Grade 12 Account Note

Ratio Analysis

Introduction

Financial statement analysis is the process of analyzing financial statement of a company of a company so as to obtain meaningful information about its survival, stability, profitability, solvency and growth prospects. The financial statement analysis can be performed by using a number of techniques such as comparative statements, common size statements and ratio analysis. Ratio analysis is the more popularly and widely used technique of financial statement analysis.

 

Meaning and definition

Ratio analysis is a process of determining and presenting the quantities relationship between two accounting figures to calculate the strength and weaknesses of a business. In simple word, ratio analysis is quotient of two numerical variables which shows the relationship between the two figures, accordingly, accounting ratio us a relationship between two numerical variable obtains from financial statements such as income statement and the balance sheet. Accounting ratio are used as an important tool of analysing the financial performance of the company over the years ans as comparative position among other companies in the industry.

In other words, ratio analysis is the process of determining and interpreting numerical relationship between figures of financial statement.

According to Kennedy and McMullan, the relationship of one term to another expressed in simple mathematical form is known as ratio.

% of profit = $\frac{{{\rm{Profit}}}}{{{\rm{Capital}}}}$ * 100

Ratio can be expressed in the following terms:

Ratio method: This method shows the relationship between two figures in ratio or proportion. It is expressed by simple division of one item by another i.e 2:8:1, 0:8:1 and so on.
Rate method: This method shows relationship in rate or times, like 4 times or 5 times and so on.
Precentage method: The relationship between two figures can be presented in percentage like 20%, 30% and so on.

 

IMPORTANCE AND ADVANTAGES OF RATIO ANALYSIS

Ratio analysis is an important tool for analysising the company’s financial performance. The following are the important advantages of the accounting ratios.

Analysing financial statement: Ratio analysis an important technique of financial statement analysis. Accounting ratios are useful for understanding the financial position of the company. Different users such as investors, management, bankers and creditors use the ratios to analyse the financial statement of the company for their decision making purpose.

Judging efficiency: Accounting ratios are important for judging the company's efficiency in terms of its operations and management. They help judge how well the company has been able to utilize its assets and earn profits.

Locating weakness: Accounting ratios can also be used in locating weakness of the company's operations even though its overall performance may be quite good. Management can then pay attention to the weaknesses and take remedial measures to overcome them.

Formulating plans: Although accounting ratios are used to analyze the company's past financial performance, they can also be used to establish future trends of its financial performance. As a result, they help formulate the company's future plans.

Comparing performance: It is essential for a company to know how well it is performing over the years and as compared to the other firms of the similar nature. Besides, it is also important to know how well its different divisions are performing among themselves indifferent years.

Inter-intra firm comparison: A firm may like to compare its performance with that of other firms and of industry in general. The comparison is called 'inter-firm comparison'. If the performance of different units belonging to the same firm is to be compared, then it is called 'intra-firm comparison'. Such comparison is almost impossible without proper accounting ratios.

 

Classification of ratios

Accounting ratio can be classified from different point of view. Ratio may be used to evaluate the company’s liquidity, efficiency, leverage, profitability. The ratio may be classified as following;

Liquidity ratio: Liquidity represents one's ability to pay its current obligations or short-term debts within a period less then a year. Liquidity ratios, therefore, measure a a company's liquidity positions. The ratios are important from the viewpoint of its creditors as well as management. The liquidity position of the company can be measured mainly by using two liquidity such as follows:

a)Current ratio

b)Quick ratio

Current ratio

Current ratio is also known as short-term solvency ratio or working capital ratio. This ratio is used to assets the short-term financial position of the business. In other words, it is an indicator of the firm's ability to meet its short-term obligations;

it is calculated by;

Current ratio = $\frac{{{\rm{Current\: assets}}}}{{{\rm{Current\: liabilities}}}}$

 

Quick ratio

Quick ratio is another measure of a company's liquidity. It is also known as liquid ratio or acid test ratio. However, although it is used to test the short-term solvency or liquidity position of the firm, it is a more stringent measure of liquidity than the current ratio. This ratio is calculated by dividing liquid assets by current liabilities. liquid assets asset cash and other assets which ate either equivalent to cash or convertible into cash within a very short period of time. Thus liquid assets are also called monetary current assets.

Quick ratio = $\frac{{{\rm{Liquid\: assets}}}}{{{\rm{current\: \: liabilities}}}}$

 

Fixed assets Turnover ratio

Fixed assets turnover ratio is termed as the ratio of sales to fixed assets. Fixed turnover ratio indicates how efficiently the fixed assets are used. It measures the efficiency with which the firm has been its fixed assets to generate sales.

Fixed assets turnover  ratio= $\frac{{{\rm{Sales}}}}{{{\rm{\: Net\: fixed\: assets}}}}$

 

Total fixed turnover ratio

The ratio shows the relationship between total assets and sales. Total assets turnover ratio indicates how well the firm's total assets are being used to generate its sales.

Total assets turnover ratio = $\frac{{{\rm{Net\: sales}}}}{{{\rm{Total\: assets}}}}$

 

Capital employed turnover ratio

Capital employed turnover ratio establishes the relationship between the amount of sales ad capital employed, it shown how efficiently capital employed in the company has been utilized in generating sales revenue.

Capital employed turnover ratio = $\frac{{{\rm{Sales}}}}{{{\rm{\: Capital\: employed}}}}$

 

Leverage ratios

Leverage ratios are also called long-term solvency ratios or capital structure ratios. The term solvency implies the ability of a company to meet the payments associated with its long-term debts. Thus, solvency ratios are the measure of the company's ability to meet its long-term obligations. Generally, these ratios are expressed in proportions.

The following are the major types of leverage ratios:

a)Debt-equity ratio

b)Debt to total capital ratio

 

Debt-equity ratio

The debt-equity ratio is calculated to ascertain the soundness of the company's long-term financial position. It indicates the extent to which it depends upon borrowed funds for its existence. It portrays the proportion if its total funds acquired by way of external financing.

Debt-equity ratio = $\frac{{{\rm{Long}} - {\rm{term\: debt}}}}{{{\rm{Shareholders\: fund}}}}$

Alternatively,

Debt-equity ratio =  $\frac{{{\rm{Total\: debt}}}}{{{\rm{Total\: shareholders\: fund}}}}$

Long-term debt: The debt which is payable after current year is called long term-debt. Long-term debt refers to borrowed funds. Long-term debts include term loans, debentures, bonds, mortgage loans and secured loans.

Total debt: it includes both short-term debt as well as long-term debt. Short-term debts are the current liablilities.

 

Shareholder's fund: Shareholders fund is also called as net worth or shareholders' equity. Shareholders fund is the amount, which belongs to the company's shareholders or owners. It includes equity share capital, preference share capital, reserve and surplus, accumulated profits, reserve funds, general reserves, capital reserve, share premium, share forfeiture, retained earnings, reserve for contingency, sinking fund for renewal of fixed  assets and fixed assets and redemption of debenture. The fictitious assets such as preliminary expenses, underwriting commissions, discount on issue of shares, or debentures are deducted while determining shareholders' fund.

 

Turnover ratios

Turnover ratios are also known as activity or efficiency ratios. The total funds raised by the company are invested in acquiring various assets for its operations. The assets are acquired to generate the sales revenue and the position of profit depends upon the value of sales. These ratios establish the relationship sale with various assets. Ratio and express in integrates or times rather then percentage or proportion. The turnover ratios are mostly computed to measure the efficiency.

The following are the types of turnover ratio;

 

Inventory turnover ratio

This ratio is also called stock turnover ratio. This ratio shows the relationship between the cost of goods sold and the average inventory. This ratio measures how frequently the company's inventory turn into sales. It, therefore, shows the efficiency with which the company's inventory has been converted into sales.

It is calculated by,

Inventory turnover ratio =  $\frac{{{\rm{Sales}}}}{{{\rm{Closing\: inventory}}}}$  

 

Debtor  turnover ratio     

It is also termed as receivable turnover ratio. This ratio establishes the relationship between net credit sales and average debtor for the year. It shows how quickly the credit (debtor or receivables) of the company has been converted into cash. This ratio is calculated by using the following formula

Debtor turnover ratio= $\frac{{{\rm{Net\: credit\: sales}}}}{{{\rm{Average\: account\: receivable}}}}{\rm{\: }}$

 

Average collection period           

It is also called debt collection period or average age of debtors and receivables.it indicates how long it takes to realize the credit sales. It also measures the average creditor period enjoyed by the customers. It indicates the average time lag between credit sales and their conversion into cash.

 

Profitability ratios

The main objective of a company is to earn profit is both a means and an end to the company. Therefore, profitability shows the overall efficiency of the company. Profitability ratios are the measure of its overall efficiency. Generally, profitability ratio can be calculated in term of the company's sales, investments, and earning and dividends. The following are the main types of profitability ratios:

1. Profitability in relation to sales

Gross profit margin
Net profit margin

 

2. Profitability in relation to investment

Return on assets
Return on shareholder equity
Return on shareholder find
Return on capital employed

 

3. Profitability in terms of earning and dividend

Earning per share
Dividend per share

 

Gross profit ratio

Gross profit ratio is also termed as gross profit margin. This ratio shows the relationship between gross profit and net sales and it measures the overall profitability of the company in terms of sales. It is generally expressed in percentage.

It is calculated by,

Gross profit = $\frac{{{\rm{Gross\: profit}}}}{{{\rm{Net\: Sales}}}}$ * 100  
 

Net profit ratio

This ratio is also called net profit margin. This ratio measures the overall profitability of a business by establishing the relationship between net profit and net sales. This ratio is calculated by dividing net profit tax by net sales and multiplying by 100.

 

Return of assets

This ratio measure the relationship between the total assets and net profit after tax plus interest. It measures the productivity of the assets and determines how effectively the total assets have been used by the company.

Return of assets =$\frac{{{\rm{Net\: profit\: after\: tax}} + {\rm{Interest}}}}{{{\rm{Total\: assets}}}}$

 

Return on shareholders' equity

This ratio expresses the profitability of a business in relation to the owners fund.

It is calculated by,

Return on shareholders' equity =   $\frac{{{\rm{Net\: profit\: after\: tax}}}}{{{\rm{\: Total\: shareholde}}{{\rm{r}}^{\rm{'}}}{\rm{s\: equity}}}}$ * 100
 

Return on capital employed

The net result of operation of a business is either profit or loss. The funds used by the company to generate profit consist of both properties fund and borrowed funds. Therefore, the company's overall performance can be judged in terms of capital employed.

Return on capital employed = $\frac{{{\rm{Net\: profit\: after\: tax}} + {\rm{Interest}}}}{{{\rm{Capital\: Employed}}}}$ * 100

 

Earning per share

Earning per share measures the profit available to equity shareholder on per share basis. This ratio express the earning power of the company in terms of a share held by the equity shareholders. This ratio computed by dividing the net profits after preference dividend by the number of equity shares outstanding.

Earning per share = $\frac{{{\rm{Net\: profit\: after\: tax}} - {\rm{Preference\: dividend}}}}{{{\rm{No}}.{\rm{\: of\: equity\: shares\: outstanding}}}}$

 

Dividend per share

The profits earned by the company finally belong to the equity shareholder. Therefore,  all or some of them are distributed to them which are known as dividends. This ratio shows how much share of stock held by them is paid out as dividend. The amount of earning distributed and paid as cash dividend is considered for calculating the dividend per share.

Dividend per share = $\frac{{{\rm{Dividend\: available\: to\: shareholders}}}}{{{\rm{No}}.{\rm{\: of\: equity\: share\: outstanding}}}}$


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