Ratio Analysis :
This is the most commonly used tool for analysis of financial statements.
A ratio is comparison of two figures and can illustratively be expressed as:
| Current Ratio | 1.33 |
| Debt Equity Ratio | 1:2 |
| Profitability Ratio | 21.4% |
Both the figures, used in calculation of a ratio, can be from either P& L account, or balance sheet or one can be from P& L account and the other from balance sheet. Ratios help in comparison of the financial performance and financial position of an entity with other entities, as also for comparison with its own status over the years. While different users of financial statements are interested in different ratios, some of the important ratios are:
Profitability Ratios:
Operating profit margin (OPM) and Net profit margin (NPM) are calculated by dividing the figures of operating profit (EBIT which means earnings before interest and tax) and net profit respectively by the net sales. OPM is an indicator of the operating efficiency of the enterprise while NPM is an indication of ability to withstand the adverse business conditions.
Liquidity Ratios:
These are Current ratio (CR) and Quick ratio or acid test ratio. While CR is a ratio of total current assets to total current liabilities, quick ratio is calculated by dividing current assets (excluding inventory) by total current liabilities. These ratios indicate the capacity of an enterprise to meet its short term obligations. It is quick ratio because out of total current asset the inventory is taken out and the balance is mostly Sundry Dr. or advances as paid and are nearer (quick) to be converted in to cash.
Capital Structure Ratios:
Debt Equity Ratio (DER) is a ratio of total outside long term liability to the Net worth of an enterprise. High debt equity ratios are an indication of high borrowings in relation to the owned funds but also affects the viability of the operation of the enterprise, as higher borrowings mean higher costs and lower operating margins. In case of those enterprises, which are not capital intensive (i.e. the requirement of fixed assets is low), this ratio may not indicate the correct picture as working capital borrowings, which are not indicated by DER, may be disproportionate to the capital. To get a better result, the ratio of Total Outside Liabilities (TOL) to Tangible Net Worth (TNW) can be used. For bank and auditors the bad ratio indicates higher risks for the company and may be a guide line to plough back more profit within the business.
Coverage Ratios:
Interest Coverage Ratio (ICR) and Debt Service Coverage Ratio (DSCR) are the important ratios under this category. ICR is calculated by dividing EBIT (earnings before interest and tax) by total interest on long term borrowings. DSCR is ratio of total cash flows before interest (net profit + depreciation + interest on long term borrowings) to total repayment obligation (installment + interest on long term borrowings).
Turnover Ratios:
Inventory Turnover Ratio:
This is one of the important ratios to measure the skills of the management of the firm. This is an indicator of how fast or slow is the movement of inventory. It is calculated by dividing cost of goods sold by average inventory. A higher ratio indicates faster movement of inventory. This is also used for calculating average inventory holding period. Also it indicates a faster working capital borrowed and helps in lower interest liabilities. Today use of just in time and lean production system helps to a greater extent in reducing inventory level.
Debtors’ Turnover Ratio: This is another important ratio to measure the efficiency of the receivables management of the firm. It is an indicator of how fast or slow the debtors are realized. It is calculated by dividing the net credit sales of a company by average debtors outstanding during the year. A higher ratio indicates faster collection of debts. This is also used for calculating average collection period.
For this the formula is: Total Credit Sales ÷ Average Sundry Dr, in case it comes 4 : 1, the relation will be (12 months ÷ 4) = 3 months