Ratio analysis

• Ratio is an arithmetical expression of relationship between two related or interdependent items.
• Accounting ratios are mathematical expressions that show the relationship between various items or groups of items shown in financial statements.
• When ratios are calculated on the basis of accounting information, they are called accounting ratios.
• Ratio analysis is a technique which involves re-grouping of data by application of arithmetical relationship.
• The objectives of ratio analysis are to know the areas of an enterprise which need more attention and to know about the potential areas which can be improved on.
• Ratio analysis is useful in analysis of financial statements, simplifying accounting figures, judging the operating efficiency of business, and identifying problem areas.
• Accounting ratios may be classified as liquidity ratios, solvency ratios, and profitability ratios.
• Profitability ratios are used to assess the efficiency of use of various resources and include return on investment, return on equity, and return on assets.
• Liquidity ratios measure the firm’s ability to fulfil its short-term financial obligations and include current ratio/working capital ratio and liquid ratio/quick ratio/acid test ratio.
• Solvency ratios judge the long-term financial position of an enterprise and include debt to equity ratio.
• Limitations of ratio analysis include accounting ratios ignoring qualitative factors, absence of universally accepted terminology, ratios being affected by window-dressing, effects of inherent limitations of accounting, and misleading results in the absence of absolute data.
• Since non-operating assets are excluded while determining capital employed, income from non-operating assets should also be excluded from profit.
• When Assets Approach is Followed, capital employed is computed by adding non-current assets (fixed assets, intangible fixed assets, non-current trade investments, long-term loans and advances), working capital (current assets minus current liabilities), and non-operating assets.
• Operating profit ratio establishes the relationship between the operating profit and net sales.
• Operating cost is the cost of materials consumed, purchases of stock-in-trade, change in inventories of finished goods, work-in-progress and stock-in-trade, employees benefits expenses, and other expenses (other than non-operating expenses).
• Operating profit ratio is an indicator of operational efficiency of the business.
• Capital employed can be calculated from liabilities side approach and assets side approach as follows:
• Return on investment or capital employed establishes the relationship between net profit before interest, tax and preference dividend and capital employed (equity + debts).
• When Liabilities Approach is Followed, capital employed is computed by adding shareholders’ funds (share capital, reserves and surplus) and non-current liabilities (long-term borrowings and long-term provisions).
• Stock turnover ratio or Inventory turnover ratio indicates the number of times the stock is turned in sales during the accounting period, i.e it measures how fast the stock is moving through the firm and generating sales.
• Trade Receivables or Debtors turnover ratio indicates economy and efficiency in the collection of amount due from debtors.
• Operating Expenses are calculated as the sum of Employees Benefits Expenses, Other Expenses (Other than non-operating expenses) and Depreciation and Amortisation Expenses.
• Proprietors’ Funds or Shareholders’ Funds are included in total assets.
• Gross profit ratio shows the relationship between the net sales gross profit to net sales (revenue from operations)
• Total assets to debt ratio establishes a relationship between total assets and total long-term debts.
• Working capital turnover ratio shows the number of times the working capital has been rotated in generating sales.
• Cost of Goods Sold is calculated as the sum of Cost of Materials Consumed, Purchases of Stock-in-trade, Change in Inventories of Finished Goods, Work-in-progress and Stock in-trade and Direct Expenses.
• Interest coverage ratio expresses the relationship between net profit before interest and tax and interest payable on long-term debts.
• Profitability Ratios measure the profitability of a business assessing the and helps in overall efficiency of the business.
• Net profit ratio shows the relationship between net profit and revenue from operations i.e net sales.
• Operating ratio establishes the relationship between operating cost and revenue from operations i.e net sales.
• Turnover or Performance or Activity Ratios measure how efficiently a company is using its assets to generate sales.
• Trade payables or Creditors turnover ratio indicates the speed with which the amount is being paid to creditors.
• Revenue from Operations is calculated as the sum of Sales or Revenue, Other Operating Income and Excise Duty.
• Proprietary ratio establishes the relationship between proprietors’ funds and total assets.