Ratio Analysis

Ratio analysis (accounting ratios)

              If a company earns 50 crore as revenue, we cannot comment on the performance of the company. This is so because 50 crore is an absolute figure. Commenting is possible only with comparison with any relative figure or in other words in comparison with the revenue of other firms or own revenue figures of previous years. Ratios are an important tool of comparison. Ratio is an arithmetical relation between two arithmetical figures. An accounting ratio may be defined as a relationship between two accounting figures established with a purpose. The relationship between the accounting figures must be meaningful and should serve a purpose. There is no sense in developing a relationship between rent paid and bad debts. But there is a relationship between sales and profits earned.

Users of accounting ratios

1. Management:             The management wants to judge its own performance over the years. It also wants to compare its performance with other companies in the same industry. On the basis of the ratios, the management is able to take the right decisions in terms of planning for growth.

2. Shareholders:             The shareholders want to see the company progressing. They want to know whether the money invested by them is bearing fruits or not. Their want is expressed in Return on Investment ratio. A higher ratio brings pleasure to them.

3. Creditors:      The creditors are interested to know the ability of the company to pay their dues in time. They want to know the short term and long-term liquidity of the company. This can be observed by liquidity ratios like current ratio etc.

4. Investors:      The investors and long-term creditors are interested in the ability of the company to pay the interest in time. They may be interested to know the relationship between interest and the profits earned by the company. This can be analyzed with the help of Interest coverage ratio and Return on Investment etc.

Limitations of Ratio Analysis

1. Price Level Changes:  If the price level changes frequently, the ratio analysis do not help because comparison with the ratios of previous years become difficult due to different price level in previous years.

2. Only Quantitative Analysis:    Ratios present only quantitative analysis. If there is any increase in production of two firms is 1000 each it will treat the two firms as equally efficient even if one firm increases its production from 2000 to 3000 units and the other firm increase its production from 10000 to 11000 units. So, the ratios can sometimes be misleading.

3. Window Dressing:      Sometimes the accounts may be manipulated. The real position may be concealed.

4. Reliability of the financial data: The ratios will be reliable only if the data used in calculating ratios is reliable.

5. Different accounting policies: Different accounting policies makes the financial data unfit for calculating ratios.

6. Personal Bias of the investigator:       Sometimes the investigator has to make a choice between various alternatives. A personal bias in choosing the alternative may give an unfit ratio which may lead to wrong decisions.

Classification or types of ratios

Ratios are classified into 4 categories

1.       Liquidity Ratios also called as short term solvency ratios.

2.       Solvency Ratios

3.       Activity ratios also known as Turnover ratios or Performance ratios

4.       Profitability ratios

1. 1. 2. 2. 1. 2.

Liquidity Ratios Current Ratio =     Current Assets                           Current Liabilities Current Assets = Current Investments + Inventories (Excluding Spare Parts and Loose Tools) + Trade Receivables + Cash and Cash Equivalents + Short Term Loans and Advances + Other Current Assets. Current Liabilities = Short Term Borrowings + Trade Payables + Other Current Liabilities + Short-term Provisions. (Standard Current Ratio:- 2:1) Liquid  Ratio =    Liquid Assets                           Current Liabilities Liquid Assets = Current Assets - Inventories - Prepaid expenses Current Liabilities = Short - Term Borrowings +Trade Payable + Other Current Liabilities + Short - term Provision Solvency Ratios Debt Equity Ratio = Debt                        Equity Debt = Long Term Borrowings + Long Term Provisions Equity/Shareholder’s Funds = Share Capital + Reserves and Surplus  OR Non-Current Assets (Tangible Assets + Intangible Assets + Non-Current Trade Investments + Long-Term Loans & Advances) + Working Capital – Non-Current Liabilities (Long-Term Borrowings  + Long-Term Provisions) (Standard Debt Equity Ratio:- 2:1) Working Capital = Current Assets–Current Liabilities Total Assets to Debt Ratio = Total Assets Debt Total Assets = Non-Current Assets (Tangible Assets + Intangible Assets + Non-Current

Investments + Long-Term Loans & Advances) + Current Assets (Current Investments + Inventories Trade Receivables + Cash & Cash Equivalent + Short-Term Loans & Advances + Other Current Assets). Debt = Long Term Borrowings + Long Term Provisions 3.     Proprietary Ratio =  Proprietors Funds                             Total Assets Proprietors Funds = Share Capital + Reserves and Surplus OR Non-Current.Assets (Tangible Assets + Intangible Assets + Non-Current Trade Investments + Long- Term Loans & Advances) + Working Capital–Non-Current Liabilities (Long-Term Borrowings + Long-Term Provisions) Total Assets = Non-Current Assets (Tangible Assets + Intangible Assets + Non- Current Investments + Long –Term Loans & Advances) + Current Assets (Current Investments + Inventories including Spare Parts & Loose Tools + Trade Receivables + Cash & Cash Equivalent + Short-Term Loans & Advances + Other Current Assets). 4.. Interest Coverage Ratio = Net Profit before interest and tax Interest on Long term debt Significance/Objectives/Importance 1.     This ratio indicates that a firm can pay interest due on long term debts or not. 2.     Higher ratio indicates that firm can pay interest on long term debts without any hurdle. 3.     Low ratio indicates that firm may face proble min paying the interest due on long term debts.

Formula of Capital Employed üLiabilities side approach

Shareholder’s Fund (Share Capital + Reserves & surpluses) + Non-Current liabilities (Long term-borrowing + long term Provisions

üAssets Side Approach

Non-Current Assets (Tangible Assets + Intangible Assets + Non-Current investment + Longterm Loans & Advances) + Working Capital

ØIt is Assumed that all Non-Current Investments are Trade Investments only.

ØInterest on Non-Trade Investments should be deducted from Profit before Interest, Tax and Dividend. Therefore it cannot be a part of Non-Current Investments.

3. 1. 2.	Activity Turnover Ratio Inventory Turnover Ratio = Cost of Revenue from operations Average Inventory Cost of Revenue from Operation = Revenue from Operation – Gross Profit OR Opening Inventory + Net Purchases + Direct Expenses (Assume to be given) – Closing Inventories   OR Cost of materials consumed + purchase of stock-in-trade + change in Inventory (Finished Goods; Work in Progress & Stock-in-trade) + Direct Expenses (Assume given) Average Inventory = Opening Inventory + Closing Inventory2 Trade Receivable Turnover Ratio = Net credit revenue from operation Average Trade Receivable  Net Credit Sales = Total Sales - Cash Sales) OR Credit Revenue from Operation = Revenue from Operation – Cash Revenue from Operation Average Trade Receivables = Opening + Trade Receivable + Closing trade receivable /2	4. 1. 2. 3.	Profitability Ratios Gross Profit Ratio =  Gross profit _____ x 100 Net Revenue from Operations Gross Profit = Revenue from Operation – Cost of Revenue from Operations Cost of Revenue from Operation = Opening Inventory (excluding Spare Parts and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Spare Parts and Loose Tools) OR Revenue from Operation – Gross Profit Operating Ratio = Cost of Revenue from operation+ Operating Expenses x100 Net Revenue from operations Cost of Revenue from Operation = Opening Inventory (excluding Spare Parts and Loose Tools) + Net Purchases + Direct Expenses–Closing Inventory (excluding Spare Parts and Loose Tools) OR Revenue from Operation – Gross Profit Operating Expenses = Office, Administrative, Selling and Distribution Expenses, Employees Benefit expenses, Depreciation & Amortisation Operating Profit Ratio = Operating Profit____x 100 Revenue from operations Operating Profit = Net Profit (After Tax) + Non-Operating Expenses/Losses–Non Operating Incomes       OR Gross Profit + Operating Income–Operating
Trade Receivable = Debtors + Bills Receivables 3.           Trade payable Turnover Ratio = Net Credit Purchase Average Trade Payable Net Credit Purchase = Total Purchases – Cash Purchases Average Trade Payables = Opening Trade Payables + Closing trade Payables 2 Trade Payables = Creditors + Bills Payable 4.           Working Capital Turnover Ratio = Net Revenue from Operations                                                                       Working Capital *Working Capital =Current Assets – Current Liabilities Current Asset = Current Investments + Inventories (Excluding Spare Parts and Loose Tools) + trade Receivables + Cash and Cash Equivalents + Short Term Loans and Advances + Other Current Assets Current Liabilities = Short-Term Borrowings + Trade Payables + Other Current Liabilities + Short- term Provisions		4. 5.	Expenses Non-Operating Expenses = Interest on Long Term Borrowing + Loss on sale of Fixed or Non-Current Assets Non-Operating Income = Interest received on investments + Profit of sale on Fixed Assets or Non- Current Assets Net Profit Ratio = Net Profit x 100 Net Revenue from operations Net Profit before Interest & Tax = Gross Profit + Other Incomes – Indirect Expenses Return on Investment (ROI) or Yield on Capital = NET PROFIT before interest, tax & dividend   x 100 Capital Employed Net Profit before Interest, Tax and Dividend = Gross Profit + other Income–Indirect Expenses

üA ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage, and a number of times.

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