RATIO ANALYSIS

Q. What do you mean by Ratio analysis?

 

The information given in the basic financial statement serves no useful purpose unless it is interpreted and analysed in some comparable terms. The ratio analysis is one of the tools in hands of those who want to know something more from the financial statements. Ratio analysis is the process of determining and presenting in arithmetical terms the relationship between figures and group of figures drawn from these statements. Ratio is the basis of this analysis. A ratio may be defined as the relationship between two or more things. An accounting figure conveys some meaning if it is related to some other relevant information. Thus, the relationship between two accounting figure, expressed mathematically is known as a financial ration )or simply as a ratio). The ratio can be calculated by dividing one figure by the other.

The ratio may be expressed in any of the three ways-.

1. RATE, which is the ratio between the two numerical facts over a period of time e.g. stock turnover in three times a year.

2. Pure Ratios or Proportions, which are arrived at by the simple division of one number by another e.g., current asset to current liability ratio is 2:1

3. Percentage which is a special type of rate expressing the relationship in hundred. It is arrived at by multiplying the quotient by 100 e.g., gross profit is 25% of sales.

SIGNIFICANCE OR IMPORTANCE OF RATIO ANALYSIS

Q. What is the significance or importance of Ratio Analysis:

 

Mainly the persons interested in the analysis of the financial statements can be grouped under three heads (i) Owners or investors, (ii) Creditors and (iii) Financial executives. The importance of analysis varies materially with the purpose for which it is calculated. The primary information which seeks to be obtained from these statements differs considerable reflecting the purpose that the statement is to serve.

 

The significance of these ratios varies for these three groups as their purpose differs widely. These investors are mainly concerned with the earning capacity of the company whereas the creditors including bankers and financial institutions are interesting in knowing the ability of enterprise to meet its financial obligations timely. The financial executives are concerned with evolving analytical tools that will measure and compare costs, efficiency, liquidity and profitability with a view to making intelligent decisions.

 

The Significance or importance of Financial ratio analysis can be judged from the following facts.

 

1.  A useful tool in the hands of analyst:

Ratios are exceptionally useful tools with which one can infer the financial performance of the enterprise over a period of time, with the help of ratio analysis conclusions can be drawn regarding several aspects such as financial health profitability and operational efficiency of the undertaking. The financial health of the concern can be known with the help of different ratios. Ratios point out firm’s liquidity position to meet its short-term obligations and long term solvency. They indicate strength and weaknesses of the firm.

2.  Inter-Firm comparison:

Ratio analysis provides inter-firm comparison or comparison with industry averages by comparing the firms ratios with those of other competitive and progressive firms. An inter firm comparison exhibits the firms relative position vis-a-vis its competitors. If comparison shows a variance, the possible reasons of variations may be identified and if results are negative the corrective actions may be initiated immediately bring them in line. It is also helpful in forewarning the corporate sickness and helps the management to take corrective action.

3.  Trend Analysis:

Ratio analysis enables a firm to take the time dimension into account. In other words, it facilitates the management to know whether the firms financial position is improving or deteriorating or is constant over the years by setting a trend with the help of ratios. The analyst with the help of ratio analysis can know the direction of movement whether favourable or unfavourable. An analysis of the trend of strategic ratios may help the management in the task of planning, forecasting and controlling.

Thus ratio analysis plays a very important role in the interpretation of the financial statements correctly and to make the figures comparable and more meaningful.

RATIOS

Q. Describe the following ratios:

a)  Gross Profit Ratio;

b)  Net Profit Ratio;

c)  Operating ratio;

d)  Working Capital Turnover ratio;

 

a)    Gross Profit Ratio:

This ratio expresses relationship between gross profit and net sale. Its formula is:

Gross Profit  x 100

Net sales     

Significance of Gross Profit Ratio:

The ratio indicates the degree to which the selling price of goods per unit may decline without resulting in losses from operations to the firm. It also helps in ascertaining whether the average percentage of mark up on the goods is maintained.

b)    Net Profit Ratio:

This ratio indicates net margin earned on a sale of Rs. 100. it is calculated as follows:

Net Operating Profit      x 100

Net Sales

Significance of Net Profit Ratio:

This ratio helps in determining the efficiency with which affairs of the business are being managed. An increase in the ratio over the previous period indicate improvement in the operational, efficiency of the business provided the gross profit ratio is constant. The ratio is thus an effective measure to check the profitability or business.

 

c)    Operating Ratio:

This ratio is a complementary of net profit ratio. In case the net profit ratio is 20% it means that the operating ratio is 80%. It is calculated as follows:

Operating Costs       x  100

Net Sales

Significance of Operating Ratio;

This ratio is the test of the operational efficiency with which the business is being carried. The operating ratio should be low enough to leave a portion of sales to give a fair return to the investors. A comparison of the operating ratio will indicate whether the cost component is high or low in the figure of sales. In case the comparison shows that there is increase in this ratio, the reason for such increase should be found out and management be advised to check the increase.

 

d)    Working Capital Turnover Ratio:

This ratio indicates whether or not working capital has been effectively utilized in making sales. The ratio is calculated as follows:

Net      Sales

Working Capital

i) Debtors Turnover Ratio (debtors Velocity):

Debtors constitute an important constituent of current assets and therefore the quality of debtors to a great extent determines a firm’s liquidity. Two ratios are used by financial analysis to judge the liquidity of a firm. They are (i) Debtors turnover ratio, and (ii) Debt collection period ratio.

The debtors turnover ratio is calculated as under:

             Credit         Sales            

Average Accounts Receivable

 

Significance of Working Capital Turnover ratio:

Sales of accounts receivable ratio indicates the efficiency of the staff entrusted with collection of book debts. The higher the ratio, the better it is, since it would indicate that debts are being collected more promptly. For measuring the efficiency, it is necessary to set up a standard figure; a ratio lower than the standard will indicate in efficiency.

 

ii)   Debt collection period ratio:

The ratio indicates the extent to which the debts have been collected in time. It gives the average debts collected in time. It gives the average debt collection period. The ratio is very helpful to the lenders because it explains to them whether their borrowers are collecting money within a reasonable time. an increase in the period will result in greater blockage of funds in debtors. The ratio may be calculated by any of the following methods:

 

a)        Months (or days) in a year  

          debtors turnover

 

b)    Average account receivable x Months or days in a year

                               Credit sales for the year

 

c)                        Accounts Receivable            

        Average monthly or daily credit sales

CHARACTERISTICS OF CAPITAL BUDGETING

Question expected – Describe the characteristics of Capital Budgeting?

SIGNIFICANCE AND PRICIPLES OF CAPITAL BUDGETING

Question expected as – What is the significance and principles of Capital Budgeting?