RATIO ANALYSIS
DEFINITION OF RATIO ANALYSIS
Khan and Jain define the term ratio analysis as “the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial conditions can be determined.”
Importance of Ratio Analysis
- Analysis of Financial Statements
- Analysis of Operational Efficiency of the Firms
- Helps in Understanding the Profitability of the Company
- Helps in Identifying the Business Risks of the Firm
- Helps in Identifying the Financial Risks of the Company
- For Planning and Future Forecasting of the Firm
- To Compare the Performance of the Firms
Relationship between two or more variables.
TYPES OF RATIO ANALYSIS
1) Liquidity Ratio
2) Leverage/solvency Ratio
3)Activity ratio (efficiency of assets)
4) Profitability(profit of the firm)
1) Liquidity ratio – ability of firm to meet its current liabilities.
Short term solvency
It includes 3 ratio’s
1- Current ratio.
2- Liquid ratio.
3-Working capital ratio.
Current ratio shows relationship between current assets and current liabilities.
Its ideal ratio 2:1
It is susceptible to window dressing
Current ratio = current assets/ current liabilities
Acid test/quick ratio/liquid ratio– whether the firm is in a position to pay its current liabilities within a month or immediately.
Most rigorous test of liquidity
Ideal ratio 1:1
Quick ratio = liquid assets/ current liabilities
Liquid assets include all current assets except stock and prepaid expenses.
Net working capital ratio = current assets – currents liabilities
LEVERAGE OR SOLVENCY RATIO ( soundness of the long term financial policies of the firm)
1) Debt equity ratio – desirable 2:1 , relationship between long term loans and shareholders fund or net worth.
2) Total assets to debt ratio = total assets/ long term loans
3) Total assets includes all current as well as fixed assets and exclude all fictitious assets such as- preliminary expenses, underwriting commission, share issue expenses, discount on issue, debit balance of p & l account. 4
ACTIVITY RATIO OR TURNOVER RATIO (it indicates the rapidity with which the resources available to the concern are being used to produce sales.
Calculated on the basis of sales or cost of sales Inventory turnover ratio/ stock turnover ratio – relationship between cost of goods sold & average stock
Cost of goods sold/ average stock
Indicates whether stock has been efficiently used or not
Shows the speed with which the stock is rotated into sales or number of times the stock is turned into sales during the year.
Higher the ratio better it is
Ratio can be used for comparing the efficiency of sales policies of two firms doing same type of business.
Whose stock turnover is higher will be treated as more efficient.
Debtor turnover ratio = net credit sales/ average debtors + average br
Credit sales= total sales – cash sales
Average collection period = number of days in year/ debtor turnover ratio
Creditors turnover ratio/ payables turnover ratio= net credit purchase/ average creditors + average bills payable
It indicates the speed with which the amount is being paid to creditors
It increase the credit worthiness of the firm.
Average payment period = 365 days / creditors turnover ratio
Working capital turnover ratio= net sales/ working capital
Important in non- manufacturing concerns
Shows number of times working capital has been rotated in producing sales.
PROFITABILITY RATIO/ INCOME RATIO
The efficiency & success of a business can be measured with the help of profitability ratio.
Gross profit ratio = gross profit/net sales *100
Net sales= sales- sales return
The margin of profit available on sales, higher the gross profit better it is.
Operating profit- measures the proportion of an enterprise cost of sales & operating expenses.
Operating profit= cost of goods sold + operating expenses/net sales* 100
Gross profit= net sales- cost of goods sold
Cost of goods sold= net sales- gross profit
Operating expenses include office & administration expenses + selling & distribution expenses + discount+ bad debt+ interest on short term loans.
Not included non- operating expenses such as loss on sales of assets, loss from fires, charities, donations, income tax.
Lower operating ratio is better
Net profit ratio= net profit / net sales * 100
Operating profit ratio= operating profit/net sales* 100
Operating profit = gross profit- operating expenses
EPS (Earning per share) – its shows the overall profitability of a company.
Earnings refer to profit available for equity shareholders.
EPS= net profit (after tax, dividend on interest)/ no of equity shares
This ratio is helpful in the determination of the market price of equity share of the company.
The capacity of the company to declare dividends on equity shares.
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