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 interrelated 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 interfirm comparison. Principles of Ratio Selection
The following principles should be considered before selecting the ratio:

(1) 
Ratio should be logically interrelated. 

(2) 
Pseudo ratios should be avoided. 

(3) 
Ratio must measure a material factor of business. 

(4) 
Cost of obtaining information should be borne in mind. 

(5) 
Ratio should be in minimum numbers. 

(6) 
Ratio should be facilities comparable. 
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 interrelationship 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 cooperation 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.
I.LIQUIDITY RATIOS
Liquidity Ratios are also termed as ShortTerm Solvency Ratios. The term liquidity means the extent of quick convertibility of assets in to money for paying obligation of shortterm 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 :
Components of Current Assetsand Current Liabilities

Current Assets 

Current Liabilities 
l. 
Cash in Hand 
t. 
Sundry Creditors 
2. 
Cash at Bank 

(Accounts Payable) 
3. 
Sundry Debtors 
2. 
Bills Payable 
4. 
Bills Receivable 
3. 
Outstanding and Accrued Expenses 
5. 
Marketable Securities 
4. 
Income Tax Payable 

( ShortTerm) 
5. 
ShortTerm Advances 
6. 
Other ShortTerm Investments 
6. 
Unpaid or Unclaimed Dividend 
7. 
Inventories : 
7. 
Bank Overdraft (ShortTerm period) 

(a) Stock of raw materials 



(b) Stock of work in progress 



(c) Stock of finished goods 


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 shortterm financial position of a company or shortterm 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 shortterm 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
Quick Ratio can be calculated by two basic components of quick assets and current liabilities. Quick Assets = Current Assets  (Inventories+ Prepaid expenses)
Current liabilities represent those liabilities which are payable within a year
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 daytoday 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 shortobligations 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
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