RATIO ANALYSIS

 Meaning & Definition

• Ratio: The term ratio refers to the numerical or quantitative relationship between two items / variables.

• According to Wixon, Kell and Bedford, “a ratio is an expression of the quantitative relationship between two numbers’

• Ratio Analysis: the process of determining and interpreting numerical relationship b/w figures of the financial statements.

Nature of ratio analysis

• Powerful tool for financial analysis• Helps analyze financial statements more clearly• They are not deciding factor , rather help to take

correct decisions. • Serve as indicators of financial strength,

soundness,weakness & position of a concern• Figures convey much meaning when studied in

relation to one another

Inter-Firm & Intra-Firm comparison

• Inter-firm comparison refers to comparison of two or more firms organized by a trade association with the objective of providing information regarding the competitive position of participating companies to improve productivity & profitability.

• Intra-firm comparison refers to the comparison of the different department or divisions belonging to a single firm with a view of ascertaining the strength & weaknesses of the different departments.

Conditions for inter-Firm comparison

• Similarities of firm – nature, size, age, capital, product…

• Uniformity in accounting procedure – inventory, depreciation

• Disclosure of information • Use of accounting ratios for comparison.• The success depends on cooperation of all

participating firms, confidentiality, full disclosure by all firms.

Advantages of Ratio analysis

• Important technique of financial analysis• Helps in judging financial health of a firm• Helps in decision-making• Useful in simplifying accounting figures• Useful in judging operating efficiency• Useful in forecasting & planning• Useful in locating weak areas• Useful in in comparison of performance• Useful to all stakeholders

Limitations of Ratio Analysis

• Limited use of a single ratio - Comparative study required

• Limitations of financial statements • Only quantitative aspects• Lack of adequate standards• Problems of price level changes• Changes in accounting procedures / polices• Personal bias• Ratios devoid of absolute figures may distort facts.

CLASIFICATIONOF RATIOS

Traditional Classification

FunctionalClassification

SignificanceRatios

a. Balance sheet Ratios

b. P & L A/C Ratios

c. Composite Ratios

a. Profitability Ratios

b. Turnover Ratios

c. Liquidity Ratios

d. Long-term solvency / Leverage Ratios

a. Primary Ratios

b. Secondary Ratios

Profitability Ratios

Based on Sales• Gross Profit ratio• Operating ratio• Operating profit ratio• Net profit ratio• Expense ratio

Based on Investments• Return on investment• Return on capital

employed• Return on shareholder’s

equity• Return on Equity

shareholder’s funds• Return on total Assets• Earnings per share• Price-Earning ratio

Turnover ratios1. Inventory / Stock turnover ratio

2. Debtors turnover ratio/Debtors velocity

3. Debt collection period

4. Creditors turnover ratio/Creditors velocity

5. Debt payment period

6. Fixed Assets turnover ratio

7. Total Asset turnover ratio

8. Capital turnover ratio

9. Working Capital turnover ratio

Liquidity Ratios1. Current Ratio2. Liquid ratio/ Acid test ratio / quick ratio3. Absolute liquid or Cash ratio

Leverage Ratios1. Debt-Equity ratio2. Debt to Shareholders equity3. Debt to total funds ratio4. Proprietary Ratio5. Capital Gearing ratio6. Interest Coverage ratio7. Dividend coverage ratio

Profitability Ratios

• Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner: -

• Gross Profit Ratio = Gross Profit/Net Sales x 100

• Where Gross Profit = Net Sales – Cost of Goods Sold

• Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock

• And Net Sales = Total Sales – Sales Return

Gross Profit Ratio

• Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses.

• It is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realisation of fixed expenses of the business.

Net Profit Ratio:

• Net Profit Ratio shows the relationship between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner: -

• Net Profit Ratio = Net Profit/Net Sales x 100• Where Net Profit = Gross Profit – Selling and

Distribution Expenses – Office and Administration Expenses – Financial Expenses – Non Operating Expenses + Non Operating Incomes.

• And Net Sales = Total Sales – Sales Return

Net Profit Ratio:

• Objective and Significance:

This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years’ ratios, the increment shows the efficiency of the concern.

Operating Profit Ratio:

• Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner: -

• Operating Profit Ratio = Operating Profit/Net Sales x 100

• Where Operating Profit = Gross Profit – Operating Expenses

• Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes

• And Net Sales = Total Sales – Sales Return

• Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.

Operating Ratio:

• Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses.

• Operating Ratio = Operating Cost/Net Sales x 100• Where Operating Cost = Cost of goods sold + Operating

Expenses• Cost of Goods Sold = Opening Stock + Net Purchases +

Direct Expenses – Closing Stock• Operating Expenses = Selling and Distribution

Expenses, Office and Administration Expenses, Repair and Maintenance.

• Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit.

Return on Investment or Return on Capital Employed

a. This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.

• Return on Capital Employed = Net Profit before Interest, Tax and Dividend/Capital Employed x 100

• Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets. OR

• Capital Employed = Fixed Assets + Current Assets – Current Liabilities

Objective and Significance

• ROCE measures the profit, which a firm earns on investing a unit of capital.

• The return on capital expresses all efficiencies and inefficiencies of a business.

• To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working.

• This ratio influences the market price of the shares.

• The higher the ratio, the better it is.

Return on Equity

a. The ratio establishes relationship between profit available to equity shareholders with equity shareholders’ funds.

• Return on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders’ Funds x 100

• Where Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Fictitious Assets

Objective and Significance

• Return on Equity judges the profitability from the point of view of equity shareholders.

• This ratio has great interest to equity shareholders.

• The investors favour the company with higher ROE.

Earning Per Share

• Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares.

• Earning Per Share = Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares

Objective and Significance

• EPS helps in determining the market price of the equity share of the company.

• It also helps to know whether the company is able to use its equity share capital effectively when compared to other companies.

• It also tells about the capacity of the company to pay dividends to its equity shareholders.

Price-Earning ratio

• Price-Earning ratio = Market Price per Share

                                   Earning per Share• Indicates:

* Price which investors are ready to pay for every rupee of earning