Ratio Analysis

Ratio Analysis: Meaning, Classification and Limitation of Ratio Analysis!Meaning:

Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.
This relationship can be expressed as a percent or as a quotient. Ratios are simple to calculate and easy to understand. The persons interested in the analysis of financial statements can be grouped under three heads,
i) owners or investors
ii) creditors and
iii) financial executives.
Although all these three groups are interested in the financial conditions and operating results, of an enterprise, the primary information that each seeks to obtain from these statements differs materially, reflecting the purpose that the statement is to serve.
Investors desire primarily a basis for estimating earning capacity. Creditors are concerned primarily with liquidity and ability to pay interest and redeem loan within a specified period. Management is interested in evolving analytical tools that will measure costs, efficiency, liquidity and profitability with a view to make intelligent decisions.
Ratio analysis is useful in many ways to different concerned parties according to their respective requirements. Ratio analysis can be used in the following ways:

To know the financial strength and weakness of an organization.
To measure operative efficiency of a concern.
For the management to review past year’s activity.
To assess level of efficiency.
To predict the future plans of a business.
To optimize capital structure.
In inter and intra company comparisons.
To measure liquidity, solvency, profitability and managerial efficiency of a concern.
In proper utilization of assets of a company.
In budget preparation.
In assessing solvency of a firm, bankruptcy position of a firm, and chances of corporate sickness.

Classification of Ratios:Financial ratios can be classified under the following five groups:1) Structural
2) Liquidity
3) Profitability
4) Turnover
5) Miscellaneous.
1. Structural group:The following are the ratios in structural group:i) Funded debt to total capitalisation:The term ‘total’ capitalisation comprises loan term debt, capital stock and reserves and surplus. The ratio of funded debt to total capitalisation is computed by dividing funded debt by total capitalisation. It can also be expressed as percentage of the funded debt to total capitalisation. Long term loans
Total capitalisation (Share capital + Reserves and surplus + long term loans)
ii) Debt to equity:

Due care must be given to the; computation and interpretation of this ratio. The definition of debt takes two foremost. One includes the current liabilities while the other excludes them. Hence the ratio may be calculated under the following two methods:
Long term loans + short term credit + Total debt to equity = Current liabilities and provisions Equity share capital + reserves and surplus (or)
Long-term debt to equity =
Long – term debt / Equity share capital + Reserves and surplus
iii) Net fixed assets to funded debt:

This ratio acts as a supplementary measure to determine security for the lenders. A ratio of 2:1 would mean that for every rupee of long-term indebtedness, there is a book value of two rupees of net fixed assets:
Net Fixed assets funded debt
iv) Funded (long-term) debt to net working capital:The ratio is calculated by dividing the long-term debt by the amount of the net working capital. It helps in examining creditors’ contribution to the liquid assets of the firm.
Long term loans Net working capital
2. Liquidity group:

It contains current ratio and Acid test ratio.
i) Current ratio:It is computed by dividing current assets by current liabilities. This ratio is generally an acceptable measure of short-term solvency as it indicates the extent to which he claims of short term creditors are covered by assets that are likely to be converted into cash in a period corresponding to the maturity of the claims. Current assets / Current liabilities and provisions + short-term credit against inventory
ii) Acid-test ratio:It is also termed as quick ratio. It is determined by dividing “quick assets”, i.e., cash, marketable investments and sundry debtors, by current liabilities. This ratio is a bitterest of financial strength than the current ratio as it gives no consideration to inventory which may be very a low- moving.

3. Profitability Group:The results of business operations can be calculated through profitability ratios. These ratios can also be used to know the overall performance and effectiveness of a firm. Two types of profitability ratios are calculated in relation to sales and investments.
It has five ratio, and they are calculated as follows:4. Turnover group:Activity ratios are also called turnover ratios. Activity ratios measure the efficiency with which the resources of a firm are employed.
It has four ratios, and they are calculated as follows:5. Miscellaneous group:It contains four ratio and they are as follows:Standards for comparison:For making a proper use of ratios, it is essential to have fixed standards for comparison. A ratio by itself has very little meaning unless it is compared to some appropriate standard. Selection of proper standards of comparison is a most important element in ratio analysis. The four most common standards used in ratio analysis are; absolute, historical, horizontal and budgeted.
Absolute standards are those which become generally recognised as being desirable regardless of the company, the time, the stage of business cycle, or the objectives of the analyst. Historical standards involve comparing a company’s own’ past performance as a standard for the present or future.
In Horizontal standards, one company is compared with another or with the average of other companies of the same nature.
The budgeted standards are arrived at after preparing the budget for a period Ratios developed from actual performance are compared to the planned ratios in the budget in order to examine the degree of accomplishment of the anticipated targets of the firm.

Advantages of Ratio Analysis

• It is powerful tool to measure short and long-term solvency of a company.
• It is a tool to measure profitability and managerial efficiency of a company.
• It is an important tool to measure operating activities of a business.
• It helps in analyzing the capital structure of a company.
• Large quantitative data may be summarized using ratio analysis.
• It relates past accounting performances with the current.
• It is useful in coordinating the different functional machineries of a company.
• It helps the management in future decision-making.
• It helps in maintaining a reasonable balance between sales and purchase and estimating working capital requirements.

Limitations:

The following are the limitations of ratio analysis:1. It is always a challenging job to find an adequate standard. The conclusions drawn from the ratios can be no better than the standards against which they are compared.
2. When the two companies are of substantially different size, age and diversified products,, comparison between them will be more difficult.
3. A change in price level can seriously affect the validity of comparisons of ratios computed for different time periods and particularly in case of ratios whose numerator and denominator are expressed in different kinds of rupees.
4. Comparisons are also made difficult due to differences of the terms like gross profit, operating profit, net profit etc.
5. If companies resort to ‘window dressing’, outsiders cannot look into the facts and affect the validity of comparison.
6. Financial statements are based upon part performance and part events which can only be guides to the extent they can reasonably be considered as dues to the future.
7. Ratios do not provide a definite answer to financial problems. There is always the question of judgment as to what significance should be given to the figures. Thus, one must rely upon one’s own good sense in selecting and evaluating the ratios.