RATIO ANALYSIS

  • 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:
  1. Different methods of trading followed by them
  2. Different uses of sources of capital
  3. 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.

    Advantages

    1. It is concerned with significant data relationships which give the decision maker insights into the company being assessed.
    2. It involves a study of total financial picture. By evaluating this the analyst can recommend and indicate positive action with confidence.
    3. It helps in predicting company failures
    4. It helps the management to analyze business situations and to monitor their performance as well as that of competitors.
    5. It helps to chalk out future plans for the company

        Current ratio 

        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) 

        Current assets

        • 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.

          Current liabilities

          • 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

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