Prepared by Fred M’mbololo 1 RATIO ANALYSIS Meaning of Ratio:- A ratio is simple arithmetical expression of the relationship of one number to another. It may be defined as the indicated quotient of two mathematical expressions. According to Accountant’s Handbook by Wixon, Kell and Bedford, “a ratio is an expression of the quantitative relationship between two numbers”. Ratio Analysis:- Ratio analysis is the process of determining and interpreting numerical relationship based on financial statements. It is the technique of interpretation of financial statements with the help of accounting ratios derived from the balance sheet and profit and loss account. Ratio analysis can also be defined as the process of determining and presenting the relationship of items and group of items in the financial statements. Ratio can assist management in its basic functions of forecasting, planning coordination, control and communication”. It is helpful to know about the liquidity, solvency, capital structure and profitability of an organization. It is also a helpful tool in assisting the management make good business decisions and judgments, in the current uncertain and constantly changing environment. Ratio analysis can represent following three methods. Ratio may be expressed in the following three ways : 1. Pure Ratio or Simple Ratio :- It is expressed by the simple division of one number by another. For example , if the current assets of a business are kshs 500,0000 and its current liabilities are kshs150,000, the ratio of ‘Current assets to current liabilities’ will be 3.33:1. Current Ratio= Current Assets divided by Current liabilities, the ideal ratio is 2:1, but in the example given above its 3.33:1 A high ratio indicates under trading and over capitalization while a Low ratio indicates over trading and under capitalization.
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Prepared by Fred M’mbololo 1
RATIO ANALYSIS
Meaning of Ratio:- A ratio is simple arithmetical expression of the relationship of one number to
another. It may be defined as the indicated quotient of two mathematical expressions.
According to Accountant’s Handbook by Wixon, Kell and Bedford, “a ratio is an expression of the
quantitative relationship between two numbers”.
Ratio Analysis:-
Ratio analysis is the process of determining and interpreting numerical relationship based on financial
statements. It is the technique of interpretation of financial statements with the help of accounting
ratios derived from the balance sheet and profit and loss account.
Ratio analysis can also be defined as the process of determining and presenting the relationship of items
and group of items in the financial statements.
Ratio can assist management in its basic functions of forecasting, planning coordination, control and
communication”.
It is helpful to know about the liquidity, solvency, capital structure and profitability of an organization. It
is also a helpful tool in assisting the management make good business decisions and judgments, in the
current uncertain and constantly changing environment.
Ratio analysis can represent following three methods.
Ratio may be expressed in the following three ways :
1. Pure Ratio or Simple Ratio :- It is expressed by the simple division of one number by another.
For example , if the current assets of a business are kshs 500,0000 and its current liabilities are
kshs150,000, the ratio of ‘Current assets to current liabilities’ will be 3.33:1.
Current Ratio= Current Assets divided by Current liabilities, the ideal ratio is 2:1, but in the example given
above its 3.33:1 A high ratio indicates under trading and over capitalization while a Low ratio indicates
over trading and under capitalization.
Prepared by Fred M’mbololo 2
2. ‘Rate’ or ‘So Many Times :- In this type , it is calculated how many times a
figure is, in comparison to another figure. For example , if a firm’s credit
sales during the year are Kshs. 200,000 and its debtors at the end of the
year are Kshs. 100,000 , its Debtors Turnover Ratio is 200,000/100,000 = 2
times. It shows that the credit sales are 2 times in comparison to debtors.
3. Percentage :- In this type, the relation between two figures is expressed in
hundredth. For example, if a firm’s capital is Kshs.500,000 and its profit is
Kshs.20,000 the ratio of profit capital, in term of percentage, is
(20,000/500,000*100) = 4%
ADVANTAGE OF RATIO ANALYSIS
1. Helpful in analysis of Financial Statements.
2. Helpful in comparative Study.
3. Helpful in locating the weak spots of the business.
4. Helpful in Forecasting.
5. Estimate about the trend of the business.
6. Fixation of ideal Standards.
Prepared by Fred M’mbololo 3
7. Effective Control.
8. Study of Financial Soundness.
LIMITATIONS OF RATIO ANALYSIS
1. Comparison not possible if different firms adopt different accounting policies.
2. Ratio analysis becomes less effective due to price level changes.
3. Ratio may be misleading in the absence of absolute data.
4. Limited use of a single data.
5. Lack of proper standards.
6. False accounting data gives false ratio.
7. Ratios alone are not adequate for proper conclusions.
8. Effect of personal ability and bias of the analyst.
CLASSIFICATION OF RATIOS
Ratio may be classified into the four categories as follows:
A. Liquidity Ratio
a. Current Ratio
b. Quick Ratio or Acid Test Ratio
B. Leverage or Capital Structure Ratio
a. Debt Equity Ratio
b. Debt to Total Fund Ratio
c. Proprietary Ratio
Prepared by Fred M’mbololo 4
d. Fixed Assets to Proprietor’s Fund Ratio
e. Capital Gearing Ratio
f. Interest Coverage Ratio
C. Activity Ratio or Turnover Ratio
a. Stock Turnover Ratio
b. Debtors or Receivables Turnover Ratio
c. Average Collection Period
d. Creditors or Payables Turnover Ratio
e. Average Payment Period
f. Fixed Assets Turnover Ratio
g. Working Capital Turnover Ratio
D. Profitability Ratio or Income Ratio
(A) Profitability Ratio based on Sales :
a. Gross Profit Ratio
b. Net Profit Ratio
c. Operating Ratio
d. Expenses Ratio
Prepared by Fred M’mbololo 5
(B) Profitability Ratio Based on Investment :
I. Return on Capital Employed
II. Return on Shareholder’s Funds :
a. Return on Total Shareholder’s Funds
b. Return on Equity Shareholder’s Funds
c. Earning Per Share
d. Dividend Per Share
e. Dividend Payout Ratio
f. Earning and Dividend Yield
g. Price Earning Ratio
LIQUIDITY RATIO
(A) Liquidity Ratio:-
A class of financial metrics is used to determine a company's ability to pay off
its short-terms debts obligations. Generally, the higher the value of the ratio,
the larger the margin of safety that the company possesses to cover short-
term debts.
.
(B) Liquidity is the ability of the firms to meet its current obligations as they fall
due. A company's ability to turn short-term assets into cash to cover debts is
of the utmost importance when creditors are seeking payment. Bankruptcy
analysts and mortgage originators frequently use the liquidity ratios to
determine whether a company will be able to continue as a going concern
Prepared by Fred M’mbololo 6
Liquidity ratio include the following two ratios :-
a. Current Ratio
b. Quick Ratio or Acid Test Ratio
a. Current Ratio:- This ratio explains the relationship between current assets
and current liabilities.
Current assets
This section of the balance sheet shows the assets a business owns which are
either cash, cash equivalents, or are expected to be turned into cash during the
next twelve months.
Current assets are, therefore, very important to cash flow management and
forecasting, because they are the assets that a business uses to pay its bills,
repay borrowings, pay dividends and so on,
Current assets are listed in order of their liquidity – or in other words, how easy
it is to turn each category of current asset into cash.
Prepared by Fred M’mbololo 7
The main elements of current assets are:
Inventories Inventories (often also called “stocks”) are the least liquid kind of current
asset. Inventories include holdings of raw materials, components, finished products ready to sell and also the cost of “work-in-progress” as it passes
through the production process.
For the balance sheet, a business will value its inventories at cost. A profit is only earned and recorded once inventories have been sold.
Not all inventories can eventually be sold. A common problem is stock
“obsolescence” – where inventories have to be sold for less than their cost (or thrown away) perhaps because they are damaged or customers no longer demand them. For these inventories, the balance sheet value should be the
amount that can be recovered if the stocks can finally be sold.
Trade and other
receivables
Trade debtors are usually the main part of this category. A trade debtor is
created when a customer is allowed to buys goods or services on credit. The sale is recognised as revenue (income statement) when the transaction takes place and the amount owed is added to trade debtors in the balance sheet. At
some stage in the future, when the customer settles the invoice, the trade debtor balance converts into cash!
Most businesses operate with a reasonably significant amount owed by trade debtors at any one time. It is not unusual for customers to take between 60-90 days to pay amounts owed, although the average payment period varies by
industry. Of course some customer debts are not eventually paid – the
customer becomes insolvent, leaving the business with debtor balances that it cannot recover.
When a business is doubtful whether a customer will settle its debts it needs to make an allowance for this in the balance sheet. This is done by making a
“provision for bad and doubtful debts” which effectively reduces the value of trade debtors to the total amount that the business reasonably expects to
receive in the future.
Short-term investments
A business with positive cash balances can either hold them in the bank or invest them for short periods – perhaps by placing them on short-term
deposit. Such investments would be shown in this category.
Cash and cash
equivalents
The most liquid form of current assets = the actual cash balances that the
business has! The bank account balance would be the main item in this category.
Prepared by Fred M’mbololo 8
Current liabilities
Current liabilities represent amounts that are owed by the business and which
are due to be paid within the next twelve months. Current liabilities are normally
settled from the amounts available in current assets. The main elements of
current liabilities are:
Prepared by Fred M’mbololo 9
The main elements of current liabilities are
Trade and other
payables
The main element of this is normally “trade creditors” –
amounts owed by a business to its suppliers for goods and
services supplied. A trade creditor is the reverse of a trade
debtor. A business buys from a supplier and then pays for those
goods and services some time later – the period depends on the
length and amount of credit the supplier allows.
Short-term
borrowings
Amounts in this category represent the amounts that need to be
repaid on outstanding borrowings in the next year. For example,
a business may have a bank loan of £2million of which £250,000
is due to be repaid six months after the balance sheet date. In
the balance sheet, the bank loan would be split into two
categories: £250,000 as short-term borrowings and the
remainder (£1,750,000) in the borrowings figure in non-current
liabilities.
Current tax
liabilities
This category shows the tax liabilities that the business is still to
pay to the government. This will mainly comprise corporation
tax, income tax and VAT.
Provisions This is a category that can contain a variety of amounts due. For
example, it would include any dividends due to be paid to
shareholders. More importantly, it will also include any
estimates of potential costs which the business might incur in
relation to known disputes or other issues. For example, if the
business is subject to legal claims or is planning to make
redundancies in the near future – then the likely costs of these
issues needs to be provided for in the balance sheet
Prepared by Fred M’mbololo 10
Non-current liabilities: This category shows the longer-term liabilities that a
business has. By “longer-term”, we mean liabilities that need to be settled in
more than one year’s time. This would include bank loans which are not yet due
for repayment.
Significance :- According to accounting principles, a current ratio of 2:1 is
supposed to be an ideal ratio.
It means that current assets of a business should be at least, twice the size of its
current liabilities. The higher ratio indicates better liquidity position, implying that
the firm will be able to pay its current liabilities more easily. If the ratio is less than
2:1, it indicates that the company is experiencing liquidity and working capital
problems.
The biggest drawback of the current ratio is that it is prone to “window dressing”.
b. Quick Ratio:-
Quick Ratio interpretation
Quick Ratio is an indicator of company's short-term liquidity. It measures the ability to use its quick assets (cash and cash equivalents, marketable securities and accounts receivable) to pay its current liabilities. Quick ratio formula is:
Quick ratio specifies whether the assets that can be quickly converted into cash are sufficient to cover current liabilities.
Ideally, quick ratio should be 1:1.
If quick ratio is higher, company may keep too much cash on hand or have a problem collecting its accounts receivable. Higher quick ratio is needed when the company has difficulty borrowing on short-term notes. A quick ratio higher than 1:1 indicates that the business can meet its current financial obligations with the available quick funds on hand.
A quick ratio of lower than 1:1, may indicate that the company relies too much on inventory or
other assets to pay its short-term liabilities.
Prepared by Fred M’mbololo 11
Many lenders are interested in this ratio because it does not include inventory, which may or may
not be easily converted into cash.
LEVERAGE OR CAPITAL STRUCTURE RATIO
(C) Leverage or Capital Structure Ratio :-
1. Any ratio used to calculate the financial leverage of a company to get an idea of the
company's methods of financing or to measure its ability to meet financial obligations. There
are different ratios, but the main ones include debt, equity, and interest charges.
2. A ratio used to measure a company's mix of operating costs, giving an idea of how changes
in output will affect operating income. Fixed and variable costs are the two types of operating
costs; depending on the company and the industry, the mix will differ
These ratio include the following:
a. Debt Equity Ratio:- This ratio can be expressed in two ways:
First Approach : According to this approach, this ratio expresses the
relationship between long term debts and shareholder’s fund.
Formula:
Debt Equity Ratio=Long term Loans/Shareholder’s Funds or Net Worth
Long Term Loans:- These refer to long term liabilities which mature after one
year. These include Debentures, Mortgage Loan, Bank Loan, Loan from Financial
institutions and Public Deposits etc.
Shareholder’s Funds :- These include Equity Share Capital, Preference Share
Capital, Share Premium, General Reserve, Capital Reserve, Other Reserve and
Credit Balance of Profit & Loss Account.
Prepared by Fred M’mbololo 12
Second Approach : According to this approach the ratio is calculated as follows:-
Debt equity ratio is calculated for using second approach.
Significance :- This Ratio is calculated to assess the ability of the firm to meet its
long term liabilities. Generally, debt equity ratio of is considered safe.
If the debt equity ratio is more than that, it shows a rather risky financial position
from the long-term point of view, as it indicates that more and more funds invested
in the business are provided by long-term lenders.
The lower this ratio, the better it is for long-term lenders because they are more
secure in that case. Lower than 2:1 debt equity ratio provides sufficient protection
to long-term lenders.
b. Debt to Total Funds Ratio : This Ratio is a variation of the debt equity ratio and
gives the same indication as the debt equity ratio. In the ratio, debt is expressed in
relation to total funds, i.e., both equity and debt.
Formula:
Debt to Total Funds Ratio = Long-term Loans/Shareholder’s funds + Long-term Loans
Significance :- Generally, debt to total funds ratio of 0.67:1 (or
67%) is considered satisfactory. In other words, the proportion of long term loans
should not be more than 67% of total funds.
A higher ratio indicates a burden of payment of large amount of interest charges
periodically and the repayment of large amount of loans at maturity. Payment of
interest may become difficult if profit is reduced. Hence, good concerns keep the
Prepared by Fred M’mbololo 13
debt to total funds ratio below 67%. The lower ratio is better from the long-term
solvency point of view.
c. Proprietary Ratio:- This ratio indicates the proportion of total funds provide by owners or
shareholders.
The proprietary ratio (also known as net worth ratio or equity ratio) is used to evaluate the soundness of the capital structure of a company. It is computed by dividing the stockholders’ equity by total assets.
Formula:
Some analysts prefer to exclude intangible assets (goodwill etc.) from the denominator of the above formula. In that case, the formula would be written as follows:
The information about stockholders’ equity and assets is available from balance sheet.
Example:
Total assets $ 950,000
Intangible assets
150,000
Stockholder’s equity
440,000
From the above information we can compute proprietary ratio as follows:
(440,000 / 800,000 ) × 100
55%
The proprietary ratio is 55%. It means stockholders’ has contributed 55% of the total tangible assets. The remaining 45% have been contributed by creditors.