RATIO ANALYSIS

Definition of 'Ratio Analysis' 

A tool used by individuals to conduct a quantitative analysis of information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company. Ratio analysis is predominately used by proponents of fundamental analysis.

There are many ratios that can be calculated from the financial statements pertaining to a company's performance, activity, financing and liquidity. Some common ratios include the price-earnings ratio, debt-equity ratio, earnings per share, asset turnover and working capital.

Ratio Analysis is a widely used tool in Financial World. Not, alone for finance management ,even for day-to-day usage and for Business an efficient user. Let us see with an Example.  

                

Let us consider your salary as monthly Rs.35,000 / -.Your savings are monthly 15,000/- That means in ratio your savings are (12,000/35,000) is 34 %.We are comparing your savings with your salary. But your friend who is also earning the same salary is saving Rs.15,000/-, that is 42 %. After thorough analysis and research when comparing your expenses with your friend you can come to a conclusion that you can still save some amount larger than say 35%. So, in future your savings may be 35%. After this ratio analysis you are managing and improving yourself.  

                

Like the same manner, the stocks you ought to buy various ratios are compared with their competitors and you can assess the Efficiency of the purchased stock. Ratio Analysis is a very big ocean and here we are taking some important ratios. The ratios can be classified according to,

1)     Based on gain,

2)     Based on Operations,

3)     Based on Efficiency Management,

4)     Based on Company’s Debts ……etc..  

Let us see the Gain based ratio :-

        

The company BHEL accounts statement ending with the financial year March – 2010, is given below. It is a general format.

a)     Gross sales Turnover – 33226.25 Crores.

b)     Stock Adjustments     -   786.65    Cores.

c)     Total Expenses           -  27913.71 Cores.

d)     Operating Profit          -   6099.19   Cores.  ( 33226.25 + 786.65 – 27913.71)

Operating profit is termed as gain before Interest, Depreciation and Income Tax. It means 

Net sales minus Direct Expenses  = Net Profit.

Now we can see the Operating Profit Margin.

O.P.M      =      Operating Profit / Net Sales.   

According to the above the financial year ending March – 2010, Operating profit Margin is 18.4 % ( 6099.19 / 33226.25 )

        

Likewise Net Profit ( Net gain ) Margin is also very useful.

Net Profit Margin = Net Profit / Gross Income.

Net sales when added with other income with stock adjustments gross income may be obtained. 

For the BHEL Company other income ( Either through Investments, sale on assets, or any other income not connected to the business ) is 

a)     1085.73 Cores

b)     Stock Adjustments – 786.65 Cores,

c)     Total income in that year – 35098.63 Cores,

d)     Net gain  - 4310.64 Cores. 

                        

This ratio between Net gain Vs Total income is Net Profit Margin. BHEL March – 2010, net profit margin is 12.30 % (4310.64 / 35098.63 ) By this ratio for each and every rupee sales, how much gains obtained can be known to us,

Except this 

1)     Ratio between Raw Material Vs Sales

2)     Ratio between Sales, Management, & Common Expenses Vs Sales,

3)     Ratio between Electricity & Fuel Vs Sales.

Based on our Analysis we can going on add the ratios required. Merely calculating is not enough. With calculation, we have to compare with the companies competitors with the ratios. Then only the efficiency of the Organization can be worked out. Like your friend,  

Again some important ratios can be seen below,

1)     Small industries, with their raw materials ( Inventory ) present may consider their business as stronger.

2)     But medium and large scale industries don’t think like that. The main reason is we are talking about hundreds of Cores. (Products)

                        

Apart from these the Japanese people had climbed a step ahead and introduced the “Just in time Inventory Management” which is widely used today. Each and every Organization if try to calculate the rotational cycle (or sales) ten they may be able to work out their Organizations Efficiency in both sales and Gain. 

                

For Example if you are a Provision store Owner. Your daily sales is Rs.10,000/-. You are soling for Rs 36,00,000, assumed per year. At anytime Rs.3,00,000 worth materials are present in your shop. It means your materials (products0 rotation is 36/3 = 12% If you are able to measure this rotation your gain (profit) may definitely increase. Let us see the BHEL Company rotation rate as given below,  

(Inventory Turnover = Annual Sales / Year End Value of inventory products present )  

BHEL Companies

a)     Year end inventory is Rs.9235.46 Cores ( According to Balance Sheet)   

b)     That year net sales is Rs.33226.25 Cores.

So, BHEL Companies inventory turnover is 3.6 ( This inventory turnover being more is much better. It means those times the company had rotated its inventory (Products) 

Like above ratios, a company how much debts received, is very much important for investors like us. Conservative investors would think that the concerns should hold no debts within them. To analyze this a ratio Debt to Equity ratio is used. BHEL Concerns,

a)     Total debts ending March – 2010 – 127.75 Cores,

b)     That years share capital and reserves works out to 15917.36 Cores,

So, its Debt to Equity ratio is 0.008 (Less than 1 %) ( 127.75 / 15917.36) For some Organizations we have heard of even 100% or 200% present. Production based Organizations if debts are largely present , if an Economical Crisis occurs , those Organizations would be pushed to the bottom line.   

Debt to Equity Ratio = Total Debts / Share holders Capital. 

A point should be kept in mind while analyzing ratio Analysis. For each and every sector this ratios must be considered, separately. For Example,

1)     Finance based Organizations

2)     Retail sectors

3)     Production based Organizations

4)     Electricity producing Organizations etc…

For each and every sector the needs may differ. So, the ratios may also differ. 

For Example,

1)     In retail field the turn over ratio will be    -  more.

2)     Finance connected Organizations         -  Debts present will be more.

3)     Electricity Organizations                         -  Debts present will be more.      

So, while analyzing the ratios belonging to same sector with same size would be reasonable.

Traditional Classification of Ratios:

This is traditional method of classifying ratios. Under this category, ratios are classified into:

1. Balance Sheet or Position Statement ratios:

Balance sheet or position statement ratios are those ratios which are derived from two variables appearing in the balance sheet. For example, current ratio, debt equity ratio etc.

2. Profit and Loss Account or Income Statement Ratios:

Sometimes also known as operating ratios are derived from the variables appearing in the manufacturing, trading and profit and loss account. For example, inventory turnover ratio, gross profit ratio, expense ratio etc.

3. Inter Statement Ratios:

Inter statement ratios also known as combined or mixed ratios are such ratios which establish relationship between variables picked up from both the statements i.e. balance sheet and final account. For example debtors turnover, assets turnover, return on capital etc.

Functional Classification or Classification According to Test Specified:

Under this classification, ratios may be grouped in accordance with the type of test they are supposed to perform. Thus, ratios may be grouped as:

1. Liquidity Ratios:

Liquidity ratios are the ratios meant for testing short-term financial position of a business. These are designed to test the ability of the business to meet its short-term obligation promptly. For example, current ratio, quick ratio fall under this group.

2. Solvency Ratios: 

Solvency ratios are also known as leverage ratios. These are meant for testing long term financial soundness of any unit. Primarily these establish and study relationship between owned funds and loaned funds. For example, debt-equity ratio, capital gearing ratio etc., are covered under this group.

3. Efficiency Ratios:

Efficiency ratios are also known as activity ratios. These are meant to study the efficiency with which the resources of the unit have been used. These are also popularly known as turnover ratios. Examples are; inventory turnover ratio, return on investment etc.

Meanings, Nature and Usefulness of Ratios Analysis:

Meanings of Ratio:

According to J. Batty, "The term accounting ratios is used to describe significant relationships which exist between figures shown in a balance sheet, in a profit and loss account, in a budgetary control system or in any other part of the accounting organization"
In simple words, "Ratio" is the numerical relationship between two variables which are connected with each other in some way or the other. Ratios may be expressed in any one of the following manners
As a number the relationship between 500 and 100 may be expressed as 5(500 divided by 100).
As a fraction the above may alternatively be expressed as former being 5 times of the latter or latter being 1/5^thof the former.
As a percentage the relationship between 100 and 500 may be expressed as 20% of the latter (100/500 x 100) = 20%.
As a proportion the relationship between 100 and 500 may be expressed as 1 : 5. Ratio analysis facilitates the presentation of information of financial statements in simplified, concise and summarized form.

Nature of Ratio Analysis:

Ratios, by themselves, are not an end but only one of the means of understanding the financial health of a business entity. Ratio analysis is not capable of providing precise answers to all the problems faced by any business unit. Ratio analysis is basically a technique of:

1.   Establishing meaningful relationship between significant variables of financial
statements and

2.   Interpreting the relationships to form judgment regarding the financial affairs of the unit.

Usefulness of Ratio Analysis:

Usefulness of ratio analysis depends upon identifying:

1.   Objective of analysis

2.   Selection of relevant data

3.   Deciding appropriate ratios to be calculated

4.   Comparing the calculated ratios with norms or standards or forecasts; and

5.   Interpretation of the ratios

Important Factors For Understanding Ratios Analysis:

Quality of Financial Statements:

The reliability of ratios is linked with the quality of financial statements. Financial statements which have been prepared by faithful adherence to generally accepted accounting principles (GAAP). Generally accepted accounting principles are likely to contain reliable data. Calculation of ratios from such financial statements is bound to be more useful and trustworthy.

Purpose of Analysis:

Users of accounting information are different such as short-term and long-term creditors; owners and would be investors; trade unions; tax authorities; competitors etc., object of each group of interested parties is also different such as liquidity or solvency or profitability, etc. So, before undertaking the analysis, one should be clear about the object of analysis. It is the object of analysis which determines the area (liquidity, solvency, profitability, leverage, activity etc.) to be studied, analyzed and interpreted.

Selection of Ratios:

There is no end to the number of ratios which can be calculated. In 1919, Alexander Wall developed an elaborated system of ratio analysis. The same has been extended and modified over the period of time. So the ratios to be calculated should be selected judiciously taking into consideration the object of analysis. The ratios selected should serve the purpose of analysis. For example, short term creditors 'purpose is liquidity whereas owners' purpose may be served by solvency.

Standards to be Applied:

Any ratio in itself i.e. in isolation is meaningless. It must be compared with some standard to arrive at any logical conclusion. The analyst can choose the comparing standard from (a) Rule of thumb (b) past ratios (c) projected standards or (d) industry standards. Selection of standards for the purpose of interpretation will also depend upon the object of the analysis and the capacity of the analyst. For example, management (being the insider) can opt. for project standards whereas any outsider's choice shall be limited to the published information of the unit.

Capability of the Analyst:

Analysis is a tool in the hands of the analyst. Knife (as a tool) in the hands of a criminal may take the life but the knife (as a tool) in the hands of a surgeon may give new life to a patient. Interpretation depends on the educational background; professional skill; experience and intuition of the professional conducting it.

Ratios to be used only as Guide:

Ratios can provide, at the best, the starting point. The analyst, before arriving at the conclusion, should take into consideration all other relevant factors financial and non-financial; macro and micro. For example, general condition of economy; values of society; priorities of the government etc., are the important factors.

Significance and Usefulness of Ratio Analysis:

Ratios as a tool of financial analysis provide symptoms with the help of which any analyst is in a position to diagnose the financial health of the unit. Financial analysis may be compared with biopsy conducted by the doctor on the patient in order to diagnose the causes of illness so that treatment may be prescribed to the patient to help him recover. As, already hinted different groups of persons are interested in the affairs of any business entity, therefore, significance of ratio analysis for various groups is different and may be discussed as follows:

Usefulness to the Management:

1. Decision Making:

Mass of information contained in the financial statements may be unintelligible a confusing. Ratios help in highlighting the areas deserving attention and corrective action facilitating decision making.

2. Financial Forecasting and Planning:

Planning and forecasting can be done only by knowing the past and the present. Ratio help the management in understanding the past and the present of the unit. These also provide useful idea about the existing strength and weaknesses of the unit. This knowledge is vital for the management to plan and forecast the future of the unit.

3. Communication:

Ratios have the capability of communicating the desired information to the relevant persons in a manner easily understood by them to enable them to take stock of the existing situation:

4. Co-ordination is Facilitated:

Being precise, brief and pointing to the specific areas the ratios are likely to attract immediate grasping and attention of all concerned and is likely to result in improved coordination from all quarters of management.

5. Control is more Effective:

System of planning and forecasting establishes budgets, develops forecast statements and lays down standards. Ratios provide actual basis. Actual can be compared with the standards. Variances to be computed an analyzed by reasons and individuals. So it is great help in administering an effective system of control.

Usefulness to the Owners/Shareholders:

Existing as well as prospective owners or shareholders are fundamentally interested in the (a) long-term solvency and (b) profitability of the unit. Ratio analysis can help them by analyzing and interpreting both the aspects of their unit.

Usefulness to the Creditors

Creditors may broadly be classified into short-term and long term. Short-term creditors are trade creditors, bills payables, creditors for expenses etc., they are interested in analyzing the liquidity of the unit. Long-term creditors are financial institutions, debenture holders, mortgage creditors etc., they are interested in analyzing the capacity of the unit to repay periodical interest and repayment of loans on schedule. Ratio analysis provides, both type of creditors, answers to their questions.

Usefulness to Employees:

Employees are interested in fair wages: adequate fringe benefits and bonus linked with productivity/profitability. Ratio analysis provides them adequate information regarding efficiency and profitability of the unit. This knowledge helps them to bargain with the management regarding their demands for improved wages, bonus etc.

Usefulness to the Government:

Govt. is interested in the financial information of the units both at macro as well as micro levels. Individual unit's information regarding production, sales and profit is required for excise duty, sales tax and income tax purposes. Group information for the industry is required for formulating national policies and planning. In the absence of dependable information, Govt. plans and policies may not achieve desired results.

Limitations of Ratios Analysis:

Ratio analysis is a widely used and useful technique to evaluate the financial position and performance of any business unit but it suffers from a number of limitations. These limitations must be kept in mind by the analyst while using this technique.

Reliability is Linked with Accounting Data:

Ratios are calculated on the basis of accounting information. Accounting system has certain in built limitations like historical cost, going concern value, stable monetary value, etc. So, limitations of accounting data affect the quality of ratios also. After, all ratios can't be more reliable than the reliability of data itself.

Qualitative Factors are Ignored:

Ratio analysis is only a quantitative analysis. Sometimes qualitative factors may be  important. For example, management may be justified in making huge purchases of raw material in anticipation of large demand of its product for the coming period. But ratios are not capable of considering qualitative factors.

Isolated Ratios is Meaningless:

Ratios assume significance only when studied in proper context and if compared with norms or over a period. Ratio in itself does not convey any sense.

Ratio Analysis is Historical:

Ratios are based on the facts contained in financial statements. These statements contain
past records. Past may be less important or irrelevant for the management than present and future.

Different Accounting Practice Render Ratios Incomparable:

Accounting permits alternative treatment of many items like depreciation, valuation of tock, deferred expenses etc. Ratios based on statements prepared by following different practices are not comparable.

Price Level Changes Affect the Utility of Ratio Analysis:

Comparison of ratios over a period of time relating to same unit may be misleading. For example, sales may be static in quantity but higher in dollar value due to inflation.

Incompetence or Bias of Analyst:

Much depends upon the skill, integrity and competence of the analyst to use ratios judiciously.

Lack of Adequate Standards:

There are no well-accepted standards or rule of thumb for all ratios which might be expected as norms for comparison. It renders interpretation of ratios difficult and to some extent arbitrary.

Window Dressing:

Financial statements can easily be "window dressed" to depict better than real picture of the enterprise. Moreover the analyst depending only upon published financial statements will not be in a position to get inside information.