Concept and Meaning of Ratio Analysis

Concept of Ratio Analysis

Ratio analysis is the mathematical form of expressing the numerical or arithmetical relationship between two figures. It is a widely used financial analysis tool which is expressed when one figure is divided by another. It is the systematic use of ratios that determines and interprets the numerical relationship between two financial items. Ratio analysis assesses the strength and weakness as well as evaluates the historical performances and current financial conditions of a firm.

According to Kohler, “A ratio is the relationship of one amount to another expressed as the ratio of or as a simple, fraction, integer, decimal fraction or percentage.”

According to Hunt, William and Donaldson, “Ratios are simply a means of highlighting in arithmetical terms of the relationship between figures draw from financial statements.”

Methods of Ratio Analysis

The ratio is the numerical relationship between 2 financial items and the relationship can be expressed as:

1. Percentage method:
   The relationship is expressed in percentage.
   For example; Assume, Sales (Rs.100,000) & Net profit (Rs.25,000):
   Net profit margin = \(\frac {Net profit}{Sales}\) x 100%
   = \(\frac {25,000}{1,00,000}\)× 100%
   = 25%
   
   
2. Fraction method or Rate method:
   Here, one item is expressed in terms of other relative items.
   For example; Assume as above:
   Net profit margin =\(\frac {Net profit}{Sales}\) x 100%
   =\(\frac {25,000}{1,00,000}\) x 100%
   = ¼ or 0.25 times
   
   
3. Proportion method or Ratio method:
   Under this method, the relationship is expressed in proportion or ratio.
   For example; Assume as above:
   Net profit margin =\(\frac {Net profit}{Sales}\) x 100%
   =\(\frac {25,000}{1,00,000}\) x 100%
   = 1: 4

Uses of Ratio Analysis

1. Situation diagnosis:
   Ratio study can help in analyzing both weak and strong points of an enterprise. This can be made by studying ratios for a number of years of an enterprise or by the comparison of similar ratios. An analysis comparing the current assets with current liabilities can also be prepared for different enterprises.
   
   
2. Helpful in planning:
   Ratios help in planning purposes by expressing the enterprise’s targets such as the market share or the profitability rate or the saving rate. For this, the ratios of past years and also of the competitors are analyzed.
   
   
3. Monitor performance:
   Monitor performance is an important means for checking the results achieved as per expectations and if the firm has earned the targeted and adequate profit. For this, the performance target is laid down in ratios and compared with the target ratio.

Importance of Ratio Analysis

• Current ratio and Quick ratio helps in assessing the short-term solvency / liquidity of the firm.

• Profitability ratios help in evaluating the financial performance of the firm.

• Ratios show the degree of efficiency in the management and the utilization of resources and assets.

• Capital structure ratios help in indicating the financial strength or the long-term solvency of the firm.

• Ratios throw light on the firm’s current status on the use of debt funds or whether the firm is exposed to any serious financial strain.

• Trend analysis of ratios over a period of years will indicate the direction of the firm’s financial policies.

• Ratios help with the planning and forecasting of the firm’s business activities for periods as ratios tend to have predictor values.

Limitations of Ratio Analysis

• Ratio analysis is based on the historical accounting information which sometimes makes it difficult to predict the future condition of the business or consider the changes in the price level.

• For evaluating the progress and future prospects of an organization, both quantitative and qualitative aspects are to be considered. However, financial statements ignore it.

• Financial analysis statement is not bias free as the analyst has to choose from several available financial statements on her own personal preference.

• Ratio analysis is affected by inflation and in such situation, it may not predict the true position of the firm.

• Sometimes, straight-jacket comparison of ratios may be misleading because different firms follow different accounting policies.

Types of Ratios

Liquidity Ratios

1. Current ratio:
This ratio shows the quantitative relationship between current assets and current liabilities. Also known as the working capital ratio, it indicates the ability of the firm in meeting the current obligation as expressed in terms of current liabilities. It can be calculated as:

• Current ratio = \(\frac {Current assets}{Current liabilities}\)

where,
Current Assets = Assets that can be converted into cash or cash equivalent within a year or an accounting period. Some common Current Assets are:

Current liabilities = Liabilities that are dischargeable within a year or an accounting period. Some common Current Liabilities are:

Illustration:

The Balance Sheet of ‘ARMY Co.’ as on 31^st December is given below. Calculate the Current ratio.

Solution:

Here,

Current assets = Sundry debtors + Prepaid expenses + Stock + Cash and bank
= Rs. (1,30,000 + 1,00,000 + 45,000 + 1,20,000)
= Rs. 3,95,000

Current liabilities = Sundry creditors + Short term loans + Provision for taxation
= Rs. (30,000 + 25,000 + 50,000)
= Rs. 1,05,000

Finally,

Current ratio = \(\frac {Current assets}{Current liabilities}\)
= \(\frac {3,95,000}{1,05,000}\)
= 3.76: 1 times

2. Quick/ Liquid Ratio:
This ratio shows the relationship between quick assets and current liabilities. Also called the Acid-test ratio, it is the improvised version of current ratio and gives a more precise measure of liquidity than the current ratio. It is calculated as:

• Quick Ratio = \(\frac {Quick assets}{Current liabilities}\)

where,

Quick Assets = Current assets – Prepaid expenses – inventories / stock

Illustration:

The SME Co.’s current ratio is 2 times and its quick ratio is 1.5 times. Holding current assets of Rs. 3,50,000, what is its level of current liabilities and its level of inventories?

Solution:

Given,

Current assets = Rs. 3,50,000
Current ratio = 2 times
Quick ratio = 1.5 times
current liabilities = ?

We have,

Current ratio = \(\frac {Current assets}{Current liabilities}\)

or, 2 = \(\frac {3,50,000}{Current liabilities}\)

or, C.L = Rs. 1,75,000

Again,

Quick ratio = \(\frac {Current assets-inventory}{Current liabilities}\)

or, 1.5 = \(\frac {3,50,000-inventory}{1,75,000}\)

or, Inventory = Rs. 87,500

Leverage Ratios or Capital Structure Ratios

1. Debt equity ratio (Debt to shareholders’ fund ratio):
This ratio shows the relationship between total debts or long-term debts and shareholders’ funds. Also known as the solvency ratio, it tests the long-term solvency of the firm. It can be calculated as:

• Debt equity ratio = \(\frac {Long term debt}{Shareholders’ fund}\)
  or,
• Debt equity ratio = \(\frac {Total debts}{Shareholders’ fund}\)

Below are some long-term debts:

• Total debts = long-term debts + Current liabilities
• Total debts = Total assets – shareholders’ fund

Below are some of the examples of Shareholders’ fund or equity:

Illustration:

The Balance Sheet of ‘Carat Co.’ as on 31^st December is given below. Calculate the Current ratio.

Required: Debt equity ratio

Solution:

Here,

Total debts
= Debenture + Loan
= Rs. (21,000 + 6,000)
= Rs. 27,000

Shareholders’ fund
= Equity share + Preference share + reserve + P/L account – Preliminary exp.
= Rs. (16,000 + 10,000 + 12,000 + 5,000 – 3,000)
= Rs. 40,000

Finally,

Debt equity ratio
= \(\frac {Total debts}{Shareholders’ fund}\)
= \(\frac {27,000}{40,000}\)
= 67.5%

2. Debt to capital ratio:
This ratio shows the relationship between debt and total capital of a company. It helps in establishing a link between total long-term funds available in the business and funded debt. It is calculated as:

Debt to capital ratio = \(\frac {Long-term debts}{Capital employed}\)

where,

Capital employed = Sum of debts & Permanent capital

• Capital employed = Debt + Shareholders’ fund
• Capital employed = Net fixed assets + Woking capital
• Capital employed = Total assets – Current liabilities

Illustration:

Required:

• Debt equity ratio
• Debt to capital ratio

Solution:

Total debts:
= Debenture + Loan + Bond
= Rs. (21,000 + 6,000 + 15,000)
= Rs. 42,000

Shareholders’ fund:
= Equity share + Preference share + reserve + P/L account + Share premium – Preliminary exp. – Underwriter’s commission
= Rs. (16,000 + 10,000 + 12,000 + 5,000 + 7,000 – 3,000 – 12,000)
= Rs. 35,000

Capital employed = Long-term debt + Shareholder’s fund = Rs. (42,000 + 35,000) = Rs. 77,000

Then,

• Debt equity ratio
  = \(\frac {Total debts}{Shareholders’ fund}\)
  = \(\frac {42,000}{35,000}\)
  = 1.2%

  
  Again

• Debt to capital ratio
  = \(\frac {Long-term debts}{Capital employed}\)
  = \(\frac {42,000}{77,000}\)
  = 0.545:1

References:

Koirala, Madhav et.al., Principles of Accounting -XII, Buddha Prakashan, Kathmandu

Shrestha, Dasharatha et.al., Accountancy -XII, M.K. Prakashan, Kathmandu

Bajracharya, Puskar, Principle of Accounting-XII, Asia Publication Pvt. Ltd., Kathmandu