RATIO ANALYSIS
Ratio analysis is the process of determining and presenting the relationship of items and group of items in the statements. According to Batty J. Management Accounting “Ratio can assist management in its basic functions of forecasting, planning coordination, control and communication”.
(A) LIQUIDITY RATIO
It refers to the ability of the firm to meet its current liabilities. These ratio are used to assess the short-term financial position of the concern. Liquidity ratio include two ratio
a) Current Ratio:- This ratio explains the relationship between current assets and current liabilities of a business. Current Ratio = Current Assets/ Current Liabilities Significance:-This ratio is used to assess the firm’s ability to meet its short term liabilities on time. According to accounting principle a current ratio of 2:1 is supposed to be an ideal ratio. It means that current assets of a business should at least be twice of its current assets.
(b)Quick Ratio:- Quick ratio indicates whether the firm is in a position to pay its current liabilities within a month or immediately. Quick Ratio = Liquid Assets/(All Current Liabilities – Bank Overdraft) Significance:-An ideal quick ratio is said to be 1:1. If it is more, it is considered to be better. This ratio is a better test of short-term financial position of the company.
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(B) LEVERAGE OR SOLVENCY RATIO This ratio disclose the firm’s ability to meet the interest costs regularly and Long term indebtedness at maturity. These ratio include the following ratios : (a) Debt Equity Ratio:-This ratio express the relationship between long term debts and shareholders fund. Debt equity Ratio = Long term loans/ Shareholder’s Fund Significance: - This ratio is calculated to assess the ability of the firm to meet its long term liabilities. If the debt equity ratio is more it shows a rather risky financial position from the long term point of view, as it indicates that more and more funds invested in the business are provided by long term lenders.
(b). Debt to Total Funds Ratio: This Ratio is a variation of the debt equity ratio and gives the same indication as the debt equity ratio. Significance- This ratio expresses the relationship between total assets and long term loans. It measures the extent to which long term loans are covered by assets which indicates the margin of safety available to providers of long term loans.
c. Proprietary Ratio:- This ratio indicates the proportion of total funds provide by owners or shareholders. Proprietary Ratio = Equity / Total assets Significance:- A higher proprietary ratio is generally treated an indicator of sound financial position from long term point of view, because it means that the large proportion of total assets is provided by equity and hence the firm Is less dependent on external sources of finance.
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d. Fixed Assets to Proprietor’s Fund Ratio:- This ratio is also know as fixed assets to net worth ratio. Fixed Asset to Proprietor’s Fund Ratio = Fixed Assets/Proprietor’s Funds
Significance:- The ratio indicates the extent to which proprietor’s
(Shareholder’s) funds are sunk into fixed assets. Normally , the purchase of fixed assets should be financed by proprietor’s funds. If this ratio is less than 100%, it would mean that proprietor’s fund are more than fixed assets and a part of working capital is provided by the proprietors. This will indicate the long-term financial soundness of business. e. Capital Gearing Ratio:-This ratio establishes a relationship between equity capital and fixed cost bearing capital. Capital Gearing Ratio = Equity Share Capital+ Reserves + P&L Balance/ Fixed cost Bearing Capital Significance:The high gearing will be beneficial to equity shareholders when the rate of interest/dividend payable on fixed cost bearing capital is lower than the rate of return on investment in business. Thus, the main objective of using fixed cost bearing capital is to maximize the profits available to equity shareholders.
f. Interest Coverage Ratio:- This ratio is also termed as ‘Debt Service Ratio’ Interest Coverage Ratio = Net Profit before charging interest and tax / Fixed Interest Charges Significance :- This ratio indicates how many times the interest charges are covered by the profits available to pay interest charges. This ratio measures the margin of safety for long-term lenders. An interest coverage ratio of 6 or 7 times is considered appropriate.
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(C) ACTIVITY OR TURNOVER RATIO These ratio are calculated on the bases of ‘cost of sales’ or sales, therefore, these ratio are also called as ‘Turnover Ratio’. a.Inventory Turnover Ratio:- This ratio indicates the relationship between the cost of goods sold during the year and average stock kept during that year. Inventory Turnover Ratio = Cost of Goods Sold / Average Stock Significance:-This ratio indicates whether stock has been efficiently used or not. It shows the speed with which the stock is rotated into sales or number of times the stock is turned into sales during the year. The higher the ratio, better it is, since the stock is selling quickly. b. Debtors Turnover Ratio :-This ratio indicates the relationship between credit sales and average debtors during the year . Debtor Turnover Ratio = Net Credit Sales / Average account recievable debt Significance :- This ratio indicates the speed with which the amount is collected from debtors. The higher the ratio, the better it is, since it indicates that amount from debtors is being collected more quickly. The more quickly the debtors pay, the less the risk from bad- debts, and so the lower the expenses of collection and increase in the liquidity of the firm.
c. Average Collection Period:- This ratio indicates the time with in which the amount is collected from debtors and bills receivables. Average Collection Period = Debtors + Bills Receivable / Credit Sales per day Significance :-Thisratio shows the time in which the customers are paying for credit sales. A higher debt collection period is thus, an indicates of the inefficiency and negligency on the part of management. On the other hand, if there is decrease in debt collection period, it indicates prompt payment by debtors which reduces the chance of bad debts.
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d. Creditors Turnover Ratio:- This ratio indicates the relationship between credit purchases and average creditors during the year . Creditors Turnover Ratio = Net credit Purchases / Average account payable Significance:- This ratio indicates the speed with which the amount is being paid to creditors. The higher the ratio, the better it is, since it will indicate that the creditors are being paid more quickly which increases the credit worthiness of the firm. e. Working Capital Turnover Ratio:- This ratio reveals how efficiently working capital has been utilized in making sales. Working Capital Turnover Ratio = Cost of Goods Sold / Working Capital Significance:- This ratio is important in non manufacturing concerns where current assets play major role in generating rules. This ratio reveals how efficiently working capital has been utilised in making sales.
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(D) Profitability Ratios or Income Ratios:-The main object of every business concern is to earn profits. ( a) Gross Profit Ratio: This ratio shows the relationship between gross profit and sales. Gross Profit Ratio =( Gross Profit / Net Sales) *100 Significance:- This ratio measures the margin of profit available on sales. No ideal standard is fixed for this ratio, but the gross profit ratio should be adequate enough not only to cover the operating expenses but also to provide depreciation, interest on loans, dividends and creation of reserves.
(b) Net Profit Ratio:-This ratio shows the relationship between net profit and sales. Net Profit Ratio = Net Profit / Net sales *100 Significance :-This ratio measures the rate of net profit earned on sales. It helps in determining the overall efficiency of the business operations. An increase in the ratio over the previous year shows improvement in the overall efficiency and profitability of the business.
(c) Operating Ratio:-This ratio measures the proportion of an enterprise cost of sales and operating expenses in comparison to its sales. Operating Ratio =( Cost of Goods Sold + Operating Expenses/ Net Sales) *100 Significance:-It is the measurement of the efficiency and profitability of the business enterprise. It indicates the extent of sales that is absorbed by cost of goods sold and operating expenses. Lower the operating ratio, better it is, because it will leave higher margin of profit on sales.
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(d) Earning Per Share (E.P.S.) :-This ratio measure the profit available to the equity shareholders on a per share basis
Earning Per Share = Net Profit – Dividend on Preference Shares / No. of Equity Shares
Significance:-This ratio helpful in the determining of the market price of the equity share of the company. The ratio is also helpful in estimating the capacity of the company to declare dividends on equity shares.
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doc_996108509.docx
Ratio analysis is the process of determining and presenting the relationship of items and group of items in the statements. According to Batty J. Management Accounting “Ratio can assist management in its basic functions of forecasting, planning coordination, control and communication”.
(A) LIQUIDITY RATIO
It refers to the ability of the firm to meet its current liabilities. These ratio are used to assess the short-term financial position of the concern. Liquidity ratio include two ratio
a) Current Ratio:- This ratio explains the relationship between current assets and current liabilities of a business. Current Ratio = Current Assets/ Current Liabilities Significance:-This ratio is used to assess the firm’s ability to meet its short term liabilities on time. According to accounting principle a current ratio of 2:1 is supposed to be an ideal ratio. It means that current assets of a business should at least be twice of its current assets.(b)Quick Ratio:- Quick ratio indicates whether the firm is in a position to pay its current liabilities within a month or immediately. Quick Ratio = Liquid Assets/(All Current Liabilities – Bank Overdraft) Significance:-An ideal quick ratio is said to be 1:1. If it is more, it is considered to be better. This ratio is a better test of short-term financial position of the company.
1|Page
(B) LEVERAGE OR SOLVENCY RATIO This ratio disclose the firm’s ability to meet the interest costs regularly and Long term indebtedness at maturity. These ratio include the following ratios : (a) Debt Equity Ratio:-This ratio express the relationship between long term debts and shareholders fund. Debt equity Ratio = Long term loans/ Shareholder’s Fund Significance: - This ratio is calculated to assess the ability of the firm to meet its long term liabilities. If the debt equity ratio is more it shows a rather risky financial position from the long term point of view, as it indicates that more and more funds invested in the business are provided by long term lenders.
(b). Debt to Total Funds Ratio: This Ratio is a variation of the debt equity ratio and gives the same indication as the debt equity ratio. Significance- This ratio expresses the relationship between total assets and long term loans. It measures the extent to which long term loans are covered by assets which indicates the margin of safety available to providers of long term loans.
c. Proprietary Ratio:- This ratio indicates the proportion of total funds provide by owners or shareholders. Proprietary Ratio = Equity / Total assets Significance:- A higher proprietary ratio is generally treated an indicator of sound financial position from long term point of view, because it means that the large proportion of total assets is provided by equity and hence the firm Is less dependent on external sources of finance.
2|Page
d. Fixed Assets to Proprietor’s Fund Ratio:- This ratio is also know as fixed assets to net worth ratio. Fixed Asset to Proprietor’s Fund Ratio = Fixed Assets/Proprietor’s Funds
Significance:- The ratio indicates the extent to which proprietor’s
(Shareholder’s) funds are sunk into fixed assets. Normally , the purchase of fixed assets should be financed by proprietor’s funds. If this ratio is less than 100%, it would mean that proprietor’s fund are more than fixed assets and a part of working capital is provided by the proprietors. This will indicate the long-term financial soundness of business. e. Capital Gearing Ratio:-This ratio establishes a relationship between equity capital and fixed cost bearing capital. Capital Gearing Ratio = Equity Share Capital+ Reserves + P&L Balance/ Fixed cost Bearing Capital Significance:The high gearing will be beneficial to equity shareholders when the rate of interest/dividend payable on fixed cost bearing capital is lower than the rate of return on investment in business. Thus, the main objective of using fixed cost bearing capital is to maximize the profits available to equity shareholders.
f. Interest Coverage Ratio:- This ratio is also termed as ‘Debt Service Ratio’ Interest Coverage Ratio = Net Profit before charging interest and tax / Fixed Interest Charges Significance :- This ratio indicates how many times the interest charges are covered by the profits available to pay interest charges. This ratio measures the margin of safety for long-term lenders. An interest coverage ratio of 6 or 7 times is considered appropriate.
3|Page
(C) ACTIVITY OR TURNOVER RATIO These ratio are calculated on the bases of ‘cost of sales’ or sales, therefore, these ratio are also called as ‘Turnover Ratio’. a.Inventory Turnover Ratio:- This ratio indicates the relationship between the cost of goods sold during the year and average stock kept during that year. Inventory Turnover Ratio = Cost of Goods Sold / Average Stock Significance:-This ratio indicates whether stock has been efficiently used or not. It shows the speed with which the stock is rotated into sales or number of times the stock is turned into sales during the year. The higher the ratio, better it is, since the stock is selling quickly. b. Debtors Turnover Ratio :-This ratio indicates the relationship between credit sales and average debtors during the year . Debtor Turnover Ratio = Net Credit Sales / Average account recievable debt Significance :- This ratio indicates the speed with which the amount is collected from debtors. The higher the ratio, the better it is, since it indicates that amount from debtors is being collected more quickly. The more quickly the debtors pay, the less the risk from bad- debts, and so the lower the expenses of collection and increase in the liquidity of the firm.
c. Average Collection Period:- This ratio indicates the time with in which the amount is collected from debtors and bills receivables. Average Collection Period = Debtors + Bills Receivable / Credit Sales per day Significance :-Thisratio shows the time in which the customers are paying for credit sales. A higher debt collection period is thus, an indicates of the inefficiency and negligency on the part of management. On the other hand, if there is decrease in debt collection period, it indicates prompt payment by debtors which reduces the chance of bad debts.
4|Page
d. Creditors Turnover Ratio:- This ratio indicates the relationship between credit purchases and average creditors during the year . Creditors Turnover Ratio = Net credit Purchases / Average account payable Significance:- This ratio indicates the speed with which the amount is being paid to creditors. The higher the ratio, the better it is, since it will indicate that the creditors are being paid more quickly which increases the credit worthiness of the firm. e. Working Capital Turnover Ratio:- This ratio reveals how efficiently working capital has been utilized in making sales. Working Capital Turnover Ratio = Cost of Goods Sold / Working Capital Significance:- This ratio is important in non manufacturing concerns where current assets play major role in generating rules. This ratio reveals how efficiently working capital has been utilised in making sales.
5|Page
(D) Profitability Ratios or Income Ratios:-The main object of every business concern is to earn profits. ( a) Gross Profit Ratio: This ratio shows the relationship between gross profit and sales. Gross Profit Ratio =( Gross Profit / Net Sales) *100 Significance:- This ratio measures the margin of profit available on sales. No ideal standard is fixed for this ratio, but the gross profit ratio should be adequate enough not only to cover the operating expenses but also to provide depreciation, interest on loans, dividends and creation of reserves.
(b) Net Profit Ratio:-This ratio shows the relationship between net profit and sales. Net Profit Ratio = Net Profit / Net sales *100 Significance :-This ratio measures the rate of net profit earned on sales. It helps in determining the overall efficiency of the business operations. An increase in the ratio over the previous year shows improvement in the overall efficiency and profitability of the business.
(c) Operating Ratio:-This ratio measures the proportion of an enterprise cost of sales and operating expenses in comparison to its sales. Operating Ratio =( Cost of Goods Sold + Operating Expenses/ Net Sales) *100 Significance:-It is the measurement of the efficiency and profitability of the business enterprise. It indicates the extent of sales that is absorbed by cost of goods sold and operating expenses. Lower the operating ratio, better it is, because it will leave higher margin of profit on sales.
6|Page
(d) Earning Per Share (E.P.S.) :-This ratio measure the profit available to the equity shareholders on a per share basis
Earning Per Share = Net Profit – Dividend on Preference Shares / No. of Equity Shares
Significance:-This ratio helpful in the determining of the market price of the equity share of the company. The ratio is also helpful in estimating the capacity of the company to declare dividends on equity shares.
7|Page
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