Ratio Analysis: Meaning of Ratio, Users of Ratios, Advantages of Ratio Analysis

 

Concept and Meaning of Ratio

Ratio is the relationship between two accounting figures of financial statement.

The financial statements are income statement (trading, profit and loss account) and balance sheet.

Income statement shows the operating result of the company.

Balance sheet shows the financial position at the end of accounting year.

 

Financial statements are analysed to obtain meaningful information about company’s survival, stability, profitability, solvency and growth prospect.

The budget analyses are often performed by employing a number of techniques like comparative statements, common size statements and ratio analysis.

Ratio analysis is the widely used technique and most popular technique to analyse financial statement.

 

In a simple word, ratio is a quotient of two numerical variables; that shows the relationship between the two financial figures.

Accordingly, accounting ratio is a relationship between two numerical financial data obtained from financial statements.  

Company and users of ratio use accounting ratios as an important tool of analyzing the financial performance of the company over the years; and its comparative position among other companies in the industry.

 

Ratio analysis is the process of determining and interpreting numerical relationship between financial figures of financial statements.

Often, accounting figure does not provide much meaning by itself.

For significant information about the company’s financial performance these figures have to be analyses.

Ratio helps to evaluate the strengths and weakness of a business.

Ratio is calculated from the financial statement by outsider parties like creditors, investors, financial institutes and management of the company.

Users of ratio calculate according to their interest for analysis and interpretation of a firm’s financial health.

 

Definition

According to Kohler Accounting Dictionary, “A ration is the relationship of an amount to another expressed as the ratio of simple fraction, decimal fraction or percentage.”

According to R.N. Anthony, “A ratio is simply one number expressed in terms of another; It is found by dividing one number by other.”

 

Limitation of Ratio Analysis

Although ratio is most important tools to analysis two different numbers yet it has some limitation.

These limitations are as follow:

Incorrect data of financial statement may mislead to analysis.

Past events may not effective in future; therefore past analysis may not for future.

The ratio analysis ignores quality, it takes only quantity.

It does not adjust price level change.

Sometime company shows arithmetical window dressing data to attract investors, it mislead true analysis.

Difficult to fix ratios standard because all ratios do not have their standard.

 

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Users of Ratios

Generally, ratios are calculated from financial statement like income statement and balance sheet.

Ratio analysis is made or calculated by the management of the company but there are different users also.

These users are:

Creditors

They are short term loan providers.

They also provide materials to the company on regular basis.

They are interested to the ability of the company about payment. Therefore, they do analysis from ratios.

 

Lenders

They are long-term loan providers.

They want return on their investment.

The company provides interest on their investment.

They are interested to take their interest and principal amount.

 

Investors

They are founder investors of the company.

They are equity shareholders.

They want higher dividend on their investment.

Dividend is totally depending on profit.

More profit more dividends and vice versa.

 

Management

They are main responsible for profit generating of the company.

They plan, evaluate, apply and analyze the ratios from past for the future.

They take decision and change policy from past experience.

 

Importance and Advantages of Ratio Analysis

The important advantages of the accounting ratios are given below:

Analyzing financial statements

Ratio analysis is an important technique to analyses financial statement.

Accounting ratios are useful tools for understanding the financial position of the company.

There are different users of ratio to analyze the financial situation of the company for their decision making purpose.

They are investors, management, bankers and creditors etc.

 

Judging efficiency

Accounting ratios are important tools for judging the company’s efficiency.

Ratio helps to judge company’s operations and management.

It also helps to judge how well the company has been able to utilise its assets and earn profits.

 

Locating weakness

Accounting ratios can be used in locating weakness of the company’s operations even though its overall performance may be quite good.

Management can pay attention to the weakness and take remedial measures to overcome them.

 

Formulating plans

Users of accounting ratios use to analyze the company’s past financial performance.

From past performance, they can analyses future trends of its financial performance.

As a result, they help and assist to formulate the company’s future plans.

 

Comparing performance

It is necessary for a company to know how well it is performing over the years.

Company also compares to the other firms of the similar nature.

Besides this, it is also important to know how well company’s different divisions are performing among themselves in different years.

Ratio analysis facilitates such comparison. 

 

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Classification of ratio

There are mainly two kinds of ratio

1.    Statement ratio

2.    Functional ratio

According to different bases, there are following ratios:

 

−

Statement Ratio
Balance sheet ratio	Mixed ratio
Current ratio	Stock turnover ratio
Liquid ratio (quick/acid test)	Debtors turnover ratio
Debt equity ratio	Average collection ratio
Current assets ratio	Capital employed turnover ratio
Fixed assets turnover ratio	Return on assets
Total assets turnover ratio	Return on capital employed
	Return on shareholder equity
Income statement ratio	Return on common shareholder equity
Gross profit ratio
Net profit ratio
Operating ratio

 

Functional Ratio

1. Liquidity ratio	4. Activities or turnover ratio
Current ratio	Inventory/ stock turnover ratio
Liquid ratio (quick/acid test)	Debtors turnover ratio
	Average collection period
2. Leverage ratio	Fixed assets turnover ratio
Debt equity ratio	Capital employed turnover ratio
Debt to total capital ratio	Total assets turnover ratio
Interest coverage ratio
Fixed charge coverage ratio	5. Earnings ratio
	Earnings per share
3. Profitability ratio	Dividend  per share
Gross profit ratio	Dividend payout ratio
Net profit ratio	Dividend yield ratio
Operating ratio	Earning yield ratio
Return on capital employed	Dividend yield ratio
Return on shareholders’ equity	Price earnings ratio
Return on equity capital	Earning power ratio
Return on assets

 

 

Ratio Terminology

Here are the lists of ratio terms and their charts.

Learners are suggested to compare these lists with financial statement like income statement, retained earnings and balance sheet.

 

Current assets   

Cash balance	Prepaid expenses	Stock (inventory, merchandise)
Bank balance	Debtors (customers)	Raw materials
Short-term marketable security	Accrued income	Work in progress
Bills receivable	Account receivable	Trade investment

 

Current liabilities

Bank overdraft	Account payable	Short term loan
Creditors (suppliers)	Outstanding expenses	Provision for tax
Bills payable	Advance income	Provision for bad debts*

 

Fixed assets

Plant and machinery	Furniture and fitting	Investment
Land and building	Equipment	Premises
Equipment

Note: depreciation must be deducted, net fixed assets = asset – depreciation

 

Long-term loan or debts

Debentures	Long-term loan	Debentures premium
Mortgage loan	Bank loan	Deferred tax

 

Shareholders’ equity (shareholders fund, permanent capital, net worth)

Equity shares	Retained earning	Less:
Preference shares	Profit and loss (Cr)	Preliminary expenses
Share premium	Dividend equalization fund	Profit and loss (Dr)
Share forfeiture	Sinking fund	Underwriting commission
Capital reserve	Compensation fund	Loss on issue of debentures
General reserve	Investment fund etc	Discount on issue of debentures etc
Reserve and surplus

 

Ratio equations

Cost of goods sold (COGS) = Sales ‒ Gross profit

Or = Opening stock + Net purchase + Carriage ‒ Closing stock

 

Quick assets = Current assets – Stock – Prepaid expenses

Working capital = Current assets – Current liabilities

Long term loan   = Total debts – Current liabilities

Sales = COGS* + Gross profit

Fixed charge = Preference dividend + Interest + Permanent debts

 

 

Capital employed (total capital, permanent capital)

= Shareholders equity + Long term loan

= Total assets – Total current liabilities

= Fixed assets + Working capital

= Long term loan + Current liabilities

 

Income Statement

Particulars	Amount
Sales	xxxx
Less: Variable cost	(xxx)
Contribution	xxxx
Less: Fixed cost	(xxx)
EBDIT	xxxx
Less: Depreciation	(xxx)
EBIT	xxxx
Less: Interest on loan and debentures	(xxx)
EBT	xxxx
Less: Tax	(xxx)
EAT	xxxx
Less: Preference dividend (PD)	xxxx
Earnings available to equity shareholder	xxxx

 

Where:

EBDIT = earnings before depreciation. Interest and tax

ENIT = Earnings before interest and tax

EBT = Earnings after tax

EAT = Earnings after tax

 

 

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