Ratio Analysis (Accounting Ratios)

What is Ratio Analysis?

Ratio analysis is the main source of analysis of financial statements for a given period. You can do an analysis of the performance of the financial statements. It can do on any financial statement. As we know the main financial statements are statements of financial position (Balance Sheet), Statement of Profit or Loss. Ratio analysis helps to understand the behavior of the company assets and other financial items. Ratios are the most reliable way to analyze the business or operation. Ratios help in the ways below to the organizations.

·         It helps to compare the periodical data.

·         It helps to understand the financial position.

·         It helps to identify future financial behavior and issues.

·         It helps to forecast and plan the strategies for the business or operation.

·         It helps to get the technical decisions.

·         It acts as a benchmark.

Limitations of Ratio Analysis

·         Historical Information

Financial Statements show historical data; hence the ratios cannot show the 100% accurate data for the futuristic data analysis.

·         Manipulation of financial statements

We have seen many instances of manipulating financial statements in the world. You may remember the company “Enron” once became the world number one ranked company manipulating their financial statements. Because of the manipulation of the financial they could show a larger revenue and could sell their shares at soaring prices in the stock market.

·         Inflation Effect

Inflation always influences the financial performance of the company. The data has been presented via ratios based on a particular inflation rate in history. But inflation is changing every day and every time.

·         Change in Accounting policies

Accounting policies are changing periodically. If we compare the historical data which is older like 10 years with the current year, there can be accounting policy changes during this period. Also, there are minor changes between industry and companies too.

·         Seasonal Effects

Financial performances differ from time to time and season to season, there are off season and on season. Also, there are climate seasons such as winter, Spring, Summer, Fall.

·         Operational Changes

It is difficult to compare the revenue models of a company with another company because the policies, procedures and other conditions can vary from company to company. 

Types of Ratio Analysis

There are four types of Ratio Analysis in practice.

• 1.      Liquidity Ratios
• 2.      Profitability Ratios
• 3.      Leverage Ratios
• 4.      Activity Ratios/Efficiency Ratio

#1. Liquidity Ratios

Liquidity ratios are used to measure the company’s liquidity. This measures the short-term capacity of payments. If the ratio is high, the company has a prominent cash position. We can call the cash position good if the liquidity ratio is more than one.

1.1 Current Ratio

Current ratio shows how much current assets are available to pay off the current liabilities. Current Assets include Inventory, Debtors, Prepayments, Cash at Bank, Cash in Hand etc. Current Liabilities include Creditors, Short term Loans and Bank overdraft, Other Payables.

Current Ratio = Current Assets / Current Liabilities

1.2 Quick ratio/Acid Test Ratio

It is same as current ratio, but the more liquidate. The calculation is done without considering the inventory.

Quick Ratio = Quick Assets / Current Liabilities

Quick Assets are being calculated as below.

Quick Assets = Current Assets - Inventory

1.3 Cash Ratio

It only includes the assets which are highly liquidate or which can be immediately converted into cash.

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

 

#2. Profitability Ratio

It is about the efficiency of profit making. It measures the capacity of earnings based on the employed capital.

2.1 Gross Profit Ratio

Gross profit ratio calculated by dividing the gross profit by net revenue.

Gross Profit Ratio = (Gross Profit / Net Revenue) X 100

Net revenue is being calculated as below. It means that the Gross sales netting with the Sales returns. Normally we can get the gross profit from the profit and loss account. The gross profit is the profit before the operational expenses. It is net Revenue minus Cost of Goods Sold as below.

Net Revenue = Sales - Returned Sales

Gross Profit = Net Revenue - Cost of the Sold Goods

The cost of sales consists of the direct costs incurred to produce goods and services. It includes Raw Material cost, Labor cost etc.

2.2 Operating Ratio

This function calculates the Operational expenses subject to the Net Revenue.

Operating Ratio = ((Cost of the Sold Goods + Operating Expenses) / Net Revenue) X 100

The only new part here is Operating expenses. We have other parts in the above. Operating expenses consist below main categories. Administration Expenses, Selling and Marketing expenses, Finance Expenses, Information Technology Expenses.

2.3 Net Profit Ratio

You need to take the net profit after tax which is the ultimate profit for shareholders.

Net Profit Ratio = (Net Profit after Tax / Net Revenue) X 100

 

Return on Capital Employed (ROCE)

Return on capital employed = (Profits Before Interest and Taxes /Capital Employed) X 100

Earnings per Share

Earnings Per Share = Profit Available to Equity Shareholders / Weighted Average Outstanding Shares

 

#3. Leverage Ratios

3.1 Debt to Equity Ratio

This indicates the ratio of combination between equity and debt. The ratio should not exceed 2:1.

Debt to Equity Ratio = Total Debts / Total Equity

3.2 Debt Ratio

This measures how much liabilities have against Total Assets. Here we divide the Total Liabilities by the Total Assets. You can get the Total liability directly statement of financial position or you can deduct total equity from the total assets.  

Debt Ratio = Total Liabilities / Total Assets

3.3 Proprietary Ratio

This measures how much shareholders have invested out of total assets. You need to divide Shareholder funds by Total Assets.

Proprietary Ratio = Shareholder Funds / Total Assets

3.4 Interest Coverage Ratio

This function measures the ability to pay the interest expenses in the company.

Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense

 

#4. Activity Ratios/Efficiency Ratio

4.1 Working Capital Turnover Ratio

We can use this equation to find how efficiently company funds have been used during the period.

Working Capital Turnover Ratio = Net Sales / Net Working Capital

4.2 Inventory Turnover Ratio

This function measures how efficiently do the conversion of inventory to sales for a given period.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

4.3 Asset Turnover Ratio

This is an important ratio measurement. This computes how much is the earning against the assets of the company for a given period.

Asset Turnover Ratio = Net Revenue / Assets

4.4 Debtors Turnover Ratio

If the company makes the sales on a credit basis, this ratio is very important, and the credit controller should act to keep this ratio at an efficient level. It measures how efficiently debtors collected in the period.

Debtors Turnover Ratio = Credit Sales / Average Debtors