RATIO ANALYSIS

Lecture # 06

IRFAN NEPAL
INTRODUCTION OF RATIO ANALYSIS

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Introduction of Ratio Analysis
Ratio analysis is the process of determining and interpreting numerical relationships
based on financial statements. A ratio is a statistical yardstick that provides a measure
of the relationship between two variables or figures.

This relationship can be expressed as a percent or as a quotient. Ratios are simple to

calculate and easy to understand. The persons interested in the analysis of financial
statements can be grouped under three heads,

i) Owners or investors

ii) Creditors and

iii) Financial executives

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OBJECTIVE OF RATIO ANALYSIS
The main objectives of analyzing financial statement with the help of ratios are:

1. The analysis would enable the calculation of not only the present earning capacity
of the business but would also help in the estimation of the future earning capacity.

2. The analysis would help the management to find out the overall as well as the
department wise efficiency of the firm on the basis of the available financial info.

3. The short term as well as the long term solvency of the firm can be determined
with the help of ration analysis.

4. Inter – firm comparison becomes easy with the help of ratios.

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ADVANTAGES OF RATIO ANALYSIS:
• Financial statement prepared at the end of the year do not always convey to the
reader the real profitability and financial health of the business.

• They contain various facts and figures and it is for the reader to conclude what
these figures indicated.

• Ratio Analysis is an important tool for analyzing these financial statements .

• Some important advantage derived by the firm by the use of accounting ratios are:

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ADVANTAGES OF RATIO ANALYSIS

• Help in Financial statement analysis

• Simplified accounting figures

• Helps in calculating operation efficiency of the business Enterprise

• Facilities inter- firm comparison

• Makes inter- firms comparison possible

• Helps in forecasting

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MEANING OF RATIOS
• A ratio is one figure expressed in terms of another figure.

• It is mathematical yardstick of measuring relationship of two figures or items or

group of items, which are related, is each other and mutually inter-dependent.

• It is simply the quotient of two numbers. It can be expressed in fraction or in

decimal point or in pure number.

• Accounting ratio is an expression relating to two figures or two accounts or two

set accounting heads or group of items stated in financial statement.

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IMPORTANCE OF RATIO ANAYSIS
The ratios are useful for the following parties.

1. Investors, both present as well as potential investors.

2. Financial analysis.

3. Stock broker and stock exchange authorities.

4. Government.

5. Tax Department.

6. Competitors

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IMPORTANCE OF RATIO ANAYSIS
7. Research analysis and students

8. Creditors and supplier.

9. Banks and financial institutions.

10.Company's management.

11.Finance managers

12.Mutual funds.

13.Other interested parties like credit rating agencies.

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CLASSIFICATION OF RATIOS
Different types of ratios are computed depending on the purpose for which they are
needed. Broadly speaking, they are grouped under four heads:

1. Liquidity ratios

2. Solvency ratios

3. Turnover or Activity ratios

4. Profitability ratios

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The ratios are worked out to analyze
The ratios are worked out to analyze the following aspect or areas of business organization.
1) Solvency:
a) Long-term solvency
b) Short-term solvency
c) Immediate solvency
2) Stability
3) Profitability
4) Operational efficiency
5) Credit standing
6) Structural analysis.
7) Utilization of resources and
8) Leverage or external financing.
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The ratios can be classified as under
The ratios are used for different purposes, for different users and for different
analysis. The ratios can be classified as under:

a) Traditional classification

b) Functional classification

c) Classification from user‘s point of view

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Traditional classification

As per this classification, the ratios readily suggest through their names, their
respective resources.

From this point of view, the ratios are classified as follows

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Traditional classification

a) Balance Sheet Ratio :- This ratio is also known as financial ratios. The ratios
which express relationships between two items or group of items mentioned in the
balance sheet at the end of the year.

Example :

Current ratio, Liquid ratio, Stock to Working Capital ratio, Capital Gearing ratio,
Proprietary ratio, etc.

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Traditional classification

b) Revenue Statement Ratio :- This ratio is also known as income statement ratio
which expresses the relationship between two items or two groups of items which
are found in the income statement of the year.

Example :

Gross Profit ratio, Operating ratio, Expenses Ratio, Net Profit ratio, Stock Turnover
ratio, Operating Profit ratio.

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Traditional classification

Combined Ratio :- These ratios shows the relationship between two items or two
groups of items, of which one is from balance sheet and another from income
statement (Trading A/c and Profit & Loss A/c and Balance Sheet).

Example :

Return on Capital Employed, Return on Proprietors‘ Fund ratio, Return on Equity

Capital ratio, Earning per Share ratio, Debtors' Turnover ratio, Creditors Turnover
ratio.

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Functional Classification of Ratios :
The accounting ratios can also be classified according their functions as follows.

(a) Liquidity Ratios These ratios show relationship between current assets and
current liabilities of the business enterprise.

Example : Current Ratio, Liquid Ratio.

b) Leverage Ratios :- These ratios show relationship between proprietor's fund and
debts used in financing the assets of the business organization.

Example : Capital gearing ratio, debt-equity ratio, and proprietary ratio. This ratio
measures the relationship between proprietors fund and borrowed funds.
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Functional Classification of Ratios :
c) Activity/Turnover Ratio: This ratio is also known as turnover ratio or
productivity ratio or efficiency and performance ratio. These ratios show
relationship between the sales and the assets. These are designed to indicate the
effectiveness of the firm in using funds, degree of efficiency, and its standard of
performance of the organization.

Example : Stock Turnover Ratio, Debtors' Turnover Ratio, Turnover Assets Ratio,
Stock working capital Ratio, working capital Turnover Ratio, Fixed Assets Turnover
Ratio.

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Functional Classification of Ratios
d) Profitability Ratio:- These ratios show relationship between profits and sales
and profit & investments. It reflects overall efficiency of the organizations, its
ability to earn reasonable return on capital employed and effectiveness of
investment policies.

Example:

i) Profits and Sales: Operating Ratio, Gross Profit Ratio, Operating net profit Ratio,
Expenses Ratio etc.

ii) Profits and Investments: Return on Investments, Return on Equity Capital etc.

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Functional Classification of Ratios
e) Coverage Ratios: -

These ratios show relationship between profit in hand and claims of outsiders to be

paid out of profits.

Example: Dividend Payout Ratio, Debt Service Ratio and Debt Service Coverage

Ratio. Classification from the view point of user Ratios from the users’ point of

view are classified as follows.

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Functional Classification of Ratios
1- Shareholders' point of view: -

These ratios serve the purposes of shareholders. Shareholders, generally expect the
reasonable return on their capital. They are interested in the safety of shareholders
investments and interest on it.

Example:

Return on proprietor’s fund, Return on Capital, Earning per share.

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Functional Classification of Ratios
b) Long term creditors:-

Normally leverage ratios provide useful information to the long term creditors
which include debenture holders, vendors of fixed assets, etc. The creditors
interested to know the ability of repayment of principal sum and periodical interest
payments as and when they become due.

Example: Debt equity ratio, return on capital employed, proprietary ratio.

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Functional Classification of Ratios
c) Short term creditors: - The short-term creditors of the company are basically
interested to know the ability of repayment of short-term liabilities as and when
they become due. Therefore, the creditors has important place on the liquidity
aspects of the company's assets.

Example:

a) Liquidity Ratios - Current Ratio, Liquid Ratio

b) Debtors Turnover Ratio

c) Stock working capital Ratio.

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Functional Classification of Ratios
c) Short term creditors:

The short-term creditors of the company are basically interested to know the ability
of repayment of short-term liabilities as and when they become due. Therefore, the
creditors has important place on the liquidity aspects of the company's assets.

Example:

a) Liquidity Ratios - Current Ratio, Liquid Ratio

b) Debtors Turnover Ratio

c) Stock working capital Ratio.

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