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Financial Ratio Analysis is the calculation and comparison of main indicators - ratios which are derived from the information given in a company's financial statements(which must be from similar points in time and preferably audited financial statements and developed in the same manner). It involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status. This Analysis is primarily designed to meet informational needs of investors, creditors and management. The objective of ratio analysis is the comparative measurement of financial data to facilitate wise investment, credit and managerial decisions. Some examples of analysis, according to the needs to be satisfied, are:
• Horizontal Analysis - the analysis is based on a year-to-year comparison of a firm's ratios,
• Vertical Analysis - the comparison of Balance Sheet accounts either using ratios or not, to get useful information and draw useful conclusions, and
• Cross-sectional Analysis - ratios are used and compared between several firms of the same industry in order to draw conclusions about an entity's profitability and financial performance. Inter-firm Analysis can be categorized under Cross-sectional, as the analysis is done by using some basic ratios of the Industry in which the firm under analysis belongs to (and specifically, the average of all the firms of the industry) as benchmarks or the basis for our firm's overall performance evaluation.
The informational needs and appropriate analytical techniques needed for specific investment and credit decisions are a function of the decision maker’s time horizon(short versus long term investors and creditors). A pervasive problem when comparing a firm’s performance over time(trend or time series analysis) or with other firms(cross sectional or common size analysis) is changes in the firm’s size over time and the different sizes of firms which are being compared. However, one approach to this problem is to use common size statements in which the various components of the financial statements are standardized by expressing them as a percentage of some base (base in the income statement is sales and base in the balance sheet is total assets). See sample file below for further understanding.
In general, a process of standardization is being achieved by the use of ratios. They can be used to standardize financial statements allowing for comparisons over time, industry, sector and cross-sectionally between firms and further facilitate the evaluation of the efficiency of operations and/or the risk of the firm’s operations regarding the scope and purpose of evaluation. Ratios measure a firm’s crucial relationships by relating inputs(costs) with output(benefits) and facilitate comparisons of these relationships over time and across firms.
Many attractive categories of financial ratios and numerous individual ratios have been proposed in the literature. The most prominent literature on financial analysis - though non-exhaustive - indicates the following categories of ratios:
Profitability
• Gross Profit ratio = ( Gross Profit / Sales) * 100
• Operating Profit = ( Operating profit / Sales) * 100
• Return on Capital Employed (ROCE) , in times = ( Profit before interest and tax / Capital Employed)
or Return on Equity (ROE), in times = Net Income ÷ (Average Equity during the period)
Very often, the reported profits are adjusted to reflect sustainable levels of performance and thus instill more meaning to the computation and interpretation of the financial ratios. In this context, EBITDA is used, which is calculated by excluding from the profit figure the tax, interest, depreciation and amortisation amount. Non-reccuring expenses or income is also excluded when this can be substantiated to enhance the interpretation of the derived ratio figures. EBITDA figure can be used as an approximation of the underlying cash flows which at the same time incorporate the future potentials of the company's profitability rather than just the cash generation of a financial year.
Activity or Management Efficiency ratios
• Debtors days, in days = ( Av. Debtors / Sales ) * 365
• Creditors days, in days = ( Av. Creditors / COGS ) * 365, where COGS is the Cost of Goods Sold by the firm
• Stock days, in days = ( Av. Stock / COGS ) * 365
Where "Av.", is the Average amount of the opening and closing balance of the corresponding account of the financial year the Analysis is being undertaken.
Market or Investment ratios
• Dividend cover, in times = ( Profit after tax / dividends )
• Dividend yield = ( Dividend / Share price )
• P/E = ( Share price / Earnings per share )
• EPS = ((Profit after tax - pref. dividends) / Total number of ordinary shares outstanding )
Each category can be further utilized and an in-depth analysis can be adopted to reflect the corresponding needs of each user, i.e. a bank considering whether to lend a specific company would focus more on financial and liquidity - as the risk of lending to a company that does not have the resources to repay the loan is of great concern for a bank - and profitability ratios, to see whether the company's earnings are adequate to cover the interest on the loan. An analysis from an investor's point of view on the other hand would focus more on profitability and investment ratios, to evaluate the prospects of his potential returns.
Note that there is no absolute guidance or specific definition of ratios and therefore special consideration should be undertaken when ratios are used to make comparison either in a cross-sectional analysis or Inter-firm (as described above).
Limitations of ratios and potential impact in the financial analysis
• Ratios are not predictive, as they are usually based on historical information notwithstanding ratios can be used as a tool to assist financial analysis.
• They help to focus attention systematically on important areas and summarise information in an understandable form and assist in identifying trends and relationships (see methods for facilitating the financial analysis above).
• However they do not reflect the future perspectives of a company, as they ignore future action by management.
• They can be easily manipulated by window dressing or creative accounting and may be distorted by differences in accounting policies.
• Inflation should be taken into consideration when a Ratio Analysis is being applied as it can distort comparisons and lead to inappropriate conclusions.
• Comparisons with industry averages is difficult for a conglomerate firm since it operates in many different market segments.
• Seasonal factors may distort ratios and thus must be taken into account when making ratios are used for financial analysis.
• Not always easy to tell that a ratio is good or bad. Must be always used as an additional tool to back up or confirm other financial information gathered.
• Different operating and accounting practices can distort comparisons.
Ratio Analysis
TABLE OF CONTENTS
Q.1. What is meant by accounting ratios? How are they useful?
Answer: A relationship between various accounting figures, which are connected with each other, expressed in mathematical terms, is called accounting ratios.
According to Kennedy and Macmillan, "The relationship of one item to another expressed in simple mathematical form is known as ratio."
Robert Anthony defines a ratio as – "simply one number expressed in terms of another."
Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations. Absolute figures are useful but they do not convey much meaning. In terms of accounting ratios, comparison of these related figures makes them meaningful. For example, profit shown by two-business concern is Rs. 50,000 and Rs. 1,00,000. It is difficult to say which business concern is more efficient unless figures of capital investment or sales are also available.
Analysis and interpretation of various accounting ratio gives a better understanding of the financial condition and performance of a business concern.
Q.2. What do you mean by ratio analysis? What are the advantages of such analysis? Also point out the limitations of ratio analysis.
Answer: Ratio analysis is one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern. Simply, ratio means the comparison of one figure to other relevant figure or figures.
According to Myers, " Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements."
Advantages and Uses of Ratio Analysis
There are various groups of people who are interested in analysis of financial position of a company. They use the ratio analysis to workout a particular financial characteristic of the company in which they are interested. Ratio analysis helps the various groups in the following manner: -
1. To workout the profitability: Accounting ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern. In this way profitability ratios show the actual performance of the business.
2. To workout the solvency: With the help of solvency ratios, solvency of the company can be measured. These ratios show the relationship between the liabilities and assets. In case external liabilities are more than that of the assets of the company, it shows the unsound position of the business. In this case the business has to make it possible to repay its loans.
3. Helpful in analysis of financial statement: Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc.
4. Helpful in comparative analysis of the performance: With the help of ratio analysis a company may have comparative study of its performance to the previous years. In this way company comes to know about its weak point and be able to improve them.
5. To simplify the accounting information: Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations.
6. To workout the operating efficiency: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilising the resources.
7. To workout short-term financial position: Ratio analysis helps to workout the short-term financial position of the company with the help of liquidity ratios. In case short-term financial position is not healthy efforts are made to improve it.
8. Helpful for forecasting purposes: Accounting ratios indicate the trend of the business. The trend is useful for estimating future. With the help of previous years’ ratios, estimates for future can be made. In this way these ratios provide the basis for preparing budgets and also determine future line of action.
Limitations of Ratio Analysis
In spite of many advantages, there are certain limitations of the ratio analysis techniques and they should be kept in mind while using them in interpreting financial statements. The following are the main limitations of accounting ratios:
1. Limited Comparability: Different firms apply different accounting policies. Therefore the ratio of one firm can not always be compared with the ratio of other firm. Some firms may value the closing stock on LIFO basis while some other firms may value on FIFO basis. Similarly there may be difference in providing depreciation of fixed assets or certain of provision for doubtful debts etc.
2. False Results: Accounting ratios are based on data drawn from accounting records. In case that data is correct, then only the ratios will be correct. For example, valuation of stock is based on very high price, the profits of the concern will be inflated and it will indicate a wrong financial position. The data therefore must be absolutely correct.
3. Effect of Price Level Changes: Price level changes often make the comparison of figures difficult over a period of time. Changes in price affects the cost of production, sales and also the value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison.
4. Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision making. For example, average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis.
5. Effect of window-dressing: In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way.
6. Costly Technique: Ratio analysis is a costly technique and can be used by big business houses. Small business units are not able to afford it.
7. Misleading Results: In the absence of absolute data, the result may be misleading. For example, the gross profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000 and sales are Rs. 20,000 and profit earned by the other one is Rs. 10,00,000 and sales are Rs. 40,00,000. Even the profitability of the two firms is same but the magnitude of their business is quite different.
1.8. Absence of standard university accepted terminology: There are no standard ratios, which are universally accepted for comparison purposes. As such, the significance of ratio analysis technique is reduced.
Q.3. Classify the various profitability ratios. Also explain the meaning, method of calculation and objective of these ratios.
Answer:
Classification of various profitability ratios: -
a. Gross Profit Ratio (CBSE Outside Delhi 2001, Delhi 2002)
b. Net Profit Ratio
c. Operating Net Profit Ratio
d. Operating Ratio (CBSE Outside Delhi 2001)
e. Return on Investment or Return on Capital Employed (CBSE 1998, 2000, Outside Delhi 2001)
f. Return on Equity (CBSE 1999)
g. Earning Per Share (CBSE Outside Delhi 2001)
Meaning, Objective and Method of Calculation: -
a. Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner: -
Gross Profit Ratio = Gross Profit/Net Sales x 100
Where Gross Profit = Net Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
And Net Sales = Total Sales – Sales Return
Objective and Significance: Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. The gross profit ratio of current year is compared to previous years’ ratios or it is compared with the ratios of the other concerns. The minor change in the ratio from year to year may be ignored but in case there is big change, it must be investigated. This investigation will be helpful to know about any departure from the standard mark-up and would indicate losses on account of theft, damage, bad stock system, bad sales policies and other such reasons.
However it is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realisation of fixed expenses of the business.
b. Net Profit Ratio: Net Profit Ratio shows the relationship between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner: -
Net Profit Ratio = Net Profit/Net Sales x 100
Where Net Profit = Gross Profit – Selling and Distribution Expenses – Office and Administration Expenses – Financial Expenses – Non Operating Expenses + Non Operating Incomes.
And Net Sales = Total Sales – Sales Return
Objective and Significance: In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years’ ratios, the increment shows the efficiency of the concern.
c. Operating Profit Ratio: Operating Profit means profit earned by the concern from its business operation and not from the other sources. While calculating the net profit of the concern all incomes either they are not part of the business operation like Rent from tenants, Interest on Investment etc. are added and all non-operating expenses are deducted. So, while calculating operating profit these all are ignored and the concern comes to know about its business income from its business operations.
Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner: -
Operating Profit Ratio = Operating Profit/Net Sales x 100
Where Operating Profit = Gross Profit – Operating Expenses
Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes
And Net Sales = Total Sales – Sales Return
Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.
d. Operating Ratio: Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses.
Operating Ratio = Operating Cost/Net Sales x 100
Where Operating Cost = Cost of goods sold + Operating Expenses
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Operating Expenses = Selling and Distribution Expenses, Office and Administration Expenses, Repair and Maintenance.
Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit.
e. Return on Investment or Return on Capital Employed: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.
Return on Capital Employed
= Net Profit before Interest, Tax and Dividend/Capital Employed x 100
Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets
Or
Capital Employed = Fixed Assets + Current Assets – Current Liabilities
Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.
f. Return on Equity: Return on equity is also known as return on shareholders’ investment. The ratio establishes relationship between profit available to equity shareholders with equity shareholders’ funds.
Return on Equity
= Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders’ Funds x 100
Where Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Fictitious Assets
Objective and Significance: Return on Equity judges the profitability from the point of view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of equity funds invested in the firm. The investors favour the company with higher ROE.
g. Earning Per Share: Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares.
Earning Per Share
= Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares
Objective and Significance: Earning per share helps in determining the market price of the equity share of the company. It also helps to know whether the company is able to use its equity share capital effectively with compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.
• Horizontal Analysis - the analysis is based on a year-to-year comparison of a firm's ratios,
• Vertical Analysis - the comparison of Balance Sheet accounts either using ratios or not, to get useful information and draw useful conclusions, and
• Cross-sectional Analysis - ratios are used and compared between several firms of the same industry in order to draw conclusions about an entity's profitability and financial performance. Inter-firm Analysis can be categorized under Cross-sectional, as the analysis is done by using some basic ratios of the Industry in which the firm under analysis belongs to (and specifically, the average of all the firms of the industry) as benchmarks or the basis for our firm's overall performance evaluation.
The informational needs and appropriate analytical techniques needed for specific investment and credit decisions are a function of the decision maker’s time horizon(short versus long term investors and creditors). A pervasive problem when comparing a firm’s performance over time(trend or time series analysis) or with other firms(cross sectional or common size analysis) is changes in the firm’s size over time and the different sizes of firms which are being compared. However, one approach to this problem is to use common size statements in which the various components of the financial statements are standardized by expressing them as a percentage of some base (base in the income statement is sales and base in the balance sheet is total assets). See sample file below for further understanding.
In general, a process of standardization is being achieved by the use of ratios. They can be used to standardize financial statements allowing for comparisons over time, industry, sector and cross-sectionally between firms and further facilitate the evaluation of the efficiency of operations and/or the risk of the firm’s operations regarding the scope and purpose of evaluation. Ratios measure a firm’s crucial relationships by relating inputs(costs) with output(benefits) and facilitate comparisons of these relationships over time and across firms.
Many attractive categories of financial ratios and numerous individual ratios have been proposed in the literature. The most prominent literature on financial analysis - though non-exhaustive - indicates the following categories of ratios:
Profitability
• Gross Profit ratio = ( Gross Profit / Sales) * 100
• Operating Profit = ( Operating profit / Sales) * 100
• Return on Capital Employed (ROCE) , in times = ( Profit before interest and tax / Capital Employed)
or Return on Equity (ROE), in times = Net Income ÷ (Average Equity during the period)
Very often, the reported profits are adjusted to reflect sustainable levels of performance and thus instill more meaning to the computation and interpretation of the financial ratios. In this context, EBITDA is used, which is calculated by excluding from the profit figure the tax, interest, depreciation and amortisation amount. Non-reccuring expenses or income is also excluded when this can be substantiated to enhance the interpretation of the derived ratio figures. EBITDA figure can be used as an approximation of the underlying cash flows which at the same time incorporate the future potentials of the company's profitability rather than just the cash generation of a financial year.
Activity or Management Efficiency ratios
• Debtors days, in days = ( Av. Debtors / Sales ) * 365
• Creditors days, in days = ( Av. Creditors / COGS ) * 365, where COGS is the Cost of Goods Sold by the firm
• Stock days, in days = ( Av. Stock / COGS ) * 365
Where "Av.", is the Average amount of the opening and closing balance of the corresponding account of the financial year the Analysis is being undertaken.
Market or Investment ratios
• Dividend cover, in times = ( Profit after tax / dividends )
• Dividend yield = ( Dividend / Share price )
• P/E = ( Share price / Earnings per share )
• EPS = ((Profit after tax - pref. dividends) / Total number of ordinary shares outstanding )
Each category can be further utilized and an in-depth analysis can be adopted to reflect the corresponding needs of each user, i.e. a bank considering whether to lend a specific company would focus more on financial and liquidity - as the risk of lending to a company that does not have the resources to repay the loan is of great concern for a bank - and profitability ratios, to see whether the company's earnings are adequate to cover the interest on the loan. An analysis from an investor's point of view on the other hand would focus more on profitability and investment ratios, to evaluate the prospects of his potential returns.
Note that there is no absolute guidance or specific definition of ratios and therefore special consideration should be undertaken when ratios are used to make comparison either in a cross-sectional analysis or Inter-firm (as described above).
Limitations of ratios and potential impact in the financial analysis
• Ratios are not predictive, as they are usually based on historical information notwithstanding ratios can be used as a tool to assist financial analysis.
• They help to focus attention systematically on important areas and summarise information in an understandable form and assist in identifying trends and relationships (see methods for facilitating the financial analysis above).
• However they do not reflect the future perspectives of a company, as they ignore future action by management.
• They can be easily manipulated by window dressing or creative accounting and may be distorted by differences in accounting policies.
• Inflation should be taken into consideration when a Ratio Analysis is being applied as it can distort comparisons and lead to inappropriate conclusions.
• Comparisons with industry averages is difficult for a conglomerate firm since it operates in many different market segments.
• Seasonal factors may distort ratios and thus must be taken into account when making ratios are used for financial analysis.
• Not always easy to tell that a ratio is good or bad. Must be always used as an additional tool to back up or confirm other financial information gathered.
• Different operating and accounting practices can distort comparisons.
Ratio Analysis
TABLE OF CONTENTS
Q.1. What is meant by accounting ratios? How are they useful?
Answer: A relationship between various accounting figures, which are connected with each other, expressed in mathematical terms, is called accounting ratios.
According to Kennedy and Macmillan, "The relationship of one item to another expressed in simple mathematical form is known as ratio."
Robert Anthony defines a ratio as – "simply one number expressed in terms of another."
Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations. Absolute figures are useful but they do not convey much meaning. In terms of accounting ratios, comparison of these related figures makes them meaningful. For example, profit shown by two-business concern is Rs. 50,000 and Rs. 1,00,000. It is difficult to say which business concern is more efficient unless figures of capital investment or sales are also available.
Analysis and interpretation of various accounting ratio gives a better understanding of the financial condition and performance of a business concern.
Q.2. What do you mean by ratio analysis? What are the advantages of such analysis? Also point out the limitations of ratio analysis.
Answer: Ratio analysis is one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern. Simply, ratio means the comparison of one figure to other relevant figure or figures.
According to Myers, " Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements."
Advantages and Uses of Ratio Analysis
There are various groups of people who are interested in analysis of financial position of a company. They use the ratio analysis to workout a particular financial characteristic of the company in which they are interested. Ratio analysis helps the various groups in the following manner: -
1. To workout the profitability: Accounting ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern. In this way profitability ratios show the actual performance of the business.
2. To workout the solvency: With the help of solvency ratios, solvency of the company can be measured. These ratios show the relationship between the liabilities and assets. In case external liabilities are more than that of the assets of the company, it shows the unsound position of the business. In this case the business has to make it possible to repay its loans.
3. Helpful in analysis of financial statement: Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc.
4. Helpful in comparative analysis of the performance: With the help of ratio analysis a company may have comparative study of its performance to the previous years. In this way company comes to know about its weak point and be able to improve them.
5. To simplify the accounting information: Accounting ratios are very useful as they briefly summarise the result of detailed and complicated computations.
6. To workout the operating efficiency: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilising the resources.
7. To workout short-term financial position: Ratio analysis helps to workout the short-term financial position of the company with the help of liquidity ratios. In case short-term financial position is not healthy efforts are made to improve it.
8. Helpful for forecasting purposes: Accounting ratios indicate the trend of the business. The trend is useful for estimating future. With the help of previous years’ ratios, estimates for future can be made. In this way these ratios provide the basis for preparing budgets and also determine future line of action.
Limitations of Ratio Analysis
In spite of many advantages, there are certain limitations of the ratio analysis techniques and they should be kept in mind while using them in interpreting financial statements. The following are the main limitations of accounting ratios:
1. Limited Comparability: Different firms apply different accounting policies. Therefore the ratio of one firm can not always be compared with the ratio of other firm. Some firms may value the closing stock on LIFO basis while some other firms may value on FIFO basis. Similarly there may be difference in providing depreciation of fixed assets or certain of provision for doubtful debts etc.
2. False Results: Accounting ratios are based on data drawn from accounting records. In case that data is correct, then only the ratios will be correct. For example, valuation of stock is based on very high price, the profits of the concern will be inflated and it will indicate a wrong financial position. The data therefore must be absolutely correct.
3. Effect of Price Level Changes: Price level changes often make the comparison of figures difficult over a period of time. Changes in price affects the cost of production, sales and also the value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison.
4. Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision making. For example, average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis.
5. Effect of window-dressing: In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way.
6. Costly Technique: Ratio analysis is a costly technique and can be used by big business houses. Small business units are not able to afford it.
7. Misleading Results: In the absence of absolute data, the result may be misleading. For example, the gross profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000 and sales are Rs. 20,000 and profit earned by the other one is Rs. 10,00,000 and sales are Rs. 40,00,000. Even the profitability of the two firms is same but the magnitude of their business is quite different.
1.8. Absence of standard university accepted terminology: There are no standard ratios, which are universally accepted for comparison purposes. As such, the significance of ratio analysis technique is reduced.
Q.3. Classify the various profitability ratios. Also explain the meaning, method of calculation and objective of these ratios.
Answer:
Classification of various profitability ratios: -
a. Gross Profit Ratio (CBSE Outside Delhi 2001, Delhi 2002)
b. Net Profit Ratio
c. Operating Net Profit Ratio
d. Operating Ratio (CBSE Outside Delhi 2001)
e. Return on Investment or Return on Capital Employed (CBSE 1998, 2000, Outside Delhi 2001)
f. Return on Equity (CBSE 1999)
g. Earning Per Share (CBSE Outside Delhi 2001)
Meaning, Objective and Method of Calculation: -
a. Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner: -
Gross Profit Ratio = Gross Profit/Net Sales x 100
Where Gross Profit = Net Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
And Net Sales = Total Sales – Sales Return
Objective and Significance: Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. The gross profit ratio of current year is compared to previous years’ ratios or it is compared with the ratios of the other concerns. The minor change in the ratio from year to year may be ignored but in case there is big change, it must be investigated. This investigation will be helpful to know about any departure from the standard mark-up and would indicate losses on account of theft, damage, bad stock system, bad sales policies and other such reasons.
However it is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realisation of fixed expenses of the business.
b. Net Profit Ratio: Net Profit Ratio shows the relationship between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner: -
Net Profit Ratio = Net Profit/Net Sales x 100
Where Net Profit = Gross Profit – Selling and Distribution Expenses – Office and Administration Expenses – Financial Expenses – Non Operating Expenses + Non Operating Incomes.
And Net Sales = Total Sales – Sales Return
Objective and Significance: In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years’ ratios, the increment shows the efficiency of the concern.
c. Operating Profit Ratio: Operating Profit means profit earned by the concern from its business operation and not from the other sources. While calculating the net profit of the concern all incomes either they are not part of the business operation like Rent from tenants, Interest on Investment etc. are added and all non-operating expenses are deducted. So, while calculating operating profit these all are ignored and the concern comes to know about its business income from its business operations.
Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner: -
Operating Profit Ratio = Operating Profit/Net Sales x 100
Where Operating Profit = Gross Profit – Operating Expenses
Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes
And Net Sales = Total Sales – Sales Return
Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.
d. Operating Ratio: Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses.
Operating Ratio = Operating Cost/Net Sales x 100
Where Operating Cost = Cost of goods sold + Operating Expenses
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Operating Expenses = Selling and Distribution Expenses, Office and Administration Expenses, Repair and Maintenance.
Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit.
e. Return on Investment or Return on Capital Employed: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.
Return on Capital Employed
= Net Profit before Interest, Tax and Dividend/Capital Employed x 100
Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets
Or
Capital Employed = Fixed Assets + Current Assets – Current Liabilities
Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.
f. Return on Equity: Return on equity is also known as return on shareholders’ investment. The ratio establishes relationship between profit available to equity shareholders with equity shareholders’ funds.
Return on Equity
= Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders’ Funds x 100
Where Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Fictitious Assets
Objective and Significance: Return on Equity judges the profitability from the point of view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of equity funds invested in the firm. The investors favour the company with higher ROE.
g. Earning Per Share: Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares.
Earning Per Share
= Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares
Objective and Significance: Earning per share helps in determining the market price of the equity share of the company. It also helps to know whether the company is able to use its equity share capital effectively with compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.