A financial ratio is a relationship of two values of financial statements. Ratiosbasically are mathematical expressions, which are calculated to derive certainconclusion. The ratio may be expressed as number of times, proportion orpercentage. There are number of ratios, but which to consider for a particulartype of analysis is left to the personal judgement of the analyst. As a matter offact, all the ratios are for different purposes and have different objectives.
Uses of Ratios.
Ratios offer help in intra firm comparisons, industry comparison and also for inter-firm comparison. Financial position of the entity can be studied. Limitations & problems of Ratio analysis:
Ratios are based on financial statements, so contain almost all of the deficiencies of those accounts. Some ratios are open for manipulation and need to be interpreted with care. Inter-firm comparisons are faced with the problem that different organizations might use rather different accounting policies. Detailed knowledge of a company’s markets is seldom obtainable from the published accounts, but is extremely important for assessing future profitability. Ratios are useful when comparing similar organizations operating under similar conditions. Comparisons with different types of organizations can be misleading. There is a real danger that ratio analysis can lead to conclusions, which are over-simplified. Types of Ratios.
Turnover Ratios:Debtors Turnover Ratio Creditors Turnover Ratio. Inventory Turnover Ratio.
Liquidity Ratios: Current Ratio Acid Test Ratio
Profitability Gross Profit Ratio Net Profit Ratio Material cost ratio Expenses Ratios Return on Capital Return on Proprietor’s Funds
Uses of Ratios.
Ratios offer help in intra firm comparisons, industry comparison and also for inter-firm comparison. Financial position of the entity can be studied. Limitations & problems of Ratio analysis:
Ratios are based on financial statements, so contain almost all of the deficiencies of those accounts. Some ratios are open for manipulation and need to be interpreted with care. Inter-firm comparisons are faced with the problem that different organizations might use rather different accounting policies. Detailed knowledge of a company’s markets is seldom obtainable from the published accounts, but is extremely important for assessing future profitability. Ratios are useful when comparing similar organizations operating under similar conditions. Comparisons with different types of organizations can be misleading. There is a real danger that ratio analysis can lead to conclusions, which are over-simplified. Types of Ratios.
Turnover Ratios:Debtors Turnover Ratio Creditors Turnover Ratio. Inventory Turnover Ratio.
Liquidity Ratios: Current Ratio Acid Test Ratio
Profitability Gross Profit Ratio Net Profit Ratio Material cost ratio Expenses Ratios Return on Capital Return on Proprietor’s Funds
Debt Equity Ratio
Average Debtors x 365 divided by Sales
Average Collection period.
Average Creditors x 365 divided by Credit purchases.
Average payment period.
Average inventory x 365 divided by material cost
Holding period of stock
current ratio = Current Assets / Current Liabilities.
quick ratio = Quick Assets / Quick liabilities.
gross profit ratio = Gross profit / Net sales x 100
net profit ratio = Net profit / Net sales x 100
material cost ratio = Material cost / Net sales x 100
expenses ratio = Expenses / Net sales x 100
return on capital = PBIT / Capital employed x 100
Return on Proprietor’s Funds = PAT / Proprietor’s Funds
debt equity ratio = Total outside debt / Equity or Shareholders’ funds.
Proprietary Ratio = Proprietor’s funds /Total Assets x 100
Interest coverage Ratio = PBIT / Fixed interest charges
Debt coverage Ratio = PATID / (Interest + Repayment installments)
COMPONENTS OF RATIO
Average debtors = Opening debtors + Closing debtors divided by 2
Current assets = Stock + debtors + cash & bank balance + loans & advances + Prepaid expenses
Current liabilities = Creditors + BP + O/S expenses + IT payable + Dividend payable + Bank overdraft ( not if permanent)
Quick Assets = Current Assets less ( Stock + prepaid expenses)
Quick Liabilities. = Current liabilities less Bank overdraft
Gross Profit = Sales less material cost.
Net Profit = Sales less all expenses + any other income.
Debt = Long term loans + debentures + Bank overdraft
Equity = Equity share capital + Preference share capital +Free Reserves – (Accumulated losses + deferred revenue expenditure) = Net worth = Proprietor’s funds.
PBIT = Profit before Tax + interest.
PATID = Profit after Tax + Interest + Depreciation. = Annual cash flow.
PAT = Profit less I. Tax.
Capital employed = Net Fixed Assets + Current assets less Current liabilities.
Other Ratios:
Sales per employee:Sales / staff strength
Sales generation:Sales / salaries & wages
Profit per employee:PBT / staff strength
Profit generation:PBT / salaries & wages
Remuneration level:Salaries & wages / staff strength
Dividend per share: :Dividend / Number of shares
Earnings per share:PAT less Pref. Dividend / number of shares
Dividend pay out ratio:Dividend / Earnings per share
Dividend yield: Dividend per share / Market price per share
Book value per share:Ordinary shareholder's equity / number of shares
Price-earnings ratio:Market price per share / Earnings per share.
DECISIONS ON VARIOUS RATIOS
Turnover Ratios:
Debtors Turnover Ratio: This ratio measures the average number of day’s credit given to debtors. It helps to assess the efficiency of the debt collection department. Debt collection period should be kept as low as possible, consistent with maintaining customer goodwill and market trend.
Creditors Turnover Ratio:
This ratio measures the average number of days credit is exploited from suppliers. Credit given by suppliers depends on various factors such as demand & supply position of material, industry trends, competition etc.
Inventory Turnover Ratio:
This ratio measures the average number of days for which stock is held. It helps to assess the efficiency of stock utilization. Various factors affect the stock level held by the organization such as product, production-seasonal or otherwise, demand pattern, competition, funds availability etc.
Liquidity Ratios:
Current Ratio:
This ratio is concerned with the assessment of an organization's ability to meet its short-term obligations. The ratio must be high enough for safety. However, high current assets do not normally lead to high profits in themselves, so the usual trade-off between risk and return exists. Industry norm is 2:1
Acid Test Ratio:
This ratio is also concerned with short-term liquidity. In a sense it is more appropriate measure since liquid assets represent the source of funds from which current liabilities will probably be met.
Industry norm is 1:1
Profitability Ratios:
Gross Profit Ratio: GP / Margin on sales
Net Profit Ratio: Net profit on sales. It indicates organization's ability to generate profits from sales.
Material cost ratio: Material cost to sales
Expenses Ratios: Expenses to sales.
Return on Capital: This ratio is expressed as a percentage. Generally higher the return the better.
Return on Proprietor’s Funds: This ratio provides a measure of the percentage return on the investment made by the owners.
Solvency Ratios:
Debt Equity Ratio:
This ratio is concerned with establishing the relationship between external and internal long-term financing. The use of long-term debt in the capital structure has both advantages and disadvantages, and in practice the level of debt actually existing is the result of a balancing process. The main advantage of debt is that it provides an opportunity for greater returns to shareholders. Industry norm is 2:1
Proprietary Ratio:
It measures the owner's contribution of funds. Interest coverage Ratio: This ratio measures the safety available to Bank for recovery of interest. Industry norm is 2:1
Debt coverage Ratio:
This ratio measures the safety available to Bank for recovery of interest & loan installment. Industry norm is 2.5 : 1
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