RATIO ANALYSIS

Meaning of Ratio A ratio is only a comparison of the numerator with the denominator. The term ratio refers to the numerical or quantitative relationship two figures. A ratio is the relationship between two figures, and obtained by dividing the former by the latter. Ratios are designed to show how one number is related to another. It is worked out by dividing one number by another. Ratio analysis is an important and age old technique of financial analysis. The data given in financial statements, in absolute from, are dump and are unable to communicate anything. Ratios are relative from of financial data and very useful technique to check upon the efficiency of a firm. Some ratios indicate the trend or progress or downfall of the firm. IMPORTANCE OF RATIO ANALYSIS The inter relationship that exists among the different items appeared in the financial statements, are revealed by accounting ratios. Ratio analysis of a firms financial statements is of interest to a number of parties, mainly, shareholders, creditors, financial executives etc. Shareholders are interested with earning capacity of the firm: creditors are interested in knowing the ability of firm to meet its financial obligations: and financial executives are concerned with evolving analytical tools that will measure and compare costs, efficiency, liquidity and profitability with a view to making intelligent decisions. 1. Aid to measure General Efficiency: - Ratios enable the mass of accounting data to be summarized and simplified. They act as an index of the efficiency of the enterprise. As such they serve as an instrument of management control. 2. Aid to measure Financial Solvency:- Ratio are useful tools in the hands of management and other concerned to evaluate the firms performance over a period of time by comparing the present ratio with the past ones. They point out firms liquidity position to meet its short term obligations and long term solvency. 3. Aid in Forecasting and Planning: - Ratio analysis is an invaluable aid to management in the discharge of its basic function such as planning, forecasting, control etc. The ratio that is derived after analyzing and scrutinizing the part result helps the management to prepare budgets to formulate policies and to prepare the future plan of action etc.

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4. Facilitate decision-making:- It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called surveyor of efficiency. They help management in decision-making. 5. Aid in corrective Action: - Ratio analysis provides inter-firm comparison. They highlight the factors associated with successful and unsuccessful firms. If comparison shows an unfavorable variance, corrective actions can be initiated. Thus, it helps the management to take corrective action. 6. Aid in Intra Firm Comparison: - Intra firm comparisons are facilitated. It is an instrument for diagnosis of financial health of an enterprise. If facilitates the management to know whether the firms financial position is improving or deteriorating by setting a trend with the help of ratios. 7. Act as a Good Communication: - Ratios are an effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners and other interested parties. The communications by the use of simplified and summarized ratios are more easy and understandable. 8. Evaluation of Efficiency: - Ratio analysis is an effective instrument which, when properly used, is useful to assess important characteristics of business- liquidity, solvency, profitability etc. A study of these aspects may enable conclusions to be drawn relating to capabilities of business. 9. Effective Tool: - Ratio analysis helps in making effective control of the business-measuring performance, control of cost etc. Effective control is the keynote of better management. Ratio ensures secrecy. Figures, in their absolute forms, shown in the financial statements are neither significant nor able to be compared. In fact, they are dump. But ratios have power to speak.

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IMPORTANCE OF RATIOS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Ratios act as an index of efficiency of a firm. They serve as an instrument of management control. They are useful in evaluating performance. They facilitate and help in forecasting future events. They help management in exercising effective decisions. They help management to take corrective actions. They facilitate intra firm comparisons. They play effective role for easy and clear communications. They ensure secrecy. They facilitate inter-firm comparisons.

LIMITATIONS OF RATIO ANALYSIS Ratio analysis is, as already mentioned, a widely-used tool of financial analysis. It is because ratios are simple and easy to understand. But they must be used very carefully. They suffer from various limitations. For instance, financial statements suffer from a number of limitations and may therefore; affect the quality of ratio analysis. If due care is not taken, they might confuse rather than clarify the situation. Different firms may use these terms in different sense or the same firm may use them to mean different things at different times. Some of the limitations of the ratio analysis are given below:1. Differences in Definitions: - Comparisons are made difficult due to differences in definitions of various financial terms. Lack of standard formula for working out ratios makes it difficult to compare them. They are worked out on the basis of different items in different industries. 2. Limitations of Accounting Records: - Ratio analysis is based on financial statements which are themselves subject to limitations. Thus, ratios calculated on the figures given in the financial statements, also suffers from similar limitations. 3. Lack of Proper Standards: - It is very difficult to ascertain the standard ratio in order to make proper comparison. Because, if differs from firm to firm, industry to industry. Apart from this, it may also have happened that in one firm, a current ratio of 2:1 is found to be quite satisfactory, whereas in another firm 2:5:1

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may be unsatisfactory. Again a high current ratio may not necessarily mean sound liquid position when current assets include large inventory or inventory consisting of obsolete items. 4. No Allowances for Price Level Changes:- Due to changes in price level of various years. Comparison of ratios of such years cannot give correct conclusion. A change in the price level can seriously affect the validity of comparison of ratios computed for different time periods. For instance, a firm which has purchased an asset at a lower price will show a higher return, than the firm which has purchased the assets at a higher price. 5. Changes in Accounting Procedure: - Comparison between two variables proves worth provided their basis of valuation is identical. But in reality, it is not possible, such as methods of valuation of stock (FIFO or LIFO) or charging different methods of depreciation on fixed assets etc. Thus, if different methods are followed by different firms for their valuation, then comparison will practically be of no use. 6. Qualitative Factors are ignored: - Ratios are tools of quantities analysis only and normally qualitative factors which may generally influence the conclusions derived are ignored while computing ratios. For instance, high current ratio may not necessarily mean sound liquid position when current assets include a large inventory consisting of mostly obsolete items. Therefore, it is very difficult to generalize whether a particular ratio is good or bad. 7. Limited use of Single Ratio: - A single ratio would not be able to convey anything. Ratios can be useful only when they are computed in sufficient large number. If too many ratios are calculated. Therefore, ratio analysis cannot give satisfactory results. 8. Background is overlooked: - When inter-firm comparison is made, they differ substantially in age, size, nature of product etc. When an inter-firm comparison is made, these factors are not considered. Therefore, ratio analysis cannot give satisfactory results. 9. Limited Use: - Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. Ratio analysis is not a substitute for sound judgment. But ratios are tools to aid in applying judgment. Conclusions drawn from the ratio analysis are not sure indicators of bad or good management. They merely convey certain observations which need future investigations, otherwise wrong conclusions may be drawn. Computations of ratios are not useful unless they are interpreted. 10. Personal Bias: - Ratios have to be interpreted and different people may interpret the same ratio in different ways. Ratios are only means of financial analysis but no an end in themselves. Ratios are simple to Ratio Analysis (Management Accounting) MCA RK Page 4

understand and easy to calculate. Therefore, there is a tendency to over employ them. It should be clearly noted that ratios are only tools and the personal judgment of analyst is more important. The analyst has to carry future investigations and exercise his judgment in arriving at a correct diagnosis. 11. Arithmetical Window Dressing: - Window-dressing means manipulation of accounts in a way so as to conceal vital facts and present the statements in a way show better position than what it actually is. By doing so, it is possible to cover up bad financial position. Therefore, ratios based on such figures are not reliable. 12. Changing Policies: - Ratios are computed on the basis of past result. Past is not an indicator of future. Ratios computed from historical data are used for predicting and projecting the likely events in the future. Such ratios may provide a glimpse of a firms past performance. But forecast for the future may not be correct as several other factors like management policies, market conditions etc. may induce future operations. CLASSIFICATION OF RATIOS Financial ratios have been classified in several ways. A number of standpoints may be used as base for classifying the ratios. It is a matter of great surprise that no uniformity has been achieved in this regard. Different authors have classified the ratios in varying groups. To illustrate the short-term creditors main interest is in the liquidity position or short-term solvency of the firm long-term creditors are more interested in the long-term solvency and profitability analysis and the analysis of the firms financial conditions: management is interested in evaluating every activity of the firm because they have to protect the interests of all parities. Thus accounting ratios may be classified on the following bases leading to somewhat overlapping categories. (A) Classification by Statements The Traditional classification is based on those statements from which information is obtained for calculating the ratios. The ratios are classified as follows:-

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CLASSIFICATION BY USERS STATEMENTS

Balance Sheet Ratios (Financial Ratios) Egs: Liquidity Ratio Current Ratio Stock Ratio Proprietary Ratio Debt-Equity Ratio Capital Gearing etc. (B) Classification by Users

Profit & Loss A/c Ratios (Operating Ratios) Egs: Gross Profit Ratio Net Profit Ratio Operating Ratio Expense Ratio etc.

Inter-statement Ratios (Composite/Mixed Ratios) Egs; Return on Capital Employed Return on Shareholders Fund Turn over of Working Capital Debtors Turnover Ratio etc.

This classification is based on the parties who are interested in making the use of ratio:CLASSIFICATION BY USERS

Ratios for Management Egs: Operating Ratio Debtors Turnover Stock Turnover Solvency Ratio Return on Capital etc..

Ratio for Creditors Egs: Current Ratio Solvency Ratio Fixed Asset Ratio Creditors Turnover etc.

Ratios for Shareholders Egs: Yield Rate Proprietary Ratio Dividend Rate Capital Gearing Return on Capital Fund etc.

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(c) Classification According to Importance This basis of classification of ratios has been recommended by the British Institute of management. They are two types:CLASSIFICATION BY IMPORTANCE

Primary Ratios Primary Ratios Egs: Asset Turnover Profit Ratio Operating Profit Ratio Return on Capital Fund etc. Egs:

Secondary Ratios Working Capital turnover Stocks of Current Assets Stock to Fixed Assets
Fixed Assets to Total Assets Stock Velocity

Expenses Ratio etc. (D) Classification by Purpose/Function This is a classification based on the purpose for which an analyst computes these ratios. The modern approach of classifying the ratios is according to the purpose or object of analysis. Normally, ratios are used for the purpose of assessing the profitability and sound financial position. Thus, ratios according to the purpose are more meaningful. There can be several purposes which can be listed. For analysis, it is customary to group the purposes into board headings. The following are the board categories of accounting ratios from functional point of view:-

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Classification By purpose

SOLVENCY (Stability)

PROFITABILITY

ACTIVITY (Performance)

EARNINGS

Short-Term (Liquidity)

Long-Term

Current Ratio Liquidity Ratio Cash Position Ratio Stock Ratio Debtors Velocity Creditors Velocity etc.

Gross Profit Ratio Net Profit Ratio Expenses Ratio Operating Profit Ratio Return on Capital Employed Ratio etc.

Dividend Ratio Earnings per share Price Earnings Ratio Pay-out Ratio Earning power Ratio

Property Ratio Debt-equity Ratio Leverage Ratio Security Ratio Interest coverage etc.

Capital Turnover Creditors Turnover Debtors Turnover Cash Turnover Stock Turnover etc.

Balance Sheet Ratio

Calculate 1) Current Ratio Ratio Analysis (Management Accounting) MCA RK Page 8

2) Quick Ratio or Acid Test Ratio or Liquidity Ratio 3) Debt Equity Ratio 4) Proprietary Ratio 5) Capital Gearing Ratio Current Assets Current Ratio = -------------------------------------Current Liabilities Current Assets = Stock + Sundry Debtors + Bills Receivables + Cash at Bank = 2,00,000 + 1,00,000 + 10,000 + 40,000 = 3,50,000 Current Liabilities = Sundry Creditors + Bills Payables = 1,00,000 + 50,000 = 1,50,000 So, Current Ratio = 3,50,000/1,50,000 = 2.33 : 1 Liquid Asset Quick Ratio = ----------------------------------Liquid Liabilities Liquid Asset = Current Assets Stock Prepaid Expenses Liquid Liabilities = Current Liabilities Bank Overdraft So, Quick Ratio = 1,50,000/1,50,000 =1:1 Proprietary Fund Proprietary Ratio = -------------------------------------Total Assets Proprietary Fund = Share Capital + Profit & Loss Account + General Reserve (Shareholders Fund) [If only share capital is given in the question than it would be treated as equity share capital only] = 2,00,000 + 30,000 + 40,000 Ratio Analysis (Management Accounting) MCA RK Page 9

=2,70,000 So, Proprietary Ratio = 2,70,000/8,40,000 = 0.32 : 1 Borrowed Fund Debt Equity Ratio = -------------------------------------Shareholders Fund Borrowed Fund = All the funds of liabilities side except proprietors fund = (Liabilities Proprietors Fund) So, Borrowed Fund = 5,70,000/2,70,000 = 2.11 : 1 Fixed Interest Bearing Securities Capital Gearing Ratio = --------------------------------------------------------Equity Share Capital Fixed Interest Bearing Securities = 12% Debentures = 4,20,000 So, Capital Gearing Ratio = 4,20,000/2,00,000 = 2.1 : 1

Profit & Loss Account Ratio

= Cost of goods sold =

[Opening Stock] + [Purchases] - [Closing Stock] + All Direct Expenses

Net Profit Ratio = Net Profit Net Sales X 100 Page 10

Ratio Analysis (Management Accounting) MCA RK

Operating Ratio

= =

Cost of goods sold + operating expenses Net Sales

X 100

Operating expenses

[Administrative Expenses] + [Financial Expenses] + [Selling Expenses]

Numerical From the following particulars, found in the trading Profit & Loss Account of a company Ltd, work out the operation ratio of the business concern. Trading account of a company ltd. for the period ending 31st March Particulars To Opening Stock To Purchases To Direct Expenses To Gross Profit Rs. 1400 6400 300 2500 10600 Profit & Loss Account of A Company Ltd., for the period ending 31st March:Particulars To operating expenses: (a) (b) Administrative Exp. Selling & Distribution Exp. 100 300 100 500 2500 Operating Ratio Cost of Goods Sold: = Direct Expenses. = Operating expenses = = [1400 + 6400 600 + 300] = Rs. 7500 [Administrative Exp. + S & D Exp. + Fin. Expenses] [1600 + 300 100] Page 11 Opening Stock + Purchases Closing Stock + All = Cost of goods sold + operating expenses Net Sales X 100 2500 Rs. Particulars By Gross Profit Rs. 2500 10600 Particulars By Net Sale By Closing Stock Rs. 10000 600

Financial Expenses To Net Profit

Ratio Analysis (Management Accounting) MCA RK

Rs. 2000 7500 + 2000 10,000 95% Ans. X 100

. . .

Operating Ratio = =

Numerical The following figures relate to the trading activity of Hind Traders Limited for the year ended 30th June. Sales Purchases Opening Stock Closing Stock Sales Return Selling & Distribution Expenses:Salaries Advertising Traveling Administrative Expenses:Salaries Rent Stationary & Postage etc. Financial Expenses:Depreciation Other charges Provision for taxation Non-Operating Income:Dividend on Shares Profit ion sales of shares Non-operating Expenses:Loss on Sale of Assets You are required to find:(i) (ii) (iii) Solution:Ratio Analysis (Management Accounting) MCA RK Page 12 Gross Profit ratio Net-Profit ratio Operating ratio 4000 9000 3000 93,000 16,500 40,000 27,000 2,700 2,500 15,300 4,700 2,000 5, 20,000 3, 22,250 76,250 98,500 20,000

Trading Account of Hind Traders Ltd., for the year ended 30th June Particulars To Opening Stock To Purchase To Gross Profit Rs. 76,250 3,22,250 20,00,000 By closing stock 5,98,500 Profit & Loss Account of Hind Traders Ltd., for the year ended 30th June Particulars To Selling & Distribution Exp:Salaries Advertising Traveling To Administrative Exp:(a) Salaries (b) Rent (a) Stationary, Postage etc. To Financial Exp:(a) (b) (c) Depreciation Other charges Provision for taxation. 9,300 16,500 40,000 4,000 88,000 2,12,000 2, 00,000 5, 00,000 40% X 100 Page 13 2,12,000 27,000 2,700 2,500 15,300 4,700 2,000 Rs. Particulars By Gross Profit By non-operating Income:(a) (b) shares Dividend on Shares Profit on Sale of 9,000 3,000 Rs. 2,00,000 Particulars By Sales - Sales Return Rs. 5,20,000 20,000 5,00,000 98,500 5,98,500

To non-operating Exp:Loss on Sale of Assets Net Profit:-

(1) Gross Profit Ratio = = (2) Operating Ratio =

X 100

Cost of goods + Operating Exp. Net-Sales Ratio Analysis (Management Accounting) MCA RK

= = (3) Net Profit Ratio = =

2, 00,000 + 1, 20,000 5, 00,000 84% 88,000 5, 00,000 17.6% X 100

X 100

Q. 1) From the following information of Blue Hills Ltd. prepare the Balance Sheet as on 31.03.2008 Fixed assets Rs 6,00,000; Working Capital Rs 4,00,000; Working Capital ratio 2:1; Fixed assets to turnover Ratio 4; Gross profit ratio 25%; Debtors velocity 1.5 months; Creditors velocity 2 months; Stock velocity 2 months; Net profit ratio 5%; Reserve 2/3rd of net profit; Capital gearing ratio (long term debt to proprietary fund) 1:1 Q. 2) From the information placed here under, prepare a balance sheet of XYZ Ltd. Stock velocity : 6 times; Capital turnover ratio : 2 times; Fixed Asset turnover Ratio : 4 times; Gross Profit Ratio : 20%; Debt-Collection Period : 2 months; Creditors Payment Period : 73 days; Gross profit was Rs 60,000. Closing stock was Rs 5,000 in excess of the opening stock. Q. 3) From the following information make out a statement of proprietors fund with as many details as possible: Current Ratio 2.5; Liquid Ratio 1.5; Proprietary Ratio 0.75 (Fixed Assets/Proprietors Fund); Working Capital Rs 60,000; Reserve & Surplus 40,000; Bank overdraft Rs 10,000; there is no long term loan or fictitious assets. Q. 4) From the following information relating to PG India Ltd., prepare a statement of Proprietary Fund with as much details as possible. Stock velocity : 6; Capital Turnover Ratio: 4; Fixed Assets turnover Ratio : 4; Gross Profit ratio : 20%; Debtors velocity : 2 months; Creditors velocity : 72 days; Gross Profit: Rs 60,000; Reserve & Surplus : Rs 20,000; there was no long term debt; Closing stock was Rs 5,000 in excess of opening stock. Q. 5) From the following particulars of Sonu Ltd., prepare Trading and P/L Account for the year ended 31.03.2006 and Balance Sheet as on that date: Equity Share Capital: Rs 5,00,000; Long Term Debt: Rs 1,00,000; Current Assets: Rs 4,00,000; Working Capital Ratio 2; Liquid Ratio 1; Fixed assets to turnover ratio 33.33%; Stock turnover ratio 6 times; Gross profit ratio Ratio Analysis (Management Accounting) MCA RK Page 14

20%; Net profit to Gross profit ratio 20%; Debt collection period 1 month; Reserve & Surplus to Equity share capital 0.2 Q.6) From the following information, draw the balance sheet of Sourav & Co. Ltd., as on 31st March, 2004: Current Ratio: 2; Profit before interest and tax to capital employed: 10%; Fixed assets turnover ratio (based on net sales): 1.6; Closing stock: 12.5% of sales; Owners equity to fixed assets 8/15; Debtors turnover: 1 months; Long term debt to owners equity: 5:4; Profit after interest but before tax: Rs 1,00,000; Interest on long term debt: Rs 80,000; Tax: Rs 40,000; Cash & Bank balances: Rs 1,00,000; Current assets = Stock + Debtors + Cash & Bank balances. Make necessary assumptions that you think appropriate.

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