Sunday, August 10, 2014

AHSEC - 12: Ratio Analysis Important Questions for Feb' 2018 Exam

Unit – 9: Ratio Analysis
Q.N.1. what do you mean by ratio analysis? What are the objectives and advantages of such analysis? Also point out the limitations of ratio analysis.                       2012, 2012
Answer: 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
1. To know the area of the business which need more attention.
2. To know about the potential areas which can be improved with the effort in the desired direction.
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business.
4. To provide information for decision making.
5. To provide information for inter-firm and intra-firm comparison.
Advantages and Uses of Ratio Analysis
1. Helpful in analysis of financial situation: It helps the management to know about the earning capacity and financial strength and weakness of the business concern.

2. Helpful in intra-firm comparison: Ratio analysis also makes possible comparison of the performance of the different division of the firm.
3. Helpful in inter firm comparison: It provides data for inter firm comparison. Ratios reveal strong and weak firms, overvalued and undervalued firms, successful and unsuccessful firm.
4. Simplifies the accounting information: It simplifies the financial statements. It gives a brief idea about the whole story of changes in the financial condition of a business.
5. Useful for forecasting: Ratios are helpful in business planning and forecasting. What should be the course of action in the future can be decided with the help of trend percentage.

Limitations of Ratio Analysis
1.       False Result: Ratios are calculated from the financial statements, so the reliability of ratio is dependent upon the correctness of the financial statements.
2.       Ignores Price Level Changes: A change in the price level makes the ratio analysis of different accounting years invalid because accounting records ignores change in value of money.
3.       Qualitative aspect Ignored: Since the financial statements are based on quantitative aspects only, the quality aspect such as quality of management, quality of labour force etc., are ignored while calculating accounting ratios.
4.       Lack of standard ratio: There is almost no single standard ratio against which the may be measured and compared.
5.       Not free from Bias: Financial statements are largely affected by the personal judgment of the accountant in selecting accounting policies, therefore accounting ratios are also not free from this limitations.
Q.N.2. Explain the meaning and method of calculation of some specific ratios.
Ans: Some of the useful ratios are explained below:
A. 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 include Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Stock of Goods, Short-term Investments, Prepaid Expenses, and Accrued Incomes etc.
Current Liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
B. 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 include 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 include Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
C. 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
D. 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

E. 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.
F. 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.
G. 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.
Q.N.3. What is Earning per Share?
Ans:   EPS = Profit available for Equity Shareholders / No. of Equity Shares
Q.N.4. What is Book Value per Share?
Ans:   Book Value Per Share = Equity shareholders’ Funds / No. of Equity Shares
Q.N.5. What are the types of Ratios according to traditional classification?                         2016, 2017
Ans:   A) Types of ratio according to traditional classification:
1. Income Statement Ratio: A ratio of two variables from the income statement is known as Income Statement Ratio. For example: gross profit ratio, net profit ratio, operating ratio, operating profit ratio, stock turnover ratio etc.
2. Balance Sheet Ratio: In case both variables are from balance sheet, it is classified as balance sheet ratio. For example: Debt-equity ratio, total asset to debt ratio, Proprietory ratio, current ratio, liquid ratio/acid-test ratio etc.
3. Composite Ratio: If a ratio is computed with one variable from income statement and another variable from balance sheet, it is called Composite Ratio. For example: Return on investment ratio, return on capital employed, Fixed assets turnover ratio, working capital turnover ratio etc.
B) Functional classification of ratio: Under this classification, ratios may be grouped in the following types:
a) Liquidity Ratios: 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. For example: Current ratio, liquid ratio and absolute liquid ratio falls under this group.
b) Solvency Ratios or leverage ratios: Solvency ratios are calculated to determine the ability of the business to service its debt in the long Run. For example: Debt-equity ratio, total asset to debt ratio, Proprietory ratio and capital gearing ratio are covered under this group.
c) Efficiency or turnover or activity Ratios: These ratios are calculated to study the efficiency with which the resources of the unit have been used. For example: Inventory turnover ratio, debtor’s turnover ratio, creditor’s turnover ratio and fixed assets turnover ratios are covered under this group.        2017
d) Profitability Ratios: These ratios measure the operating efficiency i.e. the financial result of the unit during the accounting period. For example: gross profit ratio, net profit ratio, operating ratio, operating profit ratio and return on investment are covered under this group.