

Current Ratio
Current ratio is a relationship of current asset to current liabilities and is computed to measure general liquidity and is most widely used to make analysis of the short term financial position or liquidity of the firm. Current Ratio = Current Asset Current Liabilities

Current liabilities represent the immediate financial obligations of the company. Current assets are the sources of repayment of current liabilities. An enterprise should have a reasonable current ratio. Although there is no hard and fast rule still current ratio of 2:1 is considered to be satisfactory. Components of current ratio Current asset cash in hand cash at bank marketable securities(short term) short term investments bill receivable sundry debtor inventories (stock) prepaid expenses Current liabilities Outstanding Expenses / Accrued Expenses Bills Payable Sundry Creditors Short term Advances Income tax Payable Dividends Payable Bank Overdraft

Acid Test or Liquidity or quick ratio

Liquidity ratio is a relationship of liquid asset with current liabilities and is computed to assess the short term liquidity of the enterprise. Liquid asset against the current liabilities give the liquid ratio.

Acid Test Ratio = Quick Assets = Current Assets (stock + Prepaid expenses)

One of the defects of current ratio is that it does not measure accurately to meet financial commitments as and when they arise. This is because the current assets include also items that are not easily realizable, such as stock. The acid test ratio is a refinement of current ratio and is calculated to measure the ability of the company to meet the liquidity requirements in the immediate future. A minimum of 1: 1 is expected which indicates that the concern can fully meet its financial obligations.

Activity Ratios Activity Ratios 1. Inventory Turnover Ratio

2. Debtor Turnover Ratio or Receivable Turnover Ratio

3. Creditor or Payable Turnover Ratio 4. Working Capital Turnover

4. Fixed Assets Turnover Ratio

5. Current Assets Turnover Ratio

Inventory Turnover Ratio

Inventory turnover ratio establishes relationship between the cost of goods sold during a given period and the average amount of inventories carried during the period. It indicates whether the investment in stock has been efficiently used or not, the purpose being to check whether only the required minimum amount is invested in stocks.

Inventory Turnover

Thus, only an optimum inventory turnover ratio ensures adequate working capital and also enables the businesses to earn a reasonable margin of profits. The ratio is usually expressed as number of times the stock has turned over. As a major portion of the bank advance is for the holding of inventory, a study of the adequacy of abundance of the stocks held by the company in relation to its production needs requires to be made carefully by the bank.

A higher ratio may mean (higher turnover or less holding periods): The stocks are moving well and there is efficient inventory management ; or The stocks are purchased in small quantities. This may be harmful if sufficient quantities are not available for production needs; secondly, buying in small quantities may increase the cost. Contrarily, a lower ratio (i.e.., lower turnover of longer holding period may be an index of (1) Accumulation of large stocks not commensurate with production requirements, (2) A reflection of inefficient inventory management or over-valuation of stocks for balance sheet purposes ; or Stagnation in sales, if stocks comprise mostly finished goods.

Debtor Turnover Ratio or Receivable Turnover Ratio

Debtor turnover ratio establishes the relationship between net credit sales and average debtors (or receivables) of the year. Average debtors are calculated by dividing the sum of the debtor in the beginning and at the end by 2.

Debtor Turnover Ratio

Net Credit Sales Average Debtor = No of Times

Trade Debtor = Sundry Debtor + Bills Receivables and Accounts Receivables Average Trade Debtors = Opening Trade Debtors + Closing Trade Debtors 2

NOTE: Debtors should always be taken at gross value. No provision for bad and doubtful debts be deducted from them. It indicates how quickly debtors are converted into cash and thus indicates the efficiency of staff entrusted with collection of amount due from debtor. A high ratio is better since it would indicate that debts are being collected more promptly. A ratio lower than the standard would indicate inefficiency in collecting and more investment in debtors than required.

Creditor or Payable Turnover Ratio

Creditor turnover ratio shows the relationship between net credit purchase and total payable or average payable. In the course of business operations, affirm has to make credit purchases and incur short term liabilities. A supplier of goods, i.e., creditor, is naturally interested in finding out how much time the firm is likely to take in repaying its creditors. Creditor or Payable Turnover Ratio = Net Credit Purchases Total or Average payables (Creditors + Bill payable) Average Payable = (opening creditors + bill payable) + (closing creditors + bill payable) 2 The objective of calculating this ratio is to establish the number of times the creditor are turnover in relation to purchases. Thus the low ratio, the better is the liquidity position of the firm, and higher the ratio, the lesser is the liquidity position of the firm.

Working Capital Turnover

Working capital turnover ratio establishes the relationship between working capital and sales. The use of this ratio is two fold. First, it can be used to measure the efficiency of the use of working capital in the unit. Secondly, it can be used as a base for measuring the requirements of working capital for an expected increase in sales.

Working Capital Turnover

=

Number of Times

working capital = current asset current liabilities Higher the ratio the better it is. But a very high ratio may indicate overtrading ----- the working capital being inadequate for scale of operations.

Fixed Assets Turnover Ratio

Fixed asset turnover ratio establishes the relationship between fixed asset and net sales

(fixed asset depreciation) = Number of Times The ratio shows the efficiency of the concern in using its fixed assets. Higher ratios indicate higher efficiency because every rupee invested in fixed assets generates higher sales. A lower ratio may indicate inefficiency of assets. It may also be indicative of under utilizations or non-utilization of certain assets. Thus with the help of this ratio, it is possible to identify such underlined or unutilized assets and arrange for their disposal.

Current Assets Turnover Ratio

The ratio is calculated to ascertain the efficiency of use of current assets of the concerns. With an increase in sales, current assets are expected to increase. However, an increase in the ratio shows that current assets turned over faster resulting in higher sales for a given investment in current assets.

Higher ratio is generally an index of better efficiency and profitability of the concern. This ratio gives a general impression about the adequacy of working capital in reaction to sales.

Leverage Ratio Leverage Ratio 1. Debt-Equity Ratio 2. Total Asset to Debt Ratio 3. Proprietary Ratio Debt-Equity Ratio
The Debt equity ratio is computed to ascertain soundness of the long term financial position of the firm. This ratio expresses relationship between debt (external equity) and equity (internal equities). Debt means long term loans, i.e. debenture, loans(long term) from financial institutions. Equity means shareholders funds, i.e. preference share capital, equity share capital, reserves less losses and factious assets like preliminary expenses.

Debt-Equity Ratio

Debt (long term loans) Equity (shareholders funds)

Generally a ratio of 2: 1 (i.e., 2 units of debt for 1 unit of equity) is considered normal, but in certain cases relaxations are allowed.

Total Asset to Debt Ratio

It establishes the relationship between total asset and total long term loans. The two components of this ratio, i.e. total asset and debt are computed as follows: Total asset: it includes fixed asset as well as current asset. However, it does not include fictitious assets like preliminary expenses, underwriting commission, share issue expenses etc

Long term Debt: it refers to debt that will mature after one year. It includes debentures, bonds, and loans from financial institutions. Total Asset to Debt Ratio = Total Assets 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 loan for its existence

Proprietary Ratio
Proprietary ratio establishes the relationship between proprietors fund and total asset. Proprietors fund means share capital plus reserve and surplus, both of capital and revenue nature. Loss and fictitious asset, if any are deducted. Proprietary Ratio = Proprietors Fund or Shareholders Funds Total Assets (excluding fictitious assets)

This ratio indicates the general financial strength of the concern. It is a test of the soundness of the financial structure of the concern. The ratio is of great significance to creditors since it enables them to find out the proportion of shareholders funds in the total investment in the business. In case of companies which depend entirely on owned funds and have no outside liabilities, the ratio will be 100%. A high ratio is welcome to the creditors because it secures their position by providing a high margin of safety.

Coverage Ratios Coverage Ratios 1.Interest Coverage Ratio 2. Preference Dividend Coverage Ratio Interest Coverage Ratio
This ratio also known as times interest earned ratio. It indicates the firms ability to meet interest (and other fixed-charges) obligations. This ratio is computed as:

Interest Coverage Ratio =

EBIT Interest

Earnings before interest and taxes are used in the numerator of this ratio because the ability to pay interest is not affected by tax burden as interest on debt funds is deductible expense. This ratio indicates the extent to which earnings may fall without causing any embarrassment to the firm regarding the payment of interest charges. A high interest coverage ratio means that an enterprise can easily meet its interest obligations even if earnings before interest and taxes suffer a considerable decline. A lower ratio indicates excessive use of debt or inefficient operations.

Preference Dividend Coverage Ratio

This ratio measures the ability of a firm to pay dividend on preference shares which carry a stated rate of return. This ratio is computed as: Preference Dividend Coverage Ratio = EAT (Preference dividend liability)

Earning after tax is considered because unlike debt on which interest is charged on the profit of the firm, the preference dividend is treated as appropriation of profit. This ratio indicates margin of safety available to the preference shareholders. A higher ratio is desirable from preference shareholders point of view.

Profitability Ratios Profitability Ratios 1.Gross Profit Ratio 2. Operating Ratio 3. Net Profit Ratio 4. Return on Investment or Return on Capital Employed Ratio 5. Earnings Per Share (EPS) 6. Dividend Per Share (DPS) 7. Price Earnings Ratio 8. Return on Proprietors funds 9. Dividend Payout Ratio 10. Dividend Yield Ratio

11. Earnings Yield Ratio Gross Profit Ratio

This ratio establishes relationship between gross profit on sales to net sales of a firm, which is calculated in percentage. Its formula is:

Gross Profit Ratio

Net sales mean gross sales (both cash and credit) minus sales return. Gross profit ratio is a reliable guide to the adequacy of selling price and efficiency of trading activities. The ratio is compared to earlier year ratios or with the ratio of the other firms. Higher the gross profit the better it is.

Operating Ratio
It is computed to establish relationship between operating costs and net sales. This ratio indicates the proption that the cost of sales or operating cost bear to sales.

Operating ratio =

cost of good sold + operating expenses Net sales operating cost Net sales

Operating ratio =

Here Cost of good sold = opening stock + purchases + direct expenses + manufacturing expenses closing stock or sales gross profit It is the test of the operational efficiency of the business. Lower the operating ratio, the better it is, because it would leave higher margin to meet interest, dividend, etc.

Net Profit Ratio

Net profit ratio establishes the relationship between net profits and sales, i.e. it shows the percentage of net profit earned on the sales. Net profit is computed by deducting all direct costs i.e. administrative and marketing

expenses, financial charges and making adjustments for non operating expenses from net sales and adding non operating incomes.

Net Profit Ratio =

Net Profit Net Sales

This ratio serves a similar purpose as, and is used in conjunction with, the gross profit ratio. Higher the net profit the better it is.

Return on Investment or Return on Capital Employed Ratio

Return on capital employed ratio establishes the relationship of profit (profit means profit before interest and tax) with capital employed. The net result of operations of a business is either profit or loss. The sources i.e. funds used by the business to earn this (profit or loss) are proprietors (shareholders) funds and loan. Yield on capital is another term employed to express it. Return on Investment (ROI) = Profit before interest, tax and dividend Capital employed

The ratio is usually expressed in percentage. Capital employed is computed by any of the following methods. Total of 1. Share capital (both preference and equity) 2. Reserves, and 3. Long term loans. Less 1. Fictitious assets (like preliminary expenses), and 2. Non operating assets like investments. Alternatively, Total of 1. Fixed assets (cost less deprecation), and 2. Working Capital, i.e. current assets minus current liabilities This ratio also helps in judging performance efficiency of different departments or units within the enterprise. To judge whether the ratio is satisfactory or not, it should be compared with its own past ratios or with the ratios of similar enterprise in the industry or with the industry average

Earnings Per Share (EPS)

It is the earning of a company attributes to the equity shareholders divided by the number of equity shares. In other words, this ratio measures the earning available to an equity shareholder on per share basis. It is computed with the help of the following formula:

Earnings per share = Net profit after tax preference dividend Number of equity shares

The numerator indicates the funds available for distribution as dividend to equity share holders. As the name indicates the ratio indicates the earnings made by the company per equity share. A comparison with the ratio for similar companies will indicate whether the company is using its capital effectively or not.

Dividend Per Share (DPS)

The dividend per share ratio is computed by dividing the profit distributed as equity dividend (i.e. dividend paid to equity share holders) by the number of equity share issued.

Dividend per share = RS. . Per share The objective of computing this ratio is to measure the dividend distributed per equity share. Higher the dividend per share, better it is and vice versa. Not all the earnings available for distribution are declared as dividend of the company. This ratio indicates the actual amount declared as dividend by the company.

Price Earnings Ratio

Price earning ratio establishes the relationship between the market price of the share and earning per share. In the other words, it indicates, how many time is the market price of share to its earnings.

Price Earnings Ratio

Earnings per share

This ratio is helpful in governing the market price of the share. This is most widely used ratio in the stock exchange by the inventors. This ratio indicates as how much the public is ready to pay for future earning prospects of the company. A higher price earning ratio indicates the faith of investors in the stability and appreciation of company earnings. This ratio can be used in forecasting market value of the share on a certain future date the formula is:

Market price per share = price earning ratio * EPS The market value of a share is affected by many factors. Hence, this ratio is used for knowing the position of overt or under valuation of the shares

Return on Proprietors funds

This ratio serves the requirements of the shareholders specially to know the return on their investments in the business.

Return on Proprietors Funds

Return on net worth, Return on shareholders Funds.

Dividend Payout Ratio

This ratio indicates the actual dividend paid to the shareholders. It throws light on the dividend policies of the company.

Dividend payout ratio

Dividend Yield Ratio

Yield is the actual return for the shareholders on the investment. The dividend is declared on the face value of shares Dividend Yield Ratio

. Thus 20% dividend declared on a share of the face value of Rs. 10 would fetch Rs. 2 as dividend. But, if the shareholder has acquired the share from the market for Rs. 40, the actual yield will be Dividend Yield Ratio

Earnings Yield Ratio

This ratio measures the yield earned by the company per share.

Earnings Yield Ratio

Summary The ratios are normally used in the accounting section are for validation, verification and for improvement of the company. The real success of any management lies with proper vision, mission towards the up-gradation of our society. Reference: 1. 2. 3. 4. 5. Accounting and Financial Management, Shashi k. Gupta, R.K. Sharma, Lalit Bhalla Analysis of Financial Statement, T.S Grewals www.encyclopedia.com http://www.netmba.com/finance/financial/ratios/ http://www.wikinvest.com/wiki/Ratio_Analysis