What is Ratio Analysis?
Ratio is a quantitative or arithmetical expression between two similar items which are interdependent on each other, and the accounting information on the basis of which the ratio is calculated is known as "accounting ratio".
An analysis of financial statement with the help of computing accounting ratio is known as Ratio Analysis. It is the process of identifying and interpreting relationship between two items of the financial statement to provide true and fair value of the financial statement which depicts the financial position of the company. It also helps people to understand the company in a meaningful way.
Objective of Ratio Analysis
Financial ratio plays an important role in financial analysis and financial management as it helps various users who are interested in the financial statement. With the help of ratio analysis, the figures in the financial statement are in a simplified and systematic manner which can be easily understood by any user. Some of the main objectives of ration analysis are:
To simplify the accounting information, to determine liquidity, short- term solvency (ability of the enterprise to meet its short- term financial obligations) and long-term solvency (ability of the enterprise to pay its long-term liabilities) of the business, to access the operating efficiency of the business, to analyze the profitability of the business, to help in comparative analysis, i.e., inter-firm and intra-firm comparison.
Advantages of Ratio Analysis
Following are the advantages of ratio analysis:
- Tool for analysis of financial statements: Accounting ratios are useful for understanding the financial position of an enterprise. Bankers, investors and creditors analyze balance sheet and statement of profit and loss using ratios.
- Simplifies accounting date: Accounting ratio simplifies, summarizes and systematizes accounting data to make it understandable. Its main contribution lies in communicating precisely the interrelationships which exists between various elements of financial statements.
- Assessing the operating efficiency of business: Accounting ratios are useful for assessing the financial health and performance of an enterprise. It is assessed by evaluating liquidity, solvency, profitability, etc.
- Forecasting Purposes: Accounting ratios are helpful in business planning and forecasting.
- Locating weak areas: Accounting ratios assist in locating the weak areas of the business even if the overall performance is good. The management can then pay attention to the weaknesses and take remedial actions.
Expression of Ratio
Accounting ratio can be expressed in any of the following ways:
In this form, the relationship between two items is expressed in ratio. For example, current ratio expresses the relationship between current assets and current liabilities. Current ratio = Current Assets ÷ Current liabilities
It is expressed in percentage. For example, net profit ratio which relates net profit revenue from operations. Net Profit Ratio = Net Profit ÷ Revenue
It, being a particular figure is expressed in number of times when compared to another figure. For example, trade payables’ turnover ratio, which shows relationship between net credit purchases and average trade payables, is 4 times.
It is expressed in fraction. For example, ratio of fixed assets to share capital is 3 ÷ 4 = 0.75.
Types of Ratio Analysis
Liquidity ratios are those ratios which are compared to evaluate the capability of the entity to meet its short-term liabilities. Commonly used liquidity ratios are as follows:
Current ratio establishes the relationship between current assets and current liabilities. It indicates whether the enterprise will be able to meet its short-term financial obligations as and when they become due for payment.
The ideal current ratio is 2:1, current asset should be double of current liabilities. If the value of the current ratio is below 2 then it shows the inability of the firm to pay off its short-term debts or obligations and if the value is above 2 this shows that the firm has sufficient cash or liquid asset to meet its short term obligations.
It is also known as acid test ratio. This ratio helps in determining whether the company has enough cash or any easily convertible quick funds to meet its short-term liabilities. It only includes cash or that asset that can be converted into cash and into cash equivalent quickly or in a very short period of time. For example, current investment, bill receivables, debtors, marketable securities etc. It does not include inventories because it cannot be converted into cash quickly. The ideal quick ratio is 1:1. The formula for calculating quick ratio is
Quick ratio = Current Assets ÷ Current liabilities
Quick Asset = Current Asset - Inventories - Prepaid Expenses
Solvency means the ability of the firm to pay off its long-term debts. So, this ratio is calculated to determine the long-term financial position of a firm. This ratio is calculated to measure the solvency of the business. The most common solvency ratio is debt to equity ratio.
Debt to equity ratio
This is one of the most common ratios used for evaluating the financial leverage of a company. This is an important metric in corporate finance to find the extent to which a company finances its operations by using debt or wholly owned funds.
Debt to Equity Ratio = Long Term Debt/ Total Equity
Where, Long Term Debt = Debentures + Long Term Loans
Equity = Equity and Preference Share Capital + Reserves – Fictitious Asset
The ideal debt to equity ratio is 2:1. In case of high debt-to-equity ratio, then it is an indication that the business includes a lot of debt which might make it difficult for the business to meet its long-term debts in future. It also indicates that business have more creditors than investors. On the other hand, if the ratio is low, then it’s good for the business as it is financially secured.
Debt ratio is a ratio of total debt to total assets. This ratio indicates the share of company’s assets which are being financed by debt. A ratio greater than 1 is an indication that major portion of assets is funded by debt & the chance of default for the company is also high. The formula for calculating this ratio is
Debt Ratio = Total Debt ÷ Total Assets
This ratio establishes relationship between shareholder’s funds with the total assets of the firms. It is an important ratio for determining the long-term solvency of the firm. This ratio is also known as equity ratio or total worth to total assets ratio.
Proprietary ratio = shareholder funds ÷ capital employed or net asset
Interest coverage ratio
It is the ratio which deals with the servicing of interest on loan. It acts as the measure of security of interest that is payable on long-term debt. It expresses the relationship between the profit available for interest and the amount of interest payable. It reveals the number of times interest on long term debt is covered. A high ratio ensures safety of interest of debts. It also indicates availability of surplus of shareholders.
Formula Net Profit before interest on tax ÷ interest on long term debt
Efficiency ratios help in determining how efficiently a business is using its existing resources in order to get maximum revenues. Efficiency ratio indicates the activity and operational efficiency of the business concern. The better the management of the asset the larger is the amount of sales and the profit. Efficiency ratios are also called as performance or activity ratios. Higher efficiency ratio indicates good profitability and good utilization of resources. So, the different types of efficiency ratios are as follows:
Inventory turnover ratio
Inventory turnover ratio establishes relationship between cost of revenue from operations and cost of goods sold and average inventory carried during that period. It aims to determine the efficiency with which the inventory has been carried out during that period. This ratio reveals the number of times the finished stock is turned over during a given accounting period. Formula for calculating this ratio is
A high inventory ratio indicates that demand for the product is high and good inventory management has been done while the low inventory ratio implies overstocking, bad buying or the demand of the product is low in the market.
Trade payable turnover ratio
Trade payable turnover ratio shows the velocity with which creditors or trade payables are paid and establishes relationship between net credit purchases and total payables or average payables.
Trade receivable turnover ratio
It measures how many times a business can turn its account receivable into cash. It also helps in measuring the efficiency of the business to utilize its asset. It shows the efficiency with which the debts are allocated. It will act as the interest of the business; if the ratio is higher, it means that the debts are collected quickly. Formula for calculating this ratio is,
Working capital ratio
Working capital means the capital that is used by the business for doing day to day activities. This ratio implies how effectively the business manages its working capital. The formula for calculating this ratio is
Profitability refers to the ability of the business to earn profit. It shows the efficiency of the business. These ratios measure the profit earning capacity of the company. Profitability has a direct link with sales. This is why we calculate the ratio on the basis of sales. Generally, profitability ratios are calculated in percentage. Some of the profitability ratios are,
Gross profit ratio: It shows the relationship between the gross profit and sales. This ratio shows the margin of profit on sales. In order to calculate this ratio we would require gross profit and sales.
Operating ratio: Operating ratio also known as operating cost or operating expense ratio is a metric used to evaluate the day-to-day operational performance of the company. It helps in evaluating how effective a company is in maintaining operations at a lesser cost with a certain level of revenue and sales. A smaller ratio indicates that the company has more revenue against total expenditure.
Net profit ratio: This ratio establishes relationship between net profit and net sales. Net profit is gross profit less selling distribution and financial expenses. The net profit is determined after adding operating and non-operating to gross profit and subtracting operating and non-operating expenses there from.
Net profit ratio indicates the operational efficiency of the firm. Increase in net profit ratio indicates that companies perform better whereas decrease in net profit ratio indicates managerial inefficiency of the company.
Context and Applications
This topic is significant in the professional exams for both undergraduate and
Graduate courses, especially for
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