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Ratios analysis

INTRODUCTION
The major financial statements of a company are the balance sheet, income
statement and cash flow statement (statement of sources and applications of
funds). These statements present an overview of the financial position of a
firm to both the stakeholders and the management of the firm. But unless the
information provided by these statements is analyzed and interpreted
systematically, the true financial position of the firm cannot be understood.
The analysis of financial statements plays an important role in determining
the financial strengths and weaknesses of a company relative to that of other
companies in the same industry. The analysis also reveals whether the
company's financial position has been improving or deteriorating over time.

Meaning of Ratio:

A ratio is simple arithmetical expression of the relationship of one number


to another.
Financial ratio analysis involves the calculation and comparison of ratios
which are derived from the information given in the company's financial
statements. The historical trends of these ratios can be used to make
inferences about a company's financial condition, its operations and its
investment attractiveness. Financial ratio analysis groups the ratios into
categories that tell us about the different facets of a company's financial state
of affairs. Some of the categories of ratios are described below:

Ratio Analysis expresses the relationship among selected


items of financial statement data. A ratio expresses the
mathematical relationship between one quantity and
another. Ratio is a relationship between two or more variable
expressed in; (I) Percentage, (ii) Rate (iii) Proportion.
CLASSIFICATION OF Ratios
Ratios should be analysis under the fallowing elements heading:

Profitability Ratios

Short term liquidity

It refers to the ability of the firm to meet its current


liabilities. The liquidity ratio, therefore, are also called ‘Short-
term Solvency Ratio’. These ratios are used to assess the
short-term financial position of the concern. They indicate
the firm’s ability to meet its current obligation out of current
resources.

Current Ratio: This ratio explains the relationship between


current assets and current liabilities of a business.

Significance: - According to accounting principles, a


current ratio between 1, 5 and 2 are supposed to be an ideal
ratio. It means that current assets of a business should, at
least, be twice of its current liabilities. The higher ratio
indicates the better liquidity position; the firm will be able to
pay its current liabilities more easily. If the ratio is less than
it indicates lack of liquidity and shortage of working capital.

This ratio can be improved by an equal decrease in both


current assets and current liabilities

Acid test:
An ideal quick ratio is said to be 1:1. If it is more, it is
considered to be better. This ratio is a better test of short-
term financial position of the company.

Working capital ratios


Shareholders

Profitability Ratios

This ratio reflects the overall profitability of the business

Profitability ratios measure the income or operating success


of an enterprise for a given period of time. Income, or the
lack of it, affects the company’s liquidity position and the
company’s ability to grow. As a consequence, both creditors
and investors are interested in evaluating earning power
profitability. Profitability is frequently used as the ultimate
test of management’s operating effectiveness.

Its include

ROCE
Return on capital employed is a key element in indicating a company
performance. Is the return the company is making form its long term capital
investment before interest and tax? It could be compared to the interest that
would be received if the money is to be invested in the bank.

Since profit is the overall objective of a business enterprise,


this ratio is a barometer of the overall performance of the
enterprise.
It measures how efficiently the capital employed in the
business is being used.

Example: the ROCE going down indicate that the company is earning less
from the capital it has invested into the business.

GROSS PROFIT MARGIN

Is the percentage profit the company is making form the sales after it has
paid for the goods? This ratio measures the relationship between gross profit
and sales. This ratio shows the profit that remains after the manufacturing
costs have been met. It measures the efficiency of production as well as
pricing.
Net profit PROFIT MARGIN

Operating expenses

Fixed Assets Turnover


Asset turnover is the relationship between sales and assets
| Financial Statement Analysis 13

· The firm should manage its assets efficiently to maximize sales.


· The total asset turnover indicates the efficiency with which the firm
Uses all its assets to generate sales.
· It is calculated by dividing the firm’s sales by its total asset

Short term liquidity

Current ratios: This ratio explains the relationship between


current assets and current liabilities of a business.

Significance:

According to accounting principles, a current ratio of 2:1 is


supposed to be an ideal ratio.
It means that current assets of a business should, at least,
be twice its current liabilities. The higher ratio indicates the
better liquidity position; the firm will be able to pay its
current liabilities more easily. If the ratio is less than 2:1, it
indicates lack of liquidity and shortage of working capital.
The biggest drawback of the current ratio is that it is
susceptible to “window dressing”. This ratio can be improved
by an equal decrease in both current assets and current
liabilities.

Acid test

CONCLUSION

Ratio analysis has a major significance in analyzing the financial


performance of a company over a period of time. Decisions affecting
product prices, per unit costs, volume or efficiency have an impact on the
profit margin or turnover ratios of a company. Similarly, decisions affecting
the amount and ratio of debt or equity used have an affect on the financial
structure and overall cost of capital of a company. Understanding the inter-
relationships among the various ratios, such as turnover ratios and leverage
and profitability ratios, helps managers invest in areas where the risk
adjusted return is maximum. In spite of its limitations, ratio analysis can
provide useful and reliable Information if relevant data is used for analysis.

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