Meaning - Ratio Analysis is a study of relationship among various financial factors in a business.
Objective - The objective of ratio analysis is to judge the earning capacity, financial soundness and operating efficiency of a business organisation.
Classification
i) Income Statement Ratios - These ratios are calculated on the basis of the amounts of income statement (Profit & Loss Account) only. Ex - gross profit ratio, net profit ratio, stock turnover ratio etc.
ii) Position Statement Ratios - These ratios are calculated on the basis of the amounts of position statement (Balance Sheet) only. Ex - current ratio, debt equity ratio etc.
iii) Inter-Statement Ratios or composite Ratios - These ratios are based on amounts of income statement as well as position statement. Ex - fixed assets turnover ratio, net profit to capital employed ratio etc.
iv) Liquidity Ratios - These ratios measure the short term solvency i.e the firm's ability to pay current dues.
v) Solvency Ratios - The term solvency implies ability of an enterprise to meet its long term indebtedness and thus solvency ratios convey an enterprises ability to meet its long term obligations.
vi) Activity Ratios - Activity Ratios also termed as Performance or Turnover Ratios, judge how well the facilities at the disposal of enterprise are being utilised. In other words, these ratios measures the effectiveness with which a concern uses resources at its disposal.
1. Current Ratio - Current Ratio is a relationship of current assets to current liabilities and is computed to assess the short-term financial position of the enterprise. It means current ratio is an indicator of the enterprise's ability to meet its short terms provisions since the ratio assumes that current assets can be converted into cash to meet its current liabilities.
A lower ratio indicated that the enterprise may not be able to meet its current liabilities on time and inadequate working capital. On the other hand a high ratio indicates funds are not used efficiently and are lying idle.
Current Ratios is calculated on a particular day not for a particular period.
2. Liquidity Ratio - Liquidity Ratio is a relationship of liquid assets with current liabilities and is computed to assess the short term liquidity of the enterprise in its correct form.
Liquid assets are those assets which are either in the form of cash or cash equivalents or can be converted into cash within a very short period. Liquid assets can be computed by deducting stock and prepaid expenses from current assets. Stock is excluded because it takes some time to be converted into cash and prepaid expenses are also not included because they do not provide cash at all.
This ratio is an indicator of short term debt paying capacity of an enterprise and thus better indicator of liquidity. This ratio is very important for banks and financial institutions but not for manufacturing concerns. The comparison of current ratio and liquidity ratio indicate the degree of inventory held.
3. Debt Equity Ratio - Debt Equity ratio is computed to ascertain the soundness of the long-term financial position of the firm. This ratio expresses a relationship between debt (external equities) and the equity (internal equities). Debt means long term debt i.e debentures, loan from financial institutions. Equity means shareholders funds i.e preference share capital, equity share capital, reserves less losses and fictitious assets like preliminary expenses.
A high debt equity ratio indicates a risky financial position while a lower ration indicates safer financial position. A lower debt equity ratio indicates use of more equity than debt which means a larger margin of safety by creditors and vice versa.
It also indicates the extent to which the enterprise depends upon outsiders for its existence.
4. Total Assets to Debt Ratio - Total Assets to Debt Ratio establishes a relationship between total assets and total long term debts.
Total Assets includes fixed as well as current assets. However, it does not include fictitious assets like preliminary expenses, underwriting commission, share issue expenses, debit balance of profit & loss account etc.
Long term Debts refers to debts that will mature after one year. It includes debentures, bonds, loans from financial institutions.
It measures the safety margin available to the providers of long term debts. It measures the extent to which debt is covered by assets. A higher ratio represents higher security to lenders for extending long term loans to the business. On the other hand, a low ratio represents a risky financial position as it means that the business depends heavily on outside loans for its existence.
5. Proprietary Ratio - Proprietary Ratio establishes the relationship between proprietor's funds and total assets. Proprietor's funds means share capital plus reserves and surplus, both of capital and revenue nature. Loss and fictitious assets are to be deducted. This ratio shows the extent to which shareholders own the business. The difference between this ratio and 100 represents the ratio of total liabilities to total assets.
It highlights the general financial position of the enterprise. This ratio is of particular importance to the creditors who can ascertain the proportion of shareholders funds in the total assets employed in the firm.
A high ratio indicates adequate safety for creditors. But a very high ratio indicates improper mix of proprietors funds and loan funds, which results in lower return on investment. A low ratio indicates inadequate or low safety cover for the creditors. It may lead to unwillingness of creditors to extend credit to the enterprise. It is so because in case of liquidation creditors being unsecured are likely to loose their money.
6. Inventory Turnover Ratio - Inventory Turnover Ratio establishes the relationship between the cost of goods sold during a given period and the average amount of inventory carried during that period. It indicates whether the investment in stock has been efficiently used or not, the purpose being to check whether only the required minimum amount is invested in stocks.
The objective of computing inventory turnover ratio is to ascertain whether investment in stock has been judicious or not i.e that only the required amount is invested in stock. A high ratio indicates that more sales are being produced by a rupee of investment in stocks. A very high inventory turnover ratio indicates overtrading and it may lead to working capital shortage. A low inventory turnover ratio indicates inefficient use of investment, over investment in stocks, accumulation of stocks at the end of period in anticipation of higher prices or unsaleable goods etc. A reasonable inventory turnover ratio ensures working capital and also enables the business to earn a reasonable margin of profits.
7. Debtor Turnover Ratio or Receivables Turnover Ratio - Debtor Turnover Ratio establishes the relationship between net credit sales and average debtors of the year. While calculating debtor turnover of a company, it is important to remember that doubtful debts are not to be deducted from total debtors, since here is the purpose to calculate number of days for which sales are tied up in debtors and not the realizable value of debtors.
This ratio indicates the number of times the receivables are turned over in a year in relation to sales. It shows how quickly debtors are converted into cash and thus indicates the efficiency of the staff entrusted with collection of amounts due from debtors.
A high ratio is better since it would indicate that debts are being collected more promptly. Prompt collection of book debts means more available funds which can be put to some other use. A lower ratio would indicate inefficiency in collection and more investment in debtors than required.
8. Creditors or Payables Turnover Ratio - Creditors Turnover Ratio shows the relationship between net credit purchases and total payable or average payable, whereas average payment period or creditors velocity signifies the credit period enjoyed by the enterprise in paying creditors.
Average payment period is calculated by dividing Total or Average Payable by Net Credit Purchases and multiplied by number of months/ days in a year.
The objective of calculating creditors turnover ratio is to establish the the number of times the creditors are turned over in relation to purchases.A high turnover ratio or shorter payment period represents the availability of less credit or early payments. A high ratio also indicates that enterprise is not availing the full credit period. This boosts up the credit worthiness of the firm. A very low turnover ratio or longer payment period implies availability of more credit or delayed payments. Thus, the lower the ratio, the better is the liquidity position of the firm and higher the ratio, the lesser is the liquid position of the firm.
9. Working Capital Turnover Ratio - This ratio establishes the relationship between working capital and sales. It indicates the number of times a unit invested in working capital produces sales. This ratio indicates whether working capital has been effectively utilised or not.
The objective of computing the ratio is to ascertain whether or not working capital has been effectively utilised in making sales. In other words, it measures the effective utilisation of working capital. It also shows the number of times a unit is invested in working capital produces sales.
10. Fixed Assets Turnover Ratio - This ratio establishes the relationship between Net Sales and Fixed Assets indicating how efficiently they have been used in achieving the sale.
The objective of computing fixed assets turnover ratio is to establish whether the investment in fixed assets is justified in relation to the sales achieved. A high ratio indicates efficient utilisation of fixed assets. On the other hand, a low ratio indicates inefficient utilisation of fixed assets. If there is a fall in the ratio, it indicates that fixed assets remained idle and therefore, the management should investigate and determine the reason for decline.
11. Gross Profit Ratio - This ratio establishes the relationship between gross profit and nest sales (both cash and credit sales) minus sales returns.
The gross profit is what is revealed by the Trading Account. It results from the difference between net sales and cost of goods sold without taking into account the expenses charged to profit and loss account. A decline in gross profit ratio is a major concern and it may be due to following reasons:
a) The prices of materials may have gone up or wages may have increased and the selling price may not have increased in proportion to it.
b) The selling price may have fallen without there being a relative fall in the prices of material or wages.
c) The closing stock may have taken wrongly or wrongly valued. The gross profit and the gross profit ratio will fall if the stock is undervalued.
d) Misappropriation of goods, so that the firm pays for them but someone else takes them away.
GP Ratio is a reliable guide to the adequacy of selling prices and efficiency of trading activities.
The objective of working gross profit ratio are:
a) To determine the selling prices so that there is adequate gross profit to cover the operating expenses, fixed charges, dividends and building up reserves.
b) To determine, how much the selling price per unit may decline without resulting in losses on operations of the firms.
12. Operating Ratio - The Operating Ratio is computed to establish the relationship between operating costs and net sales. This ratio indicates the proportion that the cost of sales or operating cost bears to sales. Cost of sales includes direct cost of goods sold as well as other operating expenses, administration, selling and distribution expenses which have matching relationship with sales.
Operating Costs = Cost of Goods Sold + Operating Expenses
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses + Manufacturing Expenses - Closing Stock
Operating Expenses = Administrative Expenses + Selling & Distribution Expenses
This ratio shows the percentage of sales absorbed by the cost of sales and operating expenses. Lower the operating ratio, the better it is because it would leave higher margin to meet interest, dividend etc.
13. Net Profit Ratio - Net Profit Ratio establishes the relationship between net profit and sales. Net profit is computed by deducting all direct costs i.e, cost of goods sold and indirect costs i.e, administrative and marketing expenses, finance charges and making adjustments for non-operating expenses from net sales and adding non-operating incomes.
The Net Profit Ratio is an indicator of overall efficiency of the business. Higher the net profit ratio better the business. This ratio helps in determining the operational efficiency of the business. An increase in the ratio over the previous period shows improvement in the operational efficiency and decline means otherwise.
14. Return on Investment (ROI) or Return on Capital Employed Ratio - Return on Capital Employed establishes the relationship of profit (profit means profit before interest and tax) with capital employed. The net result of operation of a business is either profit or loss. The sources, i.e, funds used by the business to earn this are proprietor's (shareholders) funds and loans. The overall performance of enterprise can be judged by this ratio when compared with the previous periods to judge improvement in performance.
This ratio is computed by dividing the net profit before interest, tax and dividends by capital employed.
Capital Employed can be calculated by any of the following methods:
I. Share Capital (Both Equity and Preference) + Reserves + Long term Loans - Fictitious Assets (like preliminary expenses) - Non Operating Assets like investments
II. Fixed Assets (net of depreciation) + Working Capital
This ratio measures the overall performance of the enterprise. It measures how efficiently the sources entrusted to the business are used. The return on capital employed is a fair measure of the profitability of any concern with the result that the performance of different industries can be compared.
15. Earning Per Share (EPS) - It is the earning of a company attributable to the equity shareholders divided by the number of equity shares.
This ratio helps in evaluating the prevailing market price of share in the light of profit earning capacity. The more the earning per share, better is the performance and prospects of the company.
16. Dividend Per Share (DPS) - DPS is calculated by dividing the profit distributed as equity dividend by the number of equity shares. The objective of computing this ratio is to measure the dividend distributed per equity share.
17. Price Earning Ratio - This Ratio establishes the relationship between the market price of the share and earning per share. It indicates how many times is the market price of share to its earnings.
18. Return on Equity (ROE) - ROE is the amount of net income returned as percentage of shareholder's equity.
Net Income is for the full financial year calculated before dividend paid to equity shareholders but after dividends paid to preference shareholders.
ROE is useful in comparing the profitability of company to that of other companies in the same industry.
It is different from ROCE as ROE only considers net return on the equity of the company while ROCE considers the return to all stakeholders in the company including equity, preference and debt.
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