(This article explains meaning of ratios, purpose of ratio analysis in financial analysis, many important ratios evaluated by financiers, and method and techniques of ratio analysis.)
Ratio analysis of a financial statement is the process of calculating structural relations of different items and groups in the financial statements. If any lending decision is to be properly made, the risk involved in the transaction should be properly evaluated. Risk evaluation primarily consists in the ascertainment of the ability of the prospective borrower to repay the proposed loan. The computation of ratios assists analyst to evaluate significant relationships in financial statements.
There are many methods and techniques are used in analysis of financial statements such as (i). Comparative statements/Trend Analysis (Comparison is done of current performance with past figures of the same business concern), which is called Historical standard. (ii). External Standards (comparison between two business concerns engaged in same line of business, with more or less same infrastructure and production capacities. Comparison can also be made with ‘Industry average’), iii. Goals/Corporate planning & Policies (Comparing the actual performance with the budgeted performance, to find out whether actual performance is good, to the set in goal in the prevailing circumstance.) (iv). Experience (We have to accept that the information provided in the financial statements is not an end in itself, as no meaningful conclusions can be inferred from these statements alone. Therefore banker builds up his own judgment by appraising schedule of changes in working capital, common size percentages, funds analysis etc.). The comprehensive and up-to-date information is needed to an analyst in risk assessment and credit evaluation.
Thus, the findings based on ratio analysis have to be studied along with the funds flow analysis, Cash flow analysis, other financial data such as Notes to balance sheet, Auditor’s report, Director’s report and other non-financial data having a bearing on financial events. The ratios may not make conclusion themselves, however, ratio analysis are of immense use to financial analysts for making further investigation and in making final decisions. This is because; ratios provide financial analyst certain yard stick to evaluate the financial condition and performance of a firm, as ratios reduce large figures to an easily understandable relationship. Therefore, ratio analysis has gained wide acceptance as a quantitative technique of financial management. The ‘ratio technique’ is also widely used by banks and financial institutions all over the world.
Meaning of ratio:
The term ratio means a simple division of one number by another. It is measured by the number of times one number is contained by the other, either integrally or in fraction. Generally, the ratios are of following three kinds.
i) Balance sheet ratio: Balance sheet ratios indicate the relationship between various balance sheet items.
ii) Operating ratio: The operating ratios exhibit the relationship of expense accounts to income.
iii) Inter-statement ratio: Inter-statement ratios show the relationship of balance sheet items to income and expenses accounts.
Further ratios can be classified into three broad categories which are as under.
(i) Structural ratios: Examples of structural ratios are Current Ratio, Quick ratio, proprietary or equity asset ratio, fixed assets to tangible net worth , current debt to tangible net worth, total debt to tangible net worth, inventory to net working capital, current debt to inventory etc.
(ii) Profitability ratios: Examples of profitability ratios are ‘Net profit on net sales’,’ Net profit on tangible Net worth’, ‘Gross profit to net sales’, ‘Net profit to total sales’ etc.
(iii) Turnover ratios (inter-statement ratios): Examples of Turn over ratios are Sales to receivables, sales to inventory, Sales to total assets. Turnover ratio is also known as inter-statement Ratio.
The purpose of computation of ratios:
- Current Ratio:
The current ratio is obtained by the division of total current assets by total current liabilities. (Total Current Assets ÷Total Current Liabilities)
Current assets are cash and other assets like raw material (RM), work in process (WIP), finished goods (FG), and receivables) that are expected to be converted to cash within a year.Current liabilities are the liabilities (amounts due) to be paid by the unit /company to the creditors within twelve months.
This ratio indicates credit strength by indicating how much of current assets are available for meeting each rupee of liability, in the other words, current ratio measures the solvency and adequacy of working capital in a business. It also gives the fair idea of over trading. Any rise in the current ratio shows improved credit strength and fall indicates deteriorating credit strength. Please remember, higher ratio may be good from the point of view of creditors, in the long run very high current ratio may affect profitability.
Desirable Current Ratio is 2:1.Generally, acceptable minimum current ratio in India is 1.33; any persisting trend of less than 1 over a period is a sure indicator of sickness.
- Quick ratio/Acid test:
Cash, marketable securities and account receivables to be divided by current liabilities to obtain Quick ratio
Quick ratio= (Total current assets – inventory) ÷Total current liabilities
The objective is to know the level of liquidity position to pay off all current liabilities including Bank Liabilities. The ratio indicates the extent to which current liabilities could be met without relying upon the sale of stock, which means the size of the liquid assets that can be readily converted into cash in relation to the total liability. Quick Ratio should be equal to 1 or more than 1
There is another method of computing Quick Ratio wherein
Quick ratio= [ (Cash + Receivable + RBI approved investment) ÷ ( Current Liabilities-Cash Credit Liabilities against inventory for banks)].
(The value of inventory and liabilities against inventories is excluded here because of difficulties to sell and realize the full value of inventory at short notice during liquidity crisis.)
Proprietary or Equity asset ratio:
It is computed by dividing “total share-holders’ funds” by “total assets” (Total Capital ÷Total Assets)
The ratio indicates the shareholders’ stake in asset holding and it reflects the degree of safety or margin of protection available to the creditors. Increase in ratio indicates decrease of debts which is a sign of increasing financial strength and of a good management.
- Fixed assets to tangible net worth plus term debt:
= Fixed Assets ÷ Tangible net worth + Term Liabilities.
This ratio is computed by Net fixed assets divided by net worth plus term debt.
Net-worth’ of an entity will consist of ‘paid up equity capital, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of assets but not reserves created by revaluation of assets’ adjusted for ‘accumulated loss balance, book value of intangible assets and Deferred Revenue Expenditure, if any’. The ratio shows the long term stability relationship of own and borrowed funds. The ratio should not exceed 1:1 for a manufacturing concern and 0.75:1 for wholesaler. The increase in ratio is undesirable. If the ratio increases, the margin of operating funds become too narrow, and may expose the enterprise to hazards of debt pressure and insufficiency of working capital.
- Current debt to tangible net worth ratio: = Current Liabilities÷ tangible net worth
Current debt to tangible net worth is computed by dividing current liabilities by tangible net worth. This ratio measures long term stability relationship of own and borrowed funds. Increase in ratio indicates the increase in the creditors which may result into debt pressure due to insufficiency of own capital.
- Debt Equity Ratio (DER) or Total debt to tangible net worth ratio:
DER = Long Term Liabilities+ Short term Liabilities ÷Tangible Net worth
The ratio is obtained by dividing long and short term debts by tangible net worth. This ratio indicates the relative financial stakes of the creditors compared to owners’ stake in the business.
Debt Equity Ratio is said to be satisfactory, if it is 2:1 or above. In India, acceptable DER is normally 3:1 for SSI units and 2:1 for MLI units and trading concerns. Tolerable ratio in exceptional cases is 4:1.If ratio position increases that may indicate that the business is being exposed to hazards of greater and greater borrowings and the business may slip into financial problems, especially during unexpected contingencies like sudden downward sales, customers’ preferences to change in style etc.
Some financial institutions also verify Funded Debt ÷ Equity Ratio (FDER) for financing new projects i.e FDER= Long term debts
Tangible Net Worth
This ratio measures the long-term solvency and ability of the concern to meet long-term liabilities. Acceptable FDER for SSI is 2:1, for large and medium Industries it is 1.5:1
- Inventory to net working capital ratio: Inventory ÷ Net working capital
Inventory is divided by net working capital to compute Inventory to net working capital. The thumb rule is that inventory should not exceed 80% of the working capital. If inventory position is too high, due to unsold inventory, the firm may face difficulty in meeting current obligations.
- Current debt to inventory ratio: Current Liabilities÷ inventory
Current Liabilities are divided by inventory to obtain this ratio. The steady increase in the ratio means increase of current liabilities and decrease in inventory which is not a favorable trend.
- Solvency Ratio: Total Tangible assets ÷ Total outside liability
Solvency ratio is computed by dividing total tangible assets by total outside liabilities. If tangible assets are more than a firm’s term & current liabilities, the unit can be called as solvent.
- Capital Gearing Ratio:
Fixed charge bearing long term funds ÷Total long term liabilities (Total long term liabilities=Term Liabilities +Net worth)
Gearing is utilizing external source of funds (borrowings) to increase the yield on equity. This is known as financial leverage. A company is called highly geared when its interest/fixed charge bearing funds are exorbitantly high compared to net worth. The desirable ratio is 3:1, satisfactory ratio is 5:1, and Tolerable is 8:1. A high ratio of gearing is a risky, particularly when the firm is unable to earn adequate profits in a given year, which may push the company into debt trap, due to insufficiency of own capital.
The following ratios are called Profitability Ratios. The profitability ratios are generally expressed in terms of percentage.
Dividing net profit by net sales and multiply to obtain Net profit (after tax) percentage on net sales. It is often known as net profit margin. The ratio indicates the ability of the enterprise to earn profit from the sales. Higher ratio means that the investment is rewarding. 20% return on turnover is desirable. 10% return is satisfactory. 5% is tolerable.
Division of net profit (after tax) by tangible net worth multiplied by 100 is the ‘Net Profit on Tangible Net worth Ratio’. This ratio is also known as ‘Return on Equity’. The ratio provides percentage of return on own capital.
Net Gross Profit
Net annual gross profit is divided by net sales multiplied by 100 to get this ratio. This ratio provides test of the management’s pricing policy compared to others in the business. The ratio is also used to measure profit earned between different periods. There may be several factors which contribute to changes in the ratio, namely, increase in expenses, fall in prices of commodity produced, fall in production, variation in wages, freight etc.
Annual net profit (before tax) is divided by total assets to obtain Net Profit to total assets. This ratio is also known as ‘Return on Total Assets’ (ROTA). It reflects rate of return on investments made on business. This is another test to ascertain whether the efficiency of the firm is growing or declining. 10 to 20% return on assets is desirable. Above 7% is tolerable.
TURN OVER RATIOS
The following ratios are called Turnover Ratios or inter-Statement Ratios. The method of computation and the purpose is given below.
Net annual sales divided by trade receivables to get this ratio. This ratio is also known as ‘Accounts Receivable turnover’. The time period taken for the collection of receivables is of great interest in evaluating working capital, The higher ratio indicates more rapid collection and greater liquidity of receivables.
Net annual sales divided by inventory holding to get this ratio. This ratio indicates velocity with which the goods are sold. The ratio indicates the quality of inventory turnover.
Divide sales by total assets to get this ratio. This is a rough measure for the efficient use of funds.
(The rate can also be expressed in weeks or months)
Divide Average outstanding of Receivable by Credit Sale per day to obtain Debtors velocity ratio also known as debtors turnover or average collection period. Lower the period, quicker is cash realization and higher period implies normally poor receivable management.
Payable includes bills payable and creditors for goods. This ratio is also known as Creditors Turnover, Average payment period, credit period enjoyed. High credit period is indication of either because of company’s reputation of prompt payment or because of forced credit which has to be probed.