Ratio Analysis - LDCE

RATIO ANALYSIS

(Frequently asking and Most Important Essay Question - 25 marks asked in Management accounting section of LDCE)

v  Definition: 

                        I.        A relationship expressed in mathematical terms between two figures having Cause and Effect relationship or connected in some way or other.

                      II.        An expression of the quantitative relationship that exists between two numbers.

v  One of the very effective tool of financial analysis.

v  It is useful for various groups of people, say creditors, investors, management etc, who are interested in financial statements.

v  Provides clues and symptoms of underlying conditions.

v  Computation of ratios is relatively an easy exercise.

v  The usefulness of ratio analysis depends on its intelligent and judicious interpretation. Ratios by themselves carry little sense.  Comparisons are essential for making inferences.

v  Comparisons can be with:

1. Past ratios of the same enterprise.  This shows a trend within the organization.

2. Ratios of other companies in the same Industry.  It gives insight into the relative financial health & performance of the Organization.

3. Comparisons with Pre-determined Standard Ratios ( say Benchmarks), which may be Company/Industry accepted general standards.

v  Accounting Ratios  - Different types.

Balance Sheet Ratios	Income Statement or Revenue Statement Ratios	Composite Ratios
Both items available in the  Balance Sheet only	Both items available in the  Profit & Loss A/c only	One item from Profit & Loss A/c and another item from Balance Sheet
Examples - a) Current Ratio - Assets & Liabilities b) Proprietorship Ratios - Proprietor's Assets & Total Assets	Examples - a) Gross Profit Ratio  - Gross Profit & Sales. b) Optg. Profit  -  Cost of Goods sold to Net Sales. c) Stock Turnover Ratio - Cost of Goods sold & Average Stock carried.	Examples - a) Turnover of Debtors  -  Debtors & Net Sales. b) ROCE - Return On Capital Employed  - Net profit & Proprietor's Capital

v  Financial Ratios - Different types.

Category	Examples
1. Liquidity	1. Current Ratio  2. Acid Test/Quick/Liquidity Ratio
2. Activity/Turnover	1. TOR/Investor Turnover Ratio 2. Capital employed Turnover Ratio. 3. Total Assets Turnover Ratio   4. Debtors Turnover Ratio.
3. Leverage	1. Debt: Equity Ratio
4. Profitability	1.ROCE-Return On Capital Employed 2. Return on Net Worth
5. Investment/Investors related	1. Dividends pay out Ratio 2. Dividends Yield Ratio

Advantages:

1. Facilitates understanding of Financial Statements.
2. Narrates the whole story of changes in financial condition of the Business.
3. Facilitates Inter-Firm comparison.
4. Helps in planning the operations of the firm.
5. Facilitates "Management by Exception" .  Higher management can concentrates only at the area where its intervention is narrated.  The promoters has better utilisation of time and resources.
6. Compares with standard benchmarks.  During the period of existence, the firm develops certain standards/norms. Any change in the norms passes on the right message to the Management for the course of action to be initiated.

Limitations:

1. Communicates only a relative interpretation. Every Organization has its own uniqueness and comparisons may not be valid.

Example: Government company with limited freedom cannot be compared with Private company having lot of freedom though both are in same Industry.

2. Ratios are only a tool.  Their ultimate use depends on the craftsmen who use it.  Hence ratios are not an end in themselves.  Rather they are means to an end.  They pass only guiding / warning signals.

3. Window Dressing :  Sometimes companies do Window Dressing by manipulates accounts to show the outside a better or gloomy picture as the case may be they required. Such things cannot be disclosed by Ratio Analysis ( as Ratios depends on figures available in Financial Statements)

4. Inflation distorts/misleads financial ratio analysis. Spectacular performance is enabled due to inflation, not by Management.

                                                However companies may use "Replacement Cost Method" to prevent/obviate the above limitation.

CONCLUSION

"In a nutshell, the advantages clearly outweighs limitations, considering over all benefits".