Ratio Analysis of Financial Statements

Happy Learning!!

 

 

The American Institute of Certified Public Accountants has summarized that “The financial statements reflect a combination of recorded facts, accounting conventions and personal judgments and the judgments and conventions applied, affect them materially”

Financial statements may be classified into two categories:

1)      General Purpose which consist of Balance Sheet and Profit and Loss Account

2)      Specific Purpose statements consisting of all other statements i.e Statement of Funds Flow or working capital and Cash Flow Statement

Financial Statements are very useful because they enable the process of taking economic decisions. The users of these statements include shareholders, creditors, and financial analysts and so on, each of whom require a different type of financial information.

Ratio analysis is a handy tool that can help into analyzing, investigating and determining the causes for the performance of the financial statements. The other tools to mention are Comparative financial statements, trend percentages and specialized analysis.

Ratio Analysis is a useful tool for appraisal of financial condition, efficiency and profitability of business. Ratios in financial analysis may be classified into

a)      Liquidity Ratios

b)      Leverage Ratios

c)       Activity Ratios

d)      Profitability Ratios

LIQUIDITY RATIOS: These measure the liquid position of the firm. The liquidity ratio highlights the capacity of the firm to meet its current liabilities out of current assets. The examples of liquidity ratio are:

Current Ratio: This is a measure of short term solvency. It indicates as to how many times current liabilities are covered by current assets. A ratio of 2:1 is generally considered as normal.

Current Ratio = All current assets / (Current Liability + Bank Overdraft)

Quick Ratio: This is also known as quick ratio or acid test ratio. In this ratio, slow moving assets like inventory and slow moving liabilities like Bank OD are not considered. A quick ratio of 1:1 is considered as normal.

Quick Ratio = (Current Assets minus Inventories) / (Current Liabilities and Provisions)

Inventory Turnover Ratio: This is also an activity ratio. It indicates the efficiency and inventory control and quality of a company. A higher ratio means good profits and that a smaller amount of inventories are necessary; and vice versa.

Inventory Turnover Ratio = Sales / Ending Inventory = Times

LEVERAGE RATIOS: This ratio measures the relative interest of the owners and creditors in the capitalization of the company. Some examples include:

Debt to Equity Ratio: This ratio compares the extent of borrowings and owned resources put in the business. A very high ratio will again mean heavy burden of debt.

Total Debt to net worth or equity = (Long Term Loans + Other Loans) / (Share Capital + Reserves + Surplus) = Times

Net worth to Fixed Asset Ratio: This ratio measures the extent to which risk capital is used to acquire fixed assets. A high ratio indicates that risk capital is more in fixed assets.

Net worth to Fixed Asset Ratio = (Share Capital + Reserves + Surplus) / Net fixed assets = Times

ACTIVITY RATIOS: These ratio measures the efficiency with which the funds have been employed by the company. Some examples include:

Average (Debtors) Collection Period: This measure the relationship between credit sales and period of credit allowed. It indicates the efficiency of the credit and collection policy.

Average Collection Period = (Sundry Debtors + Bills Receivable) / Sales * 365 = Number of Days

Fixed Asset Turnover ratio: This indicates how far the company’s assets are utilized for achieving higher turnover. A trend analysis can also be taken on average basis for future projections of sales.

·         Asset Turnover Ratio = Sales or Turnover / Gross Fixed Assets = Times

·         Capital Turnover Ratio = Sales or Turnover / Capital Employed = Times

 

PROFITABILITY RATIO:  These ratios measure the profit earning capacity of the company. These ratios measure the overall efficiency of the business. Some examples include:

Operating Profits to sales: As this ratio measures the operating efficiency, the interest and depreciation are not taken into account. It indicates the margin of profitability on net sales or sales after adjustment of stocks.

Operating Profit to Sales ratio = Operating Profit (before interest and depreciation) / Adjusted Sales

Return on Net Worth: This ratio measures how much is earned on owned funds employed. The ratio shows the earning capacity of owned funds.

Return on Net Worth = (Profit after Tax / Net Worth) * 100

These ratios help to grasp the relationship between various items in the financial statements. They are helpful in pointing out the trends important items and help the management to forecast. Moreover, inter-firm comparisons are possible and future market strategies can be evolved. Comparisons can be made between standard ratios and the actual performance ratios. Management can be then make corrective measures. These ratios are useful in a simple assessment of liquidity, solvency, efficiency and profitability of a firm.