financial ratio analysis i

5/20/2018 Financial Ratio Analysis I

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Financial Ratio Analysis

Ratio analysis is a process of determining and interpretingrelationships 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 anenterprise.

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 andprofit and loss accounts by means of ratios.

2) Useful in simplifying accounting figures:


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Accounting ratio simplifies summarizes and systematizes a

long array of accounting figures to make them

understandable. In the words of Biramn andDribin,

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 theoverall 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


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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 RatioAnalysis 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 forcalculation of ratio should be same.

3) Not comparableif 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.


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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 analysisonly. 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 unrelatedfigures.

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


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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


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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 1.Creditors

2.Debtors(after deducting provision) 2.Bills Payable

3.Bills Receivable (after deducting

provision) 3.Bank Overdraft

4.Stock 4.Short-term Loans

5. Marketable Securities 5.Outstanding Expenses6.Prepaid Expenses 6.Provision for Tax

7.Advance Payments 7.Unclaimed Dividend

Dividend Payable

8.Accued Interest 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


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Liquidity Ratio or Liquid Ratio or Quick Ratio or AcidTest 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 andDoubtful 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.


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Problem:

Following is the Balance sheet of XYZ Limited as on 31st

March 2009:

Liabilities Rs. Assets Rs.

Equity Share Capital2,400 shares of Rs.

10 each (fully paid)

Profit & Loss A/C

10% Debentures

Sundry Creditors

Provision for

Taxation

24,000

6,000

15,000

23,400

600

69,000=====

Machinery andEquipment

Stock

Sundry Debtors

Cash at bank

Prepaid Expenses

45,000

12,000

9,000

2,280

720

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


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Creditors + Provision for Taxation

=Rs.12,000 + Rs.9000 + Rs.2,280 + Rs.720

Rs.23,400 + Rs.600

= Rs.24000 = 1:1

Rs.24000

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


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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 itslong - 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,


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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 long-

term debts.

A higher ratio represents higher security to lenders for extending

long-term loans to the business. On the other hand, a low ratiorepresents 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.


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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.

financial ratio analysis i

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