Accounting ratio analysis - CREDIT AND LENDING DECISIONS. [BF 743]

• What is Accounting Ratio analysis? 
• Importance or advantages of ratio analysis & Types of accounting ratios
• Accounting Ratio analysis

What is a Accounting Ratio analysis?
What is Accounting Ratio analysis? Importance or advantages of ratio analysis & Types of accounting ratios

 Introduction
Financial statements are prepared by summarizing the financial transactions during a particular year. They are prepared to provide the financial information information that help to take decisions. The information properly analyzed. Analysis of financial statements is useful unless they are properly analyzed.

 Analysis of financial statements is useful in making financial and investment decisions. Financial analysis is the process of identifying the financial and weakness of the firm by properly establishing relationships between the items of financial statement i.e. income statement and balance sheet. There are various methods or techniques used in analyzing the financial statements. Ration analysis is one of the major tools used in the interpretation and evaluation of financial statements.
Meaning of ration analysis
Ration is the numerical or an arithmetical relationship between two figures. It is expressed when one figure is divided by another. Ration analysis is the process of determining and interpreting numerical relationship between figures of financial statements. Ration is used as an index or year-stick for evaluation the financial position and performance. It helps analysis to make quatitave judgment about the financial position and performance of a firm.

"A ration is simply one number expressed in terms of another. It is found by dividing one number by the other." R.N.ANTHONY
From the above definition, it is clear that ration is a relation of one amount to another amount, and is a simple fraction or integer or percentage. Ration analysis shows the numerical relationship between the data presented in the financial statements. It helps to measure profitability, solvency and performed of any business firm. It facilitates the decision makers to take the appropriate decisions based on different rations.
Presentation of ration
The quantitative relationship between two or more items of the financial statements connected with each other is referred as accounting ratio. The accounting rations may be expressed in the following ways.

1.    Percentage method: under this method, the relationship between two figures is presented is percentage. For example, if total assets of a firm are rs. 500,000 and fixed assets are rs. 100,000, the relationship can be presented as fixed assets  to be 20% of total assets i.e.

2.    Rate method: under this method, ration is expressed simply by the division of one number by another. For example, if total assets were rs. 500,000 and fixed assets were rs. 100,000, the ration ship between the two can be said as fixed assets to be 0.2 time total assets.

3.    Ratio method: under this method, the relationship between two figures is presented in ratio. Taking the previous example, the ration of fixed assets to total assets can be said to be 100, 0000: 500,000 or 1:5.

Importance or advantages of ratio analysis
Ration analysis stands for the process of determining and presenting the relationship of items and groups of items in the financial statements. It is an important technique of financial analysis. It is a way by which financial stability and health of a concern can be judged. The following are the main points to highlight the importance of ration analysis.

1.    Useful in financial position analysis: accounting rations reveal the financial position of the concern. It helps the banks, insurance companies and other financial institutions in lending and making investment decision.

2.    Useful in simplifying accounting figures: accounting rations simplify, summarize and systematize the accounting figures in order to make them more understandable, often the figures standing alone cannot help them convey any meaning but rations help them to relate with other figures.

3.    Useful in assessing the operational efficiency: accounting rations helps to have an idea of the working of a concern. The efficiency of the firm can be measured by the rations. It analysis management to asses financial requirement and operational efficiency.

4.    Useful in forecasting purposes: ration analysis is very much useful in financial forecasting and planning. It tabulates the financial information of past years for analysis the financial performance which helps for estimating the trend for the future.

5.    Useful in locating weaknesses of the business: accounting rations are of great assistance in locating the weakness of the business even though the overall performance may be efficient. Management can then pay attention to the weaknesses and take remedial measure to overcome them.

6.    Useful in comparison of performance: accounting rations facilitate the comparison between one with another firm in order to evaluate the financial performance. Management is interested in such comparison in order to know the proper and smooth functioning of a firm. Ration analysis also helps to make the necessary charges in the organizational structure.

Limitations of ration analysis
Ration analysis is an important tool the financial position of a business. However, it has some limitations which are as follows:

1.    Based on historical information: ration analysis is based on the accounting information which is historical in nature. Sometimes, rations become unable to predict the future condition of business.

2.    Ignores qualitative aspects: financial statements do not contain the entire information necessary for evaluating the progress and future procespects of an organization. It only manager, relationship with customers etc.

3.    Fails to disclose current worth of enterprises: financial statement analysis fails to disclose the current worth of an enterprise. It is based on historical facts and data which do not consider the changes in the price level.

4.    Not free from bias: financial statement analysis is done as per the personal judgment of analysis. The accountant has to make a choice out of various alternatives available so the financial statements are not free from bias.

Types of accounting rations
Ration may be classified in a number of ways keeping in view the particulate purpose. The rations used for financial analysis of business can be classified into four categories, which are as follows:

Liquidity ratios
Liquidity ratio measures the short-term solvency or liquidity position of a firm. Liquidity refers to the ability of a firm to meet its short-term obligation. It reflects the short-term financial strength of the business. These rations indicate whether the firm would be in a position to meet its short-term obligations in time. Liquidity or short-term financial position of a firm can be measured by the following ratios:

Current ratio

a. Meaning: it shows the relationship between current assets and current liabilities.

b. Objectives: it main objective is to measure the ability of the firm to meet its short-term obligations and o provide information about financial strength/ solvency.

c. Components: there are two components of this ratio as follows:
i. Current assets: those assets, which are held for their conversion into cash normally within a year or immediately or already in cash.
j. Current liabilities: those liabilities which are to be paid normally within one year or immediately.

d. Computation: this ratio is computed by dividing the current assets by the current liabilities. This ratio is usually expressed as a pure ratio e.g. 2:1 in the form a formula, this ration is express as follows:

e. Interpretation: traditionally, a current ration ratio of 2:1 is considered to be a satisfactory ratio. One the basis of traditional rule, if the current ration 2 or more, if means the firm is adequately liquid and has the ability to meet its current obligation. if the current ratio is less than 2 it means the firm has difficulty in meeting its current obligations.
However, the traditional standard of 2:1 should not be used blindly since there may be firms having current ration of less than 2, which are usually efficient in meeting their short-term obligation. Some of first having current ratio more than 2 may not be able to meet their current obligation in time. This is so because the current ratio measures the quantity of current assets and not their quality.

Quick ratio 

a.    Meaning: it shows the relationship between quick assets and current liabilities.

b.    Objectives: its main objective is to measure the ability of the firm to meet its short-term                     obligation as and when without relying upon the realization of stock.

c.    Components: there are two components of this ration as follows:

i.    Quick assets: those current assets which can be converted into cash immediately or at a short notice without loss of value. All the current assets except closing stock and prepaid expenses are quick assets.
      ii.    Current liabilities: those liabilities which are expected to be matured normally within a year.

d.    Computation: this ratio is computed by dividing the quick assets by the current liabilities, this ratio is scaly expressed as a pure ratio e.g. 1:1. This ration may be expressed as under.

e.    Interpretation: traditionally, a quick ratio of 1:1 is considered to be a satisfactory ration. However, this traditional rule should not be used blindly since a firm having a quick ratio of more than 1 may not be meeting its short-term obligation in time if its liquid assets consist of doubtful and slow paying debtors.

Working capital
The different between current assets and liabilities is knows as working capital. It is calculated by deducting total current liabilities from current assets.

Working capital = total current assets – total current liabilities
        Current assets = working capital + current liabilities
       Current liabilities = current assets – working capital

Leverage ratio of capital structure rations
Leverage rations show the long-term solvency or liquidity of a firm. It indicates whether the firm is financially sound or solvent in relation to its long-term obligations. These rations measure the firms' abilities to pay the investors regularly and repay the principal on the due date. they are also know as solvency or capital structure rations.

Long-term solvency of a firm can be measured by the following rations:
Debt equity ratio (debt to shareholders' fund ratio)

a.    Meaning: this ratio shows the relationship between long-term debts or total debts and shareholder's funds. It is a test of long-term solvency of a firm.

b.    Objective: the objectives of computing this ratio is to measure the relative proportion of debt and equity in financing the assets of a firm.

c.    Components: there are two components of this ration as follows"
i.    Long term debt: the debt that is is payable or measured in a long, period of time i.e. more than one year is knows as long term debt.
ii.    Shareholder's fund: the debt that is payable or matured in a long period of time i.e. more than one year is knows as long term debt.
iii.    Shareholders' fund: it is the fund, which is financial or claimed by the internal parties of the business. it is a also knows a shareholder's equity or net worth.

d.    Computation: this ration is computed by dividing the long-term debts or total debts by the shareholder's fund.

e.    Interpretation: it indicates the margin of safety to long-term creditors. A low debt equity ratio implies the use of more equity than debt which means larger safety margin for creditor since shareholder's equity is considered as a margin of safety by creditors and vice versa.

Debt to total capital ratio (debt to long –term fund ratio)

a.    Meaning: this ratio establishes a relationship between debt and total capital of a company. It helps to establish a link between funded debt and total long-term fund available in the business.

b.    Objective: the main objectives of computing this ratio is to measure the relative share of the debt in total capital of the organization indicating long-term solvency.
       c.    Components: there are two components of this ration as follows:



Debt to total capital ratio (debt to long –term fund ratio)

a.    Meaning: this ratio establishes a relationship between debt and total capital of a company. It           helps to establish a link between funded debt and total long-term fund available in the business.

b.    Objective: the main objectives of computing this ratio is to measure the relative share of the            debt in total capital of the organization indicating long-term solvency.
c.    Components: there are two components of this ration as follows:

I.    Long-term debt: bonds, debentures, mortgage, long-term loans, secured loan, other loan                     payable one year.

II.    Total capital: it is alos knows as capital employed or long-term fund or permanent capital. Total capital includes long-term debt plus shareholder's equity.

d.    Computation: this ration is computed by dividing the long debt or total debt by total capital or capital employed or permanent capital or long term fund.
       e.    Interpretation: in indicates the margin of safety to long-term debt or total debt. A low debt to total capital ratio refers to the use of more equity than debt which means larger safety of margin for creditors because shareholders' equity is considered as a margin of safety by creditor and vice versa.

Activity or turnover ratios
For smooth operations, a firm needs to invest in both short-term and long-term assets. Activity ratios describe the relationship between the firm's level of operations (sales) and assets needed to sustain the activity.
Activity rations can also use to forecast a firm's capital requirements (both operating and long-term). Increase in sales will require investment in additional assets. Activity rations enable the analysts to forecast these requirements and to assets the firm's ability to acquire the assets needed to sustain the forecasted growth. The followings rations can be calculated as the activity ratios.

Inventory turnover ratio (stock turnover ratio)

a.    Meaning: if shows the relationship between cost of good and average investor or net sales and closing inventory.
b.    Objective: the objective of computing this ratio is to determine the efficiently with which the inventory is converted into sales.
c.    Components: there are two components of this ratio as follows:
i.    Cost of goods sold or net sales:
ii.    Averages inventory or closing inventory
d.    Computation: this ration is computed by dividing cost of goods sold or net sales by average inventory or closing inventory.
e.    Interpretation: inventory turnover ratio measures the frequency sales and gives the answer of such question "how rapidly the inventory is selling". High inventory turnover indicates the efficient inventory management.

Debtor turnover ratio (accounts receivable turnover ratio)

a.    Meaning: it shows the relationship between credit and average debtor i.e. receivable or net sales and ending debtor i.e. receivable.
b.    Objective: the objective of computing this ratio is to determine the efficiency with which the debebture are converted into cash.
c.    Components: 

there are two components of this ration as follows:
i.    Net credit sales or net sales:
Net credit sales = total credit sales – sales return
Net sales = total sales – sales return
Total sales = cash sales + credit sales.
ii.    Average debtors or closing debtors:

d.    Computations: this ratio is computed by dividing net credit sales or net sales by average debtor or closing debtor.

Notes:
 (i) If credit sale and average debtor both can be calculated in this case net credit sales and average debtor are used to determine debtor turnover ratio.
iii.    If net credit sales and average debtor any one cannot be calculated in this case net sales and closing debtor and used to determine debtor ratio.
iv.    The turn debtor include trade debtor, book debt, account receivable, bills receivable but excluding the debtors which do not arise from the sales of goods in which the business deals in.
v.    Provision for doubtful debt is not deducted from the total amount of debtor since here, the purpose us to calculate the number of days for which sales are tied up in debtors and not to ascertain the realization value of debentures. If the provision for doubtful debt were deducted, if would give and impression that a position of debtors (to the extent of such provision) has already been collected.
e.    Interpretation: this ratio provides the information about the number of times each year a company's debtor's turn into cash. A high debtor turnover ratio indicates that debtors were converted frequently into cash and the quality of the company's debtors can be considered as good.

Average collection period/days sales outstanding

a.    Meaning: it shows the relationship between days or weeks or months in a year and debtor turnover ratio or average debtor and average net credit sales per day.
b.    Objective: the objective of computing this ratio is to know about the average length of time that an account has outstanding. It measures the leads and legs in collection relative to the company's credit period. It shows the efficient in the collection process of the receivables.
c.    Components: there are two components of this ratio as follows:
i.    Days or week or months in a year (365 or 360 days, 52 or 50 weeks, 12 months)
ii.    Debtor turnover ratio
d.    Computation: this ratio is computed as below.
e.    Interpretation: this ratio measure how rapidly how ruddily the case is collecting from debtors and lower average collection period is preferred than more average collections period.

Fixed assets turnover ratio

a.    Meaning: this ratio establishes a relationship between net sales and fixed assets.
b.    Objective: the objective of computing this ratio is to determine the efficieny with which fixed assets are utilized.
c.    Components: there are two components of this ratio as follows:
i.    Net sales which mean total sales minus sales return.
ii.    Net fixed assets which mean gross fixed assets less depreciation.
d.    Components: this ratio is computed by dividing the net sales by the net fixed assets.
e.    Interpretation: in indicated the firm's ability to generate sales due to the investment in fixed assets. Higher ratio is an indication of more efficient assets management.

Total assets turnover ratio

a.    Meaning: this ratio shows relationship between net sales and total assets.
b.    Objective: the objective of computing this ratio is to determine the efficiency of management in utilization of assets for generating sales.
c.    Components: there are two components of this ratio as follows:
i.    Net sales = total sales – sales return
ii.    Total assets, which include current assets, tangible fixed assets and intangible assets.
d.    Computation: this ratio is computed by dividing the net sales by total assets.
e.    Interpretation: it indicates the firms' ability generate sales due to the investment in total assets. Higher the ratio more efficient the management and utilization of total assets and vice-avers.

Capital employed turnover ratio

a.    Meaning: it shows the relationship between net sales and capital employed.
b.    Objective: the objective of computing this ratio is to do determine efficiency with which the capital employed or long-term fund or permanent capital is utilized.
c.    Components: there are two components of this ratio as follows:
i.    Net sales: it is calculated by subtracting the sales return from total sales.
ii.    Capital employed: it is the total of shareholder's fund and long term debt.
d.    Computation: this ratio is computed byb dividing the net sales by the capital employed. This ratio is usually expressed in times.
e.    Interpretation: this ratio indicates the firms' ability to generate sales per rupee of capital employed. In general, higher the ratio the more efferent the management and utilization of capital employed and cive-versa.

Profitability ratios

The efficiency of a business is measured by the profitability is an important measure of a company's operating success. The long-term survival of a business enterprise depends on satisfactory income earned by it. An evaluation of company's past profit may give to the investors, creditors and other a better understanding for division-making. Profitability rations measure the degree of operating success of a company in an accounting period. Profitability rations try to establish relationship among profit, turnover, capital employed, etc. the following are the important profitability ratios:

Gross profit margin or gross profit ratio

a.    Meaning: this ration measures the relationship between gross profit and net sales.
b.    Objective: the main objective of computing this ratio is to determine the efficiency which production and or purchase operation and selling operations carried on.
c.    Components: there are two components of this ratio as follows:
Gross profit: it is the excess of net sales over cost of goods sold.
d.    Computation: this ratio is computed by dividing the goods profit by the net sales. It is expressed as percentage.
e.    Interpretation: this ratio indicates i. an average gross margin earned on sales of rs. 100(ii) the limit beyond which the fall in sales price definitely result in loss and (ii) what portion of sales is left to cover operating express ( other than cost of goods sold) and non operating expenses. Higher the ratio, the more efficient the production and purchase management and vice-versa.

Net profit ratio (net profit margin)

a.    Meaning: this ratio shows the relationship between net profit and net sales.
b.    Objective: the main objective of computing this ratio is to determine the overall proftibitly due to various factors such as operational efficiency, trading on equity etc.
c.     Components: there are two components of this ration as follows:
Net profit: it is the excess of gross profit and other incomes over operating and non-operating expenses and losses.
d.    Computation: this ratio is computed by dividing the net profit after tax by the net sales. It is expresses as percentage.
e.    Interpretation: this ratio indicates an average net margin earned on sales of rs. 100 and the higher ratio is preferred. In other words, words, higher the ratio, higher the overall efficiency and better utilization of recourse. A lower ratio is indication of poor financial planning, low efficiency and lower utilization of business reserve.

Return on assets (ROA) or return on investment (ROI)

a.    Meaning: this ratio measure the relationship between net profit before interest and tax or net profit after tax plus interest or net profit after tax and total assets.
b.    Objective: the objective of computing this ratio is to find out how efficiently the total assets have been used  by the management.
c.    Components: there are two components of this ratio as follows:
i.    Net profit before interest and tax or net profit after tax plus interest or net profit after tax.
ii.    Total assets = current assets + tangible fixed assets + intangible fixed assets
d.    Computation: this ratio is computed by dividing the net profit before interest and tax or net profit after tax plus interest or net profit after tax.
e.    Interpretation: this ratio indicates the firm's ability of generating profit utilizing the total assets. Higher the ratio, the more efficiency of the management in the utilization of total assets and vice versa.

Return on shareholder's equity (ROSE)

a.    Meaning: the ratio shows the relationship between net profit after tax and shareholder's fund.
b.    Objective: the objective of computing this ratio is to find out how efficiently the funds supplied by the shareholder's have been used.
c.    Components: there are two components of this ratio as follows:
i.    Net profit: it is the excess gross profit and other incomes than operating and non-operating expenses and losses.
ii.    Shareholders' equity or shareholders' funds: it is the total claim of shareholder to the business.
D. computation: this ratio is computed by dividing net profit after tax to shareholder's equity.
E. interpretation: this ratio indicates the firm's ability of generating profit per rupees of shareholders funds. Higher the ratio, the more efficient the management and utilization of shareholders' funds.

Return on common shareholders' fund or return on equity (ROE)

a.    Meaning: this ratio measures the relationship between earning available to equity shareholder and equity shareholder's funds.
b.    Objective: the objective of computing this ratio is to find out how efficiency the funds supplied by the equity shareholders have been used.
c.    Component: there are two components of this ratio as follows:
i.    Earnings available to equity shareholder: the remaining amount after deducting preference dividend from net profit after tax.
ii.    Equity or common shareholder's fund = equity share capital + reserve and surplus + P/L a/c – losses
d.    Computations: this ratio is computed by dividing earning available to equity shareholder by equity shareholder's funds.
e.    Interpretation: this ratio indicates the firms' ability of generating profit per rupees of equity shareholders funds. Higher the ratio, the more efficient the management and utilization of equity shareholders' funds.

Earnings per share (EPS)

a.    Meaning: this ratio measures the earning available to equity shareholder on a per share basis.
b.    Objective: the objective of this ratio is to measure the profitability of the firm on per equity share basis.
c.    Components: there are two components of this ratio as follows:
i.    Earning available to equity shareholder: the remaining amount after deducting preference share dividend from net profit after tax is considered as earning available to equity shareholder'
ii.    No of equity share
d.    Computation: this ratio is computed by dividing the total earning available to equity shareholder by number of equity shares.
e.    Interpretation:  higher the earning per shares better it is and vice versa.
Dividend per shares (DPS)
a.    Meaning: it shows the relationship between total amount of dividend paid to equity shareholder and number of equity shares.
b.    Objective: the objective of computing this ratio is to know how much per share the dividend is distributed to common shareholders.
c.    Computation: there are two components of this ratio as follows:
i.    Dividend paid to equity shareholder
Total dividend to equity shareholder = % of dividend x total amount of paid up capita.
ii.    Number of equity share
d.    Components: this ratio is computed by dividing total amount of divined paid to equity shareholders by number of equity shares.
e.    Interpretation: in general, higher the dividend per share, better it is and vice versa. 

prepared by: ram shah