RATIO ANALYSIS

Introduction: Analysis and interpretation of financial statements with the help of ratios is termed as ratio analysis. Ratio analysis involves the process of computing determining and presenting the relationship of items or groups of items of financial statements. Ratio analysis was pioneered by alexander wall who presented a system of ratio analysis in the year 1909. Alexanders contention was that interpretation of financial statements can be made easier by establishing quantitive relationships between various items of financial statements. Meaning of ratio: A ratio is a mathematical relationship between two items expressed in a quantitative form. Meaning of ratio analysis: Ratio analysis is an age old technique of financial analysis. It is the process of determining and presenting the relationship of items and groups of items in the financial statements. The information provided by the financial statements in absolute form is historical and static, conveying very little meaning to the users. Accounting ratios are designed to show how one number is related to another and the meaning of such relationships. A ratio is worked out by another number. Accounting ratios measures and indicate efficiency of an enterprise in all aspects.

Profitability ratios: Profit making is the main objective of business. Aim of every business concern is to earn maximum profits in absolute terms and also in relative terms. Profit is to be maximum in terms of risk undertaken and capital employed. Ability to make maximum profit from optimum utilisation of resources by a business concern is termed as profitability. Profit is an absolute measure of earning capacity. Profitability depends on sales, costs and utilisation of resources. The following are various ratios used to analyse profitability. Return on investment or overall profitability ratio Gross profit ratio Operating ratio Operating profit ratio Net profit ratio Return on investment: Return on investment is used to measure the operational and managerial efficiency. A comparison of ROI with that of similar firms, with that of industry and with past ratio will be helpful in determining how efficiency the long -term funds of owners and creditors being put into use. Higher the ratio, the more efficient is the use of the capital employed. R.O.I= operating profit X100 Capital employed Gross profit ratio: This ratio is also known as gross margin or trading margin ratio. Gross profit ratio indicates the difference between sales and direct costs. Gross profit ratio and net sales.

Gross profit ratio= gross profit Net sales Operating ratio:

X 100

Operating ratio measures the amount of expenditure incurred in production sales and distribution of output. It indicates operational efficiency of the concern. Lower the ratio more is the efficiency. The ratio should be low enough to provide fair returns to the shareholders and other investors. Operating ratio= cost of sales + operating expenses Net sales Operating profit ratio: It is the ratio of profit made from operating sources to the sales, usually shown as percentage. It shows the operational efficiency of the firm and is a measure of the managements efficiency in running the routine operations of the firm. Operating profit ratio= operating profit X 100 Sales Net profit ratio: This ratio is also called net profit to sales ratio. It is a measure of managements efficiency in operating the business successfully from the owners point of view. It indicates the return on shareholders investments. Higher the ratio better is the operational efficiency of the business concern. Net profit ratio= net profit after tax X100 Net sales X100

Turnover ratios or activity ratios: These ratios are also called performance ratios. Activity ratios highlight the operational efficiency of the business concern. The term operational efficiency refers to effective, profitable and rational use of resources available to the concern. In order to examine the judicious utilisation of resource as well as the wisdom and farsightedness in observing the financial policies laid down in this regard, certain ratios are computed and they are collectively called turnover or activity or performance ratios. Following are various activity ratios. Inventory or stock turnover ratio Debtors turnover ratio Working capital turnover ratio Fixed assets turnover ratio Inventory or stock turnover ratio: This ratio is also called stock velocity ratio. It is calculated to ascertain the efficiency of inventory management in terms of capital investment. It shows the relationships between the sales and the amount of average inventory. This ratio is helpful in evaluating and review of inventory policy. It indicates the number of times the inventory is turned over during a particular accounting period. Stock turnover ratio= Net sales Average inventory cost Debtors turnover ratio: Debtors turnover ratio is also called as receivables turnover ratio or debtors velocity. A business concern generally adopts different methods of sales. One of them is selling on credit. Goods are sold on credit based on credit policy adopted by the firm. The customers who purchase on credit are called debtors or

book debts. Debtors and bills receivables together are called accounts receivables. Some of the customers may be prepared to accept bills for goods purchased on credit. Bills or handiest are termed as bills receivables. Debtors turnover= net credit sales Average receivables Working capital turnover ratio: Working capital ratio measures the effective utilisation of working capital. It also measures the smooth running of business or otherwise. The ratio establishes relationship between cost of sales and working capital. Working capital turnover ratio is calculated with the help of followings. Working capital turnover ratio= sales/cost of sales Net working capital Fixed assets turnover ratio: This ratio determine efficiency of utilisation of fixed assets and profitability of a business concern. Higher the ratio, more is the efficiency in utilisation of fixed assets. A lower ratio is the indication of underutilisation of fixed assets. Fixed assets turnover ratio= sales Net fixed assets Capital turnover ratio: Managerial efficiency is also calculated by establishing the relationship between cost of sales or sales with the amount of capital invested in the business. Capital turnover ratio is calculated with the help of the following..

Capital turnover= sales Capital employed

Solvency or financial ratios: Solvency or financial ratio include all ratios which express financial position of the concern. Financial ratios are calculated on the basis of items of the balance sheet. Therefore, they are also called balance sheet ratios. Financial position may mean differently to different persons interested in the business concern. Creditors, banks, management, investors and auditors have different views about financial position. The term financial position generally refers to short-term and long-term solvency of the business concern, indicating safety of different interested parties. Financial ratios are also analysed to find judicious use of funds. The significant financial ratios are classified as short-term solvency ratios and long-term solvency ratios. Therefor financial ratios are as under. Short-term solvency or liquidity ratios: Current ratio Liquid ratio Cash position ratio Long-term solvency ratios: Fixed assets ratio Debt equity ratio Proprietary ratio Capital gearing ratio

Short-term solvency or liquidity ratios: Current ratio: The ratio of current assets to current liabilities is called current ratio. In order to measure the short-term liquidity or solvency of a concern, comparison of current assets and current liabilities is inevitable. Current ratio indicates the ability of a concern to meet its current obligations as and when they are due for payment. Current ratio=current assets Current liabilities Liquid ratio: This ratio is also called Quick or Acid test ratio. It is calculated by comparing the quick assets with current liabilities. Liquid assets= quick assets or liquid assets Current liabilities Cash position ratio: This ratio is also called Absolute liquidity ratio or Super quick ratio. This is a variation of quick ratio. This ratio is calculated when liquidity is highly restricted in terms of cash and cash equivalents. This ratio measures liquidity in terms of cash and near cash items and short-term current liabilities. Cash position ratio is calculated with the help of the following. Cash position ratio=cash and bank balance + marketable securities Current liabilities

Long-term solvency ratios: Fixed assets ratio: The ratio establishes the relationship between fixed assets and long -term funds. The objectives of calculating this ratio is to ascertain the proportion of long-term funds invested in fixed assets. The ratio is calculated with given below. Fixed assets ratio= fixed assets Long-term funds Debt equity ratio: This ratio is ascertained to determine long-term solvency position of a company. Debt equity ratio is also called external-internal equality ratio. Debt-equity ratio= external equalities Internal equalities Proprietary ratio: This ratio compares the shareholder funds or owners funds and total tangible assets. In other words this ratio expresses the relationship between the proprietors funds and the total tangible assets. This ratio shows the general soundness of the company. It is of particular interest to the creditor of the company as it helps them to ascertain the shareholder funds in the total assets of the business. A high ratio indicates safety to the creditors and a low ratio shows greater risk to the creditors. Proprietary ratio= shareholders funds Total tangible assets

Capital gearing ratio: This ratio is also known as capitalisation or leverage ratio. It is also one of the long-term solvency ratios. It is used to analyse the capital structure of the company. The ratio establishes relationship between fixed interest and dividend bearing funds and equity shareholder funds. The capital gearing ratio is calculated with the help of the following. Capital gearing =long-term loans + debentures + preference share capital Equity shareholders funds