# Ratio Analysis

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- RATIO ANALYSIS P.Muralidhar M.B.A Matrusri Institute of PG Studies
- RATIO ANALYSIS Ratio analysis is the process of determining and interpreting numerical relationship based on financial statements. It is the technique of interpretation of financial statements with the help of accounting ratios derived from the balance sheet and profit and loss account.
- Basis Of Comparision Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance â improvement, deterioration or constancy â over the years. Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firmâs performance in relation to its competitors. Comparison with standards or industry average
- Ways To Interpret Accounting Ratios Single absolute ratio. Group ratio. Historical comparision. Inter-firm comparision. Projected ratios.
- Classification Of Ratios Analysis of Short Term Financial Position or Test of Liquidity. Analysis of Long Term Financial Position or Test of Solvency. Activity Ratios. Profitability Ratios.
- I. Test Of Liquidity The liquidity ratios are used to test the short term solvency or liquidity position of the business. It enables to know whether short term liabilities can be paid out of short term assets. It indicates whether a firm has adequate working capital to carry out routine business activity. It is a valuable aid to management in checking the efficiency with which working capital is being employed. It is also of importance to shareholders and long term creditors in determining to some extent the prospects of dividend and interest payment.
- Important Ratios In Test Of Liquidity Current ratio. Quick ratio. Absolute liquid ratio.
- Current Ratio It is the most widely used of all analytical devices based on the balance sheet. It establishes relationship between total current assets and current liabilities. Current assets Current ratio= Current liabilities Ideal ratio: 2:1 High ratio indicates under trading and over capitalization. Low ratio indicates over trading and under capitalization.
- Quick Ratio or Acid Test Ratio It establishes relationship between liquid assets and liquid liabilities. It is a refinement to current ratio and second testing device for working capital. Quick assets Quick ratio= Current liabilities Ideal ratio: 1:1 Usually, a high acid test ratio is an indication that the firm is liquid and has ability to meet its current or liquid liabilities in time and on the other hand a low quick ratio represents that the firmâs liquidity position is not good.
- Absolute Liquidity Ratio This ratio establishes a relationship between absolute liquid assets to quick liabilities. Absolute liquid assets Absolute liquid ratio= Quick liabilities Ideal ratio: 1:2 It means that if the ratio is 1:2 or more than this the concern can be taken as liquid. If the ratio is less than the standard of 1:2, it means the concern is not liquid. Quick assets = Current asset-(inventories + prepaid expenses) Quick Liabilities = Current liabilities â Bank overdraft Absolute liquid assets include cash in hand, cash at bank, marketable securities, temporary investments.
- II. Test Of Solvency Long term solvency ratios denote the ability of the organisation to repay the loan and interest. When an organization's assets are more than its liabilities is known as solvent organisation. Solvency indicates that position of an enterprise where it is capable of meeting long term obligations.
- Important Ratios In Test Of Solvency Debt-equity ratio. Proprietary ratio. Solvency ratio. Fixed assets to net worth ratio. Current assets to net worth ratio. Current liabilities to net worth ratio. Capital gearing ratio. Fixed assets ratio Debt servicing ratio. Dividend coverage ratio.
- Debt Equity Ratio It Is calculated to measure the relative claims of outsiders and the owners against the firmâs assets. This ratio indicates the relationship between the outsiders funds and the shareholdersâ funds. Outsiders funds Debt equity ratio= Shareholders funds Ideal ratio: 2:1; It means for every 2 shares there is 1 debt. If the debt is less than 2 times the equity, it means the creditors are relatively less and the financial structure is sound. If the debt is more than 2 times the equity, the state of long term creditors are more and indicate weak financial structure. Components of Debt Equity Ratio outsiders funds include all debts/liabilities to outsiders, whether long term or short term or whether in the form of debentures, bonds, mortgages or bills. shareholders funds consists of equity share capital, preference share capital, capital reserves, revenue reserves and reserves representing accumulated profits and surpluses like reserve for contingencies sinking funds. The accumulated losses and deferred expenses, if any should be deducted from the total to find out shareholdersâ funds, it is called net worth and the ratio may be termed as debt to net worth ratio.
- Proprietary Ratio or Net Worth Ratio It establishes relationship between the proprietors fund or shareholders funds and the total assets Proprietary funds Capital employed Proprietary ratio= or Total assets Total liabilities Ideal ratio: 0.5:1 Higher the ratio better the long term solvency (financial) position of the company. This ratio indicates the extent to which the assets of the company can be lost without affecting the interest of the creditors of the company Components Of Proprietary Ratio: Shareholders funds or Proprietary funds are equity share capital, preference share capital, undistributed profits, reserves and surpluses. Out of this amount accumulated losses should be deducted. Total assets on other hand denote total resources of the concern.
- Solvency Ratio It expresses the relationship between total assets and total liabilities of a business. This ratio is a small variant of equity ratio and can be simply calculated as 100-equity ratio Total assets Solvency ratio= Total liabilities No standard ratio is fixed in this regard. It may be compared with similar, such organisations to evaluate the solvency position. Higher the solvency ratio, the stronger is its financial position and vice-versa.
- Fixed Assets To Net Worth It is obtained by dividing the depreciated book value of fixed assets by the amount of proprietors funds. Net fixed assets Fixed assets to net worth ratio= Net worth Ideal ratio: 0.75:1 A higher ratio, say, 100% means that there are no outside liabilities and all the funds employed are those of shareholders. In such a case the return to shareholders would be lower rate of dividend and this is also a sign of over capitalization.
- Fixed Assets To Net Worth This ratio shows the extent to which ownership funds are sunk into assets with relatively low turnover. When the amount of proprietor's funds exceed the value of fixed assets, apart of the net working capital is provided by the shareholders, provided there are no other non-current assets, and when proprietorâs funds are less than the fixed assets, creditors obligation have been used to finance a part of fixed assets. The Yardstick for this measure is 65% for industrial undertakings.
- Current Assets To Net Worth Ratio It is obtained by dividing the value of current assets by the amount of proprietorâs funds. The purpose of this ratio is to show the percentage of proprietorâs fund investment in current assets. Current assets Current assets to net worth ratio= Proprietorâs fund A higher proportion of current assets to proprietorâs fund, as compared with the proportion of fixed assets to proprietorâs funds is advocated, as it is an indicator of the financial strength of the business, depending on the nature of the business there may be different ratios for different firms. This ratio must be read along with the results of fixed assets to proprietorâs funds ratio.
- Current Liabilities To Net Worth It is expressed as a proportion and is obtained by dividing current liabilities by proprietor's fund. Current liabilities Current liabilities to net worth ratio= Net worth Ideal ratio:1:3 This ratio indicates the relative contribution of short term creditors and owners to the capital of an enterprise. If the ratio is high, it means it is difficult to obtain long term funds by the business.
- Capital Gearing Ratio It expresses the relationship between equity capital and fixed interest bearing securities and fixed dividend bearing shares. Fixed interest bearing securities + fixed dividend bearing shares CGR= Equity shareholders funds Components of fixed interest bearing securities Components of equity shareholders funds Debentures Long-term loans Long-term fixed deposits Equity share capital Accumulated reserves & profits Less losses and fictitious assets
- Interpretation Of Capital Gearing Ratio When fixed interest bearing securities and fixed dividend bearing shares are higher than equity shareholders funds, the company is said to be âhighly gearedâ. Where the fixed interest hearing securities and fixed dividend bearing shares share equal to equity share capital it is said to be âevenly gearedâ. When the fixed interest bearing securities and fixed dividend bearing shares are lower than equity share capital it is said to be âlow gearedâ. If capital gearing is high, further raising of long term loans may be difficult and issue of equity shares may be attractive and vice-versa
- Fixed Assets Ratio It establishes the relationship between fixed assets and capital employed Fixed assets Fixed assets ratio= Capital employed Ideal ratio: 0.67:1 This ratio enables to know how fixed assets are financed i.e. by use of short term funds or by long term funds. This ratio should not be more than 1. Components of capital employed: 1.Owners funds, 2.Long-term loans, 3.Long-term deposits, 4.debentures.
- Fixed Charges cover or Debt Service Ratio This ratio is determined by dividing net profit by fixed interest charges. Net profit before deduction of interest and income tax Debt service ratio= Fixed interest charges Ideal ratio: 6 or 7 times; if the ratio is high it means there is higher margin of safety for the long term lenders and as such it is not difficult for the business to obtain further long term funds and vice-versa. This ratio indicates the financial ability of the enterprise to meet interest payment out of current earnings
- Dividend Cover Ratio It is the ratio between disposable profit and dividend. Disposable profit refers to profit left over after paying interest on long term borrowing and income tax. Net profit after interest and tax Dividend cover ratio= Dividend declared This ratio indicates the ability of the business to maintain the dividend on shares in future. If this ratio is higher is indicates that there is sufficient amount of retained profit. Even if there is slight decrease in profit in the future it will not affect payment of dividend in future
- III. Activity Ratio Activity ratios indicate the performance of an organisation. This indicate the effective utilization of the various assets of the organisation. Most of the ratio falling under this category is based on turnover and hence these ratios are called as turnover ratios.
- Important Ratios In Activity Ratio Stock turnover ratio. Debtors turnover ratio. Creditors turnover ratio. Wording capital turnover ratio. Fixed assets turnover ratio. Current assets turnover ratio. Total assets turnover ratio. Sales to networth ratio.
- Stock Turnover Ratio This ratio establishes the relationship between the cost of goods sold during a given period and the average sock holding during that period. It tells us as to how many times stock has turned over (sold) during the period. Indicates operational and marketing efficiency. Helps in evaluating inventory policy to avoid over stocking. Cost of goods sold Inventory turnover ratio= Average stock Cost of goods sold= sales-gross profit = opening stock + purchases â closing stock Opening stock + Closing stock Average stock= 2
- Interpretation Of Stock Turnover Ratio Ideal ratio: 8 times; A low inventory turnover may reflect dull business, over investment in inventory, accumulation of stock and excessive quantities of certain inventory items in relation to immediate requirements. A high ratio may not be accompanied by a relatively high net income as, profits may be sacrificed in obtaining a large sales volume (unless accompanied by a larger total gross profit). It may indicate under investment in inventories. But generally, a high stock turnover ratio means that the concern is efficient and hence it sells its goods quickly.
- Debtor Turnover Ratio This ratio explains the relationship of net credit sales of a firm to its book debts indicating the rate at which cash is generated by turnover of receivables or debtors. The purpose of this ratio is to measure the liquidity of the receivables or to find out the period over which receivables remain uncollected. Net credit sales Debtor turnover ratio= Average Debtors Opening balance + closing balance Average debtors= 2 Debtors include bills receivables along with book debts When information about opening and closing balances of trade debtors are not available then the debtor turnover ratio can be calculated by dividing the total sales by the balances of debtors Debtor turnover ratio = total sales/debtors
- Average Collection Period Number of working day in year Average collection period= Debtor turnover ratio The average collection period represents the average number of days for which a firm has to wait before its receivables are converted into cash
- Interpretation Of Debtor Turnover Ratio Ideal ratio: 10 to 12 times; debt collection period of 30 to 36 days is considered ideal. A high debtor turnover ratio or low collection period is indicative of sound management policy. The amount of trade debtors at the end of period should not exceed a reasonable proportion of net sales. Larger the trade debtors greater the expenses of collection.
- Creditors Turnover Ratio This ratio indicates the number of times the creditors are paid in a year. It is useful for creditors in finding out how much time the firm is likely to take in repaying its trade creditors. Net credit purchases Creditors turnover ratio= Average creditors Opening balance + closing balance Average creditors= 2 Number of working days Average payment period= Creditors turnover ratio If information about credit purchases is not available, total purchases may be taken, if opening and closing balances of creditors are not given the balances of creditors may be taken. Trade creditors include sundry creditors and bills payable.
- Interpretation Of Creditor Turnover Ratio Ideal ratio: 12 times; debt payment period of 30 days is considered ideal. Very less creditors turnover ratio, or a high debt payment period may indicate the firms inability in meeting its obligation in time.
- Working Capital Turnover Ratio This ratio indicates the number of times the working capital is turned over in the course of the year. Measures efficiency in working capital usage. It establishes relationship between cost of sales and working capital Cost of sales Working capital turnover ratio= Average working capital Opening + closing working capital Average working capital= 2 If cost of sales is not given, then sales can be used. If opening working capital is not disclosed then working capital at the year end will be used. Working capital turnover ratio= cost of sales (sales)/net working capital.
- Interpretation of Working Capital Turnover Ratio A higher ratio indicates efficient utilization of working capital and a low ratio indicates inefficient utilization of working capital. But a very high ratio is not a good situation for any firm and hence care must be taken while interpreting the ratio.
- Fixed Assets Turnover Ratio This ratio establishes a relationship between fixed assets and sales. Net sales Fixed assets turnover ratio= Fixed assets Ideal ratio: 5 times A high ratio indicates better utilisation of fixed assets. A low ratio indicates under utilisation of fixed assets.
- Total Asset Turnover Ratio This ratio establishes a relationship between total assets and sales. This ratio enables to know the efficient utilisation of total assets of a business. Net sales Total assets turnover ratio= Total assets Ideal ratio: 2 times High ratio indicates efficient utilization and ratio less than 2 indicates under utilization.
- IV. Profitability Ratio Profitability ratios indicate the profit earning capacity of a business. Profitability ratios are calculated either in relation to sales or in relation to investments. Profitability ratios can be classified into two categories. a) General Profitability Ratios. b) Overall Profitability Ratios.
- General Profitability Ratios Gross profit ratio. Net profit ratio. Operating ratio. Operating profit ratio. Expense ratio.
- Gross Profit Ratio It expresses the relationship of gross profit to net sales and is expressed in terms of percentage. This ratio is a tool that indicates the degree to which selling price of goods per unit may decline without resulting in losses. Gross profit Gross profit ratio= X 100 Net sales A low gross profit ratio may indicate unfavorable purchasing, the instability of management to develop sales volume thereby making it impossible to buy goods in large volume. Higher the gross profit ratio better the results.
- Net Profit Ratio It expresses the relationship between net profit after taxes to sales. Measure of overall profitability useful to proprietors, as it gibes an idea of the efficiency as well as profitability of the business to a limited extent. Net profit after taxes Net profit ratio= X 100 Net sales Higher the ratio better is the profitability Generally non operating incomes and expenses are excluded from the net profits for calculating this ratio
- Operating Ratio This ratio establishes a relationship between cost of goods sold plus other operating expenses and net sales. This ratio is calculated mainly to ascertain the operational efficiency of the management in their business operations. Cost of goods sold + operating expenses Operating ratio= Net sales Higher the ratio the less favorable it is because it would leave a smaller margin to meet interest, dividend and other corporate needs. For a manufacturing concern it is expected to touch a percentage of 75% to 85%. This ratio is partial index of over all profitability.
- Operating Profit Ratio This ratio establishes the relationship between operation profit and net sales. Operating profit Operating profit ratio= X 100 Net sales Operating profit ratio= 100-operating ratio Operating profit= Net sales â ( cost of goods sold + Administrative and office expenses + selling and distributive expenses.
- Expenses Ratio It establishes relationship between individual operation expenses and net sales revenue. Cost of goods sold 1. Cost of goods sold ratio= X 100 Net sales Office and admin exp 2. Admin. and office exp ratio= X100 Net sales Selling and dist. exp 3. Selling and distribution ratio= X 100 Net sales Non operating expense 4. Non-operating expense ratio= X 100 Net sales
- Test Of Overall Profitability Return on shareholders investment or Net worth ratio. Return on equity capital. Return on capital employed. Return on total resources. Dividend yield ratio. Preference dividend cover ratio. Equity dividend cover ratio. Price covering ratio. Dividend pay out ratio. Earning per share.
- Return On Shareholders Investment Shareholders investment also called return on proprietorâs funds is the ratio of net profit to proprietorâs funds. It is calculated by the prospective investor in the business to find out whether the investment would be worth-making in terms of return as compared to the risk involved in the business. Net profit (After tax and int) Return on shareholders investment= Proprietors funds
- Return On Shareholders Investment This ratio is of great importance to the present and prospective shareholders as well as the management of the company. As this ratio reveals how well the resources of a firm are being used, higher the ratio, better are the results. The return on shareholders investment should be compared with the return of other similar firms in the same industry. The inter firm comparision of this ratio determines whether their investments in the firm are attractive or not as the investors would like to invest only where their return is higher. Similarly, trend ratios can also be calculated for a number of years to get5 an idea of the prosperity, growth of deterioration in the companyâs profitability and efficiency.
- Return On Equity Capital This ratio establishes the relationship between net profit available to equity shareholders ad the amount of capital invested by them. It is used to compare the performance of company's equity capital with those of other companies, and thus help the investor in choosing a company with higher return on equity capital. Net profit â preference dividend Return on equity capital= Equity share capital (paid up)
- Return On Capital Employed This ratio is the most appropriate indicator of the earning power of the capital employed in the business. It also acts as a pointer to the management showing the progress or deterioration in the earning capacity and efficiency of the business. Net profit before taxes and interest on long â term loans and debentures Return on capital employed= Capital employed Ideal ratio: 15% If the actual ratio is equal ratio is equal to or above 15% It indicates higher productivity of the capital employed and vice versa Proprietors net capital employed = fixed assets + current assets â outside liabilities (both long and short term) Significance of the ratio: It is a prime test of the efficiency of business. It measures not only the overall efficiency of business but also helps in evaluating the performance of various departments. The owners are interested in knowing the profitability of the business in relation to amounts invested in it. A higher percentage of return on capital employed will satisfy the owners that their money is profitably utilized.
- Return of total resources This ratio acts as an yardstick to assess the efficiency of the efficiency of the operations of the business as it indicates the extent to which assets employed in the business are utilised to results in net profit Net profit Return on total recourses = X 100 Total assets
- Dividend Yield Ratio It refers to the percentage or ratio of dividend paid per share to the market price per share. This ratio throws light on the effective rate of return on investment, which potential investors may hope to earn. Dividend paid per equity share Dividend yield ratio = Market price per equity share
- Preference Dividend Cover It indicates how many times the preference dividend is covered by profits after tax. This ratio measures the margin o safety for preference shareholders. Such investors normally expect their dividend to be covered about 3 times by profits available for dividend purpose. Profit after tax Preference dividend cover = Annual programme dividend
- Equity Dividend Cover This ratio indicates the number of times the dividend is covered by the amount of profit available for equity shareholders. Net profit after tax - pref dividend Equity dividend cover = Dividend paid on equity capital Earning per equity share = Dividend per equity share Ideal ratio: 2 times; i.e. for every Rs. 100 profits available for dividend, Rs. 50 is retained in the business and Rs. 50 is distributed. Higher the ratio higher is extent of retained earnings and higher is the degree of certainty that dividend will be repeated in future
- Price Earning Ratio It shows how many times the annual earnings the present shareholders are willing to pay to get a share. This ratio helps investors to know the effect of earnings per share on the market price of the share. This ratio when calculated for several years can be used as term analysis for predicting future price earning ratios and therefore, future stock prices. Average market price per share Price earning ratio= Earning per share
- Dividend Pay Out Ratio This ratio indicates the proportion of earnings available which equity share holders actually receive in the form of dividend. Dividend paid per share Pay out ratio = Earning per share An investor primarily interested should invest in equity share of a company with high pay out ratio. A company having low pay out ratio need not necessarily be a bad company. A company having income may like to finance expansion out of the income, thus low pay out ratio. investor interested in stock price appreciation may well invest in such a company though the pay out ratio is low.
- Earning Per Share This ratio indicates the earning per equity share. It establishes the relationship between net profit available for equity shareholders and the number of equity shares. Net profit available for equity share holders Earning per share = Number of equity shares Quick assets = Current asset-(inventories + prepaid expenses) Quick Liabilities = Current liabilities â Bank overdraft Absolute liquid assets include cash in hand, cash at bank, marketable securities, temporary investments. Components of Debt Equity Ratio outsiders funds include all debts/liabilities to outsiders, whether long term or short term or whether in the form of debentures, bonds, mortgages or bills. shareholders funds consists of equity share capital, preference share capital, capital reserves, revenue reserves and reserves representing accumulated profits and surpluses like reserve for contingencies sinking funds. The accumulated losses and deferred expenses, if any should be deducted from the total to find out shareholdersâ funds, it is called net worth and the ratio may be termed as debt to net worth ratio. Components Of Proprietary Ratio: Shareholders funds or Proprietary funds are equity share capital, preference share capital, undistributed profits, reserves and surpluses. Out of this amount accumulated losses should be deducted. Total assets on other hand denote total resources of the concern. Components of capital employed: 1.Owners funds, 2.Long-term loans, 3.Long-term deposits, 4.debentures. When information about opening and closing balances of trade debtors are not available then the debtor turnover ratio can be calculated by dividing the total sales by the balances of debtors Debtor turnover ratio = total sales/debtors If information about credit purchases is not available, total purchases may be taken, if opening and closing balances of creditors are not given the balances of creditors may be taken. Trade creditors include sundry creditors and bills payable. If cost of sales is not given, then sales can be used. If opening working capital is not disclosed then working capital at the year end will be used. Working capital turnover ratio= cost of sales (sales)/net working capital. Generally non operating incomes and expenses are excluded from the net profits for calculating this ratio Proprietors net capital employed = fixed assets + current assets â outside liabilities (both long and short term) Significance of the ratio: It is a prime test of the efficiency of business. It measures not only the overall efficiency of business but also helps in evaluating the performance of various departments. The owners are interested in knowing the profitability of the business in relation to amounts invested in it. A higher percentage of return on capital employed will satisfy the owners that their money is profitably utilized.

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