Financial Ratio Analysis

Ratio analysis is a process of determining and interpreting relationships between the items of financial statements to provide a meaningful understanding of the performance and financial position of an enterprise. Ratio analysis is an accounting tool to present accounting variables in a simple, concise, intelligible and understandable form. As per Myers Ratio analysis is a study of relationship among various financial factors in a business

Objectives of Financial Ratio Analysis The objective of ratio analysis is to judge the earning capacity, financial soundness and operating efficiency of a business organization. The use of ratio in accounting and financial management analysis helps the management to know the profitability, financial position and operating efficiency of an enterprise. Advantages of Ratio Analysis The advantages derived by an enterprise by the use of accounting ratios are: 1) Useful in analysis of financial statements: Bankers, investors, creditors, etc analysis balance sheets and profit and loss accounts by means of ratios. 2) Useful in simplifying accounting figures:

Accounting ratio simplifies summarizes and systematizes a long array of accounting figures to make them understandable. In the words of Biramn and Dribin, Financial ratios are useful because they summarize briefly the results of detailed and complicated computation 3) Useful in judging the operating efficiency of business: Accounting Ratio are also useful for diagnosis of the financial health of the enterprise. This is done by evaluating liquidity, solvency, profitability etc. Such a evaluation enables management to access financial requirements and the capabilities of various business units.

4) Useful for forecasting: Helpful in business planning, forecasting. What should be the course of action in the immediate future is decided on the basis of trend ratios, i.e., ratio calculated for number of years. 5) Useful in locating the weak spots: Locating the weak spots in the business even though the overall performance may quite good. Management cab then pay attention to the weakness and take remedial action. For example if the firm finds that the increase in distribution expense is more than proportionate to the results achieved, these can be examined in detail and depth to remove any wastage that may be there. 6) Useful in Inter-firm and Intra-firm comparison: A firm would like to compare its performance with that of other firms and of industry in general. The comparison is called inter-firm comparison. If the performance of different units belonging to the same firm is to be compared, it is called intra-firm comparison. Such comparison is almost impossible without accounting ratios. Even the progress of a

firm from year to year cannot be measured without the help of financial ratios. The accounting language simplified through ratios are the best tool to compare the firms and divisions of the firm.

Limitations of Financial Ratio Analysis:

1) False Results: If Financial Statements are not correct Financial Ratio Analysis will also be correct. 2) Different meanings are put on different terms: Elements and sun-elements are not uniquely defined. An enterprise may work out ratios on the basis of profit after Tax and interest while others work on profit before interest and Tax .So, the Ratios will also be different so cannot be compared. But before comparison is to be done the basis for calculation of ratio should be same. 3) Not comparable if different firms follow different accounting Policies. Two enterprises may follow different Policies like some enterprises may charge depreciation at straight line basis while others charge at diminishing value. Such differences may adversely affect the comparison of the financial statements. 4) Affect of Price level changes: Normally no consideration is given to price level changes in the accounting variables from which ratios are computed.

Changes in price level affects the comparability of Ratios. This handicaps the utility of accounting ratios. 5) Ignores qualitative factors: Financial Ratios are on the basis of quantitative analysis only. But many times qualitative facts overrides quantitative aspects .For Example: Loans are given on the basis of accounting Ratios but credit ultimately depends on the character and managerial ability of the borrower. Under such circumstances, the conclusions derived from ratio analysis would be misleading. 6) Ratios may be worked out for insignificant and unrelated figures. Example: A ratio may be worked out for sales and investment in govt. securities. Such ratios will only be misleading. Care should be exercised to work out ratios between only such figures which have cause and effect relationship. One should be reasonably clear as to what is the cause and what is the effect. 7) Difficult to evolve a standard Ratio: It is very difficult to evolve a standard ratio acceptable at all times as financial and economic scenario are dynamic. Again the underlying conditions for different firms and different industries are not similar, so an acceptable standard ratio cannot be evolved. 8) Window Dressing: Financial Ratios will be affected by window dressing. Manipulations and window dressings affect the financial statements so they are going to affect the f. ratios also. Therefore a particular ratio may not be a definite indicator of good or bad management. 9) Personal Bias: Ratios have to be interpreted, but different people may interpret same ratios in different ways. Ratios are only tools

of financial analysis but personal judgment of the analyst is more important. If he does not posses requisite qualifications or is biased in interpreting the ratios, the conclusion drawn prove misleading.

Classification or types of Ratios 1) Liquidity Ratio 2) Financial Structure Ratio 3) Activity Ratio 4) Profitability Ratio 5) Coverage Ratio

1) Liquidity Ratio(Short Term Solvency): It measures the short-term solvency, i.e., the firms ability to pay its current dues. They comprise of Current Ratio and Liquid Ratio. Current Ratio or Working Capital Ratio is a relationship of current assets to current liabilities. Current Assets are the assets that are either in the firm of cash or cash equivalents or can be converted into cash or cash equivalents in a short time (say, within a years time) and Current Liabilities are repayable in a short time. It is calculated as follows: Current Ratio = Current Assets Current Liabilities

Significance: The objective of calculating Current Ratio is to assess the ability of the enterprise to meet its short-term liabilities promptly. It shows the number of times the current assets can

be converted into cash to meet current liabilities. As a normal rule current assets should be twice the current liabilities. Low ratio indicates inadequacy of the enterprise to meet its current liabilities and inadequate working Capital. High Ratio is an indication of inefficient utilization of funds. An enterprise should have a reasonable current ratio. Although there is no hard and fast rule yet a current ratio of 2:1 is considered satisfactory. Current Ratio is calculated at a particular date and not for a particular period. The following items are included in current assets and Current Liabilities: Current Assets Current Liabilities 1.Cash and Bank Balance 2.Debtors(after deducting provision) 3.Bills Receivable (after deducting provision) 4.Stock 5. Marketable Securities 6.Prepaid Expenses 7.Advance Payments 8.Accued Interest 1.Creditors 2.Bills Payable 3.Bank Overdraft 4.Short-term Loans 5.Outstanding Expenses 6.Provision for Tax 7.Unclaimed Dividend Dividend Payable 8.Cash credit

Important Points: 1.Working Capital =Current Assts - Current Liabilities. 2.Total Debt =Total Outsider Liability = Long term Liability+ short term Liability (current Liability) 3.Total assets=fixed assets + investment +Current assets

Liquidity Ratio or Liquid Ratio or Quick Ratio or Acid Test Ratio:

Liquidity Ratio is a relationship of liquid assets with current liabilities and is computed to assess the short- term liquidity of the enterprise in its correct form. This is calculated as follows: Liquidity Ratio =Liquid assets or quick assets Current Liabilities Quick assets= Current assets (stock + Prepaid Expenses) Liquid assets are the assets, which are either in the form of cash or cash equivalent or can be converted into cash within a very short period. Liquid assets include cash, bills receivable, marketable securities and debtors (excluding bad and Doubtful debts), etc. Stock is excluded from liquid assets as it may take some time before it is converted into cash. Similarly prepaid expenses do not provide cash at all and are thus excluded from liquid assets. A quick ratio of 1:1 is usually considered favorable, since for every rupee of current liabilities, there is a rupee of current assets. A high liquidity ratio compared to current ratio may indicate under stocking while a low liquidity ratio while a low liquidity ratio indicated overstocking.

Problem: Following is the Balance sheet of XYZ Limited as on 31st March 2009: Liabilities Rs. Assets Rs. Equity Share Capital 24,000 Machinery and 45,000 2,400 shares of Rs. Equipment 10 each (fully paid) Stock 12,000 9,000 Profit & Loss A/C 6,000 Sundry Debtors 2,280 10% Debentures 15,000 Cash at bank 720 Sundry Creditors 23,400 Prepaid Expenses Provision for 600 Taxation 69,000 69,000 ===== ===== Compute the following Ratios: 1) Current Ratio 2) Liquid Ratio On the basis of these calculations write about the conclusions you draw about the company.

Solution: 1)Current Ratio= Current assets Current Liabilities = Stock +Debtors +Bank + Prepaid Expenses

Creditors + Provision for Taxation =Rs.12,000 + Rs.9000 + Rs.2,280 + Rs.720 Rs.23,400 + Rs.600 = Rs.24000 Rs.24000 = 1:1

Normally Current Assets should be twice the current liabilities. in this case current assets are just equal to current liabilities. Hence, the short term financial position of the company cannot be said to be satisfactory.

2) Liquid Ratio =Liquid assets or quick assets Current Liabilities

Debtors + Cash at Bank = Creditors + Provision for Taxation = Rs.9000 +Rs.2,280 Rs.23400 + Rs.600 = Rs.11,280 Rs.24,000 =0.47:1 For satisfactory position Liquid ratio is 1:1.In this case it is half of its obligations and hence liquidity of the company is also unsatisfactory

2) Financial Structure/Solvency Ratio The term solvency implies ability of an enterprise to meet its indebtedness and thus conveys an enterprises ability to meet its long - term obligations. Important solvency ratios are: Debt-Equity Ratio; Total assets to Debts Ratio and Proprietary Ratio Debt-Equity Ratio- It is computed to ascertain the soundness of the long-term financial position of the firm. This ratio expresses the relationship between debt (external equities) and the equity (internal equities) Debt means long term loans, i.e., debentures, long-term loans from financial institution. Equity means shareholders funds, i.e., preference share capital, equity share capital, reserves less losses and fictitious assets like preliminary expenses. The ratio is ascertained as follows: Debt- equity Ratio = Debt (long-term loans) Equity (shareholders Funds) Higher Ratio indicates risky financial position while lower ratio indicates safe financial position. Acceptable Debt-Equity Ratio is 2:1 which means debt can be twice the equity. Significance: This ratio is significant to access the soundness of long term financial position. It also indicates the extent to which firm depends upon outsiders for its existence. It portrays the proportion of total funds acquired by a firm by way of loans.

Total Assets to Debt Ratio Total Assets includes fixed as well as current assets. However, it does not include fictitious assets like preliminary expenses,

underwriting commission, share issue expenses, discount on issue of share etc and debt balance of profit and loss account. Long term Debts refer to debts that will mature after one year. It includes debentures, bonds, loans from financial institutions. Total Assets to Debt Ratio = Total assets Long Term Debts

Ideal Ratio is 2:1 It measures the safety margin available to the providers of longterm debts. A higher ratio represents higher security to lenders for extending long-term loans to the business. On the other hand, a low ratio represents a risky financial position as it means that the business depends heavily on outside loans for its existence. In other words, investment by the proprietors is low.

Proprietary Ratio: It establishes the relationship between proprietors funds and total assets. Proprietors fund means share capital + reserves + surplus, Both of capital and revenue nature. Loss and fictitious assets are deducted. This ratio shows the extent to which the shareholders own the business. The difference between this ratio and 100 represents the ratio of total liabilities to total assets. It is computed as follows: Proprietary Ratio = Proprietors funds or share holders funds Total assets (excluding fictitious assets) Higher the ratio the better it is for all concerned. Proprietary Ratio highlights the general financial position of the enterprise. This ratio is of great importance to the creditors to ascertain the proportion of shareholders funds in the total assets employed in the firm.

A high ratio indicates adequate safety for creditors, but a very high ratio indicates improper mix of proprietors fund and loan funds, which results in lower return on investment. It is because on loans funds, interest is deductible as an expense, thus the enterprise does not pay income tax thereon. A low ratio indicates inadequacy or low safety cover for the creditors. It may lead to unwillingness of creditors to extend credit to the enterprise.