RATIO ANALYSIS TYPES AND PROBLEMS

                                       RATIO ANALYSIS

Ratio analysis refers to the analysis of various pieces of financial information in the financial statements of a business. They are mainly used by external analysts to determine various aspects of a business, such as its profitability, liquidity, and solvency.

Absolute figures are valuable but they standing alone convey no meaning unless compared with another. Accounting ratio show inter-relationships which exist among various accounting data. When relationships among various accounting data supplied by financial statements are worked out, they are known as accounting ratios.

Accounting ratios can be expressed in various ways such as:

1. A pure ratio says ratio of current assets to current liabilities is 2:1or

2.A rate say current assets are two times of current liabilities or

3. A percentage say current assets are 200% of current liabilities.

Each method of expression has a distinct advantage over the other the analyst will selected that mode which will best suit his convenience and purpose.

Uses or Advantages or Importance of Ratio Analysis

Ratio Analysis stands for the process of determining and presenting the relationship of items and groups of items in the financial statements. It is an important technique of financial analysis. It is a way by which financial stability and health of a concern can be judged. The following are the main uses of Ratio analysis:

Useful in financial position analysis: Accounting reveals the financial position of the concern. This helps banks, insurance companies and other financial institution in lending and making investment decisions.

Useful in simplifying accounting figures: Accounting ratios simplify, summaries and systematic the accounting figures in order to make them more understandable and in lucid form.

Useful in assessing the operational efficiency: Accounting ratios helps to have an idea of the working of a concern. The efficiency of the firm becomes evident when analysis is based on accounting ratio. This helps the management to assess financial requirements and the capabilities of various business units.

Useful in forecasting purposes: If accounting ratios are calculated for number of years, then a trend is established. This trend helps in setting up future plans and forecasting.

Useful in locating the weak spots of the business: Accounting ratios are of great assistance in locating the weak spots in the business even through the overall performance may be efficient.

Useful in comparison of performance: Managers are usually interested to know which department performance is good and for that he compare one department with the another department of the same firm. Ratios also help him to make any change in the organization structure.

Limitations of Ratio Analysis:

These limitations should be kept in mind while making use of ratio analyses for interpreting the financial statements. The following are the main limitations of ratio analysis.

False results if based on incorrect accounting data: Accounting ratios can be correct only if the data (on which they are based) is correct. Sometimes, the information given in the financial statements is affected by window dressing, i. e. showing position better than what actually is.

No idea of probable happenings in future: Ratios are an attempt to make an analysis of the past financial statements; so they are historical documents. Now-a-days keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future.

Variation in accounting methods: The two firms’ results are comparable with the help of accounting ratios only if they follow the some accounting methods or bases. Comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock.

Price level change: Change in price levels make comparison for various years difficult.

Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making so, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis.

No common standards: It is very difficult to by down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different.

Different meanings assigned to the some term: Different firms, in order to calculate ratio may assign different meanings. This may affect the calculation of ratio in different firms and such ratio when used for comparison may lead to wrong conclusions.

Ignores qualitative factors: Accounting ratios are tools of quantitative analysis only. But sometimes qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted.

No use if ratios are worked out for insignificant and unrelated figure: Accounting ratios should be calculated on the basis of cause and effect relationship. One should be clear as to what cause is and what effect is before calculating a ratio between two figures.

Classification of ratios: All the ratios broadly classified into four types due to the interest of different parties for different purposes. They are:

1. Liquidity ratios

2. Activity ratios

3. Solvency ratios

4. Profitability ratios

Liquidity Ratios

A business requires liquid funds in order to meet its short-term commitments. Liquidity is the ability of an organization to pay the amount as and when it becomes due, to the stakeholders.

Thus, we need to calculate the Liquidity ratios to measure liquidity. These ratios are short-term in nature. The creditors always want to know the liquidity position of the entity because of their financial stake.

Types of Liquidity Ratio

·         Current Ratio

·         Quick Ratio or Acid test Ratio

·         Cash Ratio or Absolute Liquidity Ratio

1.Current Ratio

It is one of the most common ratios for measuring the short-term solvency or the liquidity of the firm. It is the ratio between the Current Assets and Current Liabilities.

In other words, it measures whether there are enough current assets to pay the current debts with a margin of safety for potential losses in the realization of the current assets.

Usually, the ideal current ratio is 2:1. However, the ideal ratio depends on the nature of the business and the characteristics of its current assets and current liabilities. Thus,Where,

Current Ratio=Current Assets/Current Liabilities

Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Cash-at-Bank + Receivables + Loans and Advances + Disposable Investments + Advance Tax

Current Liabilities = Creditors + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + Dividend payable

 

2. Quick Ratio

It is also known as Acid-test Ratio. Quick Ratio measures the relationship between Quick Assets and Current Liabilities. It measures whether there are enough readily convertible quick funds to pay the current debts.

Thus, it is better than the Current Ratio. Quick assets include only cash and near cash assets. It does not include inventories as they are not readily convertible into cash.

lso, it does not include prepaid expenses as these are paid in advance and cannot be converted into cash. The ideal Quick Ratio or Acid-test Ratio is 1:1. Thus,

Quick Ratio or Acid-test Ratio=Quick Assets/Current Liabilities

Where,

Quick Assets = Current Assets – Inventories + Prepaid Expenses

Cash Ratio or Absolute Liquidity Ratio

It measures the absolute liquidity of the firm. It measures whether a firm can pay the current debts by using only the cash balances, bank balances and marketable securities.

We do not include Inventory and Debtors because there is no guarantee of their realization. Thus,

Cash Ratio=Cash and Bank Balances + Marketable Securities + Current Investments / Current Liabilities

Examples of Liquidity Ratios

Particulars	Amount
Inventory	140000
Sundry Debtors	280000
Cash	50000
Bills receivable	20000
Creditors	300000
Bank Overdraft	50000

FROM THE FOLLOWING PARTICULARS CALCULATE THE LIQUIDITY RATIOS:

Ans.

1.                        Current Ratio=Current Assets/Current Liabilities

          =   490000/350000 =1.4:1

          Current assets = 280000 + 140000 + 50000 + 20000= 490000

          Current Liabilities = Creditors + Bank Overdraft

           = 300000 + 50000    = 350000

Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Bills Receivable

2.                        Quick Ratio or Acid-test Ratio=Quick Assets/Current Liabilities

           = 350000/350000=1:1

                          Quick Assets = Current Assets – Inventories

                            = 490000 – 140000= 350000

3.     Absolute Quick Ratio =Cash Balance/Current Liabilities

=50000/350000=0.14:1

4.     Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing)

           = 490000 – 300000    = 190000

ACTIVITY RATIOS

This ratio helps to understand how efficient the management of the company is. As this ratio measures the efficiency of the utilization of assets of the company.

Types of Activity Ratios

 i. Stock Turnover ratio

ii. Debtor Turnover ratio

iii. Creditors Turnover ratio

I. STOCK/ INVENTORY TURNOVER RATIO

This ratio describes the relationship between the cost of goods sold and inventory held in the business. This ratio indicates how fast inventory/ Stock is consumed/ sold. A high ratio is good for the company. Low ratio indicated that stock is not consumed/ sold or remains in a warehouse for a longer period of time.

Formula: Cost of Goods Sold/Average Inventory

Average Inventory = (Opening Stock + Closing Stock)/2

Inventory Holiding Period= 365days/ Inventory Turnover ratio

II. DEBTOR TURNOVER RATIO

This ratio helps the company to know the collection and credit policies of the firm. It measures how efficiently the management is managing its accounts receivable. A high ratio represents better credit policy as compared to a low ratio.

Formula: Credit Sales/Average Debtors

Average Debtor = (Opening Debtor + Closing Debtor)/2

Debt collection period= 365days/ Debtor Turnover ratio

 

 

III. CREDITORS TURNOVER RATIO

This ratio helps the company to know the payment policy that is being offered by the vendors to the company. It also reflects how management is managing its account payable. A high ratio represents that in the ability of management to finance its credit purchase and vice versa.

Formula: Credit Purchase/ Average Creditors

Average Creditor = (Opening Creditor + Closing Creditor)/2

Credit payment period= 365days/ Creditor Turnover ratio

Example

Opening inventories	50,000
Closing inventories	60,000
Cost of goods manufactured	4,90,000

1. CALCULATE INVENTORY TURNOVER RATIO OF XYZ LTD.

Formula Stock Turnover Ratio = COGS / Average Inventory Where, COGS = Sales – Gross Profit Average Inventory = (Opening Stock + Closing Stock) / 2

Solution:

Cost of goods sold = 50,000 + 4,90,000 – 60,000 = 4,80,000

Average inventories = (50,000 + 60,000) / 2 = 55,000

Inventory turnover ratio = 4,80,000 ÷ 55,000 = 8.73

2.     CALCULATE DEBTOR TURNOVER RATIO OF XYZ LTD.

The following result of the previous financial year:

Opening Debtors	64,000
Closing Debtors	72,000
Credit Sale	8,00,000

Formula Debtor Turnover ratio = Credit Sales / Average Debtors or Debtor Turnover ratio = Credit Sales / Debtors + Bills Receivables Average Debtor = (Opening Debtor + Closing Debtor) / 2

Solution:

Average Debtors = (64,000 + 72,000) / 2 = 68,000

Debtor Turnover ratio = 800,000 / 68,000 = 11.76

3.       CALCULATE CREDITORS TURNOVER RATIO OF XYZ LTD.

Opening Creditors	30,000
Closing Creditors	50,000
Credit Purchase	5,00,000

Formula: Creditors Turnover Ratio = Credit Purchase / Average Creditors OR Creditors Turnover Ratio = Credit Purchase / Average Creditors + Bills Payable Average Creditor = (Opening Creditor + Closing Creditor) / 2

Solution:

Average Creditors = (30,000 + 50,000) / 2 = 40,000

Creditors Turnover ratio = 5,00,000 / 40,000 = 12.5

4.    CALCULATE WORKING CAPITAL TURNOVER RATIO OF XYZ

Net Sales	5,00,000
Current Asset	10,00,000
Closing Creditors	7,50,000

Formula Working Capital Turnover Ratio = Sales or Cost of Goods Sold / Working Capital Where COGS = Sales- Gross Profit Working Capital = Current Assets – Current Liabilities

Solution:

Working Capital = 10,00,000 – 7,50,000 = 2,50,000

Working Capital Turnover Ratio = 5,00,000 / 2,50,000 = 2

3.    SOLVENCY RATIOS

Solvency ratios also known as leverage ratios determine an entity’s ability to service its debt. So these ratios calculate if the company can meet its long-term debt. It is important since the investors would like to know about the solvency of the firm to meet their interest payments and to ensure that their investments are safe. Hence solvency ratios compare the levels of debt with equity, fixed assets, earnings of the company etc.

1] Debt to Equity Ratio

The debt to equity ratio measures the relationship between long-term debt of a firm and its total equity. Since both these figures are obtained from the balance sheet itself, this is a balance sheet ratio. Let us take a look at the formula.

Debt to Equity Ratio = Debt/ Equity ( or) Insider funds /Outsider Funds (or)                                        Long-Term Debt/Shareholders Funds

Lond Term Debt = Debentures + Long Term Loans

Share holders Funds = Equity Share Capital + Preference Share Capital + Reserves

The ideal debt-equity ratio 1:1

2) Interest Coverage Ratio

All debt has a cost, which we normally term as an interest. Debentures, loans, deposits etc all have an interest cost. This ratio will measure the security of this interest payable on long-term debt. It is the ratio between the profits of a firm available and the interest payable on debt instruments.

The formula is

Interest Coverage Ratio = Net Profit before Interest and Tax/Interest on                         Long-Term Debt

Solved Examples

Q: Calculate Interest Coverage ratio from the following details

i.            NPAT is 97,500

ii.            Tax Rate is 35%

iii.            Debentures are 6,00,000 at 10%

Solution:

NPAT = 97500

Tax Rate = 35%

Net Profit before tax = (97500 × 100) ÷ 65

Net Profit Before tax = 1,50,000

Debentures Interest = 6,00,000 × 10% = 60,000

Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-Term Debt

 =  150000/60000

Interest Coverage Ratio = 2.5:1

So in the current earnings before interest and tax, the firm can cover the interest cost for 2.5 times.

4.    Profitability Ratios:

Profitability ratio is used to evaluate the company’s ability to generate income as compared to its expenses and other cost associated with the generation of income during a particular period. This ratio represents the final result of the company.

TYPES OF PROFITABILITY RATIOS

1.     Gross Profit Ratio:

This ratio measures the marginal profit of the company. This ratio is also used to measure the segment revenue. A high ratio represents the greater profit margin and it’s good for the company.

Formula:

Gross Profit ÷ Sales × 100 Gross Profit= Sales + Closing Stock – op stock – Purchases – Direct Expenses

2.     Net Profit Ratio

This ratio measures the overall profitability of company considering all direct as well as indirect cost. A high ratio represents a positive return in the company and better the company is.

Formula:

Net Profit ÷ Sales × 100 Net Profit = Gross Profit + Indirect Income – Indirect Expenses

3.Earnings Per Share

This ratio measures profitability from the point of view of the ordinary shareholder. A high ratio represents better the company is.

Formula:

Net Profit ÷ Total no of shares outstanding

4.Price Earnings Ratio

This ratio is used by the investor to check the undervalued and overvalued share price of the company. This ratio also indicates Expectation about the earning of the company and payback period to the investors.

Formula:

Market Price of Share ÷ Earnings per share.

5.     Operating ratio: It is also known as operating cost ratio or operating expense ratio) is computed by dividing operating expenses of a particular period by net sales made during that period. Like expense ratio, it is expressed in percentage.

Formula:         

 Operating ratio is computed as follows:

The basic components of the formula are operating cost and net sales. Operating cost is equal to cost of goods sold plus operating expenses. Non-operating expenses such as interest charges, taxes etc., are excluded from the computations.

The following example may be helpful in understanding the computation of operating ratio:

 Example Problem :

The selected data from the records of Good Luck Company limited is given below:

·        Net sales: $400,000

·        Cost of goods sold: $160,000

·        Administrative expenses: $35,000

·        Selling expense: $25,000

·        Interest charges: $10,000

Required: Compute operating ratio for Good Luck Company Limited from the above data.

Solution:

Operating Ratio = (220,000* / 400,000) × 100

= 55%

The operating profit ratio is 55%. It means 55% of the sales revenue would be used to cover cost of goods sold and other operating expenses of Good Luck Company Limited.

*Computation of operating expenses:
Cost of goods sold + Administrative expenses + Selling expenses
= $160,000 + $35,000 + $25,000
= $220,000

Example Problem :

Particulars	Amount
Shareholder Equity
Equity Shares, 2346 share outstanding, Par value 0.05	118
Paid In Capital	5858
Retained Earning	13826
Total Shareholder Equity	19802
Total Assets	30011
Current Liability	8035
Total Sales	53553
Gross Profit	16147
Net Operating Profit	3028.65
Net Profit	3044

Profitability Ratios:      

1)            Earnings Per share = Net Profit / Total no of shares outstanding

                                                         = 3044/2346

                                                          = 1.30

2)            Gross Profit = Gross Profit / sales * 100

                                          = 16147/53553*100

                                          = 30.15%

3)            Net Profit = Net Profit / Sales*100

                                      = 3044/53553*100

                                       = 5.68%

Example Problem :

Sales from Widgets	$112,500
Cost of Goods Sold (COGS)	$ 85,040
Gross Margin	$ 27,460

The "Sales" account and the "Cost of Goods Sold" account both appear on a company's income statement. The Widget Manufacturing Company's income statement section needed for calculating its gross profit margin is presentedbelow

Calculate the Widget Company's Gross Profit.

Solution:

Gross Profit  Ratio =	Sales - Cost of goods sold Sales	$112,500 - $ 85,040 $112,500
		0.24

Example Problem : Calculate Net profit ratio?

WIDGET MANUFACTURING COMPANY CONDENSED INCOME STATEMENT FOR YEAR ENDING DEC. 31, 200Y
Sales from Widgets	$112,500
Cost of Goods Sold (COGS)	$ 85,040
Gross Margin	$ 27,460
Operating Expenses (Marketing & Administrative)	$ 18,950
Net Income Before Taxes	$ 8,510
Less: Income Taxes	$ 4,163
Net Income After Taxes	$ 4,347

Solution:

Net Profit Ratio =	Net income after taxes Sales	=	$ 4,347 $112,500
		=	0.04