Ratio Analysis

Ratio Analysis: All you need to know

Ratio analysis means the process of computing, determining, and presenting the relationship of related items and groups of items of the financial statement. Ratio analysis is a concept or technique which is as old as the accounting concept.

Ratios are important tools for financial analysis. Financial analysis is a scientific tool and it plays a key role as a tool for appraising the real worth of an enterprise, its performance during a period of time, and its pitfalls. It also helps to find out any cross-sectional and time-series linkages between various ratios.

Why ratio analysis?

Absolute figures don’t show the true picture of an organization, so to arrive at the below-mentioned factors the ratio analysis is used.

  • Liquidity position
  • Profitability
  • Solvency
  • Financial stability
  • Quality of the management
  • Safety & Security of the loans & advances to be or already been provided

Cautionary points concerning the use of ratios:

  • The dates and duration of the financial statements being compared should be the same.
  • The effects of seasonality may cause erroneous conclusions to be drawn.
  • The accounts to be compared should have been prepared on the same basis.
  • Different treatment of stocks or depreciation or asset valuations will distort the results.
  • In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used.
  • In order to identify trends at least three years of ratios are normally required.

Also Read: Dividend Distribution Tax (DDT) and Impact of abolished DDT

Notes to remember:

  • Current Liabilities are those which have either become due for payment or shall fall due for payment within 12 months from the date of the Balance Sheet.
  • Current Assets are those which undergo a change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital.
  • Net Worth & Long Term Liabilities are also called Long Term Sources of Funds.
  • Current Liabilities are known as Short Term Sources of Funds.
  • Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities.
  • Current Assets are Short Term Use of Funds.
  • Assets other than Current Assets are Long Term Use of Funds.

Ratio measurement:

  • As percentages – such as 25% or 50%. For example, if the net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.
  • As proportion – The above figures may be expressed in terms of the relationship between net profit to sales as 1: 4.
  • As pure Number/ Times – The same can also be expressed in an alternative way, such as the sale is 4 times the net profit or profit is 1/4th of the sales.

Classification of ratios:

Revenue & Profitability RatiosCapitalization RatiosWorking Capital RatiosMarket Ratios
• EBIDTA Margins• Debt to Equity Ratio• Current Ratio• Market Capitalization
• Net profit Ratio• Interest coverage ratio• Debtors’ Turnover Ratio/Debtor Days• Earning per share
• Return on Equity ratio• Debt service coverage ratio• Creditors’ Turnover Ratio/Creditor Days• P/E ratio
• Return on Capital employed ratio• Asset Turnover Ratio• Inventory Turnover Ratio/Inventory Days 
  • Net Working Capital cycle 
(1) Revenue & Profitability Ratios:

(A) Gross Profit Ratio/EBIDTA Margins: By comparing the Gross Profit percentage to Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern. A higher Gross Profit Ratio indicates efficiency in the production of the unit. EBIDTA margin assesses the company’s financial health. It is the proportion of money/income left after accounting for the cost of goods sold. Without an adequate gross margin, a company won’t be able to pay for other fixed nature expenses.  Gross Profit Ratio =  (Gross Profit  / Net Sales) x 100. and Gross Profit = (Total revenues – Material cost – Manufacturing OH -Admin Expenses).

(B) Net Profit Ratio: It is the percentage of revenue left after all expenses have been deducted from sales. This measures overall profitability. This measurement reveals the amount of profit that a business can extract from its total sales. Net Profit Ratio=(Net Profit / Net Sales) x 100 and Net Profit = (Total revenues – Material cost – Manufacturing OH -Admin Expenses – Dep – Interest cost – Tax).

(C) Return on Equity Ratio (RoE): This measures the corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. It illustrates the effectiveness of a company at turning cash put into business into greater gains & growth for the company and shareholders. • The higher the ROE, the more efficient the company’s operations are making use of invested funds. RoE =  (Net Income / shareholder’s equity).

(D) Return on Capital Employed (RoCE): It reflects a company’s ability to earn a return on all of the capital it employs. RoCE considers debt and hence provides a better indication of financial performance for companies that are capital intensive and with debt structure. A high RoCE indicates that a larger chunk of profits can be invested back into the company for the benefit of shareholders. The reinvested capital is employed again at a higher rate of return, which helps to produce higher earnings-per-share growth. RoCE =  (Earnings Before Interest & Tax (EBIT)/Capital employed). Capital Employed is the sum of equity share capital and long term funds less of capital work in progress.

(2) Capitalization Ratios:

(A) Debt to Equity: It is the relationship between the borrower’s fund (Debt) and Owner’s Capital (Equity). Also, know as gearing ratio. It indicates the relative proportion of shareholder’s equity and debt used to finance a company’s assets. A high debt/equity ratio indicates that the company is digressively financing its growth through outside borrowing, which depicts an association with a high level of risk- low profits with volatile/increased interest cost on borrowings. Total Debt = Long Term + Short Term + CPLTD. Debt to Equity = (Total Debt / Tangible Net Worth).

(B) Interest Coverage Ratio: It measures the margin of safety a company has for paying interest during a given period. This ratio determines how easily a company can pay its interest expenses on outstanding debt. A company’s ability to meet its interest obligations is an aspect of a company’s solvency, and thus ICR is a very important factor in the return for shareholders. With an ICR of at par or below 1.5 times, the ability to meet interest cost through earnings becomes questionable – indicating that it is not generating enough revenues. Interest Coverage Ratio =  (EBIT / Total Finance Cost).

(C) Debt Service Coverage Ratio: It refers to the amount of cash flow available to meet current debt obligations (including Finance expenses & principal debt due in a year). This ratio is one of the most important ones which indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals. Total Debt Service = Current Debt to be paid + Total Finance Expenses. This ratio is a credit assessment and worthiness calculator used by lenders. A DSCR of less than 1 denotes negative cash flows which means the company will be unable to cover its current debt obligations – without-drawing sources from outside. DSCR = EBIDTA/(Total Debt Service).

(D) Fixed Asset Turnover Ratio: It measures the values of a company’s sales or revenues generated relative to the value of its Fixed Assets. It is an indicator of the efficiency with which a company is deploying its assets in generating revenues. A higher ratio is considered to better, indicating that the company is generating more revenues on its usage of assets. This ratio may vary year on year basis, depending upon the quantum and nature of investments done by a company. The nature and timeline of return on the investment made also affect the interpretation of the asset turnover ratio. Asset Turnover Ratio = (Net sales/(Net Block Tangible +Intangible))

(3) Working Capital Ratios:

(A) Current Ratio: It measures the company’s ability to pay its short term obligations and is determined as the relationship between the current assets and current liabilities of a concern. This ratio measures the short term liquidity of the concern and its ability to meet its short term obligations within a time span of a year. The current ratio gives a sense of the efficiency of a company’s operating cycle or its ability to turn its products into cash. A ratio under 1 indicates that a company’s liabilities are greater than its assets. The higher the current ratio, the more capable the company is of paying its obligation. It is ideal to compare liquidity position through the current ratio of the companies in the same business/industry. The ideal Current Ratio is 2:1. Current Ratio = Current Assets/Current Liabilities.

(B) Debtor Turnover Ratio/Debtor Days: The receivables turnover ratio is an accounting measure used to quantify a firm’s effectiveness in extending credit and in collecting debts on that credit. This ratio measures how effectively a company manages/uses its assets. A high debtors’ turnover ratio indicate that the company’s collection of accounts receivable is efficient, and that the company has a high proportion of quality customers that pay off their debts quickly. This ratio is better interpretable over the years to determine whether a company’s credit practices are helping or hurting the ompany’s bottom line. DTR = ( Net Sales/Debtors), Debtor Days = 365/DTR.

(C) Creditor Turnover Ratio/Creditor Days: It is a short-term liquidity measure used to quantify the rate at which a company pays off its suppliers. A higher creditor turnover ratio is good because it will decrease the average payment period. CTR = ( Net Sales/Creditors ) Creditor Days = 365/CTR.

(D) Inventory Turnover Ratio/Inventory Days: It is a ratio showing how many times a company’s inventory is sold and replaced over a period of time. This ratio provides an insight as to whether a company is managing its stock properly. It also shows how well management is managing the cost associated with inventory or whether they’re buying excess or too little. The higher the inventory turnover ratio, the better it is since it typically implies that the Co is selling its goods quickly and is not bearing any additional inventory carrying cost. A low turnover implies weak sales and, therefore, excess inventory. ITR = ( Net Sales/Inventory ), Inventory Days = 365/ITR.

(E) Net Working Capital Cycle: The working capital cycle (WCC) is the amount of time it takes to turn the net current assets and current liabilities into cash. The Working Capital cycle is a measure of both of company’s operational efficiencies and its short-term financial health. A company will have a negative working capital cycle if the Current Ratio is less than 1. The longer the cycle is, the longer a business is tying up capital in its working capital without earning a return on it. The companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable. NWC Cycle = (Debtor days + Inventory days – Payable Days).

(4) Market Ratios:

(A) Market Capitalization: It refers to the total present market value of a company’s outstanding shares, commonly referred to as Market Cap. This value is used majorly by the investment community to determine a company’s size in the industry and also assess risk in the share. It measures the company’s worth in the open market and as well as the market’s perception of its future prospects, as it reflects what investors are willing to pay for its stock. The companies are majorly classified into large-cap (stock worth > $10 billion), mid-cap(stock worth b/w $2 billion and $10 billion) and small-cap <$2 billion). Significant changes such as the issue/sale of shares or a change in stock price can affect the market cap on any day. Market Cap = (No. of shares O/s on the last date of Financial Year * Closing Market rate on that date).

(B) Earnings Per Share (EPS): It is the portion of a company’s profit allocated to each outstanding share. It is an important fundamental used in valuing a company because it breaks down a firm’s profits on a per-share basis. EPS is typically used in conjunction with a company’s share price to determine whether it is relatively cheap or expensive. EPS = Net Profit/ Outstanding shares.

(C) Price Earnings Ratio (P/E ratio): This is used for valuing a company that measures its current share price relative to its per-share earnings. It implies the rupee amount an investor can expect to invest in a company in order to receive 1 rupee of that company’s earning. A high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.  A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. P/E ratio = Market Value of the share / Earnings per share.

The utility of ratio analysis will get further enhanced if the comparison is possible between the company and its direct competitors in the industry & between the company and its peers in the industry.

FAQs:

What are the types of Ratio?

The ratios have been classified into four categories: (1) Revenue & Profitability Ratios (2) Capitalization Ratios (3) Working Capital Ratios & (4) Market Ratios.

What is Capital employed in Ratio?

Capital Employed is the sum of equity share capital and long term funds less of capital work in progress.

What is an ideal Interest coverage Ratio?

With an interest coverage ratio of at par or below 1.5 times, the ability to meet interest cost through earnings becomes questionable – indicating that it is not generating enough revenues.

Now, Businesses with an annual turnover of up to Rs 40 lakh are GST exempt


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