RATIO ANALYSIS
Meaning
of Ratio:- A ratio is simple arithmetical
expression of the relationship of one number to another. It may be defined as
the indicated quotient of two mathematical expressions.
According
to Accountant’s Handbook by Wixon, Kell and Bedford, “a ratio is an expression
of the quantitative relationship between two numbers”.
Ratio
Analysis:- Ratio analysis is the process of
determining and presenting the relationship of items and group of items in the
statements. According to Batty J. Management Accounting “Ratio can assist
management in its basic functions of forecasting, planning coordination,
control and communication”.
It
is helpful to know about the liquidity, solvency, capital structure and
profitability of an organization. It is helpful tool to aid in applying
judgement, otherwise complex situations.
Ratio
analysis can represent following three methods.
Ratio
may be expressed in the following three ways :
1. Pure Ratio or Simple Ratio :- It is
expressed by the simple division of one number by another. For example , if the
current assets of a business are Rs. 200000 and its current liabilities are Rs.
100000, the ratio of ‘Current assets to current liabilities’ will be 2:1.
2. ‘Rate’ or ‘So Many Times :- In this
type , it is calculated how many times a figure is, in comparison to another
figure. For example , if a firm’s credit sales during the year are Rs. 200000
and its debtors at the end of the year are Rs. 40000 , its Debtors Turnover
Ratio is 200000/40000 = 5 times. It shows that the credit sales are 5 times in
comparison to debtors.
Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information. Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables. This relationship can be expressed as:
1) Fraction
2) Percentages
3) Proportion of numbers
These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.
ADVANTAGES OF RATIO ANALYSIS
1) Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies.
2) Ratios avoid distortions that may result the study of absolute data or figures.
3) Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement.
4) Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently.
5) Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future.
6) Ratios are increasingly used in trend analysis.
7) Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity.
8) Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances.
9) Ratios are yard stick increasingly used by bankers and financial institutions in evaluating the credit standing of their borrowers and customers.
LIMITATIONS OF RATIO ANALYSIS:
An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and judgment as they suffer from certain serious drawbacks. Some of them are listed below:
1. Rations can sometimes be misleading if an analyst does not know the reliability and soundness of the figures from which they are computed and the financial position of the business at other times of the year. A business enterprise for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1
2. It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In India, for example, no systematic and comprehensive industry ratios are complied.
3. The comparison is rendered difficult because of differences in situations of 2 companies are never the same. Similarly the factors influencing the performance of a company in one year may change in another year. Thus, the comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different situations.
4. Changes in the price level make the interpretations of the ratios Invalid. The interpretation and comparison of ratios are also rendered invalid by the changing value of money. The accounting figures presented in the financial statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years and as a result. Assets acquired at different dates will be expressed at different values in the balance sheet. This makes comparison meaningless.
For e.g. two firms may be similar in every respect except the age of the plant and machinery. If one firm purchased its plant and machinery at a time when prices were very low and the other purchased when prices were high, the equal rates of return on investment of the two firms cannot be interpreted to mean that the firms are equally profitable. The return of the first firm is overstated because its plant and machinery have a low book value.
5. The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make the interpretation of ratios difficult. In practice difference exists as to the meanings and accounting policies with reference to stock valuation, depreciation, operation profit, current assets etc. Should intangible assets be excluded to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued? Similarly, profit means different things to different people.
6. Ratios are not reliable in some cases as they many be influenced by window / dressing in the balance sheet.
7. The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The trend analysis is static to an extent. The balance sheet prepared at different points of time is static in nature. They do not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in financial position reveal this information, bur these statements are not available to outside analysts.
8. The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future.
CLASSIFICATION OF RATIO
Ratio
may be classified into the four categories as follows:
A.
Liquidity Ratio
a. Current Ratio
b. Quick Ratio or Acid Test Ratio
B.
Leverage or Capital Structure Ratio
a. Debt Equity Ratio
b. Debt to Total Fund Ratio
c. Proprietary Ratio
d. Fixed Assets to Proprietor’s Fund Ratio
e. Capital Gearing Ratio
f.
Interest Coverage Ratio
C.
Activity Ratio or Turnover Ratio
a. Stock Turnover Ratio
b. Debtors or Receivables Turnover Ratio
c. Average Collection Period
d. Creditors or Payables Turnover Ratio
e. Average Payment Period
f.
Fixed Assets Turnover Ratio
g. Working Capital Turnover Ratio
D.
Profitability Ratio or Income Ratio
(A)
Profitability Ratio based on Sales :
a.
Gross Profit Ratio
b.
Net Profit Ratio
c.
Operating Ratio
d.
Expenses Ratio
(B)
Profitability Ratio Based on Investment :
I.
Return on Capital
Employed
II.
Return on Shareholder’s Funds :
a. Return on Total Shareholder’s Funds
b. Return on Equity Shareholder’s Funds
c. Earning Per Share
d. Dividend Per Share
e. Dividend Payout Ratio
f.
Earning and Dividend Yield
g. Price Earning Ratio
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