Financial Ratio analysis is a very useful tools.It is
one of the important technique used in fiancial statement
anlysis.Its importance can be explained as under
- Firm's ability to meet is financial
commitments/obligations can be evaluated with Liquidity Ratios i.e
Current Ratio & quick ratio asssesss firms short term solvency
of firm
- It helps to know firms ability to repay short term
commitments,ability to meet its liabilites,availability of cash to
meet its short term obligations,& regular cash
expenses.
- Ratio analysis indicates firms long term
solvency,nature of fiancing, extent of own funds used in business
organisaation
- It indicatees relationship between Equity &
Debt.
- It indicates how much should be the ratios like Ideal
ratio for Debt Equity is 2:1,Equity to Total funds ratio should be
33%,Current ratio: 2:1,Ideal liquid ratio is 1.33:1,
- Basic indicators of firm's profitability of firm are
profitability ratio i.e Gross profit ratio,Operating profit ratio,
Net profit ratio
- ROCE,ROZ , EPS assesses financial performance of the
firm.
- Ratios assesses operating efficiency of management
& utilisation of aseets & resources of
entity.
- Firms ability to generate revenue can be evaluated by
Activity/ performance /turnover ratios like Stock turnover
ratio,debtors turnover ratio,Fixed asset turnover ratio
etc
- Financial strength /solvency is indicated by Debt
equity ratio,Gearin ratios,Leverage ratios
- Ratio analysis helps to assess whether firm is exposed
to any serious fiancial strain.
- Firm's ratio analysis helps to compare & evaluate
firm's ratio with industry average.
- It analyses firms strengths & weaknesses &
helps to take timely & corrective actions
- It helps to depict future financial position of the
company.
- It helps in Planning & forecasting business
activities for future period.
- It shows the performance of the firm at particular
point of time
- It assist in evaluating firms ability to generate cash
from current or continuing operations like cash flow yield,cash
flow to sales, cash flow to assets
- Ratio analysis assist in knowing the firm's basic
profitability,operating performance of business.
- It helps in knowing the extent of current earnings
available for meeting interest & installmetn
commitmentts.
- Ratio analysis helps in determining how fast /regularly
raw material are used in production,WIP movement,how fast inventory
is used,speed of collection of credit sales/ debtors,speed of
payment to creditors,
- Price earnings ration shows the relationship between
market price ,EPS & shareholders perception of
entiry.
Example on Ratio analysis,
- Working capital of the company is $135,000 &
current ratio is 2.5.Liquid ratio is 1.5 & Propriety ratio is
0.75.
- Bank Overdraft is $30,000.There are no Long term loans
& fictitious assets.
- Gearing ratio is 2.Retained
Earnings=$90,000.
- Calculate Current assets,Current liabilities,Net block
of asset,Propriety fund, Quick liabiliites,Quick
assets,stock
Solution:
1.Current ratio=current assets/current
liabiliites=2.5
current assets=2.5 *current liabiliites
2.Net working capital=current assets-current
liabiliites=$135,000
2.5 * current liabiliites-current
liabiliites=$135,000
1.5 current liabiliites=$135,000
so current liabiliites=$135,000/1.5
Therefore,current liabiliites= $ 90,000
Hence,Current Assets=2.5*$90000=$225,000
3. Quick ratio= Quick assets/Quick liabilites=1.5
times
Current assets-Stock/Current liabiliites-Bank OD=1.5
times
$225,000-Stock/$90,000-$30,000=1.5 times
Hence,Stock=$135,000
4. There are no Loans or fictitious assets.
Capital employed=Propriety fund=Fixed assets+ Net
working capital
Propriety ratio=Propriety funds/Total
assets=0.75
Hence,Fixed assets + Net working capital/Fixed
assets+curretn assets=0.75
Fixed assets + $135,000/Fixed
assets+$225,000=0.75
(Fixed assets + $135,000)=0.75*Fixed
assets+$225,000)
Fixed assets=$135,000
Total Propriety Fund=Fixed assets+ Net working
capital
=$135,000 +$135,000=$270,000
Share capital( Balancing figure )=$180,000
Equity + Prefernce share capital=2:1
So, Equity=$180,000*2/3=$120,000
Preference Capital=$180,000*1/3=$60,000
Retained Earnings=$90,000 (given)
Please feel free to
reach or comment back if you need further clarity or something is
missing.