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Ratio Analysis

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47 views

Ratio Analysis

Uploaded by

radhikamangal102
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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RATIO

ANALYSIS
Meaning of Ratio Analysis

 Ratio Analysis is a study of relationship among various


financial factors in a business

 Ratio Analysis is an important and powerful technique or


method, generally used for analysis of Financial
Statements.

 Ratios are the symptoms of health of an organisation


like blood pressure, pulse or temperature of an individual.
They are the indicators for the further investigation.
Objectives of Ratio Analysis
The objectives of ratio analysis are:-
• To simplify the accounting information.

• To analyse the profitability of the business.

• To help in comparative analysis, i.e, inter-firm


and intra-firm comparisons.

• To assess the operating efficiency of the


business.

• To determine liquidity, i.e, Short-term solvency


and long-term solvency of the business.
Limitations of Ratio Analysis

• Change in accounting policies


• False result
• Qualitative factors are not considered
• Window Dressing
• Personal Bias
• May not be comparable
• Price level changes are not considered
Classification or
Types of Accounting
Ratios
• There are several group of people of
persons – creditors, investors, lenders,
management and public ---interested
in the interpretation of the financial
statements.

• They interpret ratios, for those


purposes they are interested in, to take
appropriate decisions to serve their
own individual interests.
In the view of diverse requirements of the various users of
the ratios, the ratios can be classified into four
categories.
LIQUIDITY RATIOS
‘Liquidity of Business’ refers to the firm’s ability to meet its
current obligations, i.e., short- term financial liabilities.
1. CURRENT RATIO
Current Ratio establishes the relationship between current assets and
current liabilities. It is and indicator whether the enterprise will be able to
meet its short- term financial obligations as and when they become due for
payment.

Computation:

It is expressed as a ‘Pure Ratio’ say, 2 : 1.


It is also known as Working Capital ratio.

COMPONENTS OF CURRENT RATIO


INTERPRETATION OF CURRENT RATIO

• As an ideal ratio , a current ratio of 2:1, (i.e., current assets should


be twice the current liabilities) is considered satisfactory.

• The rule is based on the logic that in the worst situation, even if the
value of current assets becomes half, the firm will be able to meet
its obligations fully.

• High Current Ratio means better liquidity position. But a very high
current ratio means poor management of funds.

• Low Current Ratio may be due to inadequate investment in current


assets which may result in low liquidity and be a threat to short-
term solvency of the enterprise.
2. QUICK / LIQUID / ACID TEST RATIO
Liquid Ratio or Quick Ratio or Acid test Ratio is a liquidity ratio which
measures the ability of the enterprise to meet its short –term financial
obligations, i.e., Current Liabilities.

Computation:

It is expressed as a ‘Pure ratio’ say, 1:1.


SOLVENCY RATIOS
Solvency of a business means that the business is in a
position to meet its long-term financial obligations as and
when they become due.

‘Solvency Ratios’ are the ratios which show whether the


enterprise will be able to meet its long term liabilities.
Some important solvency ratios are :-
 Debt to Equity Ratio
 Total Debt Ratio
 Proprietary Ratio
 Interest Coverage Ratio
1. DEBT TO EQUITY RATIO
Debt to Equity ratio shows relationship between long term debts
and equities. It is also known as External- Internal Equity Ratio.

This ratio is calculated to measure the relative claims of outsiders


and owners against the firm’s assets and shows the dependence
on the outsiders.

Computation:-

2. TOTAL DEBT RATIO


Total Debt Ratio shows relationship between total assets and long
term debts of thee enterprises. It is expressed as ‘Pure ratio’ say, 1:1.

Computation:-
3. PROPRIETARY RATIO
Proprietary ratio establishes the relationship between proprietor’s
funds and the total assets of the enterprises. It may be expressed
either as ‘Pure ratio’ or ‘Percentage’.

Computation:-

4. INTEREST COVERAGE RATIO


Interest Coverage Ratio establishes the relationship between Net
Profit before Interest and Tax and Interest on long- term debts.
The Interest Coverage ratio is used to test the firm’s debt servicing
capacity .

Computation:-
ACTIVITY RATIOS
• Activity Ratios also termed as ‘Performance’ or ‘Turnover
Ratios’, measure how well the resources have been used
by the enterprise. These ratios measure the
effectiveness with which the enterprise uses its available
resources.
1. INVENTORY TURNOVER RATIO
Inventory Turnover Ratio establishes relationship betweenCost of
Revenue from Operations , i.e., Cost of Goods Sold andAverage
Inventory carried during that period.
Inventory Turnover Ratio is also known as stock turnover ratio.

Computation:-

2. TRADE RECEIVABLES TURNOVER RATIO


Trade Receivables Turnover Ratio establishes the relationship
betweenCredit Revenue from Operations, i.e., Net Credit Sales and
Average Trade Receivables of the year.

Computation:-
3. TRADE PAYABLES TURNOVER RATIO
It shows the relationship betweenNet Credit Purchases andTotal
Payables or Average Payables carried during the period of the year.

Computation:-

4. WORKING CAPITAL TURNOVER RATIO


The WTC Ratio indicates the velocity of utilization of working capital
of the firm, during the year.
The WC refers to net working capital, which is equal to total current
asset less liailities.

Computation:-
PROFITABILITY RATIOS
Efficiency in business is measured by profitability.
‘Profitability’ refers to financial performance of the
business.
Accounting Ratios measuring the profitability are known as
‘Profitability Ratios’.
1. GROSS PROFIT RATIO
• Profit is the factor of sales.
• Profit is earned, after meeting all expenses and when sales are made.
• The Gross Profit Ratio reflects the efficiency with which a firm produces/sells
its products.

Computation:-

2. NET PROFIT RATIO


• Net Profit is obtained after deducting operating expenses, interest andd
taxes from gross profit.
• Net profit includes non- operating income so the later maybe deucted to
arrive at profitability arrising from operations.

Computation:-
3. OPERATING RATIO
• Operating Ratio establishes the relationship betweenOperating Cost (Cost of
Revenue from Operations + Operating Expenses) andRevenue from
Operations.
• To identify the cause of fall or rise in net profit, each operating eexpene ratio
is to be calculated.

Computation:-

4. RETURN ON INVESTMENT (ROI)


• Return on Investment is the primary ratio that is most popularly used to
measure the overall profitability and efficiency of the business.
• When return on investment is calculated on total assets, it is called ROTA.

Computation:-

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