Interpretation of Account
Interpretation of Account
Interpretation of Account
Interpretation of Account: A detailed analysis and explanation of the financial performance of an entity incorporating the information contained within a set of financial accounts. Interpreting financial statements usually includes comparison that of one company with another or for the same company over a period of years to examine performance and trend. Other comparisons may include those on an interim basis, with published industry average figures. Users of accounting information are interested in a number of concepts, which include: profitability; liquidity; management efficiency; risk; Shareholder interest.
To do this we need access to the final accounts of the business we are investigating. There are three key areas to consider:
Each of the above can be calculated quite simply through a series of straightforward long divisions and multiplications. Using the formulae below we rapidly discover the final outcome of each ratio. However, a number alone means very little, the key skill is the ability to evaluate the numbers, and whether they reflect well on the business concerned. We will examine the profitability ratio in depth within this task. Further research and deduction is required from you to determine the meaning of our other key ratios.
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Profitability:
Gross Profit ratio o Gross Profit/Sales x 100 Net Profit Ratio o Net Profit/Sales x 100 Return on capital Employed o Net Profit/Capital Employed x 100
Liquidity:
Current ratio (sometimes called working capital ratio) o Current assets/current liabilities Liquid ratio (sometimes called the acid test ratio) o Current assets excluding stock/Current liabilities
Activity:
Stock Turnover ratio o Costs of goods sold/average stock Debtor Collection Ratio o Debtors/Credit sales over the period x 52 weeks Creditor payment ratio o Creditors/Credit purchase over period x 52 weeks
Ratio analysis provides a basis for both intra-firm as well as inter-firm comparisons. The comparison of actual ratios with base year ratios or standard ratios helps the management analyze the financial performance of the firm. Limitations of Ratio Analysis: Ratio analysis has its limitations. These limitations are described below: 1] Information problems: Ratios require quantitative information for analysis but it is not decisive about analytical output. The figures in a set of accounts are likely to be at least several months out of date, and so might not give a proper indication of the companys current financial position. Where historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based on this information will not be very useful for decision-making. 2] Comparison of performance over time: When comparing performance over time, there is need to consider the changes in price. The movement in performance should be in line with the changes in price. When comparing performance over time, there is need to consider the changes in technology. The movement in performance should be in line with the changes in technology. Changes in accounting policy may affect the comparison of results between different accounting years as misleading. 3] Inter-firm comparison: Companies may have different capital structures and to make comparison of performance when one is all equity financed and another is a geared company it may not be a good analysis. Selective application of government incentives to various companies may also distort intercompany comparison. Comparing the performance of two enterprises may be misleading.
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Inter-firm comparison may not be useful unless the firms compared are of the same size and age, and employ similar production methods and accounting practices. Even within a company, comparisons can be distorted by changes in the price level. Ratios provide only quantitative information, not qualitative information. Ratios are calculated on the basis of past financial statements. They do not indicate future trends and they do not consider economic conditions. Purpose of Ratio Analysis: 1] To identify aspects of a business performance to aid decision making 2] Quantitative process - may need to be supplemented by qualitative factors to get a complete picture. 3] 5 main areas Liquidity- the ability of the firm to pay its way Investment/shareholders-information to enable decisions to be made on the extent of the risk and the earning potential of a business investment Gearing-information on the relationship between the exposure of the business to loans as opposed to share capital Profitability- how effective the firm is at generating profits given sales and or its capital assets Financial- the rate at which the company sells its stock and the efficiency with which it uses its assets
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Balance sheets Income statement Shareholders equity statements Cash flow statements
Step 2. Quickly scan all of the statements to look for large movements in specific items from one year to the next. For example, did revenues have a big jump, or a big fall, from one particular year to the next? Did total or fixed assets grow or fall? If you find anything that looks very suspicious, research the information you have about the company to find out why. For example, did the company purchase a new division, or sell off part of its operations, that year? Step 3. Review the notes accompanying the financial statements for additional information that may be significant to your analysis. Step 4. Examine the balance sheet. Look for large changes in the overall components of the company's assets, liabilities or equity. For example, have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities? Has the proportion of debt grown rapidly, to reflect a new financing strategy? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 5. Examine the income statement. Look for trends over time. Calculate and graph the growth of the following entries over the past several years. o Revenues (sales) o Net income (profit, earnings) Are the revenues and profits growing over time? Are they moving in a smooth and consistent fashion, or erratically up and down? Investors value predictability, and prefer more consistent movements to large swings. For each of the key expense components on the income statement, calculate it as a percentage of sales for each year. For example, calculate the percent of cost of goods sold over sales, general and administrative expenses over sales, and research and development over sales. Look for favorable or unfavorable trends. For example, rising G&A expenses as a percent of sales could mean lavish spending. Also, determine whether the spending trends support the companys strategies. For example, increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on research and development.
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Look for non-recurring or non-operating items. These are "unusual" expenses not directly related to ongoing operations. However, some companies have such items on almost an annual basis. How do these reflect on the earnings quality? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 6. Examine the shareholder's equity statement. Has the company issued new shares, or bought some back? Has the retained earnings account been growing or shrinking? Why? Are there signals about the company's long-term strategy here? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 7. Examine the cash flow statement, which gives information about the cash inflows and outflows from operations, financing, and investing. While the income statement provides information about both cash and noncash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors and creditors really care about. If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 8. Calculate financial ratios in each of the following categories, for each year. You may use the formulas found in your textbook, or other materials you have from your finance and accounting courses. A summary of some useful ratios appears at the end of this document. Liquidity ratios Leverage (or debt) ratios Profitability ratios Efficiency ratios Value ratios
Graph the ratios over time, to find the trends in the ratios from year to year. Are they going up or down? Is that favorable or unfavorable? This should
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trigger further questions in your mind, and help you to look for the underlying reasons. Step 9. Obtain data for the companys key competitors, and data about the industry. For competitor companies, you can get the data and calculate the ratios in the same way you did for the company being studied. You can also get company and industry ratios from theQuicken.com Evaluator, Schwab Stock Evaluator, or other locations on my LINKS website. Compare the ratios for the competitors and the industry to the company being studied. Is the company favorable in comparison? Do you have enough information to determine why or why not? If you dont, you may need to do further research. Step 10. Review the market data you have about the companys stock price, and the price to earnings (P/E) ratio. Try to research and understand the movements in the stock price and P/E over time. Determine in your own mind whether the stock market is reacting favorably to the companys results and its strategies for doing business in the future. Review the evaluations of stock market analysts. These may be found at any brokerage site, or from various locations on my LINKS website. Step 11. Review the dividend payout. Graph the payout over several years. Determine whether the companys dividend policies are supporting their strategies. For example, if the company is attempting to grow, are they retaining and reinvesting their earnings rather than distributing them to investors through dividends? Based on your research into the industry, are you convinced that the company has sufficient opportunities for profitable reinvestment and growth, or should they be distributing more to the owners in the form of dividends? Viewed another way, can you learn anything about their long-term strategies from the way they pay dividends? Step 12. Review all of the data that you have generated. You will probably find that there is a mix of positive and negative results.
Steps in Ratio Analysis: The ratio analysis requires two steps as follows: 1] Calculation of ratio 2] Comparing the ratio with some predetermined standards. The standard ratio may be the past ratio of the same firm or industrys average ratio or a projected ratio or the ratio of the most successful firm in the industry. In interpreting the ratio of a particular firm, the analyst cannot reach any fruitful conclusion unless the calculated ratio is compared with some predetermined standard. The importance of a correct standard is oblivious as the conclusion is going to be based on the standard itself. TYPES OF COMPARISONS The ratio can be compared in three different ways: 1) Cross section analysis: One of the way of comparing the ratio or ratios of the firm is to compare them with the ratio or ratios of some other selected firm in the same industry at the same point of time. So it involves the comparison of two or more firms financial ratio at the same point of time. The cross section analysis helps the analyst to find out as to how a particular firm has performed in relation to its competitors. The firms performance may be compared with the performance of the leader in the industry in order to uncover the major operational inefficiencies. The cross section analysis is easy to be undertaken as most of the data required for this may be available in financial statement of the firm. 2) Time series analysis: The analysis is called Time series analysis when the performance of a firm is evaluated over a period of time. By comparing the present performance of a firm with the performance of the same firm over the last few years, an assessment can be made about the trend in progress of the firm, about the direction of progress of the firm. Time series analysis helps to the firm to assess whether the firm is approaching the long-term goals or not. The Time series analysis looks for (1) important trends in financial performance (2) shift in trend over the years (3) significant deviation if any from the other set of data.
3) Combined analysis: If the cross section & time analysis, both are combined together to study the behavior & pattern of ratio, then meaningful & comprehensive evaluation of the performance of the firm can definitely be made. A trend of ratio of a firm compared with the trend of the ratio of the standard firm can give good results. For example, the ratio of operating expenses to net sales for firm may be higher than the industry average however, over the years it has been declining for the firm, whereas the industry average has not shown any significant changes. The combined analysis as depicted in the above diagram, which clearly shows that the ratio of the firm is above the industry average, but it is decreasing over the years & is approaching the industry average.
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 helps 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. Shortterm 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.
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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. Importance of Ratio Analysis: As a tool of financial management, ratios are of crucial significance. The importance of ratio analysis lies in the fact that it presents facts on a comparative basis & enables the drawing of interference regarding the performance of a firm. Ratio analysis is relevant in assessing the performance of a firm in respect of the following aspects: 1] Liquidity position 2] Long-term solvency 3] Operating efficiency 4] Overall profitability 5] Inter firm comparison 6] Trend analysis. 1] Liquidity position: With the help of Ratio analysis conclusion can be drawn regarding the liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its current obligation when they become due. A firm can be said to have the ability to meet its short-term liabilities if it has sufficient liquid funds to pay the interest on its short maturing debt usually within a year as well as to repay the principal. This ability is reflected in the liquidity ratio of a firm. The liquidity ratio is particularly useful in credit analysis by bank & other suppliers of short term loans.
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2] Long-term solvency: Ratio analysis is equally useful for assessing the long-term financial viability of a firm. This respect of the financial position of a borrower is of concern to the long-term creditors, security analyst & the present & potential owners of a business. The long-term solvency is measured by the leverage/ capital structure & profitability ratio. Ratio analysis is that focus on earning power & operating efficiency. Ratio analysis reveals the strength & weaknesses of a firm in this respect. The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or if it is heavily loaded with debt in which case its solvency is exposed to serious strain. Similarly the various profitability ratios would reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved. 3] Operating efficiency: Yet another dimension of the useful of the ratio analysis, relevant from the viewpoint of management, is that it throws light on the degree of efficiency in management &utilization of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets- total as well as its components. 4] Overall profitability: Unlike the outsides parties, which are interested in one aspect of the financial position of a firm, the management is constantly concerned about overall profitability of the enterprise. That is, they are concerned about the ability of the firm to meets its short term as well as long term obligations to its creditors, to ensure a reasonable return to its owners & secure optimum utilization of the assets of the firm. This is possible if an integrated view is taken & all the ratios are considered together. 5] Inter firm comparison: Ratio analysis not only throws light on the financial position of firm but also serves as a stepping-stone to remedial measures. This is made possible due to inter firm comparison & comparison with the industry averages. A single figure of a particular ratio is meaningless unless it is related to some standard or norm. One of the popular techniques is to compare the ratios of a firm with the industry average.
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It should be reasonably expected that the performance of a firm should be in broad conformity with that of the industry to which it belongs. An inter-firm comparison would demonstrate the firms position vice-versa its competitors. If the results are at variance either with the industry average or with those of the competitors, the firm can seek to identify the probable reasons & in light, take remedial measures. 6] Trend analysis: Finally, ratio analysis enables a firm to take the time dimension into account. In other words, whether the financial position of a firm is improving or deteriorating over the years. This is made possible by the use of trend analysis. The significance of the trend analysis of ratio lies in the fact that the analysts can know the direction of movement, that is, whether the movement is favorable or unfavorable. For example, the ratio maybe low as compared to the norm but the trend may be upward. On the other hand, though the present level may be satisfactory but the trend may be a declining one.
decimal or as a pure ratio or in absolute figures as so many times. As accounting ratio is an expression relating two figures or accounts or two sets of account heads or group contain in the financial statements. Meaning of Ratio Analysis: Ratio analysis is the method or process by which the relationship of items or group of items in the financial statement are computed, determined and presented. Ratio analysis is an attempt to derive quantitative measure or guides concerning the financial health and profitability of business enterprises. Ratio analysis can be used both in trend and static analysis. There are several ratios at the disposal of an analyst but their group of ratio he would prefer depends on the purpose and the objective of analysis. While a detailed explanation of ratio analysis is beyond the scope of this section, we will focus on a technique, which is easy to use. It can provide you with a valuable investment analysis tool. This technique is called cross-sectional analysis. Cross-sectional analysis compares financial ratios of several companies from the same industry. Ratio analysis can provide valuable information about a company's financial health. A financial ratio measures a company's performance in a specific area. For example, you could use a ratio of a company's debt to its equity to measure a company's leverage. By comparing the leverage ratios of two companies, you can determine which company uses greater debt in the conduct of its business. A company whose leverage ratio is higher than a competitor's has more debt per equity. You can use this information to make a judgment as to which company is a better investment risk. However, you must be careful not to place too much importance on one ratio. You obtain a better indication of the direction in which a company is moving when several ratios are taken as a group. Objective of Ratios: Ratios are worked out to analyze the following aspects of business organizationA) Solvency1) Long term 2) Short term 3) Immediate B) Stability C) Profitability
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D) Operational efficiency E) Credit standing F) Structural analysis G) Effective utilization of resources H) Leverage or external financing Forms of Ratio: Since a ratio is a mathematical relationship between two or more variables / accounting figures, such relationship can be expressed in different ways as follows -
A] As a pure ratio: For example the equity share capital of a company is Rs. 20, 00,000 & the preference share capital is Rs. 5, 00,000, the ratio of equity share capital to preference share capital is 20, 00,000: 5, 00,000 = 4:1 . B] As a rate of times: In the above case the equity share capital may also be described as 4 times that of preference share capital. Similarly, the cash sales of a firm are Rs. 12, 00,000 & credit sales are Rs. 30, 00,000. So the ratio of credit sales to cash sales can be described as 2.5 [30, 00,000/12, 00,000] = 2.5 times are the credit sales that of cash sales. C] As a percentage: In such a case, one item may be expressed as a percentage of some other items. For example, net sales of the firm are Rs.50, 00,000 & the amount of the gross profit is Rs.10, 00,000, then the gross profit may be described as 20% of sales [10, 00,000/50, 00,000]
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Classification of Ratio:
CLASSIFICATION OF RATIO
BASED ON FINANCIAL STATEMENT 1] BALANCE SHEET RATIO 2] REVENUE STATEMENT 3] COMPOSITE RATIO BASED ON FUNCTION 1] LIQUIDITY RATIO 2] LEVERAGE RATIO 3] ACTIVITY RATIO 4] PROFITIBILITY RATIO 5] COVERAGE RATIO BASED ON USER 1] RATIOS FOR SHORT TERM CREDITORS 2] RATIO FOR SHAREHOLDER 3] RATIO FOR MANAGEMENT 4] RATIO FOR LONG TERM CREDITORS
Based on Financial Statement: Accounting ratios express the relationship between figures taken from financial statements. Figures may be taken from Balance Sheet, P& P A/C, or both. One-way of classification of ratios is based upon the sources from which are taken. 1] Balance sheet ratio: If the ratios are based on the figures of balance sheet, they are called Balance Sheet Ratios. e.g. Ratio of current assets to current liabilities or Debt to equity ratio. While calculating these ratios, there is no need to refer to the Revenue statement. These ratios study the relationship between the assets & the liabilities, of the concern. These ratios help to judge the liquidity, solvency & capital structure of the concern. Balance sheet ratios are Current ratio, Liquid ratio, and Proprietary ratio, Capital gearing ratio, Debt equity ratio, and Stock working capital ratio. 2] Revenue ratio: Ratio based on the figures from the revenue statement is called revenue statement ratios. These ratios study the relationship between the profitability & the sales of the concern. Revenue ratios are Gross profit ratio, Operating ratio, Expense ratio, Net profit ratio, Net operating profit ratio, Stock turnover ratio.
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3] Composite ratio: These ratios indicate the relationship between two items, of which one is found in the balance sheet & other in revenue statement. There are two types of composite ratiosa) Some composite ratios study the relationship between the profits & the investments of the concern. E.g. return on capital employed, return on proprietors fund, return on equity capital etc. b) Other composite ratios e.g. debtors turnover ratios, creditors turnover ratios, dividend payout ratios, & debt service ratios Based on Function: Accounting ratios can also be classified according to their functions in to liquidity ratios, leverage ratios, activity ratios, profitability ratios & turnover ratios. 1] Liquidity ratios: It shows the relationship between the current assets & current liabilities of the concern e.g. liquid ratios & current ratios. 2] Leverage ratios: It shows the relationship between proprietors funds & debts used in financing the assets of the concern e.g. capital gearing ratios, debt equity ratios, & Proprietary ratios. 3] Activity ratios: It shows relationship between the sales & the assets. It is also known as Turnover ratios& productivity ratios e.g. stock turnover ratios, debtors turnover ratios. 4] Profitability ratios: a) It shows the relationship between profits & sales e.g. operating ratios, gross profit ratios, operating net profit ratios, expenses ratios
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b) It shows the relationship between profit & investment e.g. return on investment, return on equity capital.
5] Coverage ratios: It shows the relationship between the profit on the one hand & the claims of the outsiders to be paid out of such profit e.g. dividend payout ratios & debt service ratios.
Based on User:
1] Ratios for short-term creditors: Current ratios, liquid ratios, stock working capital ratios 2] Ratios for the shareholders: Return on proprietors fund, return on equity capital 3] Ratios for management: Return on capital employed, turnover ratios, operating ratios, expenses ratios 4] Ratios for long-term creditors: Debt equity ratios, return on capital employed, proprietor ratios.
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15 Accounting Ratios:
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Liquidity Ratio: Liquidity refers to the ability of a firm to meet its short-term (usually up to 1 year) obligations. The ratios, which indicate the liquidity of a company, are Current ratio, Quick/Acid-Test ratio, and Cash ratio. These ratios are discussed below
Current Ratio: Meaning: This ratio compares the current assets with the current liabilities. It is also known as working capital ratio or solvency ratio. It is expressed in the form of pure ratio. E.g. 2:1 Formula: Current ratio = Current assets Current liabilities
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The current assets of a firm represents those assets which can be, in the ordinary course of business, converted into cash within a short period time, normally not exceeding one year. The current liabilities defined as liabilities which are short term maturing obligations to be met, as originally contemplated, within a year. Current ratio (CR) is the ratio of total current assets (CA) to total current liabilities (CL).Current assets include cash and bank balances; inventory of raw materials, semi-finished and finished goods; marketable securities; debtors (net of provision for bad and doubtful debts); bills receivable; and prepaid expenses. Current liabilities consist of trade creditors, bills payable, bank credit, and provision for taxation, dividends payable and outstanding expenses. This ratio measures the liquidity of the current assets and the ability of a company to meet its short-term debt obligation.CR measures the ability of the company to meet its CL, i.e., CA gets converted into cash in the operating cycle of the firm and provides the funds needed to pay for CL. The higher the current ratio, the greater the short-term solvency. This compares assets, which will become liquid within approximately twelve months with liabilities, which will be due for payment in the same period and is intended to indicate whether there are sufficient short-term assets to meet the short- term liabilities. Recommended current ratio is 2: 1. Any ratio below indicates that the entity may face liquidity problem but also Ratio over 2: 1 as above indicates over trading, that is the entity is under utilizing its current assets. Liquid Ratio: Meaning: Liquid ratio is also known as acid test ratio or quick ratio. Liquid ratio compares the quick assets with the quick liabilities. It is expressed in the form of pure ratio. E.g. 1:1.The term quick assets refer to current assets, which can be converted into, cash immediately or at a short notice without diminution of value. Formula: Liquid ratio = Quick assets Quick liabilities
Quick Ratio (QR) is the ratio between quick current assets (QA) and CL. QA refers to those current assets that can be converted into cash immediately without any value strength. QA includes cash and bank balances, short-term marketable securities, and sundry debtors. Inventory and prepaid expenses are excluded since these cannot be turned into cash as and when required.
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QR indicates the extent to which a company can pay its current liabilities without relying on the sale of inventory. This is a fairly stringent measure of liquidity because it is based on those current assets, which are highly liquid. Inventories are excluded from the numerator of this ratio because they are deemed the least liquid component of current assets. Generally, a quick ratio of 1:1 is considered good. One drawback of the quick ratio is that it ignores the timing of receipts and payments. Cash Ratio: Meaning: This is also called as super quick ratio. This ratio considers only the absolute liquidity available with the firm. Formula:
Since cash and bank balances and short term marketable securities are the most liquid assets of a firm, financial analysts look at the cash ratio. If the super liquid assets are too much in relation to the current liabilities then it may affect the profitability of the firm.
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Investment/ Shareholder:
Earnings per Share are calculated to find out overall profitability of the organization. Earnings per Share represent earning of the company whether or not dividends are declared. If there is only one class of shares, the earning per share are determined by dividing net profit by the number of equity shares.EPS measures the profits available to the equity shareholders on each share held. Formula: Earnings per share = Net Profit after Tax Number of equity share The higher EPS will attract more investors to acquire shares in the company as it indicates that the business is more profitable enough to pay the dividends in time. But remember not all profit earned is going to be distributed as dividends the company also retains some profits for the business Dividend per Share: Meaning: DPS shows how much is paid as dividend to the shareholders on each share held.
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Formula: Dividend per Share = Dividend Paid to Ordinary Shareholders Number of Ordinary Shares Dividend Payout Ratio: Meaning: Dividend Pay-out Ratio shows the relationship between the dividends paid to equity shareholders out of the profit available to the equity shareholders. Formula: Dividend Payout ratio = Dividend per share Earnings per share *100
D/P ratio shows the percentage share of net profits after taxes and after preference dividend has been paid to the preference equity holders. Gearing:
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Gearing means the process of increasing the equity shareholders return through the use of debt. Equity shareholders earn more when the rate of the return on total capital is more than the rate of interest on debts. This is also known as leverage or trading on equity. The Capital-gearing ratio shows the relationship between two types of capital. viz: - equity capital & preference capital & long term borrowings. It is expressed as a pure ratio. Formula: Capital gearing ratio = Preference capital+ secured loan Equity capital & reserve & surplus Capital gearing ratio indicates the proportion of debt & equity in the financing of assets of a concern.
Profitability: These ratios help measure the profitability of a firm. A firm, which generates a substantial amount of profits per rupee of sales, can comfortably meet its operating expenses and provide more returns to its shareholders. The relationship between profit and sales is measured by profitability ratios. There are two types of profitability ratios: Gross Profit Margin and Net Profit Margin.
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Meaning: This ratio measures the relationship between gross profit and sales. It is defined as the excess of the net sales over cost of goods sold or excess of revenue over cost. This ratio shows the profit that remains after the manufacturing costs have been met. It measures the efficiency of production as well as pricing. This ratio helps to judge how efficient the concern is I managing its production, purchase, selling & inventory, how good its control is over the direct cost, how productive the concern , how much amount is left to meet other expenses & earn net profit.
Net Profit ratio indicates the relationship between the net profit & the sales it is usually expressed in the form of a percentage.
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This ratio shows the net earnings (to be distributed to both equity and preference shareholders) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. Jointly considered, the gross and net profit margin ratios provide an understanding of the cost and profit structure of a firm. Return on Capital Employed: Meaning: The profitability of the firm can also be analyzed from the point of view of the total funds employed in the firm. The term fund employed or the capital employed refers to the total long-term source of funds. It means that the capital employed comprises of shareholder funds plus long-term debts. Alternatively it can also be defined as fixed assets plus networking capital. Capital employed refers to the long-term funds invested by the creditors and the owners of a firm. It is the sum of long-term liabilities and owner's equity. ROCE indicates the efficiency with which the long-term funds of a firm are utilized. Formula: Return on capital employed = NPAT *100 Capital employed
Financial: These ratios determine how quickly certain current assets can be converted into cash. They are also called efficiency ratios or asset utilization ratios as they measure the efficiency of a firm in managing assets. These ratios are based on the relationship between the level of activity represented by sales or cost of goods sold and levels of investment in various assets. The important turnover ratios are debtors turnover ratio, average collection period, inventory/stock turnover ratio,
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fixed assets turnover ratio, and total assets turnover ratio. These are described below:
Debtors Turnover Ratio (DTO): Meaning: DTO is calculated by dividing the net credit sales by average debtors outstanding during the year. It measures the liquidity of a firm's debts. Net credit sales are the gross credit sales minus returns, if any, from customers. Average debtors are the average of debtors at the beginning and at the end of the year. This ratio shows how rapidly debts are collected. The higher the DTO, the better it is for the organization. Formula: Debtors turnover ratio = Credit sales Average debtors
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Inventory or Stock Turnover Ratio (ITR): Meaning: ITR refers to the number of times the inventory is sold and replaced during the accounting period. Formula: Stock Turnover Ratio = Cost of Goods Sold Average stock ITR reflects the efficiency of inventory management. The higher the ratio, the more efficient is the management of inventories, and vice versa. However, a high inventory turnover may also result from a low level of inventory, which may lead to frequent stock outs and loss of sales and customer goodwill. For calculating ITR, the average of inventories at the beginning and the end of the year is taken. In general, averages maybe used when a flow figure (in this case, cost of goods sold) is related to a stock figure (inventories). Fixed Assets Turnover (FAT): The FAT ratio measures the net sales per rupee of investment in fixed assets. Formula: Fixed assets turnover = Net sales Net fixed assets
This ratio measures the efficiency with which fixed assets are employed. A high ratio indicates a high degree of efficiency in asset utilization while a low ratio reflects an inefficient use of assets. However, this ratio should be used with caution because when the fixed assets of a firm are old and substantially depreciated, the fixed assets turnover ratio tends to be high (because the denominator of the ratio is very low).
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Proprietors Ratio: Meaning: Proprietary ratio is a test of financial & credit strength of the business. It relates shareholders fund to total assets. This ratio determines the long term or ultimate solvency of the company. In other words, Proprietary ratio determines as to what extent the owners interest &expectations are fulfilled from the total investment made in the business operation. Proprietary ratio compares the proprietor fund with total liabilities. It is usually expressed in the form of percentage. Total assets also know it as net worth. Formula: Proprietary ratio = Proprietary fund Total fund Proprietary ratio= OR
Stock Working Capital Ratio: Meaning: This ratio shows the relationship between the closing stock & the working capital. It helps to judge the quantum of inventories in relation to the working capital of the business. The purpose of this ratio is to show the extent to which working capital is blocked in inventories. The ratio highlights the predominance of stocks in the current financial position of the company. It is expressed as a percentage. Formula: Stock working capital ratio= Stock Working Capital
Stock working capital ratio is a liquidity ratio. It indicates the composition & quality of the working capital. This ratio also helps to study the solvency of a
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concern. It is a qualitative test of solvency. It shows the extent of funds blocked in stock. If investment in stock is higher it means that the amount of liquid assets is lower. Debt Equity Ratio: Meaning: This ratio compares the long-term debts with shareholders fund. The relationship between borrowed funds & owners capital is a popular measure of the long term financial solvency of a firm. This relationship is shown by debt equity ratio. Alternatively, this ratio indicates the relative proportion of debt & equity in financing the assets of the firm. It is usually expressed as a pure ratio. E.g. 2:1 Formula: Debt equity ratio = Total long-term debt Total shareholders fund
Debt equity ratio is also called as leverage ratio. Leverage means the process of the increasing the equity shareholders return through the use of debt. Leverage is also known as gearing or trading on equity. Debt equity ratio shows the margin of safety for long-term creditors & the balance between debt & equity. Return on Proprietor Fund: Meaning: Return on proprietors fund is also known as return on proprietors equity or return on shareholders investment or investment ratio. This ratio indicates the relationship between net profits earned & total proprietors funds. Return on proprietors fund is a profitability ratio, which the relationship between profit & investment by the proprietors in the concern. Its purpose is to measure the rate of return on the total fund made available by the owners. This ratio helps to judge how efficient the concern is in managing the owners fund at disposal. This ratio is of practical importance top respective investors & shareholders.
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Formula: Return on proprietors fund = Creditors Turnover Ratio: It is same as debtors turnover ratio. It shows the speed at which payments are made to the supplier for purchase made from them. It is a relation between net credit purchase and average creditors Credit turnover ratio = Net credit purchase Average creditors Months in a year Credit turnover ratio NPAT * 100 Proprietors fund
Both the ratios indicate promptness in payment of creditor purchases. Higher creditors turnover ratio or a lower credit period enjoyed signifies that the creditors are being paid promptly. It enhances credit worthiness of the company. A very low ratio indicates that the company is not taking full benefit of the credit period allowed by the creditors.
Asset Efficiency (Management or turnover) ratios Profitability ratios Market value ratios
The liquidity or solvency ratios focus on a firm's ability to pay its short-term debt obligations. As such, they focus on the firm's current assets and current liabilities on the balance sheet. The most common liquidity ratios are the current ratio, the quick ratio, and the burn rate (interval measure). The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. It looks at the firm's long term liabilities on the balance sheet such as bonds. The most common financial leverage ratios are the total debt ratios, the debt/equity ratio, thelong-term debt ratio, the times interest earned ratio, the fixed charge coverage ratio, and the cash coverage ratio. The asset efficiency or turnover ratios measure the efficiency with which the firm uses its assets to produce sales. As a result, it focuses on both the income statement (sales) and the balance sheet (assets). The most common asset efficiency ratios are the inventory turnover ratio, the receivables turnover ratio, the days' sales in inventory ratio, the days' sales in receivables ratio, the net working capital ratio, the fixed asset turnover ratio, and the total asset turnover ratio. The profitability ratios are just what the name implies. They focus on the firm's ability to generate a profit and an adequate return on assets and equity. They measure how efficiently the firm uses its assets and how effectively it manages its operations. The market value ratios can only be calculated for publicly traded companies as they relate to stock price. The most commonly used market value ratios are the price/earnings ratio and the market-to-book ratio. These ratios allow you to compare your firm to others in your industry. They also allow you to compare different time periods of data for your firm to each other. Classification of Accounting Ratios: Ratios may be classified in a number of ways to suit any particular purpose. Different kinds of ratios are selected for different types of situations. Mostly, the purpose for which the ratios are used and the kind of data available determine the
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Classification of Accounting Ratios / Financial Ratios (B) (C) (A) Functional Classification Significance Ratios or Traditional Classification or Classification Ratios According to or Statement Ratios According to Tests Importance Profit and loss Profitability ratios Primary ratios Secondary ratios account ratios or Liquidity ratios revenue/income Activity ratios statement ratios Leverage ratios or Balance sheet ratios long term solvency ratios or position statement ratios Composite/mixed ratios or inter statement ratios
Comparative Data Financial ratio analysis is only a good method of financial analysis if there is comparative data available. The ratios should be compared to both historical data for the company and industry data. Tying it all Together - the DuPont Model: There are so many financial ratios - liquidity ratios, debt or financial leverage ratios, efficiency or asset management ratios, and profitability ratios that it is often hard to see the big picture. You can get bogged down in the detail. One method that business owners can use to summarize all of the ratios is to use the Dupont Model. The Dupont Model is able to show a business owner where the component parts of the Return of Assets (or Return on Investment ratio comes from as well as the Return on Equity ratio. For example, did ROA come from net profit or asset turnover? Did return on equity come from net profit, asset turnover, or the
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business' debt position? The DuPont model is very helpful to business owners in determining in financial adjustments need to be made.
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References:
www.Wekipedia.com
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http://www.scribd.com/doc/51540672/55/Importance-of-Ratio-Analysis
http://www.accountingexplanation.com/significance_and_usefulness_of_ratio_ analysis.htm
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