FINANCIAL ACCOUNTING

MODULE - 6

RATIO ANALYSIS

Nature of Ratio Analysis

Ratio Analysis is a technique of analysis and interpretation of financial

statements. It is the process of establishing and interpreting various ratios
for helping in making certain decisions. However, Ratio analysis is not an
end in itself. It is only a means of better understanding of financial
strengths and weaknesses of a firm.

Four steps involved in the ratio analysis are:

i. Selection of relevant data from the financial statements depending

upon the objective of the analysis.
ii. Calculation of appropriate ratios from the above data.
iii. Comparison of the calculated ratios with the ratios of the same firm
in the past, or the ratios developed from projected financial
statements or the ratios of some other firms or the comparison with
ratios of the industry to which the firm belongs.
iv. Interpretation of the ratios.

Uses and Significance of Ratio Analysis

There are different parties interested in the ratio analysis for knowing the
financial position of a firm for different purposes. The supplier of goods on
credit, banks, financial institutions, investors, shareholders and
management all make use of ratio analysis as a tool in evaluating the
financial position and performance of a firm for granting credit, providing
loans or making investments in the firm. With the use of ratio analysis one
can measure the financial condition of a firm and can point out whether
the condition is strong, good, questionable or poor. The conclusions can
also be drawn as to whether the performance of the firm is improving or
deteriorating.

a)Managerial Uses of Ratio Analysis

1. Helps in decision-making. Financial statements are prepared
primarily for decision-making. But the information provided in
financial statements is not an end in itself and no meaningful
conclusion can be drawn from the statement alone. Ratio analysis
helps in making decisions from the information provided in these

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 financial statements.

2. Helps in financing forecasting and planning. Ratio Analysis is of

much help in financial forecasting and planning. Planning is looking
ahead and the ratios calculated for a number of years work as a
guide for the future. Meaningful conclusions can be drawn for a future
from these ratios. Thus, ratio analysis helps in forecasting and planning.

3. Helps in communicating. The financial strength and weakness of

a firm are communicated in a more easy and understandable
manner by the use of ratios. The information contained in the
financial statements is conveyed in a meaningful manner to the one
for whom it is meant. Thus, ratios help in communication and
enhance the value of the financial statements.

4. Helps in co-ordination. Ratios even help in co-ordination which is

of utmost importance in effective business management. Better
communication of efficiency and weakness of an enterprise results
in better co-ordination in the enterprise.

5. Helps in control. Ratio analysis even helps in making effective

control of the business. Standard ratios can be based upon proforma
financial statements and variances or deviations, if any, can be
found by comparing the actuals with the standards so as to take a
corrective action at the right time. The weaknesses or otherwise, if
any, come to the knowledge of the management which helps in
effective control of the business.

6. Other uses. There are so many other uses of ratio analysis. It is an

essential part of the budgetary control and standard costing. Ratios
are of immense importance in the analysis and interpretation of
financial statements as they bring the strength and weakness of the
firm.

b)Utility to Shareholders/Investors

An investor in the company will like to assess the financial position

of the concern where he is going to invest. His first interest will be the
security of his investment and then a return in the form of dividend or
interest. For the first purpose he will try to assess the value of fixed
assets and the loans raised against them. The investor will feel satisfied
only if the concern has sufficient amount of assets. Long-term solvency
ratios will help him in assessing financial position of the concern.

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Profitability ratios, on the other hand, will be useful to determine
profitability position. Ratio analysis will be useful to the investor in
making up his mind whether present financial position of the concern
warrants future investment or not.

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c) Utility to Creditors

The creditors or suppliers extend short-term credit to the concern.

They are interested to know whether financial position of the concern
warrants their payments at a specific time or not. The concern pays
short-term creditors out of its current assets. If the current assets are
quite sufficient to meet current liabilities then the creditors will not
hesitate in extending credit facilities. Current and acid- test ratios will
give an idea about the current financial position of the concern.

d)Utility to Employees

The employees are also interested in the financial position of the

concern especially profitability. Their wage increases and amount of
fringe benefits are related to the volume of profits earned by the
concern. The employees make use of information available in financial
statements. Various profitability ratios relating to gross profit, operating
profit, net profit, etc. enable employees to put forward their viewpoint
for the increase of wages and other benefits.

e)Utility to Government

Government is interested to know the overall strength of the

industry. Various financial statements published by industrial units are
used to calculate ratios for determining short-term, long-term and
overall financial position of the concerns. Profitability indexes can also
be prepared with the help of ratios. Government may base its future
policies on the basis of industrial information available from various
units. The ratios may be used as indicators of overall financial strength
of public as well as private sector. In the absence of the reliable
economic information, governmental plans and policies may not prove
successful.

f) Tax Audit Requirements

Section 44 AB was inserted in the Income Tax Act by the Finance

Act, 1984. Under this section every assessee engaged in any business
and having turnover or gross receipts exceeding Rs. 1 Crore is required
to get the accounts audited by a chartered accountant and submit the
tax audit report before the due date for filing the return of income
under Section 139(1). In case of a professional, a similar report is
required if the gross receipts exceed Rs. 50 lakhs. Clause 32 of the
Income Tax Act requires that the following accounting ratios should be
given

~ Gross Profit/Turnover
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~ Net Profit/Turnover
~ Stock-in-trade/Turnover
~ Material Consumed/Finished Goods Produced.

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 Further, it is advisable to compare the accounting ratios for the year
under consideration with the accounting ratios for the earlier two years
so that the auditor can make necessary enquiries, if there is any major
variation in the accounting ratios.

Limitations of Ratio Analysis

Ratio analysis is one of the most powerful tools of financial management.

Though ratios are simple to calculate and easy to understand, they suffer
from some serious limitations:

1) Limited Use of a Single Ratio. A single ratio, usually, does not

convey much of a sense. To make a better interpretation a number of
ratios have to be calculated which is likely to confuse the analyst than
help him in making any meaningful conclusion.
2) Lack of Adequate Standards. There are no well accepted
standards or rules of thumb for all ratios which can be accepted as
norms. It renders interpretation of ratios difficult.
3) Inherent Limitations of Accounting. Like financial statements,
ratios also suffer from the inherent weakness of accounting records such
as their historical nature. Ratios of the past are not necessarily true
indicators of the future.
4) Change of Accounting Procedure. Change in accounting
procedure by a firm often makes ratio analysis misleading, e.g., a change
in the valuation of methods of inventories, from FIFO to Simple Average
Method increases the cost of sales and reduces considerably the value of
closing stocks which makes stock turnover ratio to be lucrative and an
unfavourable gross profit ratio.
5) Window Dressing. Financial statements can easily be window
dressed to present a better picture of its financial and profitability position
to outsiders. Hence, one has to be very careful in making a decision from
ratios calculated from such financial statements. But it may be very
difficult for an outsider to know about the window dressing made by a
firm.
6) Personal Bias. Ratios are only a means of financial analysis and
not an end in itself. Ratios have to be interpreted and different people
may interpret the same ratio in different ways.
7) Uncomparable. Not only industries differ in their nature but also
the firms of the similar business widely differ in their size and accounting
procedure, etc. It makes comparison of ratios difficult and misleading.
Moreover, comparisons are made difficult due to differences in definitions
of various financial terms used in ratio analysis.
8) Absolute Figures Distortive. Ratios devoid of absolute figures
may prove distortive as ratio analysis is primarily a quantitative analysis
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and not a qualitative analysis.

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 9) Price Level Changes. While making ratio analysis, no
consideration is made to the changes in price levels and this makes the
interpretation of ratios invalid.
10)Ratios are not Substitutes to Financial Statements. Ratio
analysis is merely a tool of financial statements. Hence, ratios
become useless if separated from the statement from which they
are computed.

RATIOS

(A) Traditional Classification (B) Functional Classification (C) Significance Ratios

or or or
Statement Ratios
Classification according to Ratios According to
Tests Importance
1) Balance Sheet or
Position Statement Ratios
1) Liquidity Ratios 1) Primary Ratios
2) Profit & Loss Account or
Revenue/Income Statement 2) Solvency Ratios 2) Secondary Ratios
Ratios 3) Activity Ratios
3) Composite/Mixed or 4) Profitability Ratios
Inter-Statement Ratios
5) Capital structure or
Leverage ratios

TRADITIONAL CLASSIFICATION/STATEMENT RATIOS

(1) Balance Sheet Ratios Fixed Assets (1) Profit & Loss Account Ratios
or or Revenue/Income
Position Statement Ratios Statement
Ratios
i) Current ratio
ii) Liquid ratio i) Gross Profit Ratio
(Acid Test or Quick Ratio) ii) Operating Ratio
iii) Absolute Liquidity Ratio iii) Operating Profit Ratio
iv) Debt Equity Ratio iv) Net Profit Ratio
v) Proprietary Ratio v) Expense Ratio
vi) Capital Gearing Ratio vi) Interest Coverage Ratio
vii) Assets-Proprietorship
Ratio
viii) Capital Inventory
to Working Capital
Ratio
ix) Ratio of Current Assets to
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 (1) Composite/Mixed
Ratios
or
Inter-Statement Ratios

i) Stock Turnover Ratio

ii) Debtors Turnover
iii) Payable Turnover Ratio
iv) Fixed Assets Turnover
Ratio
v) Return on Equity
vi) Return on Shareholders’
Funds
vii) Return on Capital
Employed
viii) Capital Turnover Ratio
ix) Working Capital Turnover
Ratio
x) Return on Total Resources
xi) Total Assets Turnove
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