Sunday, March 20, 2011

Ratio Analysis

The ratio analysis is one of the most powerful techniques of financial analysis. With the help of ratios financial statements can be analyzed more clearly and reasonable decisions can be taken by the management.

A ratio is an expression of the quantitative relationship between two numbers. A financial ratio is the relationship between two accounting figure expressed mathematically. For example if the current assets of a business firm on a given date are Rs. 400000 and current liabilities are Rs. 200000 then the ratio of current assets to current liabilities is .
This ratio of current assets and current liabilities can be expressed  as in following ways :

i) 2 : 1    ii) 2    iii) 2/1    iv) 2 to 1  0r   v) 200%

Ratios provide information about the financial strength, soundness, position and weakness of a business concern. Ratio analysis is a technique of analysis and interpretation of financial reports. Numbers of ratios can be calculated from the information given in the financial statements but the analyst should select the appropriate data and calculate some appropriate ratios keeping in mind the objective of analysis.

An analyst should follow the following steps in the ratio analysis :

  • Selection of appropriate data from financial statements depending upon the objective of analysis.
  • Calculation of appropriate ratios from the above data
  • Comparison of the calculated ratios of the same firm in the past or the ratios developed from projected financial statements or the ratios of some other firms or the comparison with ratios of the industry to which the firm belongs.
  • Interpretation of the ratios.
The calculation of ratios is not so difficult but its interpretation is very important. It needs skill, intelligence and foresightedness.The interpretation of ratios can be made in the following ways :

  • Rule of thumb: Single ratio does not convey much sense when it is  considered in isolation. So single ratios may be studied with the rule of thumb which are based upon well proven conventions for example 2 : 1 is considered as good ratio for current assets to current liabilities. 
  • Group of ratios: Ratios may be studied with  other related ratios to draw more meaningful and understandable conclusions. For example the ratio of current assets to current liabilities may be analyzed with the ratio of liquid assets to liquid liabilities to draw more reliable conclusions. 
  • Comparison overtime: When a firm's present ratio is compared with its past ratios then it is called comparison overtime or historical comparison. It is easiest and most popular ways of evaluating the performance of a firm. Historical comparison gives indication of firm's performance and tells whether the financial position of the firm has improved, deteriorated or remained constant over a period of time.
  • Projected ratios: Ratios can be calculated for future standards based upon the projected financial statements. These future ratios are considered as standards and the ratios calculated from actual financial statements are compared with these standards to find out any deviations. Such deviations or variances helps management to interpret in a better and understandable way.
  • Inter-firm comparison: When ratios of one firm  are compared with the ratios of some other selected firms in the same industry at the same point of time then it is called inter-firm comparison. Inter-firm comparison helps in evaluating relative financial position and performance of the firm. But while doing inter-firm comparison some factors like accounting methods, policies and procedures of different firms should be taken into consideration for interpretation of ratios.
    Classification of ratios

    The ratios are not only used by financial managers but also used by all other parties interested in knowing the financial position of the firm for different purposes. There are many types of ratios can be calculated from the information given in the financial statements. The user determines a particular ratio that might be used for financial analysis for a particular purpose. For example a bank which has given a short term loan to a firm will be interested in the liquidity position of the firm on the other case if she has given a long term loan then she will be interested in the long term financial position or the solvency of the firm.

    In view of the financial management various ratios can be classified as under :

    • Liquidity Ratios
    • Long Term Solvency or Leverage Ratios
    • Activity Ratios
    • Profitability Ratios
    Liquidity Ratios  

    Liquidity means the ability of a concern to meet its current financial obligations as and when these become due. Current or short term obligations are paid from the amounts realized from current or floating assets. Current assets are converted to cash to pay off the current liabilities. If the current assets are sufficient to meet the current or short term liabilities, then liquidity position of the firm is satisfactory. On the other hand the current liabilities may not be easily paid off out of current assets then liquidity position is not satisfactory. Following ratios are calculated to measure the liquidity position of the firm.

    • Current Ratio
    • Liquid Ratio
    • Absolute Liquid Ratio or Cash Position Ratio
    Current Ratio: Current ratio or working capital ratio is the relationship between current assets and current liabilities. These ratios are used to analyze and measure the liquidity or the short term financial position of a firm. It is calculated by dividing the total current assets by total current liabilities.

    or Current Assets : Current Liabilities

    Current assets are the assets which can be easily converted into cash within a short period of time generally one year. So current assets include cash and other assets such as bills receivables, sundry debtors, marketable securities, inventories, work-in-progress, prepaid expenses etc. Current liabilities are the financial obligations which are payable within a short period generally one year. Current liabilities include outstanding expenses, bills payable, sundry creditors, accrued expenses, income tax payable, short term advances, dividend payable, bank overdraft (if short term arrangement with the bank) etc.

    Here is an example of calculation of current ratio:

    Current Assets : Stock Rs. 70000; Sundry debtors Rs. 80000; Cash and bank balance Rs. 30000;  Bills receivables Rs. 40000; Prepaid expenses Rs. 20000
    Current Liabilities : Bills payable Rs. 24000; Sundry creditors Rs. 30000; Tax payable Rs. 20000; Outstanding expenses Rs. 10000; Bank overdraft Rs. 25000.

    Current Assets = Rs 70000 + 80000 + 30000 + 40000 + 20000 =  Rs. 240000
    Current Liabilities = Rs. 24000 + 30000 + 20000 + 10000 + 25000 = Rs.109000

    A high current ratio is an indication of good liquidity position of the firm. It tells that the firm has the ability to pay off its current obligations where as a low current ratio represents that the liquidity position of the firm is not good. As a rule of thumb or arbitrary standard the minimum of two to one ratio is considered as satisfactory for the firm.

    Liquid Ratio: Liquid ratio is a more rigorous test of liquidity of a firm than the current ratio . Liquid ratio also known as quick or acid test ratio is the relationship between liquid assets and liquid liabilities. An asset is called liquid asset when it can be converted into cash within a short period and without loss of value. Inventories are not liquid asset because they can not be converted into cash immediately without a sufficient loss of value. Similarly prepaid expenses are also not treated as liquid asset because they are not expected to convert into cash. So in the calculation of liquid ratio these two assets will be excluded from the current assets.

    Sometimes bank overdraft is excluded from the current liabilities while calculating liquid or acid test ratio because bank overdraft is generally a permanent way of financing and is not subject to be claimed in demand. So

    Taking the account balances from the above example liquid ratio can be calculated as :

    Liquid Assets = Rs. 80000 + 30000 + 40000 = Rs. 150000
    Liquid Liabilities = Rs. 24000 + 30000 + 20000 + 10000= Rs. 84000

    As a convention or rule of thumb liquid ratio of 1 : 1 is considered satisfactory. If the liquid assets are equal to liquid liabilities then the concern may be able to meet its short term obligations. Quick ratio is a rigorous test of liquidity than the current ratio. The ratio of 1 : 1 is treated as the standard but it should not be used blindly. The ratio of 1 : 1 may not be satisfactory liquidity position of the firm if all the debtors can not be realized and cash is needed immediately. In the same way a low quick ratio does not mean a bad liquidity position as inventories are not absolutely non-liquid.

    Absolute Liquid or Cash Ratio: Absolute liquid ratio is even more rigorous test of liquidity than the liquid ratio. In the calculation of absolute liquid ratio, bills receivables and debtors are excluded from the liquid assets due to the reason that these assets may not be immediately converted into cash when needed. Absolute liquid assets include cash in hand and at bank and marketable securities or temporary investments. So

    Taking the account balances from the above example absolute liquid ratio can be calculated as :

    Absolute liquid assets = Rs. 30000

    Current Liabilities = Rs. 24000 + 30000 + 20000 + 10000 + 25000 = Rs.109000

    The acceptable norm for this ratio is 0.5 : 1 or 1 : 2. Re 1 worth of absolute liquid assets are considered sufficient to pay Rs. 2 worth of current liabilities in time as all the creditors are not expected to demand cash at the same time.

    In the next posts I will discuss about other ratios.