Ratio Analysis

Megha Nagpal MBA II A

Ratio
A ratio is simply an arithmetical expression of the relationship of one number to another. According to Accountants Handbook by Wixon, Kell and Bedford, a ratio is an expression of the quantitative relationship between two numbers. For example, if the current assets of a firm on a given date are Rs. 5,00,000 and the current liabilities are Rs. 2,50,000, then the ratio of C.A to C.L will work out to be: 5,00,000 or 2:1 or 2 2,50,000

Use and Significance of Ratio Analysis.

Helps in decision making Helps in communicating Helps in co-ordination Helps in financial forecasting and planning Provide information of the company in respect of the liquidity, profitability, use of assets and capital structure

Uses contd..
Helps in Control - Appraise the performance of the company, make predictions for future performance and assist in future planning Eliminate the effects of the scale and size of different companies or different years of the same company so comparison can be provided.

Limitations of Ratio Analysis

Limited Use of a Single Ratio. Lack of Adequate Standards. Inherent Limitations of Accounting. Change of Accounting Procedures. Window Dressing. Personal Bias. Incomparable. Price Level Changes.

Classification of ratios..
Ratios can be broadly classified into four groups mainly : Liquidity Ratios Activity Ratios Profitability Ratios Capital Structure / Leverage Ratios

Liquidity ratios
Analyze the short term financial position The business ability to pay i.e. meeting short term commitments(liabilities) out of short term resources(assets) Also known as Solvency Ratios It is of two types:
Current ratio Quick ratio / Acid test ratio/ Liquid ratio

Current Ratio
It is calculated by dividing current assets by current liabilities Conventionally a current ratio of 2:1 is considered satisfactory

Acid test ratio

It is calculated by dividing quick current assets / liquid assets by current liabilities Liquid assets are current assets less stock and prepaid expenses Conventionally a quick ratio of 1:1 is considered satisfactory

Activity / Efficiency Ratios

Also called asset utilization ratios or turnover ratios Show relationship between sales and various assets of a firm The ratios under it are:
Inventory/stock turnover ratios Debtors turnover ratios Asset turnover ratios Creditors turnover ratios

Inventory Turnover Ratios

Indicates the number of times inventory is replaced during a year Relationship between cost of goods sold and inventory levels
Inventory turnover ratio =

Debtors turnover ratios

It shows relationship between credit sales and debtors In general, a high debtor turnover ratio is preferable

Debtors turnover ratio =

Asset turnover ratio

Depending on different concepts of assets employed , there are many variants of this ratio. These ratios measure the efficiency of a firm in managing and utilizing its assets

Asset turnover ratio contd..

Higher ratios are indicative of efficient management and low ratios are indicative of under utilization of resources and presence of idle capacity

Creditors turnover ratios

It shows the speed with which payments are made to the suppliers for the purchases made from them It shows relation between credit purchases and average creditors

Profitability ratios
These ratios measure the operating efficiency of the firm and its ability to ensure adequate returns to its shareholders Profitability ratios can be divided in two parts:
In relation to sales In relation to investments

Profitability ratios contd..

In relation to sales
Gross profit ratio Net profit ratio

In relation to investments
Return on assets Return on capital employed Return on shareholders equity Earnings per share Dividend per share Price earning ratio

Gross profit ratio

It is calculated by dividing gross profit by sales Expressed as a percentage It is the result of relationship between prices, sales volume and cost

Net profit ratio

It is calculated by diving net profit by sales It is indicative of a firms ability to leave a margin of reasonable compensation to the owners for providing capital after meeting all the costs
Net profit ratio = net profit after interest and taxes / net sales * 100

Return on assets(ROA)
It measures the profitability of the total funds of a firm Total assets exclude fictitious assets
Return on assets = net profit after taxes plus interest / total assets * 100

Return on capital employed (ROCE)

It measures relation between net profit and capital employed It indicates how efficiently the long term funds of owners and creditors are being used Capital employed includes share holders funds and long term borrowings
Return on capital employed = net profit after taxes plus interest / capital employed * 100

Return on shareholders equity

It measures the relationship of profits to owners fund

Return on shareholders equity = net profits after taxes /total shareholders equity *100

Earnings per share(EPS)

It measures the availability of profits to the equity shareholders on a per share basis

Earnings per share = net profit after tax preference dividend/number of equity shares

Dividend per share

It shows the dividend paid to the shareholder on a per basis share

Dividend per share = dividend paid to ordinary shareholders /number of equity shares

Price/earning ratio (P/E ratio)

It measures the expectations of the investors and market appraisal of the performance of the firm
Price earning ratio = market price per share / earning per share

Capital structure / leverage ratios

They indicate the long term solvency of a firm to meet its long term commitments The ratios that come in this category are:
Debt equity ratio Proprietary ratio Debt to total capital ratio Interest coverage ratio

Debt equity ratio

It indicates the relative proportion of debt and equity in financing the assets of the firm

Proprietary ratio
It indicates the general financial strength of the firm and long term solvency of the business

Proprietary ratio = proprietors funds/ total funds(assets)