Ratio Analysis

Ratio Analysis

Ratio analysis is the process of determining and interpreting numerical relationship based on financial statements. It is the technique of interpretation of financial statements with the help of accounting ratios derived from the balance sheet and profit and loss account. Let’s learn more about Ratio Analysis.

CLASSIFICATION OF RATIO

The ratio may be classified into the four categories as follows:

Liquidity Ratio
Leverage or Capital Structure Ratio
Activity Ratio or Turnover Ratio
Profitability Ratio or Income Ratio

Liquidity Ratio: It refers to the ability of the firm to meet its current liabilities. The liquidity ratio, therefore, are also called ‘Short-term Solvency Ratio’. These ratios are used to assess the short-term financial position of the concern. They indicate the firm’s ability to meet its current obligation out of current resources.

Liquidity ratios include two ratios

Current Ratio
Quick Ratio or Acid Test Ratio

Current Ratio: This ratio explains the relationship between current assets and current liabilities of a business.

Current Assets: Current assets’ includes those assets which can be converted into cash with in a year’s time.

Current Assets = Cash in Hand + Cash at Bank + B/R + Short Term Investment + Debtors(Debtors – Provision) + Stock(Stock of Finished Goods + Stock of Raw Material + Work in Progress) + Prepaid Expenses.

Current Liabilities: ‘Current liabilities’ include those liabilities which are repayable in a year’s time.

Current Liabilities: Bank Overdraft + B/P + Creditors + Provision for Taxation + Proposed Dividend + Unclaimed Dividends + Outstanding Expenses + Loans Payable with in a Year.

Significance: According to accounting principles, a current ratio of 2:1 is supposed to be an ideal ratio.

Quick Ratio: Quick ratio indicates whether the firm is in a position to pay its current liabilities with in a month or immediately.

‘Liquid Assets’ means those assets, which will yield cash very shortly.

Liquid Assets = Current Assets – Stock – Prepaid Expenses

Significance: An ideal quick ratio is said to be 1:1. If it is more, it is considered to be better. This ratio is a better test of short-term financial position of the company.

LEVERAGE OR CAPITAL STRUCTURE RATIO

1. Leverage or Capital Structure Ratio: This ratios disclose the firm’s ability to meet the interest costs regularly and Long term indebtedness at maturity.

These ratios include the following ratios:

Debt Equity Ratio: This ratio can be expressed in two ways:

Debt Equity Ratio = Long term Loans/Shareholder’s Funds or Net Worth

Long Term Loans: These refer to long term liabilities which mature after one year. These include Debentures, Mortgage Loan, Bank Loan, Loan from Financial institutions and Public Deposits etc.

Shareholder’s Funds: These include Equity Share Capital, Preference Share Capital, Share Premium, General Reserve, Capital Reserve, Other Reserve and Credit Balance of Profit & Loss Account.

Debt Equity Ratio = External Equities / Internal Equities

Significance: This Ratio is calculated to assess the ability of the firm to meet its long term liabilities. Generally, debt equity ratio of is considered safe.

The lower this ratio, the better it is for long-term lenders because they are more secure in that case. Lower than 2:1 debt equity ratio provides sufficient protection to long-term lenders.

2. Debt to Total Funds Ratio: This Ratio is a variation of the debt equity ratio and gives the same indication as the debt equity ratio. In the ratio, debt is expressed in relation to total funds, i.e., both equity and debt.

Debt to Total Funds Ratio = Long-term Loans/Shareholder’s funds + Long-term Loans

ACTIVITY RATIO OR TURNOVER RATIO

Activity Ratio or Turnover Ratios: These ratio are calculated on the bases of ‘cost of sales’ or sales, therefore, these ratio are also called as ‘Turnover Ratio’. Turnover indicates the speed or number of times the capital employed has been rotated in the process of doing business. Higher turnover ratio indicates the better use of capital or resources and in turn leads to higher profitability.

It includes the following:

1. Stock Turnover Ratio: This ratio indicates the relationship between the cost of goods during the year and average stock kept during that year.

Stock Turnover Ratio = Cost of Goods Sold / Average Stock

Here, Cost of goods sold = Net Sales – Gross Profit

Average Stock = Opening Stock + Closing Stock/2

Significance: This ratio indicates whether stock has been used or not. It shows the speed with which the stock is rotated into sales or the number of times the stock is turned into sales during the year.

2. Debtors Turnover Ratio: This ratio indicates the relationship between credit sales and average debtors during the year

Debtor Turnover Ratio = Net Credit Sales / Average Debtors + Average B/R

While calculating this ratio, provision for bad and doubtful debts is not deducted from the debtors, so that it may not give a false impression that debtors are collected quickly.

Significance: This ratio indicates the speed with which the amount is collected from debtors. The higher the ratio, the better it is, since it indicates that amount from debtors is being collected more quickly. The more quickly the debtors pay, the less the risk from bad- debts, and so the lower the expenses of collection and increase in the liquidity of the firm.