Question

Select seven ratios to use at year-end and describe what each ratio is used for.

Answer 1

Ratio Analysis 

The most prevalent method of analyzing a balance sheet at the year-end is through ratio analysis. The ratio analysis can be for a single year or it may extend to more than one year. The ratios can also be compared with similar ratios of others concerns to make a comparative study as well to get a clearer picture as to where does the Company stands at the year-end, when compared to the other Companies of similar genre in the market. For this, 

• First, all ratios will be worked out for each year and each set of comparable items. 

• The ratios worked out will be put in the context of a trend over several years. 

• They will be compared with similar companies/ standard ratios. 

i) for the year concerned, and 

ii) Over a period of time. 

Ratios are also classified differently on different bases. The mostly used one is the financial classification under which the ratios are broadly divided into the following five classes: 

• Liquidity ratios concerned with the short term solvency of the concern or its ability to meet financial 

obligation on their due dates. 

• Activity ratios concerning efficiency of management of various assets by the concern. 

• Leverage ratios concerning stake of the owners in the business in relation to outside borrowings or 

long term solvency. 

• Coverage ratios concerned with the ability of the company to meet fixed commitments such as 

interest on term loans and dividend on preference shares and 

• Profitability ratios concerned with the profitability of the concern. 

Few Examples:

Current Ratio 

Current ratios indicate the relation between current assets and current liabilities. Current liabilities represent the immediate financial obligations of the company. Current assets are the sources of repayment of current liabilities. Therefore, the ratio measures the capacity of the company to meet financial obligation as and when they arise. 

One of the defects of current ratio is that it does not measure accurately to meet financial commitments as and when they arise. This is because the current assets include also items that are not easily realizable, such as stock. The acid test ratio is a refinement of current ratio and is calculated to measure the ability of the company to meet the liquidity requirements in the immediate future. A minimum of 1: 1 is expected which indicates that the concern can fully meet its financial obligations. This also called as Liquid ratio or Quick ratio. 

Activity Ratios 

Debtors Velocity 

The ratio obtained should be compared with that of other similar units. If the ratio of the company being studied is greater (say, 10 weeks as against 6 weeks for the industry), it indicates that the company is allowing longer than the usual credit periods. This may be justified in the case of new companies or existing companies entering into new ventures because initially they may have to extend longer credits to capture the market. In other cases, the position needs a deeper study; it is possible that many unrealizable and long pending items are included in debtors. The company’s collection machinery may need gearing up. The chances of larger bad debts are imminent. 

Creditors velocity 

 A high ratio as compared to that obtaining in the industry (e.g., 12 weeks as compared to 8 weeks for the industry) may mean that: 

• The company in unable to pay its debts and is therefore taking longer than usual time to pay its creditors ; or 

• The company is enjoying good reputation in the market and therefore the suppliers are extending more credit ; or 

• The company may be a near-monopoly consumer and the supplier is agreeable to the credit terms dictated by the company. 

Reversely, a lower ratio would mean any of the following: 

• The company has a comfortable financial position and is paying off the creditors promptly ; or 

• The creditors may offer discount on early payments to avail of which the company is paying early. The company may do so provided the cost of borrowing is less than the discount offered ; or 

• The company does not enjoy good reputation in the market and its creditors have restricted credits ; 

or 

• The suppliers may be monopolists dictating terms to the company. 

The real reason should be found by going into the facts of individual cases. This ratio should be studied along with the debtors velocity and current ratio to judge the real situation. 

Inventory Velocity 

The ratio is usually expressed as number of times the stock has turned over. Inventory management forms the crucial part of working capital management. As a major portion of the bank advance is for the holding of inventory, a study of the adequacy of abundance of the stocks held by the company in relation to its production needs requires to be made carefully by the bank. 

 A higher ratio may mean (higher turnover or less holding periods): 

• The stocks are moving well and there is efficient inventory management ; or 

• The stocks are purchased in small quantities. This may be harmful if sufficient quantities are not available for production needs; secondly, buying in small quantities may increase the cost. 

Contrarily, a lower ratio (i.e.., lower turnover of longer holding period may be an index of (1) Accumulation of large stocks not commensurate with production requirements, (2) A reflection of inefficient inventory management or over-valuation of stocks for balance sheet purposes ; or Stagnation in sales, if stocks comprise mostly finished goods. 

Working Capital Turnover 

 The use of this ratio is twofold. First, it can be used to measure the efficiency of the use of working capital in the unit. Secondly, it can be used as a base for measuring the requirements of working capital for an expected increase in sales. 

Leverage Ratio 

 Debt-Equity Ratio 

 This is a measure of owner’s stake in the business. The proprietors may desire more of funds to be from borrowings because it carries two main advantages. First, their stake in the venture is reduced and correspondingly their risk also. Secondly, interest on borrowings is allowed as expenditure in computing taxable profits but not dividend shares. The tax is computed on the profits before any dividend is declared. But a considerable contribution from the proprietors is necessary from the creditors’ point of view to sustain the interest of the proprietors in the venture and also as a margin of safety of the creditors. Besides, excessive liabilities tend to cause insolvency. 

Total-Indebtedness Ratio 

This ratio should be watched for a period of 3 to 5 years to see its trend, if declining or decreasing. A declining trend in the ratio is a welcome sign as it shows that the company is augmenting its own sources of funds by ploughing back profits or by reducing its dependence on outside borrowing by repaying them. On the other hand, an increasing trend in the ratio should be carefully looked into by the banker. Similar to the debt-equity ratio, there is no standard single ratio of total indebtedness that can be applied to all industries. But a ratio of 4: 1 is considered normal. This ratio supplements the information supplied by the debt-equity ratio. A company may have declining debt-equity ratio but the total outside liabilities may not decrease because of increased borrowing on short term. This will be revealed by the present ratio. 

Proprietary Ratio 

This ratio indicates the general financial strength of the concern. It is a test of the soundness of the financial structure of the concern. The ratio is of great significance to creditors since it enables them to find out the proportion of shareholders funds in the total investment in the business. In case of companies which depend entirely on owned funds and have no outside liabilities, the ratio will be 100%. A high ratio is welcome to the creditors because it secures their position by providing a high margin of safety. A ratio above 50% is generally considered safe for creditors. 

Return on Investment 

This ratio measures the profits of the concern as a percentage of the total investment made. However, both the important terms involved, viz., ‘ profit’ and ‘investment’, have been interpreted in various ways and hence the formula used for this ratio also varies widely. We shall adopt the formula. For the purpose of this ratio, the operating profit is calculated by adding back to net profit:

 (1) Interest paid on the long term borrowings and debentures; (2) Abnormal and non-recurring losses; (3) Intangible assets 

written off. Similarly, from the net profit abnormal and non-recurring gains are deducted. The idea is to get profit generated out of total investments made. 

The ratio of return on investment is an important ratio in computing the profitability of the concern. It computes the profitability as against profits. A company may maintain the profits at absolute value every year but its efficiency lies in maintaining the same percentage of profit as compared to the total investment made. When one wants to analyze an increase or decrease in the rate of return, it can be done by further analysis of the ratio. Profit is decided by the rapidity with which sales are made (turnover) and the margin of profit on sales.  Profit can be increased by increasing the margin or increasing the turnover. A further analysis of the different components that enter into the above will pinpoint the factors that contributed to the increase of decrease in profits. Return on investment is also known as Return on Capital Employed. Capital employed is used to mean the total investment in the unit, i.e., total assets. 

The Financial statements and ratios furnished in this paper are normally used in the accounting section are for validation, verification and for improvement of the company. The real success of any management lies with proper vision, mission towards the up-gradation of our society.