RATIO ANALYSIS

     The ratios analysis is the most powerful tool of financial statement analysis.  Ratio simply
means one number expressed in terms of another.  A ratio is a statistical yardstick by means of
which the relationship between two or various figures can be compared or measured.  Ratios
can be found out by dividing one number by another number.  Ratios show how one number is
related to another.

1. Profitability Ratios measure the results of business operations or overall performance and
effectiveness of the firm.  Some of the most popular profitability ratios are as under:

a. Gross Profit ratio 

Gross profit ratio (GP ratio) is a profitability ratio that shows the relationship between
gross profit and total net sales revenue. It is a popular tool to evaluate the operational
performance of the business.

Gross profit = Net sales – Cost of goods

sold

Net sales = Gross sales – Sales returns

The ratio can be used to test the business condition by comparing it with past years’ ratio and
with the ratio of other companies in the industry. A consistent improvement in gross profit ratio
over the past years is the indication of continuous improvement. When the ratio is compared
with that of others in the industry, the analyst must see whether they use the same accounting
systems and practices.

b. net profit ratio

Net profit ratio (NP ratio) is a popular profitability ratio that shows relationship between net
profit after tax and net sales. It is computed by dividing the net profit (after tax) by net sales.

Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A high
ratio indicates the efficient management of the affairs of business.

To see whether the business is constantly improving its profitability or not, the analyst should
compare the ratio with the previous years’ ratio, the industry’s average and the budgeted net
profit ratio.
The use of net profit ratio in conjunction with the assets turnover ratio helps in ascertaining how
profitably the assets have been used during the period.

c. operating ratio

Operating ratio (also known as operating cost ratio or operating expense ratio) is computed by
dividing operating expenses of a particular period by net sales made during that period. Like
expense ratio, it is expressed in percentage.

The operating ratio is used to measure the operational efficiency of the management. It shows
whether or not the cost component in the sales figure is within the normal range. A low operating
ratio means a high net profit ratio (i.e., more operating profit) and vice versa.
The ratio should be compared: (1) with the company’s past years ratio, (2) with the ratio of other
companies in the same industry. An increase in the ratio should be investigated and brought to
attention of management as soon as possible. The operating ratio varies from industry to
industry.

d. return on shareholders investment or net worth

Return on shareholders’ investment ratio is a measure of overall profitability of the business and
is computed by dividing the net income after interest and tax by average stockholders’ equity. It
is also known as return on total equity (ROTE) ratio and return on net worth ratio. The ratio is
usually expressed in percentage.

Return on total equity (ROE) is used to measure the overall profitability of the company from
preference and common stockholders’ point of view. The ratio also indicates the efficiency of the
management in using the resources of the business.
Higher ratio means higher return on shareholders’ investment and a lower ratio indicates
otherwise. Investors always search for the highest return on their investment and a company that
has higher ROE ratio than others in the industry attracts more investors.

e. return on equity capital

f. dividend yield ratio

Dividend yield ratio shows what percentage of the market price of a share a company annually
pays to its stockholders in the form of dividends. It is calculated by dividing the annual dividend
per share by market value per share. The ratio is generally expressed in percentage form and is
sometimes called dividend yield percentage.
Since dividend yield ratio is used to measure the relationship between the annual amount of
dividend per share and the current market price of a share, it is mostly used by investors looking
for dividend income on continuous basis.

The ratio is important for those investors who purchase shares to earn dividend income. Also the
shares that earn higher dividend income can be sold in the market at higher prices that usually
results in higher profits for the investor.

Depending solely on dividend yield figure for making investment in a company may not be a
wise decision. A high dividend yield percentage may be due to a recent decrease in the market
price of stock of the company due to sever financial troubles. It may have to reduce the amount
of dividends in future that may further reduce the market value of its stock. Therefore, a
company with attractive dividend yield figure may not always be the best option.

g. dividend payout ratio

Dividend payout ratio discloses what portion of the current earnings the company is paying to its
stockholders in the form of dividend and what portion the company is ploughing back in the
business for growth in future. It is computed by dividing the dividend per share by the earnings
per share (EPS) for a specific period.

It can also be computed by dividing the total amount of dividend paid on common stock during a
particular period by the total earnings available to common stockholders for that period.
A low dividend payout ratio means the company is keeping a large portion of its earnings for
growth in future and a high payout ratio means the company is paying a large portion of its
earnings to its common shareholders.

Whether a payout ratio is good or bad depends on the intention of the investor. A high payout
ratio is usually preferred by those investors who purchase shares to earn regular dividend income
and a low ratio is good for those who seek appreciation in the value of common stock in future.
Companies with ample reinvestment opportunities and a high rate of return on assets usually
keep a large portion of earnings in the business and, therefore, have a low dividend payout ratio
during the first few years of establishment. Well established companies usually have a good
consistent dividend payout ratio.

2. Liquidity Ratios measure the short-term solvency of the financial position of a firm.  These
ratios are calculated to comment upon the short-term paying capacity of concern or the firm’s
ability to meet its current obligations

a. current ratio

Current ratio (also known as working capital ratio) is a popular tool to evaluate short-term
solvency position of a business. Short-term solvency refers to the ability of a business to pay its
short-term obligations when they become due. Short term obligations (also known as current
liabilities) are the liabilities payable within a short period of time, usually one year.
A higher current ratio indicates strong solvency position and is therefore considered better.

current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2:1
or higher is considered satisfactory for most of the companies but analyst should be very careful
while interpreting it. Simply computing the ratio does not disclose the true liquidity of the
business because a high current ratio may not always be a green signal. It requires a deep
analysis of the nature of individual current assets and current liabilities. A company with high
current ratio may not always be able to pay its current liabilities as they become due if a large
portion of its current assets consists of slow moving or obsolete inventories. On the other hand, a
company with low current ratio may be able to pay its current obligations as they become due if
a large portion of its current assets consists of highly liquid assets i.e., cash, bank balance,
marketable securities and fast moving inventories.

Limitations of current ratio

Current ratio suffers from a number of limitations. Some are given below:
1. Different ratio in different parts of the year:

Some businesses have different trading activities in different seasons. Such businesses may show
low current ratio in some months of the year and high in others.

2. Change in inventory valuation method:

To compare the ratio of two companies it is necessary that both the companies use same
inventory valuation method. For example, comparing current ratio of two companies would be
like comparing apples with oranges if one uses FIFO cost flow assumption and the other uses
LIFO cost flow assumption for the valuation of inventories. The analyst would, therefore, not be
able to compare the ratio of two companies even in the same industry.

3. Current ratio is a test of quantity, not quality:

It is not an exact science to test liquidity of a company because the quality of each individual
asset is not taken into account while computing this ratio.

4. Possibility of manipulation:

Current ratio can be easily manipulated by equal increase and/or equal decrease in current assets
and current liabilities. For example, if current assets of a company are $10,000 and current
liabilities are $5,000, the current ratio would be 2:1 as computed below:

$10,000 : $5,000

2:1

If both current assets and current liabilities are reduced by $1,000, the ratio would be increased
to 2.25:1 as computed below:

$9,000 : $4,000

2.25:1

In order to overcome these limitations, current ratio may be used in conjunction with some other
ratios like inventory turnover ratio, debtors turnover ratio, average collection period ratio, current
cash debt coverage ratio, debt to equity ratio and quick ratio etc. These ratios can test the quality
of some individual current assets and together with current ratio provide a better idea of
company’s solvency.

a. liquid/Acid test/Quick ratio

Quick ratio (also known as “acid test ratio” and “liquid ratio”) is used to test the ability of a
business to pay its short-term debts. It measures the relationship between liquid assets and
current liabilities. Liquid assets are equal to total current assets minus inventories and prepaid
expenses.

Quick ratio is considered a more reliable test of short-term solvency than current ratio because it
shows the ability of the business to pay short term debts immediately.
Inventories and prepaid expenses are excluded from current assets for the purpose of computing
quick ratio because inventories may take long period of time to be converted into cash and
prepaid expenses cannot be used to pay current liabilities.

3. Activity Ratio is calculated to measure the efficiency with which the resources of a firm have
been employed.  These ratios are also called turnover ratios because they indicate the speed
with which assets are being turned over into sales.  The following are the most important
activity ratios

a) inventory turnover ratio

Inventory turnover ratio (ITR) is an activity ratio and is a tool to evaluate the liquidity of
company’s inventory. It measures how many times a company has sold and replaced its
inventory during a certain period of time.

Inventory turnover
ratio = Sales / Inventory

inventory turnover ratio varies significantly among industries. A high ratio indicates fast
moving inventories and a low ratio, on the other hand, indicates slow moving or obsolete
inventories in stock. A low ratio may also be the result of maintaining excessive inventories
needlessly. Maintaining excessive inventories unnecessarily indicates poor inventory
management because it involves tiding up funds that could have been used in other business
operations.

b. average collection period

Average collection period is computed by dividing the number of working days for a given
period (usually an accounting year) by receivables turnover ratio. It is expressed in days and is
an indication of the quality of receivables.

Like receivables turnover ratio, average collection period is of significant importance when used
in conjunction with liquidity ratios.
A short collection period means prompt collection and better management of receivables. A
longer collection period may negatively affect the short-term debt paying ability of the business
in the eyes of analysts.

c. creditors/payable turnover ratio

ccounts payable turnover ratio (also known as creditors turnover ratio or creditors’ velocity) is
computed by dividing the net credit purchases by average accounts payable. It measures the
number of times, on average, the accounts payable are paid during a period. Like receivables
turnover ratio, it is expressed in times.

Accounts payable turnover ratio indicates the creditworthiness of the company. A high ratio
means prompt payment to suppliers for the goods purchased on credit and a low ratio may be a
sign of delayed payment.

Accounts payable turnover ratio also depends on the credit terms allowed by suppliers.
Companies who enjoy longer credit periods allowed by creditors usually have low ratio as
compared to others.

A high ratio (prompt payment) is desirable but company should always avail the credit facility
allowed by the suppliers.

d. working capital turnover ratio

 Working capital turnover ratio is computed by dividing the net sales by average working
capital. It shows company’s efficiency in generating sales revenue using total working capital
available in the business during a particular period of time.

Generally, a high working capital turnover ratio is better. A low ratio indicates inefficient
utilization of working capital during the period. The ratio should be compared with the previous
years’ ratio, competitors’ or industry’s average ratio to have a meaningful idea of the company’s
efficiency in using its working capital.

The working capital turnover ratio should be carefully interpreted because a very high ratio may
also be a sign of insufficient quantity of working capital in the business.

e. fixed assets turnover ratio

Fixed assets turnover ratio (also known as sales to fixed assets ratio) is a commonly used
activity ratio that measures the efficiency with which a company uses its fixed assets to
generate its sales revenue.

Generally, a high fixed assets turnover ratio indicates better utilization of fixed assets and a low
ratio means inefficient or under-utilization of fixed assets. The usefulness of this ratio can be
increased by comparing it with the ratio of other companies, industry standards and past years.

4. Long-term Solvency or Leverage Ratios – conveys a firm’s ability to meet the interest costs
and payment schedules of its long-term obligations.  The following are some of the most
important long term solvency or leverage ratios

a. Debt-to-equity ratio

Debt to equity ratio (also termed as debt equity ratio) is a long term solvency ratio that indicates
the soundness of long-term financial policies of a company. It shows the relation between the
portion of assets financed by creditors and the portion of assets financed by stockholders. As the
debt to equity ratio expresses the relationship between external equity (liabilities) and internal
equity (stockholder’s equity), it is also known as “external-internal equity ratio”.
A ratio of 1 (or 1 : 1) means that creditors and stockholders equally contribute to the assets of the
business.

A less than 1 ratio indicates that the portion of assets provided by stockholders is greater than the
portion of assets provided by creditors and a greater than 1 ratio indicates that the portion of
assets provided by creditors is greater than the portion of assets provided by stockholders.

Creditors usually like a low debt to equity ratio because a low ratio (less than 1) is the indication
of greater protection to their money. But stockholders like to get benefit from the funds provided
by the creditors therefore they would like a high debt to equity ratio.

Debt equity ratio vary from industry to industry. Different norms have been developed for
different industries. A ratio that is ideal for one industry may be worrisome for another industry.
A ratio of 1 : 1 is normally considered satisfactory for most of the companies.

If debt to equity ratio and one of the other two equation elements is known, we can work out the
third element. Consider the example 2 and 3.

b. Proprietary or Equity ratio

he proprietary ratio (also known as net worth ratio or equity ratio) is used to evaluate the
soundness of the capital structure of a company. It is computed by dividing the stockholders’
equity by total assets.
The proprietary ratio shows the contribution of stockholders’ in total capital of the company. A
high proprietary ratio, therefore, indicates a strong financial position of the company and greater
security for creditors. A low ratio indicates that the company is already heavily depending on
debts for its operations. A large portion of debts in the total capital may reduce creditors interest,
increase interest expenses and also the risk of bankruptcy.

Having a very high proprietary ratio does not always mean that the company has an ideal capital
structure. A company with a very high proprietary ratio may not be taking full advantage of debt
financing for its operations that is also not a good sign for the stockholders.

b1. Ratio fo fixed assets to shareholders’/proprietors’formula

b2. The ratio of current assets to shareholders/proprietors’funds.

Note please know its significance. And what are the uses of ratio in our analysis? Recitation
tomorrow. Please be ready thanks