UNIT 1-1 Ratio Analysis PDF

UNIT:- 1 Ratio Analysis Meaning: A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage and a number of times. When the number is calculated by referring to two accounting numbers derived from th...

UNIT:- 1 Ratio Analysis Meaning: A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage and a number of times. When the number is calculated by referring to two accounting numbers derived from the financial statements, it is termed as accounting ratio. It needs to be observed that accounting ratios exhibit relationship, if any, between accounting numbers extracted from financial statements. Ratios are essentially derived numbers and their efficacy depends a great deal upon the basic numbers from which they are calculated. Further, a ratio must be calculated using numbers which are meaningfully correlated. Objectives of Ratio Analysis: Ratio analysis is indispensable part of interpretation of results revealed by the financial statements. It provides users with crucial financial information and points out the areas which require investigation. Ratio analysis is a technique which involves regrouping of data by application of arithmetical relationships, though its interpretation is a complex matter. It requires a fine understanding of the way and the rules used for preparing financial statements. Once done effectively, it provides a lot of information which helps the analyst: 1. To know the areas 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 making cross-sectional analysis by comparing the performance with the best industry standards; and 5. To provide information derived from financial statements useful for making projections and estimates for the future. Importance (or Advantages) of Ratio Analysis: 1. Helps to understand efficacy of decisions: The ratio analysis helps you to understand whether the business firm has taken the right kind of operating, investing and financing decisions. It indicates how far they have helped in improving the performance. 2. Simplify complex figures and establish relationships: Ratios help in simplifying the complex accounting figures and bring out their relationships. They help summarise the financial information effectively and assess the managerial efficiency, firm’s credit worthiness, earning capacity, etc. 3. Helpful in comparative analysis: The ratios are not be calculated for one year only. When many year figures are kept side by side, they help a great deal in exploring the trends visible in the business. The knowledge of trend helps in making projections about the business which is a very useful feature. 4. Identification of problem areas: Ratios help business in identifying the problem areas as well as the bright areas of the business. Problem areas would need more attention and bright areas will need polishing to have still better results. 5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring in the business. The information of change helps the management a great deal in understanding the current threats and opportunities and allows business to do its own SWOT (Strength-Weakness-Opportunity-Threat) analysis. 6. Various comparisons: Ratios help comparisons with certain bench marks to assess as to whether firm’s performance is better or otherwise. For this purpose, the profitability, liquidity, solvency, etc. of a business, may be compared: (i) over a number of accounting periods with itself (Intra-firm Comparison/Time Series Analysis), (ii) with other business enterprises (Inter-firm Comparison/Crosssectional Analysis) and (iii) with standards set for that firm/industry (comparison with standard (or industry expectations). Limitations of Ratio Analysis: 1. Limitations of Accounting Data: Accounting data give an unwarranted impression of precision and finality. In fact, accounting data “reflect a combination of recorded facts, accounting conventions and personal judgements which affect them materially. For example, profit of the business is not a precise and final figure. It is merely an opinion of the accountant based on application of accounting policies. The soundness of the judgement necessarily depends on the competence and integrity of those who make them and on their adherence to Generally Accepted Accounting Principles and Conventions”. Thus, the financial statements may not reveal the true state of affairs of the enterprises and so the ratios will also not give the true picture. 2. Ignores Price-level Changes: The financial accounting is based on stable money measurement principle. It implicitly assumes that price level changes are either non-existent or minimal. But the truth is otherwise. We are normally living in inflationary economies where the power of money declines constantly. A change in the price-level makes analysis of financial statement of different accounting years meaningless because accounting records ignore changes in value of money. 3. Ignore Qualitative Aspects: Accounting provides information about quantitative (or monetary) aspects of business. But sometimes qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted. For E.g., though credit may be granted to a customer on the basis of information regarding his financial position, yet the grant of credit ultimately depends on debtor’s character, honesty, past record and his managerial ability. 4. Variations in Accounting Practices: There are differing accounting policies for valuation of inventory, calculation of depreciation, treatment of intangibles Assets definition of certain financial variables etc., available for various aspects of business transactions. These variations leave a big question mark on the cross-sectional analysis. As there are variations in accounting practices followed by different business enterprises, a valid comparison of their financial statements is not possible. 5. Forecasting: Forecasting of future trends based only on historical analysis is not feasible. Proper forecasting requires consideration of non-financial factors as well. 6. Lack of ability to resolve problems: Their role is essentially indicative and of whistle blowing and not providing a solution to the problem. Profitability Ratios Profitability ratios are a type of accounting ratio that helps in determining the financial performance of business at the end of an accounting period. Profitability ratios show how well a company is able to make profits from its operations. Let us now discuss the types of profitability ratios. Types of Profitability Ratios The following types of profitability ratios are discussed for the students of Class 12 Accountancy as per the new syllabus prescribed by CBSE: 1. Gross Profit Ratio 2. Operating Ratio 3. Operating Profit Ratio 4. Net Profit Ratio 5. Return on Investment (ROI) 6. Return on Net Worth 7. Earnings per share 8. Book Value per share 9. Dividend Payout Ratio 10. Price Earning Ratio Gross Profit Ratio Gross Profit Ratio is a profitability ratio that measures the relationship between the gross profit and net sales revenue. When it is expressed as a percentage, it is also known as the Gross Profit Margin. Formula for Gross Profit ratio is Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100 A fluctuating gross profit ratio is indicative of inferior product or management practices. Operating Ratio  Operating ratio is calculated to determine the cost of operation in relation to the revenue earned from the operations. The formula for operating ratio is as follows Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Net Revenue from Operations ×100 Operating Profit Ratio Operating profit ratio is a type of profitability ratio that is used for determining the operating profit and net revenue generated from the operations. It is expressed as a percentage. The formula for calculating operating profit ratio is: Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100 Or Operating Profit Ratio = 100 – Operating ratio Net Profit Ratio Net profit ratio is an important profitability ratio that shows the relationship between net sales and net profit after tax. When expressed as percentage, it is known as net profit margin. Formula for net profit ratio is Net Profit Ratio = Net Profit after tax ÷ Net sales Or Net Profit Ratio = Net profit/Revenue from Operations × 100 It helps investors in determining whether the company’s management is able to generate profit from the sales and how well the operating costs and costs related to overhead are contained. Also read: Net Profit Ratio Return on Capital Employed (ROCE) or Return on Investment (ROI) Return on capital employed (ROCE) or Return on Investment is a profitability ratio that measures how well a company is able to generate profits from its capital. It is an important ratio that is mostly used by investors while screening for companies to invest. The formula for calculating Return on Capital Employed is : ROCE or ROI = EBIT ÷ Capital Employed × 100 Where EBIT = Earnings before interest and taxes or Profit before interest and taxes Capital Employed = Total Assets – Current Liabilities Return on Net Worth This is also known as Return on Shareholders funds and is used for determining whether the investment done by the shareholders are able to generate profitable returns or not. It should always be higher than the return on investment which otherwise would indicate that the company funds are not utilised properly. The formula for Return on Net Worth is calculated as : Return on Shareholders’ Fund = Profit after Tax / Shareholders’ Funds × 100 Or Return on Net Worth = Profit after Tax / Shareholders’ Funds × 100 Earnings Per Share (EPS) Earnings per share or EPS is a profitability ratio that measures the extent to which a company earns profit. It is calculated by dividing the net profit earned by outstanding shares. The formula for calculating EPS is: Earnings per share = Net Profit ÷ Total no. of shares outstanding Having higher EPS translates into more profitability for the company. Book Value Per Share Book value per share is referred to as the equity that is available to the the common shareholders divided by the number of outstanding shares Equity can be calculated by: Equity funds = Shareholders funds – Preference share capital The formula for calculating book value per share is: Book Value per Share = (Shareholders’ Equity – Preferred Equity) / Total Outstanding Common Shares. Dividend Payout Ratio Dividend payout ratio calculates the amount paid to shareholders as dividends in relation to the amount of net income generated by the business. It can be calculated as follows: Dividend Payout Ratio (DPR) : Dividends per share / Earnings per share Price Earning Ratio This is also known as P/E Ratio. It establishes a relationship between the stock (share) price of a company and the earnings per share. It is very helpful for investors as they will be more interested in knowing the profitability of the shares of the company and how much profitable it will be in future. P/E ratio is calculated as follows: P/E Ratio = Market value per share ÷ Earnings per share It shows if the company’s stock is overvalued or undervalued. Liquidity Ratio Liquidity is a very critical part of a business. Liquidity is required for a business to meet its short term obligations. Liquidity ratios are a measure of the ability of a company to pay off its short- term liabilities. Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments. This is a very important criterion that creditors check before offering short term loans to the business. An organisation which is unable to clear dues results in creating impact on the creditworthiness and also affects credit rating of the company. Let us now discuss the different types of liquidity ratios. Types of Liquidity Ratio There are following types of liquidity ratios: 1. Current Ratio or Working Capital Ratio 2. Quick Ratio also known as Acid Test Ratio 3. Cash Ratio also known Cash Asset Ratio or Absolute Liquidity Ratio 4. Net Working Capital Ratio Let us know more in detail about these ratios. Current Ratio or Working Capital Ratio The current ratio is a measure of a company’s ability to pay off the obligations within the next twelve months. This ratio is used by creditors to evaluate whether a company can be offered short term debts. It also provides information about the company’s operating cycle. It is also popularly known as Working capital ratio. It is obtained by dividing the current assets with current liabilities. Current ratio is calculated as follows: Current ratio = Current Assets / Current Liabilities A higher current ratio around two(2) is suggested to be ideal for most of the industries while a lower value (less than 1) is indicative of a firm having difficulty in meeting its current liabilities. Also read: Difference Between Current Ratio and Quick Ratio Quick Ratio or Acid Test Ratio Quick ratio is also known as Acid test ratio is used to determine whether a company or a business has enough liquid assets which are able to be instantly converted into cash to meet short term dues. It is calculated by dividing the liquid current assets by the current liabilities It is represented as Quick Ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities The ideal quick ratio should be one(1) for a financially stable company. See more: Working Capital Turnover Ratio Cash Ratio or Absolute Liquidity Ratio Cash ratio is a measure of a company’s liquidity in which it is measured whether the company has the ability to clear off debts only using the liquid assets (cash and cash equivalents such as marketable securities). It is used by creditors for determining the relative ease with which a company can clear short term liabilities. It is calculated by dividing the cash and cash equivalents by current liabilities. Cash ratio = Cash and equivalent / Current liabilities Net Working Capital Ratio The net working capital ratio is used to determine whether a company has sufficient cash or funds to continue its operations. It is calculated by subtracting the current liabilities from the current assets. Net Working Capital Ratio = Current Assets – Current Liabilities Liquidity Ratio Formula Here are the important liquidity ratio formulas in a tabular format. Liquidity Ratios Formula Current Ratio Current Assets / Current Liabilities Quick Ratio (Cash + Marketable securities + Accounts receivable) / Current liabilities Cash Ratio Cash and equivalent / Current liabilities  Net Working Capital Ratio Current Assets – Current Liabilities Importance of Liquidity Ratio Here are some of the importance of liquidity ratios: 1. It helps understand the availability of cash in a company which determines the short term financial position of the company. A higher number is indicative of a sound financial position, while lower numbers show signs of financial distress. 2. It also shows how efficiently the company is able to convert inventories into cash. It determines the way a company operates in the market. 3. It helps in organising the company’s working capital requirements by studying the levels of cash or liquid assets available at a certain time.