Ratio Analysis (Part - 3) - Analysis and interpretation of Financial statements, Cost Accounting | Cost Accounting - B Com PDF Download

3.3 Financial Ratios 

Financial statements of a firm are analysed for ascertaining its profitability as well as financial position. A firm is said to be financially sound provided if it is capable of meeting its commitments both short-term and longterm. Accordingly, the ratios to be computed for judging the financial position are also known as solvency ratios and those ratios which are computed for short-term solvency are known as liquidity ratios

3.3.1 Liquidity Ratio

In a short period, a firm should be able to meet all its short-term obligations i.e. current liabilities and provisions. It is current assets that yield funds in the short period - current assets are those assets which the firm can convert into cash within one year or in short run. Current assets should not only yield sufficient funds to meet current liabilities as they fall due but also enable the firm to carry on its day to day activities. The ratios to test the short-term solvency or liquidity position of an enterprise are mainly the following:

3.3.1.1 Current Ratio

Current ratio also known as the working capital ratio, is the most widely used ratio. It is the ratio of total current assets to current liabilities and is calculated by dividing the current assets by current liabilities.

Current assets are those assets which can be converted into cash in the short-run or within one year. Likewise, current liabilities are those which are to be paid off in the short run. Current assets normally include cash in hand or at bank, inventories, sundry debtors, loans and advances, marketable securities, pre-paid expenses, etc. while current liabilities consist of sundry creditors, bills payable, outstanding and accrued expenses, provisions for taxation, proposed and un-claimed dividend, bank overdraft etc.

Current ratio indicates the firms’ commitment to meet its short-term obligations. It is a measure of testing short-term solvency or in other words, it is an index of the short-term financial stability of an enterprise because it shows the margin available after paying off current liabilities.

Generally 2:1 ratio is considered ideal for a concern. If the current assets are two times of the current liabilities, there will be no adverse effect on the business operations when the payment of liabilities is made. In fact a ratio much higher than 2:1 may be unsatisfactory from the angle of profitability, though satisfactory from the point of view of short-term solvency. A high current ratio may be taken as adverse on account of the following reasons:

1. The stock might be piling up because of poor sales.
2. The amount might be looked up in debtors due to slack collection policy.
3. The cash or bank balances might be lying idle because of no proper investment.

3.3.1.2 Liquid Ratio 

This ratio is also known as Quick Ratio or Acid Test Ratio. This ratio is calculated by relating liquid or quick assets to current liabilities. Liquid assets mean those assets which are immediately converted into cash without much loss. All current assets except inventories and prepaid expenses are categorised as liquid assets. The ratio can be computed as:

Liquidity ratio may also be computed by substituting liquid liabilities in place of current liabilities. Liquid liabilities mean those liabilities which are payable within a short period. Bank overdraft and cash credit facilities, if they become a permanent mode of financing are to be excluded from current liabilities to arrive at liquid liabilities. Thus:

This ratio is an indicator of the liquid position of an enterprise. Generally, a liquid ratio of 1:1 is considered as ideal as the firm can easily meet all current liabilities. The main difference in current ratio and liquid ratio is on account of inventories and therefore a comparison of two ratios leads to important conclusions regarding inventory holding up.

3.3.2 Long-term Solvency Ratios

Long-term sources and uses of funds form the basic input for computation of long-term solvency ratios. The investors i.e. shareholders and debenture holders both present and prospective are interested in knowing the financial status of the company so that they can take decisions for long-term investment of their funds. The following are the main ratios in this category.

3.3.2.1 Debt-Equity Ratio

Debt-equity ratio is the relation between borrowed funds and owners’ capital in a firm, it is also known as external-internal equity ratio. The debt-equity ratio is used to ascertain the soundness of long-term financial policies of the business. Debt means long-term loans i.e. debentures or long-term loans from financial institutions. Equity means shareholders’ funds i.e., preference share capital, equity share capital, reserves less loss and fictitious assets like preliminary expenses. It is calculated in the following ways:

The main purpose of this ratio is to determine the relative stakes of outsiders and shareholders.

Normally in India an ideal debt equity ratio is considered to be 2:1 if it is calculated as (i) above or 0.67:1 if calculated as (ii) above. This means that a company may borrow upto twice the amount of its capital and reserves or it may raise two-thirds of its long-term funds by way of loans. Generally loans are very profitable for shareholders since interest at a fixed rate only is payable whereas the yield generally is much higher and income-tax authorities allow interest as a deductible expenses, thus effectively reducing the interest burden of the company. A higher proportion would be risky because loans carry with them for obligation to pay interest at a fixed rate which may become difficult if profit is reduced. However a lower proportion of longterm loans would indicate an undue conservation and unwillingness to take every normal risk. Both these affect the image of the company and the value placed by the market on shares.

3.3.2.2 Proprietary Ratio

This ratio is a variant of debt-equity ratio which establishes the relationship between shareholders funds and total assets. Shareholders’ fund means, share capital both equity and preference and reserves and surplus less losses. This ratio is worked out as follows:

This ratio indicates the extent to which shareholders’ funds have been invested in the assets

3.3.2.3 Fixed Assets Ratio

The ratio of fixed assets to long-term funds is known as fixed assets ratio. It focusses on the proportion of long-term funds invested in fixed assets. The ratio is expressed as follows:

Fixed assets refer to net fixed assets (i.e. original cost-depreciation to date) and trade investments including shares in subsidiaries. Long-term funds include share capital, reserves and long-term loans.

This ratio should not be more than 1. It is the principle of financial management that not merely fixed assets but a part of working capital also should be financed by long-term funds. As such it is desirable to have the ratio at less than one i.e. say, 0.67 to indicate the fact that the entire fixed capital plus a portion of the working capital are financed by long-term funds.

3.3.2.4 Debt-Service Ratio

This ratio is also known as Fixed Charges Cover or Interest Cover. This ratio measures the debt servicing capacity of a firm in so far as fixed interest on long-term loan is concerned. It is determined by dividing the net profit before interest and taxes by the fixed charges on loans. Thus:

This ratio is expressed as ‘number of times’ to indicate that profit is number of times the interest charges. It is also a measure of profitability. Since higher the ratio, higher the profitability. The ideal ratio should be 6 to 7 times.

3.3.2.5 Capital Gearing Ratio

The proportion between fixed interest or dividend bearing funds and non-fixed interest or dividend bearing funds in the total capital employed in the business is termed as capital gearing ratio. Debentures, long-term loans and preference share capital belong to the category of fixed interest/dividend bearing funds. Equity share capital, reserves and surplus constitute non-fixed interest or dividend bearing funds. This ratio is calculated as follows:

In case the fixed income bearing funds are more than the equity shareholders’ funds, the company is said to be highly geared. A low capital gearing implies that equity funds are more than the amount of fixed interest bearing securities. This ratio indicates the extra residual benefits accruing to equity shareholders. Whether the concern is operating on trading on equity can be judged by this ratio.

3.4 Market Test Ratios

These ratios are calculated generally in case of such companies whose shares and stocks are traded in the stock exchanges. Shareholders, present and probable, are interested not only in the profits of the company but also in the appreciation of the value of their shares in the stock market. The value of shares in the stock market, besides other factors, also depends upon factors like dividends declared, earning per share, the payout policy, etc., of the companies. The following ratios reflect the effect of these factors on the market value of the shares.

3.4.1 Earning Per Share (EPS)

This is calculated as under:

This ratio measures the profit available to the equity shareholders on a per share basis. Suppose, the net income of company after preference dividend is Rs 40,000 and the number of equity shares is 6,000 then,

EPS = Rs 40,000 / 6,000 = Rs 6.66 per share.

It should be noted that net income here is the net income in income statement for the period, after taking into consideration operating, non-operating, and other items like income-tax. It should be remembered that if any dividend is payable to the preference shareholders, it has to be deducted before arriving at net income for this purpose. This ratio is of considerable importance in estimating the market price of the shares. A low E.P.S. means lower possible dividends and so lower market value, while a high EPS has a favourable effect on the market value of the shares.

However, the EPS alone does not reflect the effect of various financial operations of the business. Also, its calculation may be affected, to a considerable extent, by different accounting practices and policies relating to valuation of stocks, depreciation, etc. Therefore, this ratio should be cautiously interpreted.

3.4.2 Price Earning Ratio

This ratio establishes relationship between the market price of the shares of a company and it’s earning pershare (EPS). It is calculated as under:

Assuming the market value of a share to be Rs 40 and the EPS Rs 6.66 per share as calculated in (i) above, then the PER comes to Rs 40 / 6.66 or 6 times. This ratio helps in predicting the future market value of the shares within reasonable limits. It also helps in ascertaining the extent of under and over-valuation in the market price, thus pointing to the effect of factors generated by the company’s financial position. This can be illustrated by the following illustration:

Suppose, the actual market value per share is Rs 45 while on the basis of PER and EPS it should be 6 times of EPS, i.e., Rs 6.66 x 6 = Rs 40. The excess of Rs 5 between anticipated and actual market price reflects the effect of general economic and political conditions, the image of the company, etc.... which cannot be made out from company’s financial statements. A reciprocal of this ratio gives the capitalisation rate of current earnings per share.

3.4.3 Pay-out Ratio

This ratio expresses the relationship between what is available as earnings per share and what is actually paid in the form of dividends out of available earnings. It is a good measure of the dividend policy of the company. A higher payout ratio may mean lower retention and ploughing back of profits, a deteriorating liquidity position and little or no increase in the profit-earning capacity of the company. This ratio is calculated with the help of the following formula:

3.4.4 Dividend Yield Ratio

This ratio establishes the relationship between the market price and the dividend paid per share. It is expressed as a percentage and gives the rate of return on the market value of the shares and helps in the decision of investors who are more concerned about returns on their investment rather than its capital appreciation. This ratio is calculated as under:

Since dividends are declared on paid-up value of shares, they do not reflect the actual rate of earning if the shares are purchased at market price, which is generally different from paid-up value. This ratio removes this ambiguity by relating the dividends to the market value of shares. For example, if a company declares 20% dividend on its share of Rs 20 each, having a market value of Rs 40 each, then the real rate of return is not 20% but is 10% as calculated below:

Dividend per share / Market value per share * 100

= 4/40 * 100 =10%

It should be noted that in the calculation of all the above four ratios (market test) preference shares are ignored and their dividend is adjusted against income, before it is considered for these ratios.