Ratio analysis is the process of determining the financial ratios that are used for indicating the current going financial performance of a company using multiple types of ratios such as liquidity, profitability, activity, debt, market, solvency, efficiency, and coverage ratios and some examples of such ratios are return on equity, current ratio, quick ratio, debt-equity ratio, and so on.
Six main types of Ratio Analysis used are as follows:
- Financial Ratios
- Liquidity Ratios
- Profitability Ratios
- Turnover Ratios
- Coverage Ratios
- Control Ratios
1. Financial Ratios (Solvency Ratios):
These ratios help in discovering the long term solvency of a firm which depends on firm’s adequate available resources to meet its long term funds requirements, Proper debt equity mix to raise long term funds and earnings/ profits to pay interest and installment of long term loans in time (i.e., coverage ratios).
(i) Fixed Assets Ratio:
This FA ratio explains whether the firm has raised proper long term funds to meet its fixed assets requirements and is calculated as under:
This ratio provides an idea as to how much part of the capital employed has been used in purchasing the fixed assets for the business. If the ratio is less than 1 it is good for the business. The ideal ratio is .67.
(ii) Current Assets to Fixed Assets Ratio:
This ratio will vary from industry to industry and, therefore, no standard can be set. A decrease in this ratio reflect that trading is slack or more mechanization has been put through. An increase in this ratio reveal that inventories and debtors have excessively increased or fixed assets have been used with extreme concentration. An increase in this ratio, accompanied by increase in profit, reflects that business is expanding.
(iii) Debt Equity Ratio:
This Ratio measures the extent of equity covering the debt. This ratio is calculated to measure the comparative proportions of outsiders’ funds/ debts and shareholders’ funds invested in the company. This ratio is determined to determine the soundness of long term financial policies of that company and is also known as external-internal equity ratio.
Shareholders’ funds includes preference share capital, equity share capital, Profit & Loss A/c (Cr. Balance), capital reserves, revenue reserves and reserves reflecting marked surplus, like reserves for contingencies, sinking funds for renewal of fixed assets or redemption of debentures etc. less with fictitious assets.
Where a given debt to equity ratio shows a favorable or unfavorable financial position of the business depends on the industry and the trend of earning. A low ratio is normally considered as favorable from long-term creditors’ point of view, because a appropriate margin of protection provides safety for the creditors.
The same low ratio may be viewed as quite unsatisfactory by the shareholders because they think about neglected opportunity for using low-cost outsiders’ funds to acquire fixed assets that could earn a relatively high return. Considering the interest of both (shareholders and long-term creditors), debt to equity ratio of 2: 1 in case of (i) and 2: 3 in case of (ii) is ideal.
(iv) Proprietary Ratio:
A variant of debt to equity ratio is the proprietary ratio which shows the connection between shareholders’ funds and total tangible assets.
Ideal ratio should be 1: 3 i.e., one-third of the assets minus current liabilities should be acquired by shareholders’ funds and the other two-thirds of the assets should be financed by outsiders funds. It gives attention on the general financial strength of the business enterprise.
2. Liquidity Ratios:
These ratios are used to determine the firm’s ability to meet short term obligations/ debts. They compare short term obligations to short term (or current) resources available to meet these obligations. From these ratios, much insight can be known into the present cash solvency of the company and the company’s ability to remain solvent in the event of market adversity.
(i) Current Ratio (or Working Capital Ratio):
This is the most common used ratio. It is the ratio of current assets to current liabilities. It shows a company’s ability to cover its current liabilities with its current assets.
Ideally ratio 2 : 1 is considered ideal for a business i.e., current assets should be double of the current liabilities. If the current assets are two times of the current liabilities, there will be no adverse impact on business operations when the payment of current liabilities is made.
If the ratio is less than 2, quite difficult impact be experienced in the payment of current liabilities and day-to-day operations (working capital) of the business may suffer. If the ratio is higher than 2, it is very favorable for the creditors but, for the business, it is indicator of idle funds and a lack of enthusiasm for work.
‘Is it possible for a company to have high current ratio and still find difficulties in paying its current liabilities’? High current ratio, i.e., the ratio of current assets to current liabilities may not always indicate liquidity and be an encouraging signal from the viewpoint of short-term creditors.
All current assets cannot be treated as investments which can encash easily and sold in case cash is required. For this purpose, the liquid ratio (discussed below) is worked out.
(ii) Liquid (or Acid Test / Quick) Ratio:
This is the ratio of liquid assets to liquid liabilities. It shows a company’s ability to fulfill current liabilities with its most liquid (quick) assets. 1 : 1 ratio is considered ideal ratio for a business because it is wise to keep the liquid assets at least equal to the liquid liabilities at all times.
Liquid assets are considered those assets which are readily converted into cash and will include cash balances, bills receivable, debtors and short-term investments. Inventories, stock and prepaid expenses are not included in liquid assets because the emphasis is on the ready availability of cash in case of liquid assets.
Liquid liabilities include all of current liabilities except bank overdraft taken. This ratio is the ‘acid test’ of a concern’s financial soundness.
(iii) Absolute Liquidity (or Super Quick) Ratio:
Although receivables are generally more liquid than inventories, there may be debts/ creditors having doubt regarding their real stability in time. So, to check about the absolute liquidity of a business, both receivables and inventories/ stock are excluded from current assets and only absolute liquid assets, such as cash in hand, cash at bank and readily market realizable securities are taken into consideration.
The desirable ratio is 1 : 2, i.e., Rs.1 worth of absolute liquid assets are sufficient for Rs.2 worth of current liabilities. Although the ratio gives a more meaningful measure of liquidity, it is not in general use because the idea of keeping a large cash balance or near cash items has long since teen disproved. Cash balance generates no return and as such is less useful.
(iv) Ratio of Inventory to Working Capital:
In order to determine that there is no overstocking of product, the ratio of inventory to working capital should be checked.
Working Capital is the excess of current assets over current liabilities. Increase in volume of product sales requires increase in size of product inventory, but from a realistic financial point of view, inventory should not be more than the amount of working capital. The ideal ratio is 1 : 1.
3. Profitability Ratios:
Profitability ratios are of most important for a business. These ratios are calculated to see the end results of business activities which is the sole criterion of the overall efficiency of a business. These ratio are important to check margin rate across industries.
(i) Gross Profit Ratio:
Higher the GP ratio, the better it is. A low ratio indicates unfavorable pattern in the form of reduction in selling prices not accompanied by proportionate decrease in cost of goods or increase in cost of production. The gross profit should be appropriate to cover fixed business expenses, dividends and building up of reserves.
In many industries there is more or less recognized gross profit ratio and an analysis of this ratio will indicate whether the ratio of the company being analysed is satisfactory or not. Gross profit ratio of a firm may be compared with that of rivals in the industry to assess its operational performance in comparison to other competitors in the industry.
(ii) Operating Ratio:
This ratio reflects the proportion that the cost of sales bears to sales. Cost of goods sold (COGS) includes direct cost of goods sold as well as other operating expenses, administration, selling and distribution expenses which have direct relationship with sales.
It excludes income and expenses which have no direct connection with production and sales, i.e., non-operating incomes and expenses as interest and dividend received on investment, interest paid on long-term loans and debentures, profit or loss on sale of fixed assets or long-term investments.
Lower the ratio, the better profit it is. Higher the ratio, unfavorable it is because it would have a low margin of operating profit for the payment of dividends and expenses and the creation of reserves. This ratio should be analysed in depth to check levels of efficiency prevailing in different elements of total cost.
(iii) Expenses Ratios:
These are calculated to determine the relationship that exists between operating expenses and volume of product sales.
(iv) Operating Profit Ratio:
Operating Profit = Net Profit + Non-operating Expenses − Non-operating Income
Or = Gross Profit − Operating expenses
Or = Net profit before interest and tax.
Operating profit ratio can also be calculated with the help of operating ratio as follows: Operating Profit Ratio = 100 − Operating Ratio.
This ratio reflects the portion remaining out of every rupee worth of sales after all operating costs and expenses have been deducted. Higher the ratio the better it is.
(v) Net Profit Ratio:
This ratio is very useful to the proprietors and prospective investors because it reveals the overall profitability of the business. GP and NP Ration needs to be reported in Tax Audit form also.
The ratio is different from the operating profit ratio in as much as it is calculated after deducting non operating expenses, such as loss on sale of fixed assets etc., from operating profit and adding non-operating income like interest or dividends on investments, profit on sale of investments or fixed assets, etc., to such profit. Higher the ratio, the better it is because it gives idea of improved efficiency of the company.
(vi) Return on Capital Employed or Return on Investment (Overall Profitability Ratio):
Refer above Ratio.
(vii) Return on Shareholders’ Fund:
When it is needed to work out the profitability of the company from the shareholders point of view.
The ratio of net profit to shareholders funds shows the return % to which profitability objective is being achieved. Higher the ratio, the better it is.
(viii) Return on Equity Shareholders’ Fund or Return on Net Worth:
This ratio is a measure of the percentage of net profit to equity shareholders’ funds.
Equity Shareholders’ Fund = Equity Share Capital + Capital Reserves + Revenue Reserves
+ Balance of Profit and Loss Account − Fictitious Assets − Non-business Assets
(ix) Return on Total Assets:
This ratio is checked to measure the profit after tax against the amount invested in total assets to ascertain whether assets utilization is optimal or not.
For e.g. net profit after tax is Rs.30,000 and total assets are Rs.1,00,000. Return on total assets will be 30% [i.e., Rs.30,000 ÷ Rs.1,00,000 x 100]. The higher the ratio, the better it is for the concern.
(x) Earnings per Share:
This helps in ascertaining the market price of equity shares of the company and in checking the company’s capacity to pay dividend to its equity shareholders.
If there are both preference and equity share capitals in company, then out of net income, first preference dividends should be deducted as per norms in order to find out the net income available for equity shareholders. The performance and prospects of the company are affected by earning per share.
If EPS increases, there are chances that the company may pay more dividend or issue bonus shares. In short the market price of the share of a company will be fluctuated by all these factors. A relative comparison of earning per share of the company with another same type company will also help in deciding whether the equity capital is being effectively used or not.
Though the earning per share is the most commonly published data, yet it should be used prudently as earning per share cannot reflect the various financial operations of the business. Moreover, the financial data collected in respect of different companies may be affected by different business practices followed by the companies relating to stock in trade, depreciation etc.
(xi) Payout Ratio:
Complementary of this ratio is retained Earnings Ratio.
This ratio indicates as to which proportion of earning per share (EPS) has been used for paying dividend to shareholders and what has been retained for ploughing back.
This ratio is key important from shareholders’ point of view as it tells him that if a company has used whole or substantially the whole of it’s earning for paying dividend to them and retained nothing for future growth and expansion purposes, then there will be very low chances of capital appreciation in the shares price of the company.
We can say, an investor who is more interested in share price appreciation must look for a company having low payout ratio.
4. Turnover Ratios:
These ratios are very meaningful for a business to judge how well facilities at the disposal of the business are being used or to measure the effectiveness with which a business uses its available resources at its disposal. In other words, these will indicate effectiveness of assets usage. These ratios are usually calculated on the basis of sales or cost of goods sold and are measured in number of times rather than as a percentage.
Such ratios should be measured separately for each type of asset. The greater the ratio more will be asset effectively usage. The lower ratio will represent the under utilization of the resources available with business. The business must always plan for effective use of the assets to increase the overall efficiency of company. Following are the well known turnover ratios usually calculated by a company.
(i) Sales to Capital Employed (or Capital Turnover) Ratio:
This ratio reflects the efficiency of capital employed in the business by calculating how many times capital employed is turned-over in a stated period.
High Ratio reflects greater profits. A low capital turnover ratio should be taken to mean that substantial sales are not being made and profits are lower.
(ii) Sales to Fixed Assets (or Fixed Assets Turnover) Ratio:
This ratio measures the efficiency of the assets used in business. The effective use of assets will generate greater sales per rupee invested in all the assets of a company. The inefficient use of the asset will result in low sales volume coupled with higher overhead (expenses) charges and under utilization of the available production capacity.
Thus the management must strive for using total available resources at optimum level to achieve higher ROI. This ratio represents the number of times fixed assets are being turned-over in a given period.
This ratio represents how efficient the fixed assets are being used to generate sales in the business. The ratio is key important in manufacturing company because sales are produced not only by use of current assets but also by amount invested in fixed assets. The higher is the ratio, the better is the performance. In other way, a low ratio indicates that fixed assets are not being efficiently utilized.
(iii) Sales to Working Capital (or Working Capital Turnover) Ratio:
This ratio reflects the number of times working capital is turned-over in a given period.
The higher is the ratio, the lower is the investment in working capital and the greater are the profits. Moreover, a very high turnover of working capital is a reflection of over trading and may put the company into financial difficulties. In other way, a low working capital turnover ratio shows that working capital is not efficiently utilized.
(iv) Total Assets Turnover Ratio:
This ratio is computed by dividing the net sales from the value of total assets (i.e. Net Sales ÷ Total Assets). A high ratio is an indicator of over-trading of total assets while a low ratio reveals idle capacity. The ideal standard for the ratio is two times.
(v) Stock Turnover Ratio:
It indicates the speed at which the inventory/ stock will be converted into sales, thereby contributing for the profits of the business. When all other factors remain same, greater the turnover of inventory more will be efficiency of its management.
Further, it will be higher when sales are at full capacity and the average inventory is minimum. This ratio fix relationship between cost of goods sold during a given period and the average amount of inventory held during that period.
This ratio shows the number of times finished inventory/ stock is turned over during a given accounting period. Higher the ratio, the better it is because it denotes that finished stock is rapidly turned-over. In other way, a low stock turnover ratio is not preferable because it indicates the accumulation of obsolete stock, or the carrying of too much inventory/ stock.
Cost of Goods Sold (COGS) = Opening Stock + Purchases + Manufacturing Expenses − Closing Stock or Sales − Gross profit.
(vi) Receivable (or Debtors) Turnover Ratio:
It denotes the number of times on the average the receivable is turn over in each year. The higher the value of ratio, the more is the efficient management of receivables. It computes the accounts receivables (trade debtors and bills receivables) in terms of number of days of credit sales during a particular period.
This ratio shows collection ability of accounts receivables and tells about how the credit policy of the company is being enforced. Suppose, a company allows 40 days credit to its customers and the ratio is 50; it is a cause of anxiety to the management because debtors are outstanding for a period of 50 days.
Attempts should be made to make the collection machinery effective so that the amount due from debtors can be collected within time.
Higher the ratio, more the chances of bad debts and lower the ratio, less the chances of bad debts.
(vii) Creditors (or Accounts Payable) Turnover Ratio:
This ratio provides the average credit period enjoyed from the creditors and is calculated as under:
A high ratio denotes that creditors are being not paid within time while a low ratio gives an idea that the business is not taking full benefits of credit period allowed by the creditors.
Sometimes it is also need to calculate the average payment period (or average age of payable or debt period enjoyed) to denotes the speed with which payments for credit purchases are made to creditors.
5. Coverage Ratios:
These ratios reflect the extent to which the interests of the persons entitled to get a fixed return (i.e. interest or dividend) or a scheduled repayment as per agreed terms are safe. The higher the cover, the better it is.
(i) Fixed Interest Cover:
It shows the ability of the business to service the debt. This ratio is key important from lender’s point of view and represents whether the business would earn sufficient profits to pay periodically the interest charges.
The higher the ratio, the more secured the lenders will be in relation of their periodical interest income.
(ii) Fixed Dividend Cover:
This ratio is useful for preference shareholders entitled to get dividend at a fixed rate in priority to other shareholders.
6. Control Ratios:
Below control ratios are consumed by the management to know whether the deviations of the actual business performance from the budgeted performance are favorable or unfavorable. If the ratio is 100% or more, the performance is considered as favorable and if the ratio is less than 100% the performance is considered as unsatisfactory.
This ratio denotes the extent to which budgeted hours of activity is actually utilized. If the ratio is 85%, budgeted capacity is utilized up-to 85% and 15% capacity remains underutilized.
This ratio computes the level of activity attained during the budget period.
The ratio is a sign of the efficiency attained in production over a period. Efficiency has gone up by 35% if this ratio is 135%.
This ratio shows whether all the budgeted working days in a budget period have been available in actual practice. If the ratio is more than 100% more days have been available in actual practice and vice versa if the ratio is less than 100%.