Ratio Analysis (Part -1) - Analysis and interpretation of Financial statements, Cost Accounting | Cost Accounting - B Com PDF Download

Ratio Analysis

Ratio analysis is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one organisation or to compare two or more organisations at one point in time. Ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency.

Ratio Analysis is a important tool for any business organisation. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time.

Ratio are the symptoms like the blood pressure, the pulse or the temperature of an individual. Just as in the case of an individual, a doctor or a valid by reading the pulse of a patient or by studying the blood pressure or the temperature of a patient can diagnose the cause of his ailment, so also a financial analyst through ration analysis of the employment of resources and its overall financial position. Just as in medical science the symptoms are passive factors, to diagnose them properly depends upon the efficiency and the expertise of the doctor, so also to derive right conclusions from ratio analysis will depend upon the efficiency and depth of understanding of the financial analyst.

Accounting Ratios

An absolute figure often does not convey much meaning. Generally, it is only in the light of other information that significance of a figure is realised. A weighs 70 kg. Is he fat? One cannot answer this question unless one knows A’s age and height. Similarly, a company’s profitability cannot be known unless together with the amount of profit and the amount of capital employed. The relationship between the two figures expressed arithmetically is called a ratio. The ratio between 4 and 10 is 0.4 or 40% or 2:5. “0.4", ”40%" and “2:5" are ratios. Accounting ratios are relationships, expressed in arithmetical terms, between figures which have a cause and effect relationship or which are connected with each other in some other manner.

Accounting ratios are a very useful tool for grasping the true message of the financial statements and understanding them. Ratios naturally should be worked out between figures that are significantly related to one another. Obviously no purpose will be served by working out ratios between two entirely unrelated figures, such as discount on debentures and sales. Ratios may be worked out on the basis of figures contained in the financial statements.

Ratios provide clues and symptoms of underlying conditions. They act as indicators of financial soundness, strength, position and status of an enterprise.

Interpretation of ratios form the core part of ratio analysis. The computation of ratio is simply a clerical work but the interpretation is a taste requiring art and skill. The usefulness of ratios dependent on the judicious interpretations.

Uses of Ratio Analysis

A comparative study of the relationship, between various items of financial statements, expressed as ratios, reveals the profitability, liquidity, solvency as well as the overall financial position of the enterprises.

Ratio analysis helps to analyse and understand the financial health and trend of a business, its past performance makes it possible to have forecast about future state of affairs of the business. Interfirm comparison and intrafirm comparison becomes easier through the analysis. Past performance and future projections could be reviewed through the ratio analysis easily. Management uses the ratio analysis in exercising control in various areas viz. budgetary control, inventory control, financial control etc. and fixing the accountability and responsibility of different departmental heads for accelerated and planned performance. It is useful for all the constituents of the company as discussed under:

1. Management: Management is interested in ratios because they help in the formulation of policies, decision-making and evaluating the performances and trends of the business and its various segments.
2. Shareholders: With the application of ratio analysis to financial statements, shareholders can understand not only the working and operational efficiency of their company, but also the likely effect of such efficiency on the net worth and consequently the price of their shares in the Stock Exchange. With the help of such analysis, they can form opinion regarding the effectiveness or otherwise of the management functions.
3. Investors: Investors are interested in the operational efficiency, earning capacities and ‘financial health’ of the business. Ratios regarding profitability, debt-equity, fixed assets to net worth, assets turnover, etc., are some measures useful for the investors in making decisions regarding the type of security and industry in which they should invest.
4. Creditors: Creditors can reasonably assure themselves about the solvency and liquidity position of the business by using ratio-analysis. Such analysis helps to throw light on the repayment policy and capability of an enterprise.
5. Government: The Government is interested in the ‘financial health’ of the business. Carefully worked ratios will reflect the policy of the management and its consistency or otherwise with the overall regional and national economic policies. Such ratios help in better understanding of coststructures and may justify price controls by the Government to save the consumers.
6. Analysts: Ratio analysis is the most important technique available to the financial analysis to study the financial statements to compare the progress and position of various firms with each other and vis-a-vis the industry. 

Classification of Ratios 

Different ratios calculated from different financial figures carry different significance for different purposes. For example, for the creditors liquidity and solvency ratios are more significant than the profitability ratios, which are of prime importance for an investor. This means that ratios can be grouped on different basis depending upon their significance. The classification is rather crude and unsuitable to determine the profitability or financial position of the business. In general, accounting ratios may be classified on the following basis leading to overlap in many cases.

1. According To the Statement upon Which They Are Based

Ratios can be classified into three groups according to the statements from which they are calculated:

1.1 Balance Sheet Ratios: They deal with relationship between two items appearing in the balance sheet, e.g., current assets to current liability or current ratio. These ratios are also known as financial position ratios since they reflect the financial position of the business.

1.2 Operating Ratios or Profit and Loss Ratios: These ratios express the relationship between two individual or group of items appearing in the income or profit and loss statement. Since they reflect the operating conditions of a business, they are also known as operating ratios, e.g., gross profit to sales, cost of goods sold to sales, etc.

1.3 Combined Ratios: These ratios express the relationship between two items, each appearing in different statements, i.e., one appearing in balance sheet while the other in income statement, e.g., return on investment (net profit to capital employed); Assets turnover (sales) ratio, etc. Since both the statements are involved in the calculation of each of these ratios, they are also known as interstatement ratios.

Since the balance sheet figures refer to one point of time, while the income statement figures refer to events over a period of time, care must be taken while calculating combined or inter-statement ratios. For example while computing assets turnover ratio, average assets should be taken on the basis of opening and ending balance sheets.

2. Classification According To “Importance”

This classification has been recommended by the British Institute of Management for inter-firm comparisons. It is based on the fact that some ratios are more relevant and important than others in the process of comparisons and decision-making. Therefore, ratios may be treated as primary or secondary.

2.1 Primary Ratio: Since profit is primary consideration in all business activities, the ratio of profit to capital employed is termed as ‘Primary Ratio’. In business world this ratio is known as “Return on Investment”. It is the ratio which reflects the validity or otherwise of the existence and continuation of the business unit. In case if this ratio is not satisfactory over long period, the business unit cannot justify its existence and hence, should be closed down. Because of its importance for the very existence of the business unit it is called ‘Primary Ratio’.

2.2 Secondary Ratios: These are ratios which help to analyse the factors affecting “Primary Ratio”. These may be sub-classified as under:

2.2.1 Supporting Ratios: These are ratios which reflect the profit-earning capacities of the business and thus support the “Primary Ratio”. For example sales to operating profit ratio reflects the capacity of contribution of sales to the profits of the business. Similarly, sales to assets employed reflects the effectiveness in the use of assets for making sales, and consequently profits.

2.2.2 Explanatory Ratios: These are ratios which analyse and explain the factors responsible for the size of profit earned. Gross profit to sales, cost of goods sold to sales, stock-turnover, debtors turnover are some of the ratios which can explain the size of the profits earned. Where these ratios are calculated to highlight the effect of specific activity, they are termed as ‘Specific Explanatory Ratios’. For example, the effect of credit and collection policy is reflected by debtors turnover ratio.

3. Functional Classification

The classification of ratios according to the purpose of its computation is known as functional classification. On this basis ratios are categorised as follows:

3.1 Profitability Ratios: Profitability ratios gives some yardstick to measure the profit in relative terms with reference to sales, assets or capital employed. These ratios highlight the end result of business activities. The main objective is to judge the efficiency of the business.

3.2 Turnover Ratios or Activity Ratios: These ratios are used to measure the effectiveness of the use of capital/assets in the business. These ratios are usually calculated on the basis of sales or cost of goods sold and are expressed in integers rather than as percentages.

3.3 Financial Ratios or Solvency Ratios: These ratios are calculated to judge the financial position of the organisation from short-term as well as long-term solvency point of view. Thus, it can be subdivided into: (a) Short-term Solvency Ratios (Liquidity Ratios) and (b) Long-term Solvency Ratios (Capital Structure Ratios).

3.4 Market Test Ratios: These are of course, some profitability ratios, having a bearing on the market value of the shares.

The classification of the structure of ratio analysis cuts across the various bases on which it has been made. The determination of activity and profitability ratios are drawn partly from the balance sheet and partly from the Statement of Profit & Loss. Ratios satisfying the test of liquidity or solvency partake the items of both the balance sheet and income statement, some activity ratios coincide with those satisfying the test of liquidity, some leverage ratios belong to the category of income statement. This clearly indicates that one basis of classification crosses into other category. However, for the purpose of consideration of individual ratios, a classification of ratio on functional basis is discussed hereunder:

3.1 Profitability Ratios

A measure of ‘profitability’ is the overall measure of efficiency. In general terms efficiency of business is measured by the input-output analysis. By measuring the output as a proportion of the input, and comparing result of similar other firms or periods the relative change in its profitability can be established.

The income (output) as compared to the capital employed (input) indicates profitability of a firm. Thus the chief profitability ratio is:

Once this is known, the analyst compares the same with the profitability ratio of other firms or periods. Then, when he finds some contrast, he would like to have details of the reasons. These questions are sought to be answered by working out relevant ratios. The main profitability ratio and all the other sub-ratios are collectively known as ‘profitability ratios’.

Profitability ratio can be determined on the basis of either investments or sales. Profitability in relation to investments is measured by return on capital employed, return on shareholders’ funds and return on assets. The profitability in relation to sales are profit margin (gross and net) and expenses ratio or operating ratio.

3.1.1 Return on Investment

This ratio is also known as overall profitability ratio or return on capital employed. The income (output) as compared to the capital employed (input) indicates the return on investment. It shows how much the company is earning on its investment. This ratio is calculated as follows:

Operating profit means profit before interest and tax. In arriving at the profit, interest on loans is treated as part of profit (but not the interest on bank overdraft or other short-term finance) because loans themselves are part of the input, i.e., the capital employed and hence, the interest on loans should also be part of the output. All non-business income or rather income not related to normal operations of the company should be excluded. Thus net operating profit figure shall be IBIT, i.e., Income Before Interest and Taxation (excluding non-business income).

The income figure is reckoned before taxation because the amount of tax has no relevance to the operational efficiency. Both interest and taxation are appropriations of profit and do not reflect operational efficiency. Moreover, to compare the profitability of two different organisations having different sources of finance and different tax burden, the profit before interest and taxation is the best measure.

Capital employed comprises share capital and reserves and surplus, long-term loans minus nonoperating assets and fictitious assets. It can also be represented as net fixed assets plus working capital (i.e. current assets minus current liabilities).

In using overall profitability ratio as the chief measure of profitability, the following two notes of caution should be kept in mind. First, the figure of operating profit shows the profit earned throughout a period. The figure of capital employed on the other hand refers to the values of assets as on a balance sheet date. As the values of assets go on changing throughout a business period it may be advisable to take the average assets throughout a period, so that the profits are compared against average capital employed during a period.

Secondly, in making comparison between two different units on the basis of the overall profitability ratio, the time of incorporation of the two units should be taken care off. If a company incorporated in 2000 is compared with that incorporated in 2010, the first company’s assets will be appearing at a much lower figure than those of second company. Thus the former will show a lower capital base and if profits of both the companies are the same, the former will show a higher rate of return. This does not indicate higher efficiency; only the capital employed is lower because of the reason that it started 10 years earlier. Hence, in such cases the present value of the fixed assets should be considered for calculating the capital employed.

“Return on capital employed” should be used cautiously with clear understanding of its limitations. The ‘profits’ and “capital employed” figures are the result of a number of approximations (example, depreciation) and human judgement (valuation of assets). Therefore, the purpose of calculation of the ratio should be kept in view and appropriate figures should be selected having regard to impact of changing price levels.

Suppose a company has the following items on the liabilities side and it shows underwriting commission of Rs 1,00,000 on the assets side:

Its profit, after paying tax @ 50% is Rs 14,00,000. Profit before interest and tax will be Rs 32,50,000 which can be calculated as shown below:

The operating capital employed is Rs 95,00,000 i.e. total of all the items on liabilities side (excluding current liabilities) less Rs 1,00,000, a fictitious asset (underwriting commission).

The ROI comes to

The overall profitability ratio has two components. These are the net profit ratio (operating profit/sales x 100) multiplied by turnover ratio (sales/capital employed). Therefore, ROI, in terms of percentage:

If a management wants to maximize its profitability, it could do so by improving its net profit ratio and turnover ratio. The former refers to the margin made in each sale in terms of percentage whereas, the latter shows the utilization, i.e., rotation of the capital in making the sale. If the selling price of an article is Rs 10 whose cost is Rs 6, there is a margin of Rs 4 or 40%. This shows the gap between selling price and cost price in the percentage form. The overall profitability is also dependent upon the effectiveness of employment of capital. If in this case, sales Rs 200 were made with a capital of  Rs 100 then the rotation, i.e. the turnover is 200/100 or 2 times. Thus the business has earned a total profit of Rs 80 with a capital of Rs 100, profitability ratio being 80%, i.e., Net profit ratio x Turnover ratio = 40% x 2 = 80%.

Illustration 2

Determine which company is more profitable:

Solution:

Judging from the net margin ratio Z Ltd. appears to be more profitable. But the criteria for determining profitability is return on capital employed which in this case works out to 15% and 12% respectively for X Ltd. and Z Ltd. Hence X Ltd. is undoubtedly more profitable.

Return on investment is a good measure of profitability in as much as it is an extension of the input-output analysis. Moreover, it aids in comparing the performance efficiency of dissimilar enterprises.