RATIO ANALYSIS Meaning and definition of ratio analysis: Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strength and weaknesses of a firm as well as its historical performance and current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two variables. Significance or Importance of ratio analysis: It helps in evaluating the firms performance: With the help of ratio analysis conclusion can be drawn regarding several aspects such as financial health, profitability and operational efficiency of the undertaking. Ratio points out the operating efficiency of the firm i.e. whether the management has utilized the firm’s assets correctly, to increase the investor’s wealth. It ensures a fair return to its owners and secures optimum utilization of firms assets It helps in inter-firm comparison: Ratio analysis helps in inter-firm comparison by providing necessary data. An interfirm comparison indicates relative position.It provides the relevant data for the comparison of the performance of different departments. If comparison shows a variance, the possible reasons of variations may be identified and if results are negative, the action may be intiated immediately to bring them in line. It simplifies financial statement: The information given in the basic financial statements serves no useful Purpose unless it s interrupted and analyzed in some comparable terms. The ratio analysis is one of the tools in the hands of those who want to know something more from the financial statements in the simplified manner. It helps in determining the financial position of the concern: Ratio analysis facilitates the management to know whether the firms financial position is improving or deteriorating or is constant over the years by setting a trend with the help of ratios The analysis with the help of ratio analysis can know the direction of the trend of strategic ratio may help the management in the task of planning, forecasting and controlling. It is helpful in budgeting and forecasting: Accounting ratios provide a reliable data, which can be compared, studied And analyzed.These ratios provide sound footing for future prospectus. The ratios can also serve as a basis for preparing budgeting future line of action. Liquidity position: With help of ratio analysis conclusions can be drawn regarding the Liquidity position of a firm. The liquidity positon of a firm would be satisfactory if it is able to meet its current obligation when they become due. The ability to met short term liabilities is reflected in the liquidity ratio of a firm. Long term solvency: Ratio analysis is equally for assessing the long term financial ability of the Firm. The long term solvency s measured by the leverage or capital structure and profitability ratio which shows the earning power and operating efficiency, Solvency ratio shows relationship between total liability and total assets. Operating efficieny: Yet another dimension of usefulness or ratio analysis, relevant from the View point of management is that it throws light on the degree efficiency in the various activity ratios measures this kind of operational efficiency. Classification of ratios: Different ratios are used for different purpose these ratios can be grouped into various classes according to the financial activity. Ratios are classified into four broad categories. 1. Liquidity Ratio 2. Leverage Ratio 3. Profitability Ratio 4. Activity Ratio 1. Liquidity Ratio: Liquidity ratio measures the firms ability to meet its currentobligations i.e. ability to pay its obligations and when they become due. Commonly used ratios are: Current ratio: Current ratio is the ratio, which express relationship between current asset and current liabilities. Current asset are those which can be converted into cash within a short period of time, normally not exceeding one year. The current liabilities which are short- term maturing to be met. Current ratio Current Asset = Current liabilities Acid test ratio: The acid test ratio is a measure of liquidity esigned to overcome the Defect of current ratio. It is often referred to as quick ratio because it is a measurement of firms ability to convert its current assets quickly into cash in order to meet its current liabilities. Current asset -Inventories Acid test ratio = Current liabilities 2. Leverage or capital structure ratio: Leverage or capital structure ratios are the ratios, which indicate the relative interest of the owners and the creditors in an enterprise. These ratios indicate the funds provided by the long-term creditors and owners. To judge the long term financial position of the firm following ratios are applied. 1. Debt –equity ratio: Debt-equity ratio which expresses the relatonship between debt and equityThis ratio explains how far owned funds are sufficient to pay outside liabilities. It is calculated by following formula Long term +short term debts +current liabilities Debt equity ratio = Net worth . 2. Total Debt ratio: This ratio explains how far owned and borrowed funds are sufficient to pay debt of the firm Long term+short term borrowing+current liabilities Capital employed 3. Profitability ratio: Profitability ratio are the best indicators of overall efficiency of the business concern, because they compare return of value over and above the value put into business with sales or service carried on by the firm with the help of assets employed. Profitablity ratio can be determined on the basis of: Sales Investment Profitability ratios related to sale: 1. Gross profit to sales ratio. 2. Net profit to sales ratio or net profit of margin. 1. Gross profit to sales ratio: The gross profit to sales ratio establishes relationship between gross profit And sales to measure the relative operating efficency of the firm to reflect pricing policy Sales-cost of goods sold Gross profit to sales ratio = Sale * 100 2. Net profit margin: The net margin indicates the managements ability to earn sufficient profit on sales to earn sufficient profit on sales not only to cover all revenue operating expenses of the business, the cost of borrowed funds and the cost of goods or servicing, but also to have sufficient margin to pay reasonable comparison to shareholders on their contributions to the firm. Net profit after tax and interest Net profit margin = Sales 3. Profitability ratios related to investments: a. Return on assets b. Return on capital employed a. Return on assets: The profitability ratio here measures the relationship between net profit and assets. *100 Net profit after tax Return on assets = Fixed assets b. Return on capital employed: Net profit after taxes Return on capital employed = Total capital employed 3. Activity ratio: Activity ratio are sometimes are called efficiency ratios. Activity ratios are concerned with how efficiency the assets of the firm are managed. These ratio express relatonship between level of sales and the investment in various assets inventores, receivables, fixed assets etc. The important activity ratios are as follows: 1. Inventory turnover ratio: Raw materials consumed Inventory turnover ratio = Average stock of raw materials 2. Debt turnover ratio: This ratio shows quickly debtors are converted into cash Total sales = Debtors 3. Average collection period ratio: This ratio indicates how quickly the inventory is converted into cash. Days in a year = Debtors turnover 4. Working capital turnover ratio: This ratio shows the number of times the working capital turns in trading transaction. If it has an increasing trend over the previous year it shows that the working capital is being used efficiently. LIQUIDITY RATIOS Meaning of liquidity: The term liquidity refers to ability to pay its obligations when they become due. Liquidity ratios measure the ability of a firm to meet its short-term obligations and reflect the short-term financial strength or solvency of a firm. Liquidity ratios are classified into two types: 1. Short term liquidity and 2. Long term liquidity 1. short term liquidity: Short term liquidity refers to finance required by a firm for a period of one year or less. Short –term finance is also called working capital finance as it is required for investment in working capital or current assets like cash and bank balances, inventories, accounts receivables and marketable securities. Further short term liquidity ratios are categories into three types they are as follows: 1. Current ratio: The current ratio is the ratio of total current assets to total current liabilities it is calculated by dividing current assets by current liabilities.Current assets include cash an bank balances, marketable securities, inventory of raw material s,semi-finished and finished goods, bills receivable and prepaid expenses. The current liabilities which are short- term obligations to be met it consist of trade creditors, bills payable, bank credit, provision for taxation and outstanding expenses. Current assets Current ratio = Current liabilities 20015866 for the year 2003-2004 = ________ = 3.3:1 24146864 for the year 2004 -2005 24146864 ________ = 2.4:1 9934397 17410682 for the year 2005-2006 = ________ = 1.7:1 10002148 Interpretation: The current ratio for the year 2003-2004 is 3.30 compared to standard ratio 2:1 this ratio is higher which shows high short term liquidity efficiency at the same time holding more than sufficient current assets means inefficient use of resources The ratio for the year 2004-2005 is 2.4:1 it is as good as maintaining standard of 2:1 The ratio for the year is 1:7:1 shows below standard of 2:1 which means efficient use of funds but at the risk of low liquidity.
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