**Ratio Analysis:**

Ratio analysis is one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern. Simply, ratio means the comparison of one figure to other relevant figure or figures.

According to Myers, “Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements."

*Objectives of Ratio analysis:*
a) To know the area of the business which need more attention.

b) To know about the potential areas which can be improved with the effort in the desired direction.

c) To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business.

d) To provide information for decision making cross sectional analysis by comparing the performance with the best industry standards.

e) To provide information derived from financial statement useful for making projection and estimates for the future.

*Advantages and Uses of Ratio Analysis:*
There are various groups of people who are interested in analysis of financial position of a company used the ratio analysis to workout a particular financial characteristic of the company in which they are interested. Ratio analysis helps the various groups in the following manner: -

a) To workout the profitability: Accounting ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern.

b) Helpful in analysis of financial statement: Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc.

c) Helpful in comparative analysis of the performance: With the help of ratio analysis a company may have comparative study of its performance to the previous years. In this way company comes to know about its weak point and be able to improve them.

d) To simplify the accounting information: Accounting ratios are very useful as they briefly summaries the result of detailed and complicated computations.

e) To workout the operating efficiency: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilising the resources.

*Limitations of Ratio Analysis*
In spite of many advantages, there are certain limitations of the ratio analysis techniques. The following are the main limitations of accounting ratios:

a) Limited Comparability: Different firms apply different accounting policies. Therefore the ratio of one firm can not always be compared with the ratio of other firm.

b) False Results: Accounting ratios are based on data drawn from accounting records. In case that data is correct, then only the ratios will be correct. For example, valuation of stock is based on very high price, the profits of the concern will be inflated and it will indicate a wrong financial position. The data therefore must be absolutely correct.

c) Effect of Price Level Changes: Price level changes often make the comparison of figures difficult over a period of time. Changes in price affects the cost of production, sales and also the value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison.

d) Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision making. For example, average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis.

e) Effect of window-dressing: In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way.

**Types of Accounting Ratio:**

Ratio can be classified on the basis of the their functions in the following groups:

(A) Liquidity Ratios :

(i) Short term solvency ratio

(ii) Long term solvency ratio

(B) Profitability Ratios

(C) Activity Ratios/ Turnover Ratios

(D) Financial Ratios

The above groups are further classified into following parts :

(i) Short term solvency ratio :

(a) Current ratio

(b) Liquid ratio/Acid Test ratio

(c) Absolute liquid ratio

(ii) Long term solvency ratio :

a) Equity ratio

b) Debt ratio

c) Equity ratio

d) Net income to debt service ratio

(iii) Profitability ratio :

a) Gross Profit Ratio

b) Net Profit Ratio

c) Operating Net Profit Ratio

d) Operating Ratio

e) Return on Investment or Return on Capital Employed

f) Return on Equity

g) Earning Per Share

(iv) Activity Ratios/ Turnover Ratios :

a) Capital Turnover Ratio

b) Fixed Assets Turnover Ratio

c) Working Capital Turnover Ratio

d) Stock Turnover Ratio

e) Debtors Turnover Ratio

f) Creditors turnover ratio

(v) Financial Ratios :

(a) Debt-Equity Ratio

(b) Proprietary Ratio

(C) Capital Gearing Ratio

(d) Debt to Total Funds Ratio

(e) Fixed Assets Ratio

(f) Interest Coverage Ratio

**Meaning, Objective and Method of Calculation of various types of ratios :**

Current Ratio: Current ratio is calculated in order to work out firm’s ability to pay off its short-term liabilities. This ratio is also called working capital ratio. This ratio explains the relationship between current assets and current liabilities of a business. It is calculated by applying the following formula :

Current Ratio = Current Assets/Current Liabilities

Current Assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Stock of Goods, Short-term Investments, Prepaid Expenses, Accrued Incomes etc.

Current Liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.

Objective and Significance: Current ratio shows the short-term financial position of the business. This ratio measures the ability of the business to pay its current liabilities. The ideal current ratio is supposed to be 2:1. In case, if this ratio is less than 2:1, the short-term financial position is not supposed to be very sound and in case, if it is more than 2:1, it indicates idleness of working capital.

Liquid Ratio: Liquid ratio shows short-term solvency of a business. It is also called acid-test ratio and quick ratio. It is calculated in order to know whether or not current liabilities can be paid with the help of quick assets quickly. Quick assets mean those assets, which are quickly convertible into cash.

Liquid Ratio = Liquid Assets/Current Liabilities

Liquid assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Short-term investments etc. In other words, all current assets are liquid assets except stock and prepaid expenses.

Current liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.

Objective and Significance: Liquid ratio is calculated to work out the liquidity of a business. This ratio measures the ability of the business to pay its current liabilities in a real way. The ideal liquid ratio is supposed to be 1:1. In case, this ratio is less than 1:1, it shows a very weak short-term financial position and in case, it is more than 1:1, it shows a better short-term financial position.

Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner: -

Gross Profit Ratio = Gross Profit/Net Sales x 100

Where Gross Profit = Net Sales – Cost of Goods Sold

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock

And Net Sales = Total Sales – Sales Return

Objective and Significance: Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. This ratio can also be used in stock-inventory control. Maintenance of steady gross profit ratio is important .Any fall in this ratio would put the management in difficulty in the realisation of fixed overheads of the business.

Net Profit Ratio: Net Profit Ratio shows the relationship between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner: -

Net Profit Ratio = Net Profit/Net Sales x 100

Where, Net Profit = Gross Profit – Selling and Distribution Expenses – Office and Administration Expenses – Financial Expenses – Non Operating Expenses + Non Operating Incomes.

And Net Sales = Total Sales – Sales Return

Objective and Significance: In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years’ ratios, the increment shows the efficiency of the concern.

Operating Profit Ratio:. Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner: -

Operating Profit Ratio = (Operating Profit/Net Sales) x 100

Where Operating Profit = Gross Profit – Operating Expenses

Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes

And Net Sales = Total Sales – Sales Return

Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.

Operating Ratio: Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses.

Operating Ratio = Operating Cost/Net Sales x 100

Where Operating Cost = Cost of goods sold + Operating Expenses

(Operating Expenses = Selling and Distribution Expenses, Office and Administration Expenses, Repair and Maintenance.)

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock

Or Cost of Goods Sold = Net sales – Gross Profit

Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit.

Return on Investment or Return on Capital Employed: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.

Return on Capital Employed = Net Profit before Interest, Tax and Dividend/Capital Employed x 100

Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets

Or

Capital Employed = Fixed Assets + Current Assets – Current Liabilities

Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.

. Return on Equity: Return on equity is also known as return on shareholders’ investment. The ratio establishes relationship between profit available to equity shareholders with equity shareholders’ funds.

Return on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders’ Funds x 100

Where Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Fictitious Assets

Objective and Significance: Return on Equity judges the profitability from the point of view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of equity funds invested in the firm. The investors favour the company with higher ROE.

Earning Per Share: Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares.

Earning Per Share = Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares

Objective and Significance: Earning per share helps in determining the market price of the equity share of the company. It also helps to know whether the company is able to use its equity share capital effectively with compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.

Debt-Equity Ratio: Debt equity ratio shows the relationship between long-term debts and shareholders funds’. It is also known as ‘External-Internal’ equity ratio.

Debt Equity Ratio = Debt/Equity

Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial institution etc.

Equity (Shareholders’ Funds) = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets

Objective and Significance: This ratio is a measure of owner’s stock in the business. Proprietors are always keen to have more funds from borrowings because:

(i) Their stake in the business is reduced and subsequently their risk too

(ii) Interest on loans or borrowings is a deductible expenditure while computing taxable profits. Dividend on shares is not so allowed by Income Tax Authorities.

The normally acceptable debt-equity ratio is 2:1.

Debt to Total Funds Ratio: This ratio gives same indication as the debt-equity ratio as this is a variation of debt-equity ratio. This ratio is also known as solvency ratio. This is a ratio between long-term debt and total long-term funds.

Debt to Total Funds Ratio = Debt/Total Funds

Total Funds = Equity + Debt = Capital Employed

Objective and Significance: - Debt to Total Funds Ratios shows the proportion of long-term funds, which have been raised by way of loans. This ratio measures the long-term financial position and soundness of long-term financial policies. A higher proportion is not considered good and treated an indicator of risky long-term financial position of the business.

Fixed Assets Ratio: Fixed Assets Ratio establishes the relationship of Fixed Assets to Long-term Funds.

Fixed Assets Ratio = Long-term Funds/Net Fixed Assets

Where Long-term Funds = Share Capital (Equity + Preference) + Reserves and Surplus + Long- term Loans – Fictitious Assets

Net Fixed Assets means Fixed Assets at cost less depreciation. It will also include trade investments.

Objective and Significance: This ratio indicates as to what extent fixed assets are financed out of long-term funds. It is well established that fixed assets should be financed only out of long-term funds. This ratio workout the proportion of investment of funds from the point of view of long-term financial soundness. This ratio should be equal to 1. If the ratio is less than 1, it means the firm has adopted the impudent policy of using short-term funds for acquiring fixed assets. On the other hand, a very high ratio would indicate that long-term funds are being used for short-term purposes, i.e. for financing working capital.

Proprietary Ratio: Proprietary Ratio establishes the relationship between proprietors’ funds and total tangible assets. This ratio is also termed as ‘Net Worth to Total Assets’ or ‘Equity-Assets Ratio’.

Proprietary Ratio = Proprietors’ Funds/Total Assets

Where Proprietors’ Funds = Shareholders’ Funds = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets

Total Assets include only Fixed Assets and Current Assets. Any intangible assets without any market value and fictitious assets are not included.

Objective and Significance: This ratio indicates the general financial position of the business concern. This ratio has a particular importance for the creditors who can ascertain the proportion of shareholder’s funds in the total assets of the business. Higher the ratio, greater the satisfaction for creditors of all types.

indicates that how many times the profit covers the interest. It measures the margin of safety for the lenders. The higher the number, more secure the lender is in respect of periodical interest.

Fixed Assets Turnover Ratio: Fixed assets turnover ratio establishes a relationship between net sales and net fixed assets. This ratio indicates how well the fixed assets are being utilised.

Fixed Assets Turnover Ratio = Net Sales/Net Fixed Assets

In case Net Sales are not given in the question cost of goods sold may also be used in place of net sales. Net fixed assets are considered cost less depreciation.

Objective and Significance: This ratio expresses the number to times the fixed assets are being turned over in a stated period. It measures the efficiency with which fixed assets are employed. A high ratio means a high rate of efficiency of utilisation of fixed asset and low ratio means improper use of the assets.

Working Capital Turnover Ratio: Working capital turnover ratio establishes a relationship between net sales and working capital. This ratio measures the efficiency of utilisation of working capital.

Working Capital Turnover Ratio = Net Sales or Cost of Goods Sold/Net Working Capital

Where Net Working Capital = Current Assets – Current Liabilities

Objective and Significance: This ratio indicates the number of times the utilisation of working capital in the process of doing business. The higher is the ratio, the lower is the investment in working capital and the greater are the profits. However, a very high turnover indicates a sign of over-trading and puts the firm in financial difficulties. A low working capital turnover ratio indicates that the working capital has not been used efficiently.

Stock Turnover Ratio: Stock turnover ratio is a ratio between cost of goods sold and average stock. This ratio is also known as stock velocity or inventory turnover ratio.

Stock Turnover Ratio = Cost of Goods Sold/Average Stock

Where Average Stock = [Opening Stock + Closing Stock]/2

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock

Objective and Significance: Stock is a most important component of working capital. This ratio provides guidelines to the management while framing stock policy. It measures how fast the stock is moving through the firm and generating sales. It helps to maintain a proper amount of stock to fulfill the requirements of the concern. A proper inventory turnover makes the business to earn a reasonable margin of profit.

Debtors’ Turnover Ratio: Debtors turnover ratio indicates the relation between net credit sales and average accounts receivables of the year. This ratio is also known as Debtors’ Velocity.

Debtors Turnover Ratio = Net Credit Sales/Average Accounts Receivables

Where Average Accounts Receivables = [Opening Debtors and B/R + Closing Debtors and B/R]/2

Credit Sales = Total Sales – Cash Sales-Return Inward

Objective and Significance: This ratio indicates the efficiency of the concern to collect the amount due from debtors. It determines the efficiency with which the trade debtors are managed. Higher the ratio, better it is as it proves that the debts are being collected very quickly.

Debt Collection Period: Debt collection period is the period over which the debtors are collected on an average basis. It indicates the rapidity or slowness with which the money is collected from debtors.

Debt Collection Period = 12 Months or 365 Days/Debtors Turnover Ratio

Or

Debt Collection Period = Average Trade Debtors/Average Net Credit Sales per day

Or

365 days or 12 months x Average Debtors/Credit Sales

(360 days can also be used instead of 365 days)

Objective and Significance: This ratio indicates how quickly and efficiently the debts are collected. The shorter the period the better it is and longer the period more the chances of bad debts. Although no standard period is prescribed anywhere, it depends on the nature of the industry.

Liquidity Ratio: Liquidity ratios are calculated to have indications about the short term solvency of the business, i.e. the firm’s ability to meet its current obligations.

Solvency Ratio: Solvency ratios are calculated to determine the ability of the business to service its debt in the long Run.

Earning per Share: EPS = Profit available for Equity Shareholders / No. of Equity Shares

Book Value per Share: Book Value Per Share = Equity shareholders’ Funds / No. of Equity Shares

What are the types of Ratios according to traditional classification?

Types of ratio according to traditional classification:

Income Statement Ratio:- A ratio of two variables from the income statement is known as Income Statement Ratio.

Balance Sheet Ratio:- In case both variables are from balance sheet, it is classified as balance sheet ratio.

Composite Ratio:- If a ratio is computed with one variable from income statement and another variable from balance sheet, it is called Composite Ratio.

Profitability Ratios: The profitability or financial performance is mainly summarised in Income statement. Profitability ratios are calculated to analyse the earning capacity of the business which is the outcome of utilisation of resources employed in the business. There is a close relationship between the profit and the efficiency with which the resources employed in the business are utilised. The various ratios are:

a) Gross Profit Ratio

b) Operation Ratio

c) Operating Profit Ratio

d) Net Profit Ratio

e) Return in Investment or Return on Capital Employed

f) Return on Net Worth

g) Earning per share

h) Book value per Share

i) Dividend Payout Ratio

j) Price Earning Ratio