Ratio Analysis notes

Introduction

The analysis of the financial statements and interpretations of financial results of a particular period of operations with the help of 'ratio'  is termed as "ratio analysis." Ratio analysis used to determine the financial soundness of  a business  concern. Alexander Wall designed  a  system of  ratio  analysis  and presented it in useful form in the year 1909.

Meaning  and Definition

 

The term 'ratio'  refers to the mathematical relationship between any two inter-related variables. In other words, it establishes relationship between two items expressed in quantitative form.

According J. Batty, Ratio can be defined as "the term accounting ratio is used to describe significant relationships which exist between figures shown in a balance sheet and profit and loss account in a budgetary control system or any other part of the accounting management."

 

Ratio can be used in the form of (1) percentage (20%) (2) Quotient (say 10) and (3) Rates. In other words,  it can be expressed as a to b ;    a :  b (a is to b) or as a simple fraction, integer and decimal. A ratio is calculated by dividing one item or figure by another item or figure.

 

Analysis or Interpretations of  Ratios

 

The analysis or interpretations in question may be of  various types. The following approaches are usually found to exist:

 

(a)  Interpretation or Analysis of an Individual (or) Single ratio.

(b)  Interpretation or Analysis by referring to a group of ratios.

(c)  Interpretation or Analysis of ratios by trend.

(d) Interpretations or Analysis by inter-firm comparison. Principles of Ratio Selection

The following principles should be considered before selecting the ratio:

 

Advantages  of Ratio Analysis
 

Ratio analysis is necessary to establish the relationship between two accounting figures to highlight the significant information to the management or users who can analyse the business situation and to monitor their performance in a meaningful way. The following are the advantages of ratio analysis:

(1)    It facilitates the accounting information to be summarized and simplified in a  required form.

(2)    It  highlights  the  inter-relationship  between  the  facts  and  figures  of  various  segments  of business.

(3)    Ratio analysis helps to remove all type of wastages and inefficiencies.

(4)     It  provides  necessary  information to  the  management to  take prompt  decision  relating  to business.

(5)     It helps to the management for effectively discharge its functions such as planning, organizing, controlling, directing and forecasting.

(6)     Ratio analysis reveals profitable and unprofitable activities. Thus, the management is able to concentrate on unprofitable activities and consider to improve the efficiency.

(7)     Ratio analysis is used as a measuring rod for effective control of performance of business activities.

(8)     Ratios are an effective means of communication and informing about financial soundness made by the business concern to the proprietors, investors, creditors and other parties.

(9)     Ratio analysis is an effective tool which is used for measuring the operating results of the enterprises.

(10)    It facilitates control over the operation as well as resources of the business. (11)       Effective co-operation can be achieved through ratio analysis

(12)    Ratio analysis provides all assistance to the management to fix responsibilities.

(13)     Ratio analysis helps  to determine the performance of liquidity,   profitability and solvency position of the business concern.

 

Limitations  of Ratio Analysis

 

Ratio analysis is one of the important techniques of determining the performance of financial strength and weakness of a firm. Though ratio analysis is relevant and useful technique for the business concern, the analysis is based on the information available in the financial statements. There are some situations, where ratios are misused, it may lead the management to wrong direction. The ratio analysis suffers from the following limitations:

(1)      Ratio analysis is used on the basis of financial statements. Number of limitations of financial statements may affect the accuracy or quality of ratio analysis.

(2)      Ratio analysis heavily depends on quantitative facts and figures and it ignores qualitative data.I

(3)    Therefore this may limit accuracy.

(4)    Ratio analysis is a poor measure of a firm's performance due to lack of adequate standards laid for ideal ratios.

(5)    It  is not a  substitute for  analysis of  financial statements. It  is  merely used as  a tool  for measuring the performance of business activities. 

(6)    Ratio analysis clearly has some latitude for window dressing.

(7)    It makes comparison of ratios between companies which is questionable due to differences in methods of accounting operation and financing.

(8)     Ratio analysis does not consider the change in price level, as such, these ratio will not help in drawing meaningful inferences.

 

CLASSIFICATION  OF RATIOS

Accounting Ratios are classified on the basis of the different parties interested in making use of the ratios. A very large number of accounting ratios are used for the purpose of determining the financial position of a concern for different purposes. Ratios may be broadly classified in to:

 

(1)    Classification of Ratios on the basis of Balance Sheet.

 

(2)    Classification of Ratios on the basis of Profit and Loss Account.

 

(3)    Classification of Ratios on the basis of Mixed Statement (or) Balance Sheet and Profit and Loss Account.

 

This classification further grouped in to:

 

I.  Liquidity Ratios

 

II.   Profitability Ratios

 

III. Turnover Ratios

 

IV. Solvency Ratios

 

V.    Over all Profitability Ratios

 

These classifications are discussed hereunder :

 

1. Classification  of Ratios on the basis of Balance Sheet: Balance sheet ratios which establish the relationship between two balance sheet items.   For example, Current Ratio, Fixed Asset Ratio, Capital Gearing Ratio and Liquidity Ratio etc.

2. Classification  on the basis of Income Statements:   These  ratios   deal  with  the  relationship between two items or two group of items of the income statement or profit and loss account. For example, Gross Profit Ratio,  Operating Ratio, Operating Profit Ratio, and Net Profit Ratio etc.

3. Classification on the basis of Mixed Statements:  These ratios also known as Composite or Mixed Ratios or Inter Statement Ratios. The inter statement ratios which deal with relationship between the item of profit and loss account and item of balance sheet. For example, Return on Investment Ratio, Net Profit to Total Asset Ratio, Creditor's Turnover Ratio, Earning Per Share Ratio and Price Earning Ratio etc.

 

Liquidity Ratios are also termed as Short-Term Solvency Ratios. The term liquidity means the extent of quick convertibility of assets in to money for paying obligation of short-term nature. Accordingly, liquidity ratios are useful in obtaining an indication of a firm's ability to meet its current liabilities, but it does not reveal hew effectively the cash resources can be managed. To measure the liquidity of a firm, the following ratios are commonly used:

 

(1)    Current Ratio.

(2)    Quick Ratio (or) Acid Test or Liquid Ratio.

(3)    Absolute Liquid Ratio (or) Cash Position Ratio.

 

(1) Current  Ratio

Current Ratio establishes the relationship between current Assets and current Liabilities.  It attempts to measure the ability of a firm to meet its current obligations. In order to compute this ratio, the following formula is used :

Current Ratio =              Current Assets /Current Liabilities

 

The two basic  components of this  ratio are current  assets and current liabilities.  Current  asset normally means assets which can be easily converted in to cash within a year's time. On the other hand, current liabilities represent those liabilities which are payable within a year. The following table represents the components of current assets and current liabilities in order to measure the current ratios :

 

 

Interpretation of Current  Ratio: The ideal current ratio is 2: I.  It indicates that current assets double the current liabilities is considered to be satisfactory. Higher value of current ratio indicates more liquid of the firm's ability to pay its current obligation in time.  On the other hand, a low value of current ratio means that the firm may find it difficult to pay its current ratio as one which is generally recognized as the patriarch among ratios.

 

Advantages of Current Ratios:

 

(1)     Current  ratio helps to measure the liquidity of a firm.

(2)    It represents general picture of the adequacy of the working capital position of a company. (3)    It indicates liquidity of a company.

(4)    It represents a margin of safety, i.e., cushion of protection against current creditors.

(5)     It helps to measure the short-term financial position of a company or short-term solvency of a firm.

 

Disadvantages of Current Ratio:

 

(I)     Current ratios cannot be appropriate to all busineses it depends on many other factors.

(2)     Window· dressing is another problem of current ratio, for example, overvaluation of closing stock.

(3)     It is a crude measure of a firm's liquidity only on the basis of quantity and not quality of current assets.

 

(2) Quick Ratio (or) Acid Test or Liquid  Ratio

 

Quick  Ratio also termed as Acid Test or Liquid Ratio. It is supplementary to the current ratio. The acid test ratio is a more severe and stringent test of a firm's ability to pay its short-term obligations as and when they become due. Quick Ratio establishes the relationship between the quick assets and current liabilities.  In order to compute this ratio, the below presented formula is used :

Liquid Ratio      :

Liquid Assets

(Current Assets -  Stock and  Prepaid Expenses)

 Current Liabilities

The ideal Quick Ratio of l: I  is considered to be satisfactory.  High Acid Test Ratio is an indication that the firm has relatively better position to meet its current obligation in time. On the other hand, a low value of quick ratio exhibiting that the firm's liquidity position is not good.

 

Advantages

 

(1)    Quick Ratio helps to measure the liquidity position of a firm.

(2)    It is  used as a supplementary to the current ratio.

(3)     It is used to remove inherent defects of current ratio.

 

(3) Absolute Liquid  Ratio

 

Absolute Liquid Ratio is also called as Cash Position Ratio (or) Over Due Liability Ratio. This ratio established the relationship between the absolute liquid assets and current liabilities, Absolute Liquid Assets include cash  in hand,  cash  at bank, and  marketable securities or  temporary investments. The optimum value for this ratio should be one, i.e.,   I  :  2. It indicates that 50% worth absolute liquid assets are considered adequate to pay the 100% worth current liabilities in time. If the ratio is relatively lower than one, it represents that the company's day-to-day cash management is poor.  If the ratio is considerably more than one, the absolute liquid ratio represents enough funds in the form of cash to meet its short-obligations in time. The Absolute Liquid ~arit. caa be calculated by dividing the total of the Absolute

Liquid Assets by Total Current Liabilfties. Thus,

Absolute Liquid Ratio =  Absolute Liquid Assets/Current Liabilities