What is Ratio analysis?advantages of ratio analysis
Ratio analysis
Introduction
Financial statements are prepared by summarizing the financial transactions during a particular year. They are prepared to provided the financial information that help to take decisions. The information provided by financial statements may not meaningful and useful unless they are properly analyzed. Analysis of financial statements is useful in making financial and investment decisions. Financial analysis identifies the financial strength and weakness of the firm by properly establishing relationship between the items of financial statements i.e. income statements and balance sheet. There are various method or techniques uses in analyzing the finical statements. Ratio analysis is one of the major tools uses in the interpretation and evaluations of financial statements.
Introduction
Financial statements are prepared by summarizing the financial transactions during a particular year. They are prepared to provided the financial information that help to take decisions. The information provided by financial statements may not meaningful and useful unless they are properly analyzed. Analysis of financial statements is useful in making financial and investment decisions. Financial analysis identifies the financial strength and weakness of the firm by properly establishing relationship between the items of financial statements i.e. income statements and balance sheet. There are various method or techniques uses in analyzing the finical statements. Ratio analysis is one of the major tools uses in the interpretation and evaluations of financial statements.
Meaning of ratio analysis
A number is meaningless uncles it is compared with other. Ratio is an expression of quantitative relationship between two figure and numbers. It is expresses when one figure is compared with another. Ratio analysis determines and interlines and interprets the numerical relationship between figures of financial statements. Hence, ratio is used for evaluating the financial position and performance of a firm. In other words, it helps analysts to make quantitative judgment about the financial position and performance of a firm.
"A ratio is an expression of the quantitative relationship between two numbers."
"A ratio is the relationship of one amount to another expressed as the ratio of or as a simple, fraction integer, decimal fraction or percentage."
"A ratio is simple one number expressed in terms of another. It is found by dividing one number by the other."
From the above definitions, it is clear that ratio is the relation of one number to another. It facilitates the decision makers to take the appropriate decision based on different rations.
Presentation of ratio
The quantitative relationship two or more items of the financial statements related to each other is called accounting ratio. The accounting ratios may be expressed in the following ways:
Percentage method; under this method, the relationship between two figures is expressed in percentage.
Percentage of fixed assets to total assets = fixed assets/ total assets x 100
Rate method: under this method, the ratio is expressed by dividing one number by another.
Ratio method: according to this method, the relationship between two figures is parentages in ratio.
Importance or advantages of ratio analysis
Ratio analysis is an importance technique of financial analysis. It is a way by which financial stability and health of a concern can be judged. The following are the main points to highlight the importance of ratio analysis.
Financial position analysis: accounting ratios reveal the financial position of a concern. In office words, they ascertain the financial strength and weakness of a firm on a particular date. In turn, they help in making various financial decisions.
Simplifying accounting figures: accounting rations simplify, summarize and systemize the accounting the figures to make them understandable. These figures alone may not carry any meaning but ratios help them to relate with other figures and make them meaningful.
Asses the operational efficiency: accounting rations help to assess the operational or working efficiency of a concern during a particular period of time. They analyze the operational efficiency by evaluating the turnover and profitability. This helps the management to assess the financial requirement and operational efficiency.
Forecasting: ratio analysis is useful in financial forecasting and planning. It accumulations the financial information of past and analyzes the financial performance which helps to establish tread for the future.
Exploration of weakness of a business: accounting rations help in locating the weakness of a business. A business might have number of weakness even though the overall performance is efficient. Management can take remedial measure to overcome the weakness.
Comparison of performance: accounting ratios facilities the comparison of one firm with other in order to evaluate the financial performance. Management is interested in such comparison to find out the strength and weakness. Ratio analysis further helps to make the necessary changes is organizations structure.
Limitation of ratio analysis
Ratio analysis is an importance tool to reveal the financial condition of a business. However, it has some limitations which are as follows:
Basses of historical information: ratio analysis is based on historical accounting information. Hence, sometimes it may not be able to predict the future of business.
Ignores qualitative aspect: financial statement do not contain the entire information necessary for evaluating the progress and future prospects of an organizations. Hence, ratio analysis considers the quantities aspect only and ignores qualitative aspects such as working styles of manager, relationship with customers etc.
Fails not disclose current worth of enterprises: ratio analysis fails to disclose the current worth of an enterprise. It is based on historical facts and date which do not consider the changes in the price level.
Not free from bias: ratio analysis is also based on the personal judgment of analysis. The analysis has to make a choice out of variable alternatives available. So ratio analysis may not be free from personal basis.
Types of accounting ratios
Ratio may be classified in a number of ways according to the purpose and nature of analysis. The rations used for financial analysis of business can be classified into four categories as given below:
1. Liquidity ratio
Liquidity rations measure the short-term solvency or liquidity of a firm. Liquidity is the ability of firm to meet its short-term obligations. Liquidity rations reflect the short-term financial strength of a business. These ratios indicate whether a firm is in a position to meet its short-term obligations timely or not. There are two rations to measure the liquidity of a firm.
a. Current ratio
It shows the relationship between current assets and current liabilities. Its main objective is to measure the ability of the firm to meet its short-term obligations. There are two components of this ratio as follows:
i. Current assets: those assets which are converted into cash normally within a year are called current assets.
Cash in hand
Cash at bank
Closing stock or inventory
Bills receivable
Accounts receivable
Sunday debtors
Marketable securities
Short-term investment
Prepared or advance expense
Account income
ii. Current liability: Those liabilities which are to be discharge normally within one accounting year are called current liabilities.
Current liability
Bills payable/ account payable/ notes payable
Sundry creditors
Short-term-bank loan
Bank overdraft
Outstanding expense
Unarmed or advance income
Tax payable/ provided for tax
Divided payable/ proposed divided
Uncounted divided
b. Quick ratio
This ratio is also called liquid or acid test ratio. It shows the relationship between quick assets and current liabilities. Its main objective is to measure the ability of the firm to meet its short-term obligation as and when without relying upon the realization of stock.
This ratio is computed dividing the quick assets by the current liabilities. It is usually expresses as a pure like 1:1. This ratio may be calculated as under:
Quick ratio= quick assets/ current liabilities
There are two components of quick ratio as given below:
j. Quick assets: those current assets which can be converted into cash immediately or at a short notice without loss of value are called quick assets. All the current assets except inventories and prepared expenses are quick assets. Since inventory is not easily and readily convertible into cash, it is not quick asset. Similarly, prepared expenses are available to pay debt.
iii. Current liabilities: these liabilities which are to be discharged normally within one accounting year are called current liabilities.
Working capital
The capital that is needed to run the day to activities of a business is called working capital. It is related to the current assets and liabilities. In other words, the difference between current assets and liabilities is knows as working capital.
Working capital= current assets- current liabilities
2. Leverage rations
These ratios are also called capital structure ratios.thy show to long-term solvency or liquidity f a firm. They indicated whether the firm is finality sound or solvent in relation to its long-term obligations. These rations measure a firm's ability to pay the interest regularly and repay the principle on the due date. They re also knows as solvency ratio or capital structures rations.
Long-term solvency of a firm can be measured through the following rations:
Debt equity ratio
This ratio is also called debt to shareholders 'fund ratio. It shows the relationship between long-term debts or total and shareholder's funds. It is a test of long-term solvency of a firm. The objective of this ratio is to measure the relative proportion of debt and equity for financial in the assets of a firm.
Debt to total capital ratio
It is called debt to long-term fund ratio. This ratio established the relationship between debt and total capital of a company. It helps to establish a link between funded debt and total long-term funds available in the business. Its main objective is to measure the relative share of the debt in total capital of the company indicating long-term solvency.
This ratio is computed by divided the long-term or total debt by total capital or permanent capital or long-term fund.
Debt to total capital= long term debt/ capital employed
i. Long-term debt: the debt that Is payable or matured in a long period of time.
ii. Total capital: it is also known as capital employed or long-term fund or permanent capital. Total capital included long-term debt plus shareholder's equity.
Interest coverage ratio
This ratio ascertains the ability of a firm to pay interest on its browed capital. Hence, it is also known as debt service ratio. It is calculated with the help of net profit before interest and taxes.
Interest coverage ratio= net profit before interest and tax or EBIT/ interest
Fixed coverage ratio
This ratio shows the relationship between the net profit before interest and taxes and fixed charges. The fixed charge comprise of the interest, preference dividend and debt payment. It is calculated as under.
Fixed coverage ratio= net profit before interest and taxes/ fixed charges
3. Activity or turnover ratios
For smooth operations, a firm needs to invest in both short-term and long-term assets. Activity ratios describe the relationship between the firm's level of activity (sales) and assets employed to generate the activity.
Activities ratios are also used to forecast a firm's capital requirement both operating and long-term. Increase in sales required investments in additional assets. Activity ratios enable the analysis to forest these requirements and to assess the firm's abilities the assets needed to sustain the forecasted growth. The following rations are the activities rations.
Inventory turnover ratio
It is also called stock turnover ratio. It shows the relationship between costs of goods sold and average inventory. The objective of this ratio is to determine the efficiency which the inventory is covert into sales.
Debt turnover ratio
This ratio is also called accounts receivable turnover ratio. It shows the relationship between credit sales and average debtors or receivables. The objective of computing this ratio is to determine the efficiency with which the debtors are converted into cash.
Average collection period
It is also known as day's sales outstanding. It shows the relationship between days or weeks or months in a year and debtors turnover ratio. The objective of this ratio is to know about the average length of time that a receivable has remained outstanding. It shows the efficiency in the collection process of the receivables.
Fixed assets turnover ratio
This ratio established the relationship between net sales and fixed assets. The objective of this ratio is to determine the efficiency it which fixed assets are utilized.
Total assets turnover ratio
This ratio shows the relationship between net sales and total assets. The objective of computing this ratio is to determine the efficiency of management in utilization of assets for generating sales.
Total assets turnover ratio= net sales/ total assets= …times
Capital employed turnover ratio
This ratio shows the relationship between net sales and capital employed. The objective of computing this ratio is to determine efficiency with which the capital employed or long-term fund or permanent capital is utilized.
Capital employed turnover ratio= net sales/ capital employed = … times
4. Profitability ratios
One off the yardstick of measuring the efficiency of a firm is profitability. Hence, profitability is an important, year stick of a company's success. The long-term survival of a company depends on income earned by it. Moreover/ a firm should earn sufficient profit on each rupee of sales to meet the operating expenses and to avail returns to the owners. The profitability ratios are mentioned below.
Gross profit margin or ratio
Gross profit margin or ratio measure the relationship between gross profit and net sales. It is computed to determine to efficiency which production and or purchase operation and selling operations carried on.
Gross profit ratio= gross profit/ net sales x 100 = …%
Net profit margin or ratio
This ratio shows the relationship between net profit and net sales. The main objective of computing this ratio is to determine the overall profitability of a firm. It reflects the cost pried effectiveness of the operating. This ratio is computed by dividing the net profit net profit after tax by net sales. It is expressed as percentage of net sales.
Net profit margin= net profit after tax / net sales x 100
Operating ratio
This rat,io establishes the relationship between the operating expense and sales value. It is very importance in relation to the cost structure of a firm.
Operating ratio= operating expenses/ net sales x 100 = … %
Return on shareholder's equity
This ratio shows the relationship between net profit after tax and shareholders' fund. It finds how efficiency the fund contributed by the shareholder's have been used.
Return on shareholders' equity= net profit tax/ shareholders' equity x 100 = …%
Return on ordinary/ common shareholders' fund
It is also called return on equity. This ratio measures the relationship between earning available to equity shareholders and equity shareholder's funds. It finds out how efficiently the funds supplied by the equity shareholders have been used.
Return on equity or common shareholders' fund
= net profit after tax and preference dividend/ equity or common shareholders' fund
Return on assets
It is also called return on investment. This ratio establishes relationship between net profit and total assets or investments. The objective of measuring this ratio to find out profitability of the total assets.
Return on assets= net profit after tax/ total assets x 100 = … %
5. Other ratios
The other rations which are related to profitability are given below.
Earnings per share
It measures the per share earnings available to equity shareholders. It shows the profitability of the firm on per equity share basis.
Dividend per share
It shows the relationship between total amount of dividend paid to equity shareholders and number of equity shares. It is computed to know the dividend d distributed to common shareholders on per share basis.
Dividend per share (DPS) = total amount of dividend paid to equity shareholders/ no. of equity shares outstanding
Dividend payout ratio
This ratio ascertains the portion of dividend distributed out of the total earning. It established the relationship between dividends distributed to each share out of the earning available to each share. It is calculated as under.
Dividend payout ratio= dividend per share/ earnings per share x 100 =… %
Dividend yield ratio
It establishes the relationship between dividend distributed to each share and the market value of each share. It is calculated as under.
Dividend yield ratio= dividend per share/ market value per share x 100= … %
Earning yield ratio
It maintains the relationship between earning per share and the market value of each share. It is calculated as under:
Earning yield ratio= earnings per share/ market value per share x 100= … %
Price earnings ratio
It ascertains the relationship between the market value of each share and earnings per share. It is reciprocal to earnings yield ratio. It is calculated as under.
Price earnings ratio= market value per share/ earnings per share x 100= … %
Earning power ratio
This ratio measures the profitability of a firm in terms of both investment and operational efficiency. This ratio is calculated as under.
Earning power ratio= net profit margin x assets turnover
Net profit after tax/ sales x sales/ total assets
Changes in ratio due to company growth and merger
When two companies merge each other or one company acquires another, charges in the company's position take place. Such changes may not affect equally to both parties. It may be favorable to one party and unfavorable to another. Ratio analysis is an important tool to analysis the effect of merger and acquisition in the financial position of companies.
Liquidity rations measure the short-term solvency or liquidity of a firm. Liquidity is the ability of firm to meet its short-term obligations. Liquidity rations reflect the short-term financial strength of a business. These ratios indicate whether a firm is in a position to meet its short-term obligations timely or not. There are two rations to measure the liquidity of a firm.
a. Current ratio
It shows the relationship between current assets and current liabilities. Its main objective is to measure the ability of the firm to meet its short-term obligations. There are two components of this ratio as follows:
i. Current assets: those assets which are converted into cash normally within a year are called current assets.
Cash in hand
Cash at bank
Closing stock or inventory
Bills receivable
Accounts receivable
Sunday debtors
Marketable securities
Short-term investment
Prepared or advance expense
Account income
ii. Current liability: Those liabilities which are to be discharge normally within one accounting year are called current liabilities.
Current liability
Bills payable/ account payable/ notes payable
Sundry creditors
Short-term-bank loan
Bank overdraft
Outstanding expense
Unarmed or advance income
Tax payable/ provided for tax
Divided payable/ proposed divided
Uncounted divided
b. Quick ratio
This ratio is also called liquid or acid test ratio. It shows the relationship between quick assets and current liabilities. Its main objective is to measure the ability of the firm to meet its short-term obligation as and when without relying upon the realization of stock.
This ratio is computed dividing the quick assets by the current liabilities. It is usually expresses as a pure like 1:1. This ratio may be calculated as under:
Quick ratio= quick assets/ current liabilities
There are two components of quick ratio as given below:
j. Quick assets: those current assets which can be converted into cash immediately or at a short notice without loss of value are called quick assets. All the current assets except inventories and prepared expenses are quick assets. Since inventory is not easily and readily convertible into cash, it is not quick asset. Similarly, prepared expenses are available to pay debt.
iii. Current liabilities: these liabilities which are to be discharged normally within one accounting year are called current liabilities.
Working capital
The capital that is needed to run the day to activities of a business is called working capital. It is related to the current assets and liabilities. In other words, the difference between current assets and liabilities is knows as working capital.
Working capital= current assets- current liabilities
2. Leverage rations
These ratios are also called capital structure ratios.thy show to long-term solvency or liquidity f a firm. They indicated whether the firm is finality sound or solvent in relation to its long-term obligations. These rations measure a firm's ability to pay the interest regularly and repay the principle on the due date. They re also knows as solvency ratio or capital structures rations.
Long-term solvency of a firm can be measured through the following rations:
Debt equity ratio
This ratio is also called debt to shareholders 'fund ratio. It shows the relationship between long-term debts or total and shareholder's funds. It is a test of long-term solvency of a firm. The objective of this ratio is to measure the relative proportion of debt and equity for financial in the assets of a firm.
Debt to total capital ratio
It is called debt to long-term fund ratio. This ratio established the relationship between debt and total capital of a company. It helps to establish a link between funded debt and total long-term funds available in the business. Its main objective is to measure the relative share of the debt in total capital of the company indicating long-term solvency.
This ratio is computed by divided the long-term or total debt by total capital or permanent capital or long-term fund.
Debt to total capital= long term debt/ capital employed
i. Long-term debt: the debt that Is payable or matured in a long period of time.
ii. Total capital: it is also known as capital employed or long-term fund or permanent capital. Total capital included long-term debt plus shareholder's equity.
Interest coverage ratio
This ratio ascertains the ability of a firm to pay interest on its browed capital. Hence, it is also known as debt service ratio. It is calculated with the help of net profit before interest and taxes.
Interest coverage ratio= net profit before interest and tax or EBIT/ interest
Fixed coverage ratio
This ratio shows the relationship between the net profit before interest and taxes and fixed charges. The fixed charge comprise of the interest, preference dividend and debt payment. It is calculated as under.
Fixed coverage ratio= net profit before interest and taxes/ fixed charges
3. Activity or turnover ratios
For smooth operations, a firm needs to invest in both short-term and long-term assets. Activity ratios describe the relationship between the firm's level of activity (sales) and assets employed to generate the activity.
Activities ratios are also used to forecast a firm's capital requirement both operating and long-term. Increase in sales required investments in additional assets. Activity ratios enable the analysis to forest these requirements and to assess the firm's abilities the assets needed to sustain the forecasted growth. The following rations are the activities rations.
Inventory turnover ratio
It is also called stock turnover ratio. It shows the relationship between costs of goods sold and average inventory. The objective of this ratio is to determine the efficiency which the inventory is covert into sales.
Debt turnover ratio
This ratio is also called accounts receivable turnover ratio. It shows the relationship between credit sales and average debtors or receivables. The objective of computing this ratio is to determine the efficiency with which the debtors are converted into cash.
Average collection period
It is also known as day's sales outstanding. It shows the relationship between days or weeks or months in a year and debtors turnover ratio. The objective of this ratio is to know about the average length of time that a receivable has remained outstanding. It shows the efficiency in the collection process of the receivables.
Fixed assets turnover ratio
This ratio established the relationship between net sales and fixed assets. The objective of this ratio is to determine the efficiency it which fixed assets are utilized.
Total assets turnover ratio
This ratio shows the relationship between net sales and total assets. The objective of computing this ratio is to determine the efficiency of management in utilization of assets for generating sales.
Total assets turnover ratio= net sales/ total assets= …times
Capital employed turnover ratio
This ratio shows the relationship between net sales and capital employed. The objective of computing this ratio is to determine efficiency with which the capital employed or long-term fund or permanent capital is utilized.
Capital employed turnover ratio= net sales/ capital employed = … times
4. Profitability ratios
One off the yardstick of measuring the efficiency of a firm is profitability. Hence, profitability is an important, year stick of a company's success. The long-term survival of a company depends on income earned by it. Moreover/ a firm should earn sufficient profit on each rupee of sales to meet the operating expenses and to avail returns to the owners. The profitability ratios are mentioned below.
Gross profit margin or ratio
Gross profit margin or ratio measure the relationship between gross profit and net sales. It is computed to determine to efficiency which production and or purchase operation and selling operations carried on.
Gross profit ratio= gross profit/ net sales x 100 = …%
Net profit margin or ratio
This ratio shows the relationship between net profit and net sales. The main objective of computing this ratio is to determine the overall profitability of a firm. It reflects the cost pried effectiveness of the operating. This ratio is computed by dividing the net profit net profit after tax by net sales. It is expressed as percentage of net sales.
Net profit margin= net profit after tax / net sales x 100
Operating ratio
This rat,io establishes the relationship between the operating expense and sales value. It is very importance in relation to the cost structure of a firm.
Operating ratio= operating expenses/ net sales x 100 = … %
Return on shareholder's equity
This ratio shows the relationship between net profit after tax and shareholders' fund. It finds how efficiency the fund contributed by the shareholder's have been used.
Return on shareholders' equity= net profit tax/ shareholders' equity x 100 = …%
Return on ordinary/ common shareholders' fund
It is also called return on equity. This ratio measures the relationship between earning available to equity shareholders and equity shareholder's funds. It finds out how efficiently the funds supplied by the equity shareholders have been used.
Return on equity or common shareholders' fund
= net profit after tax and preference dividend/ equity or common shareholders' fund
Return on assets
It is also called return on investment. This ratio establishes relationship between net profit and total assets or investments. The objective of measuring this ratio to find out profitability of the total assets.
Return on assets= net profit after tax/ total assets x 100 = … %
5. Other ratios
The other rations which are related to profitability are given below.
Earnings per share
It measures the per share earnings available to equity shareholders. It shows the profitability of the firm on per equity share basis.
Dividend per share
It shows the relationship between total amount of dividend paid to equity shareholders and number of equity shares. It is computed to know the dividend d distributed to common shareholders on per share basis.
Dividend per share (DPS) = total amount of dividend paid to equity shareholders/ no. of equity shares outstanding
Dividend payout ratio
This ratio ascertains the portion of dividend distributed out of the total earning. It established the relationship between dividends distributed to each share out of the earning available to each share. It is calculated as under.
Dividend payout ratio= dividend per share/ earnings per share x 100 =… %
Dividend yield ratio
It establishes the relationship between dividend distributed to each share and the market value of each share. It is calculated as under.
Dividend yield ratio= dividend per share/ market value per share x 100= … %
Earning yield ratio
It maintains the relationship between earning per share and the market value of each share. It is calculated as under:
Earning yield ratio= earnings per share/ market value per share x 100= … %
Price earnings ratio
It ascertains the relationship between the market value of each share and earnings per share. It is reciprocal to earnings yield ratio. It is calculated as under.
Price earnings ratio= market value per share/ earnings per share x 100= … %
Earning power ratio
This ratio measures the profitability of a firm in terms of both investment and operational efficiency. This ratio is calculated as under.
Earning power ratio= net profit margin x assets turnover
Net profit after tax/ sales x sales/ total assets
Changes in ratio due to company growth and merger
When two companies merge each other or one company acquires another, charges in the company's position take place. Such changes may not affect equally to both parties. It may be favorable to one party and unfavorable to another. Ratio analysis is an important tool to analysis the effect of merger and acquisition in the financial position of companies.
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