RATIO ANALYSIS Meaning and definition of ratio analysis:
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strength and weaknesses of a firm as well as its historical performance and current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two variables. Significance or Importance of ratio analysis: •
It helps in evaluating the firms performance :
With the help of ratio analysis conclusion can be drawn regarding several aspects such as financial health, profitability and oper operat atio iona nall effic efficie ienc ncy y of the the unde undert rtak akin ing. g. Rati Ratio o poin points ts out out the the operat operating ing effic efficien iency cy of the firm i.e. i.e. whethe whetherr the manage managemen mentt has utilized the firm’s assets correctly, to increase the investor’s wealth. It ensures ensures a fair return to its owners and secures secures optimum optimum utilization utilization of firms assets •
It helps in inter-firm comparison:
Ratio Ratio analys analysis is helps helps in inter inter-fi -firm rm compari comparison son by provid providing ing necessary data. An interfirm comparison indicates relative position.It provides the relevant data for the comparison of the performance of different departments. If comparison shows a variance, the possible reasons of variations may be identified and if results are negative, the action may be intiated immediately to bring them in line. •
It simplifies financial statement:
The information given in the basic financial statements serves no usef useful ul Purp Purpos osee unle unless ss it s inte interru rrupt pted ed and and anal analyz yzed ed in some some comparable terms. The ratio analysis is one of the tools in the hands of those hose who want want to know now some someth thiing more more from from the the fina financ nciial statements in the simplified manner. manner.
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It helps in determining the financial position of the concern:
Rati Ratio o anal analys ysis is faci facili lita tate tess the the mana manage geme ment nt to know 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 analysis with the help of ratio analysis can know the direction of the trend trend of strategi strategicc ratio may help help the manageme management nt in the task of planning, forecasting and controlling.
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It is helpful in budgeting and forecasting:
Acco Accoun unti ting ng rati ratios os prov provid idee a reli reliab able le data data,, whic which h can can be compared, studied And analyzed.These ratios provide sound footing for future prospectus. The ratios can also serve as a basis for preparing budgeting future line of action. •
Liquidity position:
With With help of ratio analysis conclusions can be drawn regarding the Liquidity position of a firm. The liquidity positon of a firm would be satisfactory if it is able to meet its current obligation when they become due. The ability to met short term liabilities is reflected in the liquidity ratio of a firm. •
Long term solvency:
Ratio analysis is equally for assessing the long term financial abil abilit ity y of the the Firm Firm.. The The long long term term solv solven ency cy s meas measur ured ed by the the leverage or capital structure and profitability ratio which shows the earn earnin ing g powe powerr and and oper operat atin ing g effi effici cien ency cy,, Solv Solven ency cy rati ratio o show showss relationship between total liability and total assets. •
Operating efficieny:
Yet another dimension of usefulness or ratio analysis, relevant relevant from the View View point of management is that it throws light on the degree efficiency in the various activity ratios measures this kind of operational efficiency.
Classification Classification of ratios:
Different ratios are used for different purpose these ratios can be grouped into various classes class es according to the financial activity. activity. Ratios are classified into four broad categories. 1. Liqu Liquid idit ity y Rati Ratio o 2. Leve Levera rage ge Rat Ratio io 3. Prof Profit itab abil ilit ity y Ratio Ratio 4. Acti Activi vity ty Rat Ratio io
1. Liqu Liquid idit ity y Rat Ratio io::
Liquidity ratio measures the firms ability to meet its its currentobligations i.e. ability to pay its obligations and when they become due. Commonly used ratios are:
Current ratio: Current ratio is the ratio, which express relationship between current asset and current liabilities. Current asset are those which can be converted into cash within a short period of time, normally not exceeding one year. The current liabilities which are short- term maturing to be met. •
Current ratio Current Asset = Current liabilities •
Acid test ratio:
The acid test ratio is a measure of liquidity esigned to overcome the
Defect of current ratio. It is often referred to as quick ratio because it is a measurement of firms ability to convert its current assets quickly into cash in order to meet its current liabilities. Current asset -Inventories Acid test ratio
= Current liabilities
2. Leverage Leverage or capit capital al struct structure ure ratio: ratio:
Leve Levera rage ge or capi capita tall stru struct ctur uree rati ratios os are are the the rati ratios os,, whic which h indicate the relative interest of the owners and the creditors in an enterprise. These ratios indicate the funds provided by the long-term creditors and owners. To judge the long term financial position of the firm following ratios are applied.
1. Debt –equity ratio:
Debt-equity ratio which expresses the relatonship between debt and equityThis ratio explains how far owned funds are sufficient to pay outside liabilities. It is calculated by following formula
Long term +short term debts +current liabilities Debt equity ratio = Net worth
. 2. Total otal Deb Debtt ratio ratio:: This ratio explains how far owned and borrowed funds are sufficient to pay debt of the firm
Long term+short term borrowing+current borrowing+current liabilities Capital employed 3. Profi Profitab tabili ility ty ratio: ratio:
Profitability ratio are the best indicators of overall efficiency of the business concern, concern, because they compare compare return of value over and above the value put into business with sales or service carried on by the firm with the help of assets employed. Profitablity ratio can be determined on the basis of: • •
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Sales Investment
Profitability ratios related to sale:
1. Gross Gross profi profitt to sales sales ratio ratio.. 2. Net profit profit to to sales sales ratio or net profit of margin. margin. 1. Gr Gross oss pro profit fit to to sales sales rati ratio: o:
The gross profit to sales ratio establishes relationship between gross profit And sales to measure the relative relative operating efficency efficency of the firm to reflect pricing policy Sales-cost of goods sold Gross profit to sales ratio = * 100 Sale
2. Net Net prof profit it mar margi gin: n:
The net margin indicates the managements ability to earn sufficient profit on sales to earn sufficient profit on sales not only to cover cover all revenue revenue operat operating ing expens expenses es of the business business,, the cost of borrowed funds and the cost of goods or servicing, but also to have sufficient margin to pay reasonable comparison to shareholders on their contributions to the firm.
Net profit after tax and interest Net profit margin =
*100
Sales 3. Profita Profitabili bility ty ratios ratios related related to investm investments ents::
a. Retu Return rn on asse assets ts b. Return Return on capi capital tal employ employed ed a. Retu Return rn on asse assets ts::
The profitability ratio here measures the relationship between net profit and assets.
Net profit after tax Return on assets = Fixed assets b. Return on capital employed: Net profit after taxes Return on capital employed = Total capital employed
3. Acti Activi vity ty rati ratio: o:
Activity ratio are sometimes are called efficiency ratios. Activity ratios are concerned with how efficiency the assets of the firm are managed. These These ratio ratio express express relato relatonsh nship ip betwee between n level level of sales sales and the investment in various assets inventores, receivables, fixed assets etc. The important activity ratios are as follows: 1. Inventory turnover ratio :
Raw materials consumed Inventory turnover ratio = Average stock of raw materials 2. Debt Debt tur turnov nover er ratio: ratio:
This ratio shows quickly debtors are converted into cash Total sales
= Debtors 3. Average collection period rati o:
This ratio indicates how quickly the inventory is converted into cash. Days in a year
= Debtors turnover 4. Working capital turnover rat io:
This ratio shows the number of times the working capital turns in trading transaction. If it has an increasing trend over the previous year it shows that the working capital is being used efficiently. efficiently.
LIQUIDITY RATIOS
Meaning of liquidity:
The term liqui liquidit dity y refers refers to abilit ability y to pay pay its obliga obligatio tions ns when they become due. Liquidity ratios measure the ability of a firm to meet meet its its shor shortt-te term rm obli obliga gati tion onss and and refl reflec ectt the the shor shortt-te term rm fina financ ncia iall strength or solvency of a firm. Liquidity ratios are classified into two types: 1. Short Short term term liquid liquidity ity and 2. Long Long term term liqu liquid idit ity y 1. short short ter term m liqu liquidi idity: ty:
Short term liquidity refers to finance required by a firm for a period of one year or less. Short –term finance is also called working capital finance as it is required for investment in working capital or curre current nt asse assets ts like like cash cash and and bank bank bala balanc nces es,, inve invent ntor orie ies, s, acco accoun unts ts receivables and marketable securities. Further short term liquidity ratios are categories into three types they are as follows:
1. Current ratio:
The current ratio is the ratio of total current assets to total current liabilities it is calculated by dividing current assets by current liabil liabiliti ities. es.Cur Curren rentt assets assets includ includee cash cash an bank bank balanc balances, es, marketa marketable ble securities, inventory of raw material s,semi-finished and finished goods, bills receivable and prepaid expenses. The current liabilities which are short- term obligations to be met it cons consis istt of trad tradee cred credit itor ors, s, bill billss paya payabl ble, e, bank bank cred credit it,, prov provis isio ion n for for taxation and outstanding expenses. Current assets Current ratio = Current liabilities
20015866 for the year 2003-2004 = ________ = 3.3:1 24146864
for the year 2004 -2005
24146864 ________
= 2.4:1
9934397
17410682 for the year 2005-2006 = ________ = 1.7:1 10002148
Interpretation:
The current ratio for the year 2003-2004 is 3.30 compared to standard ratio 2:1 this ratio is higher which shows high short term liquidity efficiency at the the same same time time hold holdin ing g more more than than suff suffic icie ient nt curr curren entt asse assets ts mean meanss inefficient use of resources The ratio for the year 2004-2005 is 2.4:1 it is as good as maintaining standard of 2:1 The ratio for the year is 1:7:1 shows below standard of 2:1 which means efficient use of funds but at the risk of low liquidity. liquidity.
DECLARATION
I M/S Neelamma .M. Halyal here by declare that the project titled “RATIO ANALYSIS” submitted in partial fulfillment of requirement r equirement for award of the ADMINIATRATION” by degree of “BACHELOR OF BUSINESS ADMINIATRATION Karnataka
university Dharwad is my original work and not submitted else where for award of any degree or diploma
Date: Place: Hubli Halyal.
Neelamma.M.
