RATIO ANALYSIS

In this study notes we will cover following topics:

• Ratio analysis and its usage
• Advantages and limitations of ratio analysis
• Classification of Ratio

Accounting Ratio

Ratio is an expression of relationship between two or more items in mathematical terms.

Accounting Ratio:  Exhibition of meaningful and useful relation between different accounting data is called Accounting Ratio. Ratio may be expressed as a:b (a is to b), in terms of simple fraction, integer, or percentage.

Example:

If the current assets of a concern is Rs 4,00,000 and the current liabilities is Rs 2,00,000, then the ratio of current assets to current liabilities is given as 4,00,000 / 2,00,000 = 2. This is called simple ratio. Multiply a ratio by 100 to express it in terms of percentage.

We can express the ratio between 200 and 100 in any of the following ways:

(a) 2 : 1 (b) 2/1 (c) 200% (d) 2 to 1 (e) 2

Ratios are extremely useful in drawing the financial position of a concern.

Accounting Analysis

Comparative analysis and interpretation of accounting data is called Accounting Analysis. When accounting data is expressed in relation to some other data, it conveys some significant information to the users of data.

Ratio Analysis and its Applications

Ratio analysis is a medium to understand the financial weakness and soundness of an organization. Keeping in mind the objective of analysis, the analyst has to select appropriate data to calculate appropriate ratios. Interpretation depends upon the caliber of the analyst.

Ratio analysis is useful in many ways to different concerned parties according to their respective requirements. Ratio analysis can be used in the following ways:

• To know the financial strength and weakness of an organization.
• To measure operative efficiency of a concern.
• For the management to review past year’s activity.
• To assess level of efficiency.
• To predict the future plans of a business.
• To optimize capital structure.
• In inter and intra company comparisons.
• To measure liquidity, solvency, profitability and managerial efficiency of a concern.
• In proper utilization of assets of a company.
• In budget preparation.
• In assessing solvency of a firm, bankruptcy position of a firm, and chances of corporate sickness.

Advantages of Ratio Analysis

• It is powerful tool to measure short and long-term solvency of a company.
• It is a tool to measure profitability and managerial efficiency of a company.
• It is an important tool to measure operating activities of a business.
• It helps in analyzing the capital structure of a company.
• Large quantitative data may be summarized using ratio analysis.
• It relates past accounting performances with the current.
• It is useful in coordinating the different functional machineries of a company.
• It helps the management in future decision-making.
• It helps in maintaining a reasonable balance between sales and purchase and estimating working capital requirements.

Limitations of Ratio Analysis

Although Ratio Analysis is a very useful accounting tools to analyze and interpret different accounting equations, it comes with its own set of limitations:

• If the data received from financial accounting is incorrect, then the information derived from ratio analysis could not be reliable.
• Future prediction may not be always dependable, as ratio analysis is based on the past performance.
• To get a conclusive idea about the business, a series of ratios is to be calculated. A single ratio cannot serve the purpose.
• It is not necessary that a ratio can give the real present situation of a business, as the result is based on historical data.
• Trend analysis is done with the help of various calculated ratios that can be distorted due to the changes in the price level.
• Ratio analysis is effective only where same accounting principles and policies are adopted by other concerns too, otherwise inter-company comparison will not exhibit a real picture at all.
• Through ratio analysis, special events cannot be identified. For example, maturity of debentures cannot be identified with ratio analysis.
• For effective ratio analysis, practical experience and knowledge about particular industry is essential. Otherwise, it may prove worthless.
• Ratio analysis is a useful tool only in the hands of an expert.

Types of Ratios

There are actually two ways in which financial ratios can be classified. There is the classical approach, where ratios are classified on the basis of the accounting statement from where they are obtained. The other is a more functional classification, based on the uses of the ratios and the purpose for which they are calculated.

[A] Traditional Classification

Traditional Classification has three types of ratios, namely

1. Profit and Loss Ratios
2. Balance Sheet Ratios
3. Composite Ratios

1] Profit and Loss Ratios

When both figures are derived from the statement of Profit and Loss A/c we will call it a Profit and Loss Ratio. It can also be known as Income Statement Ratio or Revenue Statement Ratio. One such example is the Gross Profit ratio, which is the ratio of Gross Profit to Sales or Revenue. As you will notice, both these amounts will be derived from the Profit and Loss A/c. Other examples include Operating ratio, Net Profit ratio, Stock Turnover Ratio etc.

2] Balance Sheet Ratios

Just as above, if both the variables are obtained from the balance sheets, it is known as a balance sheet ratio. When such a ratio expresses the relation between two accounts of the balance sheet, we also call them financial ratios (other than accounting ratios).

Take for example Current ratio that compares current assets to current liabilities, both derived from the balance sheet. Other examples include Quick Ratio, Capital Gearing Ratio, Debt-Equity ratio etc.

3] Composite Ratios

A composite ratio or combined ratio compares two variables from two different accounts. One is taken from the Profit and Loss A/c and the other from the Balance Sheet. For example the ratio of Return on Capital Employed. The profit (return) figure will be obtained from the Income Statement and the Capital Employed is seen in the Balance Sheet. A few other examples are Debtors Turnover Ratio, Creditors Turnover ratio, Earnings Per Share etc.

[B] Functional Classification

These help us group the ratios according to the functions they perform in our understanding and analysis of financial statements. This is a more accurate and useful classification of ratios, and hence more commonly used as well. The types of ratios according to the functional classification are

1. Liquidity Ratio
2. Leverage Ratios
3. Activity Ratios
4. Profitability Ratios
5. Coverage Ratios

1] Liquidity Ratios

A firm needs to keep some level of liquidity, so stakeholders can be paid when they are due. All assets of the firm cannot be tied up, a firm must look after its short-term liquidity. These ratios help determine such liquidity, so the firm may rectify any problems. The two main liquidity ratios are Current ratio and Quick Ratio (or liquid ratio).

2] Leverage Ratios

These ratios determine the company’s ability to pay off its long-term debt. So they show the relationship between the owner’s fund and the debt of the company. They actually show the long-term solvency of a firm, whether it has enough assets to pay of all its stakeholders, as well as all debt on the Balance Sheet. This is why they are also called Solvency ratios. Some examples are Debt Ratio, Debt-Equity Ratio, Capital Gearing ratio etc.

3] Activity Ratios

Activity ratios help measure the efficiency of the organization. They help quantify the effectiveness of the utilization of the resources that a company has. They show the relationship between sales and assets of the company. These types of ratios are alternatively known as performance ratios or turnover ratios. Some ratios like Stock Turnover, Debtors turnover, Stock to Working Capital ratio etc measure the performance of a company.

4] Profitability Ratios

These ratios analyze the profits earned by an entity. They compare the profits to revenue or funds employed or assets of an entity. These ratios reflect on the entity’s ability to earn reasonable returns with respect to the capital employed. They even check the soundness of the investment policies and decisions. Examples will include Operating Profit ratio, Gross Profit Ratio, Return on Equity Ratio etc.

5] Coverage Ratios

Shows the equation between profit in hand and the claims of outside stakeholders. These are stakeholders that are required by the law to be paid, even in case of liquidation. So these types of ratios ensure that there is enough to cover these payments to such outsiders. Some examples of coverage ratios are Dividend Payout Ratio, Debt Service ratio etc.