Ratio Analysis- Dr.J.Mexon

Ratio Analysis, Interpretation of Ratios, Types of Ratios

1. DR. J. MEXON P. RAYAN MANAGEMENT ACCOUNTING – Unit 2 ( Ratio Analysis)

2. RATIO ANALYSIS Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing and interpreting various ratios for helping in making certain decisions. However, ratio analysis is not an end in itself. It is only a means of better understanding of financial strengths and weaknesses of a firm. Calculation of mere ratios does not serve any purpose, unless several appropriate ratios are analysed and interpreted.

3. Interpretation of the Ratios Single absolute ratios : Group of ratios : Historical comparison : Projected ratios :   Inter-firm comparison :

4. USES OF RATIO ANALYSIS 1. Managerial uses of Ratio Analysis Helps in decision making : Helps in financial forecasting and planning :   Helps in communicating : Helps in co-ordination :   Helps in control : Other uses : 2. Utility to Shareholders/ Investors :   3. Uses to Creditors : 4. Uses to Employees : 5. Uses to Government :

5. LIMITATIONS OF RATIO ANALYSIS Limited use of a single ratio : Lack of adequate standards : Inherent limitations of accounting : Change of accounting procedure : Window dressing : Personal bias : Un comparable : Absolute figures distortive : Price level changes : Ratios no substitutes :

6. Classification of Ratios

7. TYPES OF RATIO ANALYSIS 1. Profitability Ratios  2 . Coverage Ratios  3 . Turnover Ratios  4 . Financial Ratios  5 . Control Ratios

8. I . PROFITABILITY RATIOS Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings relative to its revenue,  operating costs , balance sheet assets, or  shareholders' equity  over time, using data from a specific point in time. Profitability is an indication of the efficiency with which the operations of the business are carried on. Poor operational performance may indicate poor sales and hence poor profits. A lower profitability may areise due to the lack of control over the expenses. Profitability refers to the  financial  performance of the business. Accounting Ratios that measure profitability are known as Profitability Ratios. Gross Profit Ratio: Operating Ratio Operating Profit Ratio Net Profit Ratio Return on Investment Return on Equity Shareholders’ Fund or Return on Net Worth: Return on Total Assets: Earnings per Share : Payout Ratio:

9. 1. Gross profit: Gross Profit Ratio establishes the relationship between gross profit and Revenue from Operations , i.e. Net Sales of an enterprise. The main objective of computing Gross Profit Ratio is to determine the efficiency of the business. We can also compare this ratio with the ratio of earlier years or with that of other firms to compare and to assess the efficiency of the  business . Therefore, Higher Gross Profit Ratio is better as it leaves a higher margin to meet operating expenses and the creation of reserves . Gross Profit Ratio = (Gross Profit/Revenue from Operations) x 100

10. 2. Operating Ratio: It establishes the relationship between operating costs and Revenue from  Operations . Operating cost includes Cost of Revenue from Operations and Operating Expenses. These are those costs which are incurred for operating activities of the business . The objective of computing Operating Ratio is to assess the operational efficiency of the business. Lower Operating Ratio is better because it leaves a higher  profit  margin to meet non-operating expenses, to pay the dividend, etc. A rise in the Operating Ratio indicates a decline in efficiency . Operating Ratio = (Cost of Revenue from Operations + Operating Expenses/Revenue from Operations) x 100

11. 3. Operating Profit ratio: Operating Profit Ratio measures the relationship between Operating Profit and Revenue from Operations , i.e. Net Sales. We compute Operating Profit Ratio by dividing operating profit by revenue from operations (Net Sales) and is express in  Percentage . Operating Profit Ratio = (Operating Profit/Revenue from Operations) x 100

12. 4. Net profit ratio: Net Profit Ratio measures the relationship between Net Profit and Net Sales . It shows the percentage of Net Profit earned on Revenue from Operations. Net Profit Ratio = (Net Profit/Net Sales) x 100 Net Profit Ratio indicates the overall efficiency of the business. Higher the Net Profit Ratio, better is the business. An increase in the ratio over the previous year shows improvement in operational efficiency.

13. 5. Return on Investment: Return on Investment or Return on Capital Employed shows the relationship of profit (profit before interest and tax) with capital employed . The result of operations of a business is either profit or loss . The funds or sources used in the business to earn profit/loss are proprietors’ (shareholders’) funds and loans. Return on Investment = (Net Profit before Interest, Tax and Dividend/Capital Employed) x 100

14. 6. Return on Equity Shareholders’ Fund or Return on Net Worth: This ratio is a measure of the percentage of net profit to equity shareholders’ funds . The ratio is expressed as follows: Here , Equity Shareholders’ Fund = Equity Share Capital + Capital Reserves + Revenue Reserves+ Balance of Profit and Loss Account − Fictitious Assets − Non-business Assets

15. 7. Return on Total Assets: This ratio is calculated to measure the profit after tax against the amount invested in total assets to ascertain whether assets are being utilized properly or not . Suppose net profit after tax is Rs.20,000 and total assets are Rs.1,00,000. Return on total assets will be 20% [i.e., Rs.20,000 ÷ Rs.1,00,000 x 100]. The higher the ratio, the better it is for the concern.

16. 8. Earning Per share: This helps in determining the market price of equity shares of the company and in estimating the company’s capacity to pay dividend to its equity shareholders. If there are both preference and equity share capitals, then out of net income first of all preference dividends should be deducted in order to find out the net income available for equity shareholders. The performance and prospects of the company are affected by earning per share.

17. 9. Payout Ratio: This ratio indicates as to what proportion of earning per share has been used for paying dividend and what has been retained for ploughing back . This ratio is very important from shareholders’ point of view as it tells him that if a company has used whole or substantially the whole of it’s earning for paying dividend and retained nothing for future growth and expansion purposes, then there will be very dim chances of capital appreciation in the price of shares of such company.

18. 2. COVERAGE RATIOS These ratios indicate the extent to which the interests of the persons entitled to get a fixed return (i.e. interest or dividend) or a scheduled repayment as per agreed terms are safe. The higher the cover, the better it is. Under this category the following ratios are calculated: ( i ) Fixed Interest Cover: ( ii) Fixed Dividend Cover:

19. Fixed Interest Cover: It really measures the ability of the concern to service the debt. This ratio is very important from lender’s point of view and indicates whether the business would earn sufficient profits to pay periodically the interest charges. Fixed Dividend Cover: This ratio is important for preference shareholders entitled to get dividend at a fixed rate in priority to other shareholders.

20. 3. TURN OVER RATIOS These ratios are very important for a concern to judge how well facilities at the disposal of the concern are being used or to measure the effectiveness with which a concern uses its resources at its disposal . In short, these will indicate position of assets usage. The greater the ratio more will be efficiency of asset usage. The lower ratio will reflect the under utilisation of the resources available at the command of the concern. ( i ) Sales to Capital Employed (or Capital Turnover) Ratio: ( ii) Sales to Fixed Assets (or Fixed Assets Turnover) Ratio: ( iii) Sales to Working Capital (or Working Capital Turnover) Ratio: ( iv) Total Assets Turnover Ratio: ( v) Stock Turnover Ratio: ( vi) Receivable (or Debtors) Turnover Ratio:

21. 4. FINANCIAL RATIOS These ratios are calculated to judge the financial position of the concern from long-term as well as short-term solvency point of view . These ratios can be divided into two broad categories: ( A) Liquidity Ratios: These ratios are used to measure the firm’s ability to meet short term obligations. They compare short term obligations to short term (or current) resources available to meet these obligations. From these ratios, much insight can be obtained into the present cash solvency of the firm and the firm’s ability to remain solvent in the event of adversity. ( i ) Current Ratio (or Working Capital Ratio): ( ii) Liquid (or Acid Test or Quick) Ratio : ( iii) Absolute Liquidity (or Super Quick) Ratio: ( iv) Ratio of Inventory to Working Capital:

22. i .) Current Ratio: This is the most widely used ratio. It is the ratio of current assets to current liabilities. It shows a firm’s ability to cover its current liabilities with its current assets. Generally 2 : 1 is considered ideal for a concern i.e., current assets should be twice of the current liabilities. If the current assets are two times of the current liabilities, there will be no adverse effect on business operations when the payment of current liabilities is made.

23. ii.) Liquid Ratio: This is the ratio of liquid assets to liquid liabilities. It shows a firm’s ability to meet current liabilities with its most liquid (quick) assets. 1 : 1 ratio is considered ideal ratio for a concern because it is wise to keep the liquid assets at least equal to the liquid liabilities at all times. Liquid assets are those assets which are readily converted into cash and will include cash balances, bills receivable, sundry debtors and short-term investments.

24. iii.) Absolute Liquidity Ratio: Though receivables are generally more liquid than inventories, there may be debts having doubt regarding their real stability in time. So, to get idea about the absolute liquidity of a concern, both receivables and inventories are excluded from current assets and only absolute liquid assets, such as cash in hand, cash at bank and readily realizable securities are taken into consideration . The desirable norm for this ratio is 1 : 2, i.e., K.1 worth of absolute liquid assets are sufficient for K.2 worth of current liabilities. Even though the ratio gives a more meaningful measure of liquidity, it is not in much use because the idea of keeping a large cash balance or near cash items has long since teen disproved. Cash balance yields no return and as such is barren.

25. iv.) Ratio of Inventory to Working Capital: In order to ascertain that there is no overstocking, the ratio of inventory to working capital should be calculated. Working Capital is the excess of current assets over current liabilities. Increase in volume of sales requires increase in size of inventory, but from a sound financial point of view, inventory should not exceed amount of working capital. The desirable ratio is 1 : 1.

26. ( B) Stability Ratios: These ratios help in ascertaining the long term solvency of a firm which depends on firm’s adequate resources to meet its long term funds requirements, appropriate debt equity mix to raise long term funds and earnings to pay interest and installment of long term loans in time (i.e., coverage ratios ). ( i ) Fixed Assets Ratio: ( ii) Ratio of Current Assets to Fixed Assets: ( iii) Debt Equity Ratio: ( iv) Proprietary Ratio:

27. i .) Fixed Asset Ratio: This ratio explains whether the firm has raised adequate long term funds to meet its fixed assets requirements. This ratio gives an idea as to what part of the capital employed has been used in purchasing the fixed assets for the concern. If the ratio is less than one it is good for the concern.

28. ii.) Ratio of Current Assets to Fixed Assets: This ratio will differ from industry to industry and, therefore, no standard can be laid down. A decrease in the ratio may mean that trading is slack or more mechanisation has been put through. An increase in the ratio may reveal that inventories and debtors have unduly increased or fixed assets have been intensively used. An increase in the ratio, accompanied by increase in profit, indicates the business is expanding.

29. iii.) Debt Equity Ratio: It measures the extent of equity covering the debt. This ratio is calculated to measure the relative proportions of outsiders’ funds and shareholders’ funds invested in the company . This ratio is determined to ascertain the soundness of long term financial policies of that company and is also known as external-internal equity ratio.

30. i v.) Proprietary Ratio: A variant of debt to equity ratio is the proprietary ratio which shows the relationship between shareholders’ funds and total tangible assets. This ratio should be 1: 3 i.e., one-third of the assets minus current liabilities should be acquired by shareholders’ funds and the other two-thirds of the assets should be financed by outsiders funds. It focuses the attention on the general financial strength of the business enterprise.

31. 5. CONTROL RATIOS C ontrol ratios are used by the management to know whether the deviations of the actual performance from the budgeted performance are favourable or unfavourable. If the ratio is 100% or more the performance is considered as favourable and if the ratio is less than 100% the performance is considered as unsatisfactory . This ratio indicates the extent to which budgeted hours of activity is actually utilized. If the ratio is 85%, budgeted capacity is utilized up-to 85% and 15% capacity remains unutilized. This ratio measures the level of activity attained during the budget period.