[3.1] INTRODUCTION: Accounting ratios are helpful in assessing the financial position and profitability of a concern.

This is done through comparison by ratio which may be(i) (ii) (iii) (iv) (v) For the same concern ever a period of years. For one concern against another. For the concern against the industry as a whole. For one concern against the predetermined standards. For one department of concern against other department of the same concern.

[3.2] NATURE OF RATIO ANALYSIS: Ratio analysis is a powerful tool of financial analysis. A ratio is defined as the indicated quotient of two mathematical expressions. And as the relationship between two or more things. In financial analysis, a ratio Is used as an index or yardstick for evaluating the financial position and performance of a firm. Analysis of financial statements is a process of evaluating relationship between component parts of financial statements to obtain a better understanding of the firms position and performance. Financial analysis Is used as a device to analyze and interpret the financial health of enterprise. The absolute accounting figures reported in the financial statements do not provide a meaningful understanding of the performance and financial performance of a firm. An accounting figure conveys meaning when it is related to some other relevant information. A ratio is known as a symptom like blood pressure the pulse rate or the temperature of an individual. It is with the help of ratios that the financial statements can be analyzed more clearly and decision are drawn from such analysis. The point to note is that a ratio indicates a quantitative relationship. Which can be, in turn, used to make a qualitative judgment. Such is the nature of all financial ratio. [3.3] CONCEPT OF RATIO ANALYSIS: Ratio analysis is one of the techniques of financial analysis where ratios are used as a yardstick for evaluating the financial condition and performance of a firm. Ratio analysis is a powerful tool of financial analysis. A ratio analysis is defined as the process of determining and interpreting numerical relationship based on financial statements. According to Betty, The term accounting ratio is used to describe significant relationship which exist between figures shown on a balance-sheet, in a profit and loss account, in a budgetary control system by Hunt, Williams and Donaldson, Ratio are simply a means of highlighting in arithmetical terms the relationship between figures drawn from financial statements. In the words of Kuchhal, A ratio is the indicated quotient of two mathematical expressions and as the relationship between two or more things. In the words of Helfert, Ratio analysis provides guides and clues especially in sporting trends towards better or poor performance and in finding out significant deviation from any average or relatively applicable standard.

Thus, a ratio helps the analyst to make qualitative judgment about the firms financial position and performance. Ratios are simple to calculate and easy to understand. [3.4] CLASSIFICATION OF RATIO ANALYSIS: Several ratios, calculated from the accounting data of the financial statements are classified into various groups according to their functions. They can be classified into the following four categories. (1) (2) (3) (4) Liquidity ratios. Leverage ratios. Activity ratios. Profitability ratios.

[3.4.1] Liquidity Ratios:Liquidity ratios measure the ability of the firm to meet its current obligations. In fact, analysis of liquidity needs the preparation of cash budgets and cash and fund flow statements but liquidity ratios by establishing a relationship between cash and other current assets to current obligations provide a quick measure of liquidity. Liquidity is a pre-requisite for the very survival of a firm. The short-term creditors of a firm are interested in the short-term liquidity of a firm. However, firm is interested in maximizing its profits. So, proper balance between liquidity and profitability is required for efficient financial management. The most common ratios which indicate the extent of liquidity are (i) Current ratio, (ii) Quick ratio. [3.4.1.1] CURRENT RATIO: (a) Meaning: Current ratio is also called working capital or 2:1 ratio. It is related to the working capital of the firm. This ratio is calculated by dividing current assets by current liabilities. (b) Components: The current assets are those assets which can be converted onto cash in a short period of time. It includes cash and bank balance, marketable securities, inventory of raw materials, semi-finished [work-in-progress] and finished goods, sundry debtors, bills receivables and pre-paid expenses, etc. The current liabilities are short-term maturity obligations to be met within an year. It includes trade creditors, bills payable, bank credit, provision for taxation, dividends payable, outstanding expenses, etc. (c) Formula: Current Ratio = Current Assets Current Liabilities

(d) Importance: The current ratio measures short-term financial solvency which is a rough measure of liquidity of a firm. It is a quantitative rather than qualitative index of liquidity. The term quantitative refers to the fact that it takes into account the total current assets without making any distinction between the various types of current assets such as cash, inventories, etc. An extremely high ratio signals excessive inventories for the current requirements anfd poor credit management in terms of over extended accounts receivable. Conventionally, a current ratio of 2:1 is considered ideal. The logic is that even with a drop-out of 50% in the value of current assets a firm can meet its obligations. [3.4.1.2] QUICK RATIO: (a) Meaning: This ratio is also known as a Acid-test ratio. Quick ratio is measure of liquidity. In this ratio a firm converts its current assets quickly into cash in order to meet its current liabilities. The acid-test ratio is between quick assets and quick liabilities. It is calculated by dividing quick assets with the quick liabilities. (b) Components: Liquid assets would include cash, debtors after providing for bad and doubtful debts and securities which can be realized without difficulty. Liquid or quick liabilities refer to current liabilities less bank overdraft. Inventories are not included in current assets. The short-term creditors would use ratio for ascertaining the current financial position of the business unit and the long-term solvency of the business unit. These ratios are also used to analyse the capital structure of the business unit. They indicate the pattern of financing and also whether long-term requirements have been met with long-term fund or not. (c) Formula: Quick Ratio = Quick Assets Quick Liabilities (d) Importance: This ratio is a more rigorous test of liquidity than the current ratio and when used in conjuction it gives a better picture of the firms ability to meet its short-term debts out of short-term assets. Generally a quick ratio of 1:1 is considered to represent ideal current financial condition. It is to be noted that, though inventories are not available to meet liquid liabilities, they can be used as a measurable extent to meet current liabilities because of their normal conversion into cash and

bills receivable as well as due to their conversion at a profit in the ordinary course yielding a large amount of cash. [3.4.2] Leverage Ratios: The short-term creditors are interested to ascertain the current financial position of the business unit and the long-term creditors to examine the long-term solvency of the business unit. A firm should have strong short-term as well as long-term financial position of the firm, financial leverage ratios are calculated. These ratios explain how the capital structure of a firm is made up or the debtequity mix adopted by the firm. The following ratios fall in this category: (1) Debt- equity ratio. (2) Proprietary ratio. (3) Interest coverage ratio. [3.4.2.1] Debt-equity ratio: (a) Meaning: This ratio is also known as External Internal Equity-ratio. It is determined to measure the firms obligation to creditors in relation to the funds invested by the owners. (b) Components: This ratio measures relationship between debt and equity- two different types of sources of funds. Debt includes secured loans and unsecured loans. Equity includes shareholders funds by way of paid up capital as well as reserve and surplus. Debt-equity ratio can be in terms of long-term debt and total debt. Long-term debt include debentures, financial assistance by way of term loans from financial institutions, banks etc. It also includes unsecured loans by way of deposits from the prospective buyers, etc. (c) Formula: Debt-Equity Ratio = Long-term debts Shareholders Funds (d) Importance: This ratio enables one to ascertain the proportion of shareholders funds in the business. The ratio indicates the extent of assets cushion available to creditors on liquidation. An acceptable norm for this ratio is considered to be 1:1. If the owners interest is greater than one of creditors the financial position is considered to be sound i.e. the business position is highly solvent. It enjoys the same importance as the current ratio has in analysis or the short-term financial position. [3.4.2.2] Proprietary Ratio:

(a) Meaning: This ratio relates the shareholders funds to total assets. It is calculated by dividing the shareholders funds by the total tangible assets. It indicates the long-term solvency of the business. (b) Components: Shareholders funds include preference and equity share capital plus reserve and surplus. Total asset include goodwill as assets. If goodwill is excluded from total assets than the total shareholders funds are to be divided by total tangible assets. Since total assets equals total liabilities it can be used as a denominator in the same formula. (c) Formula: To find out this ratio, following formula is used : Proprietary Ratio = Shareholders Funds Total Assets (d) Importance: This ratio is of greater importance to creditors, since it enables them to find out the proposition of shareholders funds in the total assets used in the business. A ratio above 50% is generally considered safe for the creditors. [3.4.2.3] Interest Coverage Ratio: (a) Meaning: This ratio is also known as debt service ratio. It is calculated by dividing the operating profits or earnings before interest and taxes[EBIT] by the fixed interest charges on loans. (b) Components: This ratio is calculated from profit and loss account. This ratio measures the relationship between what is normally available from operation of the firms and claims of the outsiders. The two variables involved in this ratio are fixed interest and net profit. There is some controversy regarding the meaning of the term net profit whether the item to be taken into account is before or after the deduction of income tax. Though arguments can be advanced on either side of the case, it is certain that the earning before income-tax is only to be used for the computation of the ratio. Since income-tax is computed after interest, interest coverage is calculated in relation to before tax earnings. (c) Formula: Interest Coverage Ratio = EBIT Fixed Interest

(d) Importance: This ratio gives an idea of the extent to which firms earning may contract before it is unable to meet interest payments out of current earnings. It is used in external financial analysis. [3.4.3] ACTIVITY RATIO: These ratios involve comparisons between the level of sales and the investment in various assets accounts. The activity ratios presume that a proper balance should exist between sales and the various assets, accounts inventories, accounts receivable, fixed assets and others. These ratios are also called. turnover ratios because they indicate the speed with which assets are being turned or converted into sales. Different activity ratios are calculated to judge the effectiveness of assets utilization. The details note of all these ratios are given below. (1) (2) (3) (4) (5) Inventory or stock turnover ratio. Debtors turnover ratio. Assets turnover ratio. Working capital turnover ratio. Total capital turnover ratio,

[3.4.3.1] INVENTORY OR STOCK TURNOVER RATIO: (a) Meaning: This ratio is also known as stock turnover ratio. It establishes relationship between cost of sales and average inventory. This ratio indicate whether investment in inventory is within its proper limit or not. Besides being an index of liquidity of firm it shows the rate at which inventories are converted into sales and then into cash. This ratio helps the finance manager to evaluate an inventory policy. (b) Components: Average inventory and the net sales are the constitutes of the ratio. Average inventory is calculated by taking inventory level at the opening date plus inventory levels at the end of each month, adding them up and dividing by thirteen. If the monthly figures are not available, then the average inventory is derived by adding stock levels at the opening and closing dates and dividing by two. Net sales means sales less return. Some firms like departmental stores which value inventories at selling price under retail method, computes this ratio. (c) Formula: Inventory Turnover Ratio = Net Sales Average Inventory (d) Importance:

Inventory turnover ratio is an effective tool to measure the liquidity of inventory. A low inventory turnover may reflect dull business, over investment in inventory, accumulation of large stocks, etc. Which high inventory turnover ratio indicates active sales. An inventory turnover ratio standing by itself means absolutely nothing. This ratio should be compared with similar ratios in the previous periods or with the ratio of other similar firms. [3.4.3.2] DEBTORS TURNOVER RATIO: (a) Meaning: This ratio is also known as Receivables Turnover Ratio. This ratio indicates the rate at which cash is generated by turnover receivables or debtors. This ratio together with average collection period, involves the following steps: (i) Calculation of daily sales: This is obtained by dividing number of working days in a year into net credit sales for the year. Cal ulation of average collection period: This is done by sales per day, as calculated in step-1, into the amount of trade debtors.

(ii)

(b) Components: Sometimes the ratio is computed from the average of debtors at the beginning and at the end of the year. In such case, comparison of the collection period of two companies would be more appropriate if both of them have the same proportion between cash and credit sales. (c) Formula: Debtors Turnover Ratio = Trade Debtors Credit Sales (d) Importance: The main objective of comparison in the debtors turnover ratio is to known how old the accounts are and partly to know how fast cash would flow in their collection. The amount of trade debtors at the end of an accounting period should not exceed a reasonable proportion of net sales. Debtors turnover ratio is an enabling device to find out as to how many days of average sales are tied up in the value of amounts owned by debtors according to balance- sheet. [3.4.3.3] ASSETS TURNOEVR RATIO: There are two types of assets turnover ratio. (i) Fixed Assets Turnover Ratio: (a) Meaning: * no. of working days [360]

In this ratio the fixed assets may be taken at original cost or present market value depending upon the object of the comparison. (b) Formula: Fixed Assets Turnover Ratio = Net Sales Fixed Assets (c) Importance : If the ratio is too high, it shows that the firm is over-trading on its assets. On the contrary if it is too low, it represents that the firm has made excessive investments in fixed assets.

(ii) TOTAL ASSETS TURNOVER RATIO: (a) Meaning: This ratio is calculated by dividing the sales by total assets. (b) Formula: Total Assets Turnover Ratio =

Sales Total Assets

(c) Importance: This ratio indicates the sales generated from investment in total assets. This ratio shows the ability of generating sales from all the financial resources available to the firms.

[3.4.3.4] WORKING CAPITAL TURNOVER RATIO: (a) Meaning: This ratio is calculated by dividing net sales by net working capital. (b) Formula: Working Capital Turnover Ratio = Net Sales Net Working Capitulate (c) Importance: This ratio gives the idea about relationship between total capital employed and net sales. Higher ratio indicates that against total capital employed net sales achieved is more and hence sources are utilized efficiently.

[3.4.4] PROFITABILITY RATIOS:

Profitability is an indication of the efficiency with which the operations of the business are carried out. The profitability of a firm can be measured by its profitability ratios. The amount and rate of profits earned depend upon the quantum of investment committed, so the profitability ratios can be calculated on the basis of their sales or investment. Owners are interested to know the profitability as it indicates the return which they can get on their investment. The profitability ratios in relation to sales are (1) Gross profit ratio, (2) Net profit ratio, (3) Expenses or Operating ratio. While profitability ratios related to investments are (1) Return on assets ratio, (2) Return on shareholders equity or investment ratio. The profitability in relation to sales can be used to assess the ability of the firms management to control the various expenses involved in generating sales. [3.4.4.1] GROSS PROFIT RATIO: (a) Meaning: This ratio expresses the relationship between gross profit and net sales. (b) Components: The basic components of gross profit ratios are net sales and gross profit. Net sales means total sales minus sales return. Gross profit is the difference between net sales and cost of production. In case of trading concern the cost includes opening stock plus purchases minus closing stock plus all direct expenses to purchases. For manufacturing concern, it will be equal to the sum of the cost of raw materials, wages, direct expenses and all manufacturing expenses. (c) Formula: Gross Profit Ratio = Gross Profit Net Sales (d)Importance: This ratio indicates the average spread between the cost of goods produced and the sales revenue. When the gross profit margin is substituted from 100%, the ratio of cost of goods produced to sales is obtained. This ratio shows profit relative to sales after the deduction of production cost and indicates the relation between production cost and selling price. In case, there is an increase in the percentage of gross profit as compared to the previous years, it may be because of one or more of the following reasons: (i) (ii) The selling price of the goods may have gone up without corresponding increase in the cost of goods produced. The cost of goods produced may have gone down without corresponding decrease in the selling price of the goods. *100

(iii)

Purchases might have been omitted or the sales figure might have been inflated.

In case, if there is a decrease in the rate of gross profit, it may be due to one or more of the following reasons: (i) (ii) (iii) (iv) There may be omission of sales. There may be decrease in the selling price of the goods sold without corresponding decrease in the cost of goods produced. There may be increase in the cost of goods produced without corresponding increase in the selling price of the goods sold. Stock at the end may be undervalued or the opening stock may be overvalued.

The analysis of these factors would reveal to the management how a depressed gross profit ratio could be improved. A high gross profit ratio is a sign of good management and hence low gross profit ratio should be carefully investigated. [3.4.4.2] NET PROFIT RATIO: (a) Meaning: This ratio is known as profit margin or return on sales ratio. It measures the relationship between net profit and net sales of a firm. Net profit ratio indicates what portion of sales is left to the proprietors after meeting all expenses. (b) Components: Net profit is the balance of profit and loss account which is arrived at after considering all nonoperating incomes such as on investment, dividend received, and non-operating expenses like loss on sale of investments. (c)Formula: Net Profit = Net Profit After Taxes And Interest Net Sales (d)Importance: This ratio is very useful to measure the overall profitability. The ratio indicates the managements efficiency in manufacturing, administration, and selling of products. If the net profit is low, the firm will fail to achieve satisfactory return on owners equity. This ratio indicates the firms capacity to withstand against adverse economic conditions. A firm with high net profit margin can make better use of favorable conditions. [3.4.4.3] OPERATING OR EXPENSES RATIO: (a) Meaning:

This ratio is complementary of net profit ratio. In case, the net profit ratio is 20%, it means that the operating ratio is 80%. This ratio is the test of the operational efficiency with which the business is being carried on. There are different concepts of operating expenses such as- (i) total expenses including cost of goods sold, selling, general and administrative expenses etc., (ii) cost of goods sold, and (iii) specific operating expenses. (b) Components: The main items are operating cost [cost of goods produced plus operating expenses] and net sales. Operating expenses normally include the following items: (i) (ii) Office and administrative expenses. Selling and distribution expenses.

Financial charges such as interest provision for taxation etc. are generally exclude from operating expenses. (c)Formula: Operating Ratio = Cost Of Goods Sold Net Sales (d)Importance: This ratio is very important for analyzing the profitability of a concern. A high operating ratio is not good since it would leave a small amount of operating income to meet interest, dividends etc. For getting a proper idea of behavior of operating expenses, the ratio has to be compared with different companies. The variations in operating ratio may occur due to different factors which are as follows: (i) (ii) (iii) (iv) Changes in the sales price. Changes in the dividend for the product. Changes in cost of goods sold and operating expenses. Changes in the proportionate shares of sales of different products with varying gross margins. The expense ratio of a firm should be compared with the ratios of other similar firms and the industry average. This will give an idea about (i) (ii) (iii) (iv) (v) Whether the firm is paying higher or lower salaries to its employees or officers with respect to other firms. Whether its capacity utilization is high or low. Whether the salesmen are getting enough commission. Whether it is unnecessarily spending or advertisements and other sales promotional activities. Whether its cost of production is high or low etc. *100

Profitability Ratios Related To Investments: This category of probability ratios attempts to measure firms profits in relation to the invested funds used to generate those profits. These ratios are very useful in assessing the overall effectiveness of the firms management. [3.4.4.4] RETURN ON ASSETS (ROA) RATIO: (a) Meaning: This ratio is the ratio of net profit to total assets. It is also known as profit to assets ratio. (b) Formula: Return On Assets Ratio = Net Profit After Taxes Total Assets (c)Importance: The return on assets is a useful measure of the profitability of all financial resources invested in the firms assets. This ratio is mainly useful to evaluate the performance of divisions in multidimensional firm. *100

RETURN ON SHAREHOLDERS EQUITY RATIO: [3.4.4.5] Earning Per Share (EPS) Ratio: (a) Meaning: The profitability of equity shareholders investment can be measured in other ways also. One such measure is to calculate earnings per share. It is calculated by dividing net profit after taxes and preference dividend by total number of shareholders. (b) Formula: Earning Per Share [EPS] Ratio = Net Profit After Taxes-Preference Dividend No. Of Equity Shares (c)Significance: EPS simply shows the profitability of the firm on per share basis. It does not reflect how much is paid as dividend and how much is retained in the business. As a profitability ratio the EPS can be used to draw inferences on the basis of-

(i) (ii) (iii)

Its trend over a period of time. Comparison with the EPS of the other firms. Comparison with the industry average.

[3.5] SIGNIFICANCE OF RATIO ANALYSIS: Many people are interested in analyzing the financial information to indicate the operating efficiency and the various aspects of the firms financial position. These ratios are used to determine a particular financial characteristic of the firm in which they are interested. Ratio analysis is relevant in evaluating the performance of a firm in determining some important aspects which are as follows: [3.5.1] Short-term Solvency: With the help of liquidity ratio analysis conclusions can be drawn regarding the liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its current obligations when they become due. A firm can be said to have the ability to meet its short-term liabilities if it has sufficient liquid funds to pay the interest and short-term debts maturing within one year. It is useful to the banks for credit analysis and for sanction of short-term loans. [3.5.2] Long-term Solvency: The financial position of a borrower is of concern to the long-term creditors, security analyst and present and potential owners of the business. The long-term solvency is measured by leverage or capital structure and profitability ratios which throw light on earning power and operating efficiency of the firm. The leverage ratios indicate whether a firm has reasonable proportion of finance or is heavily loaded with debt. [3.5.3] Operating Efficiency: Another usefulness of the ratio analysis is that it throws light on the degree of efficiency in the management and proper utilization of assets. Various activity ratios measure this kind of operational efficiency. For instance, solvency of a firm depends upon sales revenue by use of its assets both total and component-wise. [3.5.4] Overall Profitability: The management of a firm is concerned with the overall profitability i.e. they are concerned about the ability of the firm to meet its short-term and long-term obligations to its creditors and to ensure a reasonable return to its owners and secure optimum utilization of the assets of the firm. This can become possible only when an integrated view is taken and all the ratios are considered together. [3.6] USES OF RATIO ANALYSIS:

Ratio analysis enables a firm to take the time dimension into account. Using trend analysis, one can know whether the financial position of a firm is improving or deteriorating. The significance of a trend analysis of a ratio lies in the fact that the analyst can know the direction of movement i.e. whether the movement is favorable or unfavorable. Ratio analysis enables one to summaries and simplify and the mass of accounting data. Moreover, they provide the means of showing the inter-relationship which exists between various segments of business and thereby prevent any distortions that may result from the study of absolute figures. Ratio analysis is also beneficial to the management in considering of its basic functions like planning, forecasting, control etc. The trend ratios may be useful for predicting likely events in the future. Ideal ratios can be establish and the relationship between primary ratios may be used to establish the desirable co-ordination. Ratios may also be used for control of costs. Ratios are an effective means of communication. It plays an important role in informing the position of progress made by the business concern to the owners or other parties. Ratio analysis can be used as an effective weapon to assess important characteristics of business like liquidity, solvency, profitability, operational efficiency etc. It is the main tool of analysis for intra-firm and inter-firm comparisons. It is beneficial if used properly. [3.7] LIMITAIONS OF RATIO ANALYSIS: The ratio analysis is a widely used technique to evaluate the financial position and performance of a business. But there are certain problems in using ratios. The analyst should be aware of these problems. The following are some of the limitations of the ratio analysis: [3.7.1] Ratio analysis is based on financial statements which themselves are subject to certain limitations. Therefore, any ratio analysis based on such statements suffers from similar limitations. [3.7.2] In the case of inter-firm comparison no two firms are similar in age, size and product unit. So, any comparison of ratios of two such firms must take these factors into account. [3.7.3] Both the inter-period and inter-firm comparisons are affected by price level changes. A change in price-level can affect the validity of ratios calculated for different time periods. In such a case the ratio analysis may not clearly indicate the trends in solvency and profitability of the company. [3.7.4] Unless various terms like gross profit, operating profit, net profit, current assets, current liabilities etc. are properly defined comparisons become meaningless. This problem is now being solved with the adoption of International Accounting Standards. Difference in accounting policies with reference to stock valuation depreciation and other matters can also create problems in the matter of inter-firm comparison and also inter-period comparison.

[3.7.5] Ratio analysis is based on the balance-sheet prepared on the accounting data. This practice, in some cases, may lead to window dressing to cover up bad financial position. So, ratios based on such figures are not reliable. It is, therefore, preferable for the analyst to base his ratios on the average figures rather than the figures pertaining to the accounting data. [3.7.6] Ratios are simple to understand and easy to calculate. Therefore, there has been a tendency to over employ them. However, it should be clearly understand that ratios are only tools. Personal judgment of analyst is more important. Again the analyst should not merely rely on a single ratio. He has to take several ratios into account before reaching the conclusion. [3.7.7] Conclusions from analysis of statements are not sure indicators of bad or good management. They merely convey certain observations pointing to the probability of matters needing investigation. [3.7.8] Ratio analysis is only a tool and is helpful in spotting out the symptoms. The analyst has to carry out further investigations and exercise his judgment in arriving at a correct diagnosis.