RATIO ANALYSISRatio-analysis means the process of computing, determining and presenting the relationship of related items and groups of items of the financial statements. They provide in a summarized and concise form of fairly good idea about the financial position of a unit. They are important tools for financial analysis.

According to Myers, " Ratio analysis of financial statements is a study of relationship among various

financial factors in a business as disclosed by a single set of statements and a study of trend of these factors

as shown in a series of statements."

Advantages and Uses of Ratio Analysis

• To workout the profitability:• To workout the solvency:• Helpful in analysis of financial statement:• Helpful in comparative analysis of the

performance:• To simplify the accounting information:• To workout the operating efficiency:• To workout short-term financial position:• Helpful for forecasting purposes:

Limitations of Ratio Analysis

• Limited Comparability• False Results• Effect of Price Level Changes• Qualitative factors are ignored• Effect of window-dressing• Costly Technique• Misleading Results

Before looking at the ratios there are a number of cautionary points concerning their use that need to be identified :

a. The dates and duration of the financial statements being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn.

b. The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results.

c. In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.

HOW A RATIO IS EXPRESSED

• As Percentage - such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.• As Proportion - The above figures may be expressed

in terms of the relationship between net profit to sales as 1 : 4. • As Pure Number /Times - The same can also be

expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Liquidity Ratios.

• Liquidity refers to the ability of the concern to meet its current obligation as and when these become due the short- term obligations are met by releasing amounts from current floating or circulating assets. The current asset should either be liquid and near liquidity.

•Current Ratio = Current Assets Current Liabilities Rule Of Thumb is 2:1

•Quick Ratio or Acid Test Ratio = Quick Assets Current Liabilities Rule Of Thumb is 1:1

Absolute Liquid Asset = Cash& Bank+ Short Term Securities+ Temporary Investments Current Liabilities Rule of thumb = .5:1

CURRENT ASSETS CURRENT LIABILITIESCash in hand CreditorsCash at bank Bills payablesDebtors Bank overdraftTemporary investment Dividend payablesStock Income recd. In advBills receivables Outstanding expensesPrepaid expensesAccrued incomes

Current Asset Movement and efficiency ( Activity Ratio)

• Funds are invested in various assets in business to make sales and earn profit the efficiency with which assets are managed directly effect the volume of sales. The better the management the larger is the amount of sales and the profits. Activity ratio measures the efficiencies and the effectiveness with which firm manages its resources and assets. These ratios are called turnover ratios.

Working Capital Turnover ratios = Cost of goods sales Average Working Capital

Cogs = op stock+purchses+direct expenses-closing stock

Creditors or Payable Turnover Ratio = Net Credit Purchases Average Creditors

A suppliers of good of i.e. creditors, is naturally interested in finding out how much time the firm is likely to take in repaying its trade creditors.

Average Payment Period = Number of days in year Creditors’ turnover ratio

Debtor and Receivable Turnover Ratio = Net Credit Sales Average debtors

Debtors turnover ratio indicates the velocity of debt collection of firm. In simple words, it indicates the number of time average debtors( receivables) are turned over during a year.

Average Collection Period = Number of days in year Debtors’ turnover ratio

•Inventory Turnover Ratio = Cost of goods sold Average inventory

Every firm has to maintain a certain level of inventory of finished goods so as to be able to meet the requirement of the business.

Inventory Conversion Period = Number of days in a year Inventory turnover Ratio

Profitability Ratios

Gross Profit Ratio = Gross Profit X 100 Net Sales

Gross profit = sales – cost of goods sold

Net Profit Ratio = Net Profit x 100

Net Sales Operating Ratio = Operating cost x 100 Net Sales

Operating Profit Ratio = Operating Profit x 100 Net Sales Or Operating Profit Ratio = 100-Operating Ratio

Expense Ratio or Particular expense ratio = Particular Expense x 100 Net Sales

Long-term financial position and Test of Solvency.

– Debt Equity Ratio = Outsiders Fund

Shareholder’s funds Or = External Equities Internal Equities

– Funded Debt to Total Capitalization = Funded debt X 100

Total Capitalization Funded Debt = Debentures + Mortgage Loans + Bonds + Other Long Term LoansTotal Capitalization = Equity Share Capital + Preference share capital + Reserves

+ Surplus Other undistributed funds + Debentures +

Mortgage Loans + Bonds + Other long term Loans.

Proprietary and Equity Ratio = Shareholder’s Funds Total Assets

Shareholder fund= eq. share cap + pref. share cap + reserves & surpluses-fictitious assets

Fixed assets to Net Worth Ratio = Fixed Assets After depreciation Total Long- Term Funds

Solvency Ratios = Total Liabilities to Outsiders

Total Assets

Fixed Assets to Total Long Term Funds = Fixed assets after depreciation Total Long- Term funds

•Debt Service Ratio and Interest Coverage Ratio = Net Profit( Before Interest & Tax) Fixed Interest charges