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Ratio means arithmetical relationship between two figures. Ratio analysis is a widely used tool of financial analysis. The technique of ratio analysis as a technique for interpretation of financial statements deals with computation of various ratios from the information appearing on financial statements with the intention of drawing fruitful conclusions there from.
Interpretation of Ratios
Use of ratios as tools of financial analysis involves their comparison as single ratios like absolute figures are not of much use. Three types of comparisons are generally involved: 1. Trend analysis/Time series Analysis 2. Inter firm comparison 3. Comparison with standard or industry average.
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Classification of Ratios
Ratios can be broadly classified into following four groups: 1.Liquidity Group 2.Solvency or Capital structure or Leverage. Group 3.Profitability Group 4.Turnover Group 5.Miscellaneous Group
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Liquidity Ratios
Liquidity ratio measures the ability of the firm to meet its short term obligations and reflects its short term financial strength. Commercial banks and short term creditors may basically be interested in these ratios Imp Liquidity ratios are 1.Current Ratio 2.Quick or acid test ratio. 3. Absolute Cash Ratio
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Current Ratio
It is the ratio of current assets to current liabilities. Current Assets/ current liabilities Interpretations: It indicates rupees of current assets available for each rupee of current liability. As such Higher the current ratio, better will be the situation. A higher current ratio may also indicate unnecessarily higher investments in current assets in form of inventory or receivables. Current Ratio of 2:1 is supposed to be standard and ideal In this components of CA are not differentiated
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Cash and Marketable Securities Current Liabilities Objective: the objective of this ratio is to measure the ability of enterprise to meet its short term obligations as and when due without relying upon realization of stocks and debtors. Interpretation: It indicates cash and
Coverage Ratios
1.Interest Coverage Ratios 2. Preference Dividend Coverage Ratio 3. Debt Service Coverage Ratio
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Indications: Debt equity ratio indicates the stake of shareholders or owners in the organization with respect to that of creditors. A high debt equity ratio indicates that financial stake of creditors is more than that of owners. A very high debt equity ratio makes the proposition of investment in the organization a risky one. A low debt equity ratio indicates that borrowing capacity of the organization is underutilized.
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2. Proprietary Ratio
This ratio indicates the relationship between the owners funds( equity) and total assets. Proprietary ratio= proprietors funds *100 total assets Interpretation: This ratio indicates the extent to which the assets of the enterprise have been financed out of Proprietors funds. Traditionally a proprietary ratio of 1:4 is considered satisfactory .
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Indications: A high capital gearing ratio indicates that in capital structure, fixed income bearing securities are more in comparison to equity share capital. It also indicates the extent of risk to which company is subject and also the opportunity for trading on equity. It indicates the margin of safety available to the supplier of funds bearing fixed financial payments.
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EBIT (Earning before interest and taxes) Interest In this denominator considers the interest charges which is in the form of interest on long term borrowing and not the interest on working capital facilities.
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Indications: This ratio indicates the protection available to lenders of long term capital in the form of funds available to pay interest charges.
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2. Preference Dividend Coverage Ratio : Net profit after interest and taxes Preference Dividend Objective of this ratio is to measure the preference share servicing capacity of a firm so far as fixed dividend on preference shares is concerned.
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3. Debt Service Coverage Ratio. (DSCR) This is one of the most imp ratios calculated by bankers giving long term finances to the organization. net profit after taxes+ depreciation+ interest Interest on long term loans+ installment on long term loan
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Indications: This ratio is calculated to ascertain the capabilities of organization to repay the dues arising as a result of long term borrowing. Too low a DSCR indicates the insufficient earnings capacity of the organization to meet the obligations of long term borrowings.
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3. Profitability Ratios.
Profitability of a firm is measured on the basis of this ratio. Such ratios can be computed either on sales or investments. Some Profitability ratios based on sales are: 1.Gross profit ratios 2 Operating Profit Ratio 3. Net profit ratio
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Profitability ratio based on investments are: 1.Return on capital Employed 2.Return on equity or return on share holders funds 3.Return on equity share holders funds
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Interpretations: This ratio indicates: 1. Average gross margin earned on the sale of Rs 100 2. What portion of sales is left to cover operating and non operating expenses.
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Interpretation:1. It indicates the operational margin earned on a sale of Rs 100 2. It also indicates the portion of sales is available to cover non operating expenses.
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Operating Ratio
Cost of goods sold +operating expenses*100 Net sales This ratio is reciprocal to operating profit to sales ratio. Non operating expenses and non operating incomes are excluded from this ratio. The higher this ratio, the lower is the margin for operating profit. This ratio can be further analyzed to find out the percentage of each types of expenses to sales.
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Return on Equity
This is Net profit after interest and Taxes *100 shareholders funds This ratio indicates the firms ability to generate profit per rupee of share holders funds. Higher the ratio the more efficient the management and utilization of share holders funds.
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It is
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Miscellaneous Group
Earning Per share Price Earning Ratio Dividend Payout Ratio
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5. 6. 7. 8.
Only quantitative analysis and not qualitative analysis Historical Analysis Impact of Inflation Subjectivity Inadequate Only symptoms and not cure Accuracy of accounts to be considered Difference in Accounting policies
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