- The Latin word ratio stands for reason. In English ratio stands for relationship. Ratio analysis is defined as the establishment of a reasoned relationship of a fixed variable character between measurements of certain phenomenon having some kind of linkage. It shows the arithmetical relationship between two figures.
- Inter firm comparison of ratios is helpful to illustrate:
- Different methods of trading followed by them
- Different uses of sources of capital
- Different policies followed
- Ratio analysis is a method or process by which the relationship of items or groups of items in the financial statements are computed and presented.
- It is an important tool of financial analysis.
- It is used to interpret the financial statements so that the strengths and weakness of a firm, its historical performance and current financial condition can be determined.
- It is concerned with significant data relationships which give the decision maker insights into the company being assessed.
- It involves a study of total financial picture. By evaluating this the analyst can recommend and indicate positive action with confidence.
- It helps in predicting company failures
- It helps the management to analyze business situations and to monitor their performance as well as that of competitors.
- It helps to chalk out future plans for the company
It is calculated by dividing current assets by current liabilities.
Current ratio= current assets/ current liabilities
(conventionally a current ratio of 2:1 is considered satisfactory)
- Inventories of raw material, WIP, finished goods, stores, spares, sundry debtors, short term loans and bank, prepaid expenses, incomes receivable and marketable investmemts and short term securities.
- Sundry creditors, bills payable, outstanding expenses, unclaimed dividend, advances received, incomes received in advance, provisions for taxation.
Quick ratio or acid ratio
- This is a ratio between quick current assets and current liabilities(alternatively quick liabilities)
- It is calculated by dividing quick current assets by current liabilities (quick current liabilities)
Quick ratio= quick assets/ current liabilities
(conventionally a quick ratio of 1:1 is considered satisfactory)
- Quick assets are current liabilities less prepaid expenses and Inventories
- Quick liabilities are current liabilities less bank overdraft and incomes received in advance.
Debt equity ratio
- This ratio indicates the relative proportion of debt and equity in financing the assets of the firm. It is calculated by dividing long-term debt by shareholder’s fund.
Debt equity ratio = longterm debts/share holders funds
Generally financial institutions favour 2:1, however