Financial statement analysis is the process of analyzing financial statement of
a company of a company so as to obtain meaningful information about its
survival, stability, profitability, solvency and growth prospects. The financial
statement analysis can be performed by using a number of techniques such
as comparative statements, common size statements and ratio analysis. Ratio
analysis is the more popularly and widely used technique of financial
statement analysis.
Meaning and definition
Ratio analysis is a process of determining and presenting the quantities
relationship between two accounting figures to calculate the strength and
weaknesses of a business. In simple word, ratio analysis is quotient of two
numerical variables which shows the relationship between the two figures,
accordingly, accounting ratio us a relationship between two numerical variable
obtains from financial statements such as income statement and the balance
sheet. Accounting ratio are used as an important tool of analysing the financial
performance of the company over the years ans as comparative position
among other companies in the industry.
In other words, ratio analysis is the process of determining and interpreting
numerical relationship between figures of financial statement.
According to Kennedy and McMullan, the relationship of one term to another
expressed in simple mathematical form is known as ratio.
% of profit = ProfitCapitalProfitCapital * 100
Ratio can be expressed in the following terms:
Ratio method: This method shows the relationship between two figures in
ratio or proportion. It is expressed by simple division of one item by another i.e
[Link], [Link] and so on.
Rate method: This method shows relationship in rate or times, like 4 times or
5 times and so on.
Precentage method: The relationship between two figures can be presented
in percentage like 20%, 30% and so on.
IMPORTANCE AND ADVANTAGES OF RATIO ANALYSIS
Ratio analysis is an important tool for analysising the company’s financial
performance. The following are the important advantages of the accounting
ratios.
Analysing financial statement: Ratio analysis an important technique of
financial statement analysis. Accounting ratios are useful for understanding
the financial position of the company. Different users such as investors,
management, bankers and creditors use the ratios to analyse the financial
statement of the company for their decision making purpose.
Judging efficiency: Accounting ratios are important for judging the
company's efficiency in terms of its operations and management. They help
judge how well the company has been able to utilize its assets and earn
profits.
Locating weakness: Accounting ratios can also be used in locating
weakness of the company's operations even though its overall performance
may be quite good. Management can then pay attention to the weaknesses
and take remedial measures to overcome them.
Formulating plans: Although accounting ratios are used to analyze the
company's past financial performance, they can also be used to establish
future trends of its financial performance. As a result, they help formulate the
company's future plans.
Comparing performance: It is essential for a company to know how well it is
performing over the years and as compared to the other firms of the similar
nature. Besides, it is also important to know how well its different divisions are
performing among themselves indifferent years.
Inter-intra firm comparison: A firm may like to compare its performance with
that of other firms and of industry in general. The comparison is called 'inter-
firm comparison'. If the performance of different units belonging to the same
firm is to be compared, then it is called 'intra-firm comparison'. Such
comparison is almost impossible without proper accounting ratios.
Classification of ratios
Accounting ratio can be classified from different point of view. Ratio may be
used to evaluate the company’s liquidity, efficiency, leverage, profitability. The
ratio may be classified as following;
Liquidity ratio: Liquidity represents one's ability to pay its current obligations
or short-term debts within a period less then a year. Liquidity ratios, therefore,
measure a a company's liquidity positions. The ratios are important from the
viewpoint of its creditors as well as management. The liquidity position of the
company can be measured mainly by using two liquidity such as follows:
a)Current ratio
b)Quick ratio
Current ratio
Current ratio is also known as short-term solvency ratio or working capital
ratio. This ratio is used to assets the short-term financial position of the
business. In other words, it is an indicator of the firm's ability to meet its short-
term obligations;
it is calculated by;
Current ratio = CurrentassetsCurrentliabilitiesCurrentassetsCurrentliabilities
Quick ratio
Quick ratio is another measure of a company's liquidity. It is also known as
liquid ratio or acid test ratio. However, although it is used to test the short-term
solvency or liquidity position of the firm, it is a more stringent measure of
liquidity than the current ratio. This ratio is calculated by dividing liquid assets
by current liabilities. liquid assets asset cash and other assets which ate either
equivalent to cash or convertible into cash within a very short period of time.
Thus liquid assets are also called monetary current assets.
Quick ratio = LiquidassetscurrentliabilitiesLiquidassetscurrentliabilities
Fixed assets Turnover ratio
Fixed assets turnover ratio is termed as the ratio of sales to fixed assets.
Fixed turnover ratio indicates how efficiently the fixed assets are used. It
measures the efficiency with which the firm has been its fixed assets to
generate sales.
Fixed assets turnover ratio= SalesNetfixedassetsSalesNetfixedassets
Total fixed turnover ratio
The ratio shows the relationship between total assets and sales. Total assets
turnover ratio indicates how well the firm's total assets are being used to
generate its sales.
Total assets turnover ratio = NetsalesTotalassetsNetsalesTotalassets
Capital employed turnover ratio
Capital employed turnover ratio establishes the relationship between the
amount of sales ad capital employed, it shown how efficiently capital
employed in the company has been utilized in generating sales revenue.
Capital employed turnover ratio = SalesCapitalemployedSalesCapitalemployed
Leverage ratios
Leverage ratios are also called long-term solvency ratios or capital structure
ratios. The term solvency implies the ability of a company to meet the
payments associated with its long-term debts. Thus, solvency ratios are the
measure of the company's ability to meet its long-term obligations. Generally,
these ratios are expressed in proportions.
The following are the major types of leverage ratios:
a)Debt-equity ratio
b)Debt to total capital ratio
Debt-equity ratio
The debt-equity ratio is calculated to ascertain the soundness of the
company's long-term financial position. It indicates the extent to which it
depends upon borrowed funds for its existence. It portrays the proportion if its
total funds acquired by way of external financing.
Debt-equity ratio
= Long−termdebtShareholdersfundLong−termdebtShareholdersfund
Alternatively,
Debt-equity ratio
= TotaldebtTotalshareholdersfundTotaldebtTotalshareholdersfund
Long-term debt: The debt which is payable after current year is called long
term-debt. Long-term debt refers to borrowed funds. Long-term debts include
term loans, debentures, bonds, mortgage loans and secured loans.
Total debt: it includes both short-term debt as well as long-term debt. Short-
term debts are the current liablilities.
Shareholder's fund: Shareholders fund is also called as net worth or
shareholders' equity. Shareholders fund is the amount, which belongs to the
company's shareholders or owners. It includes equity share capital,
preference share capital, reserve and surplus, accumulated profits, reserve
funds, general reserves, capital reserve, share premium, share forfeiture,
retained earnings, reserve for contingency, sinking fund for renewal of fixed
assets and fixed assets and redemption of debenture. The fictitious assets
such as preliminary expenses, underwriting commissions, discount on issue of
shares, or debentures are deducted while determining shareholders' fund.
Turnover ratios
Turnover ratios are also known as activity or efficiency ratios. The total funds
raised by the company are invested in acquiring various assets for its
operations. The assets are acquired to generate the sales revenue and the
position of profit depends upon the value of sales. These ratios establish the
relationship sale with various assets. Ratio and express in integrates or times
rather then percentage or proportion. The turnover ratios are mostly computed
to measure the efficiency.
The following are the types of turnover ratio;
Inventory turnover ratio
This ratio is also called stock turnover ratio. This ratio shows the relationship
between the cost of goods sold and the average inventory. This ratio
measures how frequently the company's inventory turn into sales. It, therefore,
shows the efficiency with which the company's inventory has been converted
into sales.
It is calculated by,
Inventory turnover ratio = SalesClosinginventorySalesClosinginventory
Debtor turnover ratio
It is also termed as receivable turnover ratio. This ratio establishes the
relationship between net credit sales and average debtor for the year. It
shows how quickly the credit (debtor or receivables) of the company has been
converted into cash. This ratio is calculated by using the following formula
Debtor turnover
ratio= NetcreditsalesAverageaccountreceivableNetcreditsalesAverageaccountreceiva
ble
Average collection period
It is also called debt collection period or average age of debtors and
[Link] indicates how long it takes to realize the credit sales. It also
measures the average creditor period enjoyed by the customers. It indicates
the average time lag between credit sales and their conversion into cash.
Profitability ratios
The main objective of a company is to earn profit is both a means and an end
to the company. Therefore, profitability shows the overall efficiency of the
company. Profitability ratios are the measure of its overall efficiency.
Generally, profitability ratio can be calculated in term of the company's sales,
investments, and earning and dividends. The following are the main types of
profitability ratios:
1. Profitability in relation to sales
Gross profit margin
Net profit margin
2. Profitability in relation to investment
Return on assets
Return on shareholder equity
Return on shareholder find
Return on capital employed
3. Profitability in terms of earning and dividend
Earning per share
Dividend per share
Gross profit ratio
Gross profit ratio is also termed as gross profit margin. This ratio shows the
relationship between gross profit and net sales and it measures the overall
profitability of the company in terms of sales. It is generally expressed in
percentage.
It is calculated by,
Gross profit = GrossprofitNetSalesGrossprofitNetSales * 100
Net profit ratio
This ratio is also called net profit margin. This ratio measures the overall
profitability of a business by establishing the relationship between net profit
and net sales. This ratio is calculated by dividing net profit tax by net sales
and multiplying by 100.
Return of assets
This ratio measure the relationship between the total assets and net profit
after tax plus interest. It measures the productivity of the assets and
determines how effectively the total assets have been used by the company.
Return of assets
=Netprofitaftertax+InterestTotalassetsNetprofitaftertax+InterestTotalassets
Return on shareholders' equity
This ratio expresses the profitability of a business in relation to the owners
fund.
It is calculated by,
Return on shareholders' equity = NetprofitaftertaxTotalshareholder
′sequityNetprofitaftertaxTotalshareholder′sequity * 100
Return on capital employed
The net result of operation of a business is either profit or loss. The funds
used by the company to generate profit consist of both properties fund and
borrowed funds. Therefore, the company's overall performance can be judged
in terms of capital employed.
Return on capital employed
= Netprofitaftertax+InterestCapitalEmployedNetprofitaftertax+InterestCapitalEmplo
yed * 100
Earning per share
Earning per share measures the profit available to equity shareholder on per
share basis. This ratio express the earning power of the company in terms of
a share held by the equity shareholders. This ratio computed by dividing the
net profits after preference dividend by the number of equity shares
outstanding.
Earning per share
= Netprofitaftertax−[Link]−Pr
[Link]
Dividend per share
The profits earned by the company finally belong to the equity shareholder.
Therefore, all or some of them are distributed to them which are known as
dividends. This ratio shows how much share of stock held by them is paid out
as dividend. The amount of earning distributed and paid as cash dividend is
considered for calculating the dividend per share.
Dividend per share = [Link]