Question

1. What are some of the uses of ratio analysis? What are the three major categories and explain what each one purports to analyze? Select 6 ratios (two from each category), show how they are computed, and explain what might cause the ratios financially and/or operationally to both decrease and increase. Can you help answer this question written as a short essay 4-6 sentences?

Answer 1

Ratio Analysis

Ratio Analysis is the analysis of financial statements with the help of ratios.

It helps to understand the financial position and performance of business concern.

Uses of Ratio Analysis

• Inter-firm comparison can be made with the help of ratios, which may help management in evolving future market strategies.
• Ratios may be used as measure of efficiency.
• Ratios can effectively 'communicate' what has happened between two accounting dates.
• Ratios indicate trends in important items and thus help in forecasting.
• It make easy to grasp the relationship between various items and helps in understanding the financial statements.
• Ratios are very useful for measuring the performance and very useful in cost control.
• It helps in simple assessment of liquidity, profitability, solvency, and efficiency of the firm.

Major Categories of Ratios

A) Profitability Ratios

B) Activity Ratios

C) Solvency Ratios

A) Profitability Ratios

These Ratios give n indication of the efficiency with which the operations of business are carried on. The following are the important profitability ratios.

1. Return on Investment (ROI)
2. Price Earning Ratio (P/E Ratio)
3. Gross Profit Ratio (GPR)
4. Net Profit Ratio (NPR)
5. Operating ratio
6. Fixed Charges Cover ratio (FCCR)
7. Pay-out Ratio
8. Dividend Yield Ratio (DYR)
9. Net Worth (Return on Shareholders fund)

B) Activity Ratios

These Ratios indicate the efficiency with which capital employed is rotated in the business. The various turnover ratios are as follows.

1. Over-all Turnover Ratio
2. Fixed Asset Turnover Ratio
3. Debtor's Turnover Ratio
4. Creditor's Turnover Ratio
5. Stock Turnover Ratio

C) Solvency Ratios

These Ratios indicate about the financial position of the company. A companies considered to be financially sound if it is in a position to carry on its business smoothly and meet all its obligations both short term and long term without strain. The solvency ratios can therefore be classified into following categories:

   (i) Long Term Solvency Ratios

1. Fixed Asset Ratio
2. Debt Equity Ratio
3. Proprietary Ratio

   (ii) Short Term Solvency Ratios

1. Current Ratio
2. Liquidity Ratio
3. Super-Quick Ratio
4. Defensive Interval Ratio
5. Debt service coverage ratio

Six Ratios Discussed In Detail

A) Profitability Ratios

1. Price Earning Ratio (P/E Ratio) :- This Ratio indicates the number of times the earning per share is covered by its market price. It is calculated as follows:

                   P/E Ratio = Market price Per Equity Share / Earning Per Share

        For Example

        If the market price of an equity share is $20 and earnings per share is $5, the price earning ratio will be 4(i.e.., 20/5). This means for every one droller of earning people are prepared to pay $4. In other words, rate of return expected by the investment is 25%.

Significance : P/E Ratio helps the investors in deciding whether to buy of not to buy the shares of the company at particular price. For instance, in the example given , if EPS falls to $3, the market price of the share should be $12 (i.e.., 3*4 ). In case the market price of the share is $15, it will not be advisable to purchase the company's share at that price.

       2. Gross Profit Ratio (GPR) :- This ratio express the relationship between Gross Profit and Net Sales. It can be computed as follows:

                 GPR = Gross Profit / Net Sales * 100

Significance : The ratio indicate the overall limit with in a business must manage its operating expenses. It also helps in ascertaining whether the average percentage of mark upon goods is maintained.

B) Activity Ratios

1.    Over-all Turnover Ratio :- The Ratio indicates the number of times the capital employed has been rotated in the process of doing a business. The Ratio is computed as follows:

                  Over-all Turnover Ratio = Net Sales / Capital Employed

Significance: The overall profitability of business depends on two factors, viz., (a) the profit margin, (b) turnover.

The profit margin is disclosed by the net profit ratio while the turnover is indicated by the overall turnover ratio. A business with a lower profit margin is can achieve a higher ROI if its turnover is high. This is the reason for wholesalers earning a larger return on there investment even when they have a lower profit margin. A business should not, therefore, increase its profit margin to an extent that it results in reduced turnover resulting in reduction of overall profit.

      2. Fixed Asset Turnover Ratio: The ratio indicates to the extent to which the investment in fixed asset has contributed towards sales. The ratio can be calculated as follows :

                 Fixed Asset Turnover ratio = Net Sales / Net Fixed Asset

Significance: The comparison of fixed asset turnover ratio over a period of time indicates whether the investment in fixed assets has been judicious or not. Of course, investment in fixed asset does not push up sales immediately but the trend of increasing sales should be visible. if such Trend is not visible or increase in sales has not been achieved after the expiry of a reasonable time it can be very well said that increased investment in fixed asset has not been judicious.

C) Solvency Ratios

(i) Long Term Solvency Ratio

1. Debt Equity Ratio : The ratio is determined to ascertain the proportion between the outsiders fund and shareholders fund in the capital structure of an enterprise. The term outsiders fund is generally used to represent total long trem debt.

Debt- Equity Ratio = Total Long term Debt / Shareholders funds

OR

Total Long term Debt / Total Long term funds

The ratio is not enterprise if the long term debt does not exceed twice of shareholders fund.

Significance: The ratio is an indication of the soundness of the long term financial policies pursued by business enterprise. The excessive dependence on outsiders fund may cause insolvency of the business. The ratio provides the margin of safety to the creditors. It tells the owners to the extent to which they can gainby maintaining control with a limited investment.

(ii) Short Term Solvency Ratios

1. Current Ratio: The ratio is an indicator of the firm's commitment to meet its short term liabilities. It is expressed as follows:

                         Current Ratio = Current Asset / Current Liabilities

An ideal Current ratio is '2'. However, a ratio of 1.5 is also acceptable if the firm has adequate arrangement with its bankers to meet its shot term requirements of funds.

Significance: The ratio is an index of the concern's financial stability, since, it shows the extent to which the current assets exceed its current liabilities. A higher current ratio indicates inadequate employment of funds,while a poor current is a danger signal to the management.