What is Ratio Analysis ?
This is a branch of accountancy which deals exclusively with the relations between the various items in the Final Accounts of a concern .Thus it is the process of determining and interpreting numerical relationship between figures of the financial statement.
A ratio is simply one number expressed in terms of another numbers”.
In accounting language it is called Accounting ratios. The accounting ratio are relationship expressed in mathematical terms between two accounting figures which have meaningful relation with each other.
There ratio deals deal with the relationship between two item appear in the balance sheet or appearing in the trading and profit and loss accounts.
Types of Ratio
- CURRENT RATIO OR WORKING CAPITAL RATIO
- LIQUID RATIO OR QUICK RATIO OR ACID TEST RATIO
- DEBT EQUITY RATIO
- PROPERITARY RATIO
- CAPITAL GEARING RATIO
PROFITABILITY OR INCOME RATIOS
- GOOD PROIFT RATIO
- NET PROFIT RATIO
- OPERATING RATIO
- EXPENENSE RATIO
- RETURN ON INVESTMENT RATIO ROI
- RETURN ON EQUITY RATIO ROE
- EARNING ON DIVIDEND PER SHARE
ACTIVITY OR EFFICIENCY RATIO
- STOCK OR INVENTORY TURNOVER RATIO
- STOCK VELOCITY OR AVERAGE AGE OF INVENTORY
- DEBTORS TURNOVER RATIO
- AVERAGE COLLECTION PEROID OR DEBTORS VELOCIY
- CREDITORS TURNOVER RATIO
- AVERAGE PAYMENT PERIOD OR CREDITOR VELOCITY
Current ratio :
It shows the relation between current assets and current liabilities .
It is calculated by dividing current assets by current liabilities.
current ratio = current assets / current liabilities.
A current ratio of 2:1 is generally considered to be acceptable .If the current ratio is more than 2: 1 it is beneficial to the short term creditors .If the current ratio is less than 2:1 it indicated lack of liquidity.
Liquid ratio or quick Ratio or Acid test Ratio
\Liquid ratio is relationship between liquid assets and current liabilities or immediate liabilities .
It shows the liquidity position of a business enterprise.
Its ability of company to convert current assets into cash.
formula of Liquid ratio :
Quick Or Quick or Acid Test Ratio = Liquid Assets /Liquid Liabilities.
Liquid Assets means current Assets Minus Inventory or stock and Prepaid expenses.
Liquid Liabilities means current Liabilities Minus overdraft.
These ratio analysis ability of firm to pay off its long term liabilities.
Debts Equity Ratio:
Debts Equity ratio indicates the relationship between long term debts and equity .In other words, the debt-to-equity ratio tells you how much debt a company uses to finance its operations.
Debt Equity Ratio = Long terms Debtors or Long Terms Loan/ Shareholders funds or Net Worth
Generally, a good debt-to-equity ratio is anything lower than 1.0. A ratio of 2.0 or higher is usually considered risky. If a debt-to-equity ratio is negative, it means that the company has more liabilities than assets—this company would be considered extremely risky.
Debts refers to all long terms liabilities having maturity after one year. It includes debentures public deposit and long term loan from bank and financial institution.
- Equity also called shareholder fund or net worth denote the sum of preference share capital equity share capital, reserve, general reserve ,security premium other reserves and credit balance of profit and loss account etc. but miscellaneous expense such as preliminary expenses share issue expenses discount on issue of share /debenture ,underwriter commission etc. and debit balance of profit need to be deducted.
Proprietary Ratio :
The proprietary ratio (also known as the equity ratio) is the proportion of shareholders’ equity to total assets, and as such provides a rough estimate of the amount of capitalization currently used to support a business.
Proprietary ratio = shareholder ‘funds / Total assets
This ratio is quite significant for the creditors of business .Normally this ratio should be less than 67% .The higher the ratio the more profitable it is for the creditors and less management have to depends upon outside funds.
Capital Gearing Ratio
- Fixed cost bearing funds includes preference share , debenture , and long term loans because divided and interest are paid at fixed rate on them.
- Variable cost bearing funds include equity share capital and reserve and surplus but miscellaneous expenditure and debit balance of profit and loss should be ignored. Also known as Share holder funds.
PROFITABILITY OR INCOME RATIOS
Profitability ratio is used to evaluate the company’s ability to generate income as compared to its expenses and other cost associated with the generation of income during a particular period.
Gross Profit (GP) ratio
Gross Profit (GP) ratio is a measure that shows the relationship between the Gross Profit earned by an entity and the Net Sales of the company.
Gross profit ratio is a profitability measure that is calculated as the ratio of Gross Profit (GP) to Net Sales and therefore shows how much profit the company generates after deducting its cost of revenues.
Gross Profit = Net Sales – Cost of Goods Sold
Net Sales = Sales – Return Inwards
Cost of Goods Sold = Opening Stock + Purchases*- Closing Stock + Any Direct Expenses Incurred.
Gross profit ratio = Gross Profit /Net sales X 100
Net profit Ratio
The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining profit after all costs of production, administration, and financing have been deducted from sales, and income taxes recognized. As such, it is one of the best measures of the overall results of a firm, especially when combined with an evaluation of how well it is using its working capital.
Net profit ratio = (Net profit /Net sales) x 100
Operating Profit Ratio
Operating Profit Margin is a profitability or performance ratio that reflects the percentage of profit a company produces from its operations, prior to subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue.
Operating Profit ratio = Operating Profit / Net sales X 100
Operating profit =sales – cost of goods sold -operating expenses – depreciation .
This ratio explains the relationship between cost of goods sold and operating expenses on the one hand and net sales on the other .The formula is
Operating Ratio : Cost of Goods sold + operating expense /Net Sales X 100
Those ratio are complimentary to the operating ratio. This is the ratio of operating profit to net sales.
Operating profit ratio = operating profit / Net sales X 100
Operating profit = Gross profit – Administration expense – office (financial expenses – Selling and distribution expense.
Return on investment (ROI)
Return on investment (ROI) is calculated by dividing the profit earned on an investment by the cost of that investment. For instance, an investment with a profit of $100 and a cost of $100 would have a ROI of 1, or 100% when expressed as a percentage.
Cost of Investment /Net Return on Investment ×100%
Return on Equity (ROE)
ROE = Net Income / Shareholders’ Equity
Earning on dividend per share ratio
DPS can be calculated using the formula: DPS = (total dividends paid out over a period – any special dividends) ÷ (shares outstanding). For example, suppose company XYZ paid 1 million in dividends to its preferred shareholders last year, none of which were special dividends.
ACTIVITY OR EFFICIENCY RATIO
Efficiency ratios, also known as activity ratios, are used by analysts to measure the performance of a company’s short-term or current performance.
STOCK OR INVENTORY TURNOVER RATIO
This ratio shows the relationship between cost of goods sold during a given period and average stock carried during the period .Thus stock turnover is the number of times obtained by dividing the cost of goods sold by average stock.
Stock Turnover Ratio = Cost of goods sold / Average stock
Calculation of Cos of Goods Sold
- Cost of Goods sold = operating stock + purchases + Direct Expenses (Carriage ,wages ,Freight etc ) – Closing Stock
- Cost of Goods sold = Net Sales – Gross Profit
- Average Stock = Opening Stock + Closing Stock /2
STOCK VELOCITY OR AVERAGE AGE OF INVENTORY
Inventory turnover ratio can also be converted into number of days it is days it known as average age of inventory or stock velocity.
Average Age of Inventory = 36 days / 12 month/52 weeks / Inventory Turnover ratio
this ratio indicates the rate of at which stock are converted into sales. The higher the ratio the better it is for the business since it means that stock is being sold quickly.
DEBTORS TURNOVER RATIO
This indicates the number of times average debtors have been converted into cash during a year. This is also referred to as the efficiency ratio that measures the company’s ability to collect revenue.
The debtor days ratio calculation is done by dividing the average accounts receivables. It appears as a current asset in the corporate balance sheet. read more by the annual total sales and multiplied by 365 days
Debtors Turnover Ratio = Net Credit Sales/Average Account Receivable.
AVERAGE COLLECTION PERIOD OR DEBTORS VELOCITY
The average collection period is calculated by dividing the average balance of accounts receivable by total net credit sales for the period and multiplying the quotient by the number of days in the period