RATIO ANALYSIS Let us first understand the definition of ratio and meaning of ratio analysis 3.2.1 Definition of Ratio A ratio is defined as “the indicated quotient of two mathematical expressions and as the relationship between two or more things.” Here ratio means financial ratio or accounting ratio which is a mathematical expression of the relationship between accounting figures. 3.2.2 Ratio Analysis The term financial ratio can be explained by defining how it is calculated and what the objective of this calculation is a. Calculation Basis (Basis of Calculation) > — Atelationship expressed in mathematical terms; > — Between two individual figures or group of figures; > — Connected with each other in some logical manner; and » — Selected from financial statements of the concern b. Objective for financial ratios is that all stakeholders (owners, investors, lenders, employees etc.) can draw conclusions about the > Performance (past, present and future); a Strengths & weaknesses of a firm; and » — Can take decisions in relation to the firm. Ratio analysis is based on the fact that a single accounting figure by itself may not communicate any meaningful information but when expressed relative to some other figure, it may definitely provide some significant information. Ratio analysis is not just comparing different numbers from the balance sheet, income statement, and cash flow statement. It is comparing the number against previous years, other companies, the industry, or even the economy in general for the purpose of financial analysis. 3.2.3 Sources of Financial Data for Analysis The sources of information for financial statement analysis are: 1, Annual ReportsInterim financial statements Notes to Accounts Statement of cash flows Business periodicals. ak wn Credit and investment advisory services ‘G 3.3 TYPES OF RATIOS Liquidity Ratios*/ Short- term Solvency Ratios Capital Structure Ratios Leverage Ratios/ Long term Solvency Ratios Activity Ratios/ Performance Ratios/ iJumover|Ratiass Related to overall Return ‘on Investment (Assets/ Capital Employed/ Equity) Types of Ratios Profitability Ratios Required for analysis from Owner's point of view Related to Market/ Valuation/ Investors “Liquidity ratios should be examined taking relevant turnover ratios into consideration. 3.3.1 Liquidity Ratios The terms ‘liquidity’ and ‘short-term solvency’ are used synonymously. Classification of RatiosLiquidity or short-term solvency means ability of the business to pay its short- term liabilities. Inability to pay-off short-term liabilities affects its credibility as well as its credit rating. Continuous default on the part of the business leads to commercial bankruptcy. Eventually such commercial bankruptcy may lead to its sickness and dissolution. Short-term lenders and creditors of a business are very much interested to know its state of liquidity because of their financial stake. Both lack of sufficient liquidity and excess liquidity is bad for the organization. (a) Current Ratio: The Current Ratio is one of the best known measures of short term solvency. It is the most common measure of short-term liquidity. The main question this ratio addresses is: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets?” Current Ratio Where, Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances + Receivables/ Accruals + Loans and Advances + Disposable Investments + Any other current assets. Current Liabilities = Creditors for goods and services + Short- term Loans + Bank Overdraft + Cash Credit + Outstanding Expenses + Provision for Taxation + Proposed Dividend + Unclaimed Dividend + Any other current liabilities.The main question this ratio addresses is: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets?” Interpretation A generally acceptable current ratio is 2:1. But whether or not a specific ratio is satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. (b) Quick Ratio: The Quick Ratio is sometimes called the “acid-test" ratio and is one of the best measures of liquidity. Quick Assets Current Liabilities Where, Quick Assets = Current Assets - Inventories ~ Prepaid expenses Current Liabilities = As mentioned under Current Ratio. The Quick Ratio is a much more conservative measure of short-term liquidity than the Current Ratio. It helps answer the question: “if all sales revenues should disappear, could my business meet its current obligations with the readily convertible quick funds on hand?" Quick Assets consist of only cash and near cash assets. Inventories are deducted from current assets on the belief that these are not ‘near cash assets’ and also because in times of financial difficulty inventory may be saleable only at liquidation value. But in a seller’s market inventories are also near cash assets. Interpretation An acid-test of 1:1 is considered satisfactory unless the majority of "quick assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities. (©) Cash Ratio/ Absolute Liquidity Ratio: The cash ratio measures the absolute liquidity of the business. This ratio considers only the absolute liquidity available with the firm. This ratio is calculated as:Cash and Bank balances + Marketable Securi Current Liabilities Cash Ratio = Or, Cash and Bankbalances + Current Investments Current Liabilities Interpretation The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities/ current investments. (d) Basic Defense Interval/ Interval Measure: Cash and Bank balances + Marketable Securities ‘Opearing Expenses = No.of days (say 360) Basic Defense Interval = Current Asset Interval Measure = Current Assets “Inventories. Daily Operating Expenses Cost of GoodsSold+Selling Administartion and other General expenses -Depreciationand othernon cash expenditure No. ofdays in a year Daily Operating Expenses = Interpretation If for some reason all the company’s revenues were to suddenly cease, the Basic Defense Interval would help determine the number of days for which the company can cover its cash expenses without the aid of additional financing. (e) Net Working Capital Ratio: Net working capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It i calculated as shown below: Net Working Capi Current Assets-Current Lial (Excluding short-term bank borrowing)Interpretation Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are often tied to minimum working capital requirements. 3.3.2 Long-term Solvency Ratios /Leverage Ratios The leverage ratios may be defined as those financial ratios which measure the long term stability and structure of the firm. These ratios indicate the mix of funds provided by owners and lenders and assure the lenders of the long term funds with regard to: (i) Periodic payment of interest during the period of the loan and (ii) Repayment of principal amount on maturity. Leverage ratios are of two types: 1 Capital Structure Ratios (a) Equity Ratio (b) Debt Ratio () Debt to Equity Ratio (d) Debt to Total Assets Ratio (e) Capital Gearing Ratio (f) Proprietary Ratio 2. Coverage Ratios (a) Debt-Service Coverage Ratio (DSCR) (b) Interest Coverage Ratio (©) Preference Dividend Coverage Ratio (d) Fixed Charges Coverage Ratio 3.3.2.1 Capital Structure Ratios These ratios provide an insight into the financing techniques used by a business and focus, as a consequence, on the long-term solvency position.From the balance sheet one can get only the absolute fund employed and its sources, but only capital structure ratios show the relative weight of different sources. Various capital structure ratios are: (a)__ Equity Ratio: Shareholders' Equity CapitalEmployed Equity Ratio = This ratio indicates proportion of owners’ fund to total fund invested in the business. Traditionally, it is believed that higher the proportion of owners’ fund lower is the degree of risk. (b) Debt Ratio: Debt Ratio = Total outside liabilities Total Debt+ Net worth Or, Debt Ratio = Total Debt Net Assets Total debt or total outside liabilities includes short and long term borrowings from financial institutions, debentures/bonds, deferred payment arrangements for buying capital equipment, bank borrowings, public deposits and any other interest bearing loan. Interpretation This ratio is used to analyse the long-term solvency of a firm. (©)__Debt to Equity Rati Debt to Equity Ratio = tal Outside Liabilities _ ___Total Debt" _ Shareholders'Equity Shareholders’ Equity Or, Long-term Debt ** Shareholders' equity “Not merely long-term debt. ** Sometimes only interest-bearing, long term debt is used instead of total liabilities (exclusive of current liabilities)The shareholders’ equity is equity and preference share capital + post accumulated profits (excluding fictitious assets etc). Interpretation A high debt to equity ratio here means less protection for creditors, a low ratio, ‘on the other hand, indicates a wider safety cushion (i.e., creditors feel the owner's funds can help absorb possible losses of income and capital). This ratio indicates the proportion of debt fund in relation to equity. This ratio is very often referred in capital structure decision as well as in the legislation dealing with the capital structure decisions (i.e. issue of shares and debentures). Lenders are also very keen to know this ratio since it shows relative weights of debt and equity. Debt equity ratio is the indicator of firm’s financial leverage. (d) Debt to Total Assets Ratio: This ratio measures the proportion of total assets financed with debt and, therefore, the extent of financial leverage. Total Outside Liabilities Total Assets Debt to Total Assets Ratio = Or, Total Debt Total Assets (e) Capital Gearing Ratio: In addition to debt-equity ratio, sometimes capital gearing ratio is also calculated to show the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders i.e. equity funds or net worth. (Preference Share Capital + Debentures + Other Borrowed funds) Capital Gearing ratio = (Equity Share Capital + Reserves & Surplus -Losses) (f)_ Proprietary Ra‘ Proprietary Fund Proprietary Ratio P "y Total Assets Proprietary fund includes Equity Share Capital + Preference Share Capital + Reserve & Surplus. Total assets exclude fictitious assets and losses. Interpretation It indicates the proportion of total assets financed by shareholders.3.3.2.2 Coverage Ratios The coverage ratios measure the firm’s ability to service the fixed li ies. These ratios establish the relationship between fixed claims and what is normally available out of which these claims are to be paid. The fixed claims consist of: (i) Interest on loans (ii) Preference dividend (iii) Amortisation of principal or repayment of the instalment of loans or redemption of preference capital on maturity. The following are important coverage ratios: (a) Debt Service Coverage Ratio (DSCR): Lenders are interested in debt service coverage to judge the firm's ability to pay off current interest and instalments. Earnings available for debt services Interest + Instalments. Debt Service Coverage Ratio = Earning for debt services = Net profit (Earning after taxes) + Non-cash operating expenses like depreciation and other amortizations + Interest +other adjustments like loss on sale of Fixed Asset etc. *Fund from operations (or cash from operations) before interest and taxes also can be considered as per the requirement. Interpretation Normally DSCR of 1.5 to 2 is satisfactory. You may note that sometimes in both numerator and denominator lease rentals may be added. (b) Interest Coverage Ratio: This ratio also known as “times interest earned ratio” indicates the firm's ability to meet interest (and other fixed-charges) obligations. This ratio is computed as: Earnings beforeinterest and taxes(EBIT) Interest Coverage Ratio = InterestInterpretation Earnings before interest and taxes are used in the numerator of this ratio because the ability to pay interest is not affected by tax burden as interest on debt funds is deductible expense. This ratio indicates the extent to which earnings may fall without causing any embarrassment to the firm regarding the payment of interest charges. A high interest coverage ratio means that an enterprise can easily meet its interest obligations even if earnings before interest and taxes suffer a considerable decline. A lower ratio indicates excessive use of debt or inefficient operations. (©) Preference Dividend Coverage Ratio: This ratio measures the ability of a firm to pay dividend on preference shares which carry a stated rate of return. This ratio is computed as: Net Profit /Earning after taxes (EAT) Preference Dividend Coverage Ratio Earnings after tax is considered because unlike debt on which interest is charged on the profit of the firm, the preference dividend is treated as appropriation of profit. Interpretation This ratio indicates margin of safety available to the preference shareholders. A higher ratio is desirable from preference shareholders point of view. Similarly Equity Dividend coverage ratio can also be calculated taking (EAT - Pref. Dividend) and equity fund figures into consideration. (d) Fixed Charges Coverage Ratio: This ratio shows how many times the cash flow before interest and taxes covers all fixed financing charges. This ratio of more than 1 is considered as safe. EBIT + Depreciation Repaymentofloan 1-taxrate Fixed Charges Coverage Ratio = Interest +2. Ratios shall be calculated based on requirement and availability and may deviate from original formulae. 3. Numerator should be taken in correspondence with the denominator and vice-versa. 3.3.3 Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios These ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets. For this reason, they are often called ‘Asset management ratios’. These ratios usually indicate the frequency of sales with respect to its assets. These assets may be capital assets or working capital or average inventory. Activity Ratios/ E1 (a) Total Assets Turnover Ratio ncy Ratios/ Performance Ratios/ Turnover Ratios: (b) Fixed Assets Turnover Ratio (©) Capital Turnover Ratio (d) Current Assets Turnover Ratio (€) Working Capital Turnover Ratio (i) Inventory/ Stock Turnover Ratio (i) Receivables (Debtors) Turnover Ratio (ii) | Payables (Creditors) Turnover Ratio. These ratios are usually calculated with reference to sales/cost of goods sold and are expressed in terms of rate or times. Asset Turnover Ratios: Based on different concepts of assets employed, it can be expressed as follows: (a) Total Asset Turnover Ratio: This ratio measures the efficiency with which the firm uses its total assets. This ratio is computed a:(b) Fixed Assets Turnover Ratio: It measures the efficiency with which the firm uses its fixed assets. terpretation A high fixed assets turnover ratio indicates efficient utilisation of fixed assets in generating sales. A firm whose plant and machinery are old may show a higher fixed assets turnover ratio than the firm which has purchased them recently. (c) Capital Turnover Ratio/ Net Asset Turnover Ratio: Sales /Costof GoodsSold Net Assets Capital Turnover Ratio = Interpretation This ratio indicates the firm's ability of generating sales/ Cost of Goods Sold per rupee of long term investment. The higher the ratio, the more efficient is the utilisation of owner's and long-term creditors’ funds. Net Assets includes Net Fixed Assets and Net Current Assets (Current Assets - Current Liabilities). Since Net Assets equals to capital employed it is also known as Capital Turnover Ratio. (d) Current Assets Turnover Ratio: It measures the efficiency using the current assets by the firm. Sales /Costof GoodsSold Current Assets Current Assets Turnover Ratio = (e)_ Working Capital Turnover Ratio: Working Capital Turnover Ratio = S2188/CostofGoodssold Working Capital Interpretation Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover, and Creditors Turnover. Note: Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capita also can be taken. (i) Inventory/ Stock Turnover Ratio: This ratio also known as stock turnover ratio establishes the relationship between the cost of goods sold during theyear and average inventory held during the year. It measures the efficiency with which a firm utilizes or manages its inventory. It is calculated as follows: CostofGoodsSold / Sales ‘Average Inventory * Inventory Turnover Ratio = OpeningStock+ClosingStock “average Inventory = In the case of inventory of raw material the inventory turnover ratio is calculated using the following formula : Raw Material Inventory Turnover Ratio= _Raw Material Consumed Average Raw Mate! Interpretation This ratio indicates that how fast inventory is used or sold. A high ratio is good from the view point of liquidity and vice versa. A low ratio would indicate that inventory is not used/ sold/ lost and stays in a shelf or in the warehouse for a long time. (ii) Receivables (Debtors) Turnover Ratio: In case firm sells goods on credit, the realization of sales revenue is delayed and the receivables are created. The cash is realised from these receivables later on. The speed with which these receivables are collected affects the liquidity position of the firm. The debtor's turnover ratio throws light on the collection and credit policies of the firm. It measures the efficiency with which management is managing its accounts receivables. It is calculated as follows: Receivable (Debtor) Turnover Ratio = CreditSales Average AccountsReceivable Receivables (Debtors’) Velocity: Debtors’ turnover ratio indicates the average collection period. However, the average collection period can be directly calculated as follows:Receivable Velocity/ Average Collection Period = Average Accounts Receivables Average Daily Credit Sales Or, = 12 months /S2weeks /360days Receivable TurnoverRatio Average Daily Credit Sales = averageDai Credit Sales Interpretation The average collection period measures the average number of days it takes to collect an account receivable. This ratio is also referred to as the number of days of receivable and the number of day's sales in receivables. Payables Turnover Ratio: This ratio is calculated on the same lines as receivable turnover ratio is calculated. This ratio shows the velocity of payables payment by the firm. It is calculated as follows: Annual Net Credit Purchases Payables Turnover Ratio = “TUS N&t Creclt Purchases ‘Average Accounts Payables A low creditor's turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are settled rapidly. Payable Velocity/ Average payment period can be calculated using: Average Accounts Payable ~ Average Daily Credit Purchases Or, = 12months /52weeks /360 days Payables TurnoverRa\ In determining the credit policy, debtor's turnover and average collection period provide a unique guidance. Interpretation The firm can compare what credit period it receives from the suppliers and what it offers to the customers, Also it can compare the average credit period offered to the customers in the industry to which it belongs.The above three ratios i.e. Inventory Turnover Ratio/ Receivables Turnover Ratio are also relevant to examine liquidity of an organization. Notes for calculating Ratios: 1. Only selling & distribution expenses differentiate Cost of Goods Sold (COGS) and Cost of Sales (COS) in its absence, COGS will be equal to sales. 2. We can consider Cost of Goods Sold/ Cost of Sales to calculate turnover ratios eliminating profit part. 3. Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capital/ also can be taken in calculating the above ratios. Infact when average figures of total assets, net assets, capital employed, shareholders’ fund etc. are available it may be preferred to calculate ratios by using this information. 4, Ratios shall be calculated based on requirement and availability and may deviate from original formulae. 3.3.4 Profitability Ratios The profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflect the final results of business operations. They are some of the most closely watched and widely quoted ratios. Management attempts to maximize these ratios to maximize firm value. The results of the firm can be evaluated in terms of its earnings with reference to a given level of assets or sales or owner's interest etc. Therefore, the profitability ratios are broadly classified in four categories: (i) Profitability Ratios related to Sales (ii) Profitability Ratios related to overall Return on Investment (iii) Profitability Ratios required for Analysis from Owner's Point of View (iv) _ Profitability Ratios related to Market/ Valuation/ investors. Profitability Ratios are as follows: 1. Profitability Ratios based on Sales (a) Gross Profit Ratio (b) Net Profit Ratio (c) Operating Profit Ratio(d) Expenses Ratio 2. Profitability Ratios related to Overall Return on Assets/ Investments (a) Return on Investments (RO!) (i) Return on Assets (ROA) (ii) Return of Capital Employed (ROCE) (iii) Return on Equity (ROE) 3. Profitability Ratios required for Analysis from Owner's Point of View (a) _ Earnings per Share (EPS) (b) Dividend per Share (DPS) (c) Dividend Payout Ratio (DP) 4. Profitability Ratios related to Market/ Valuation/ Investors (a) Price Earnings (P/E) Ratio (b) Dividend and Earning Yield (c) Market Value/ Book Value per Share (MVBV) (d) QRatio 3.3.4.1 Profitability Ratios based on Sales (a) Gross Profit (G.P) Ratio/ Gross Profit Margin: It measures the percentage of each sale in rupees remaining after payment for the goods sold. Gross Profit Gross Profit Ratio = 100 Sales Interpretation Gross profit margin depends on the relationship between price/ sales, volume and costs. A high Gross Profit Margin is a favourable sign of good management. (b) Net Profit Ratio/ Net Profit Margin: |t measures the relationship between net profit and sales of the business. Depending on the concept of net profit it can be calculated as: NetProfit 195 4, Eamingsaftertaxes (EAT) | 4, Sales Sales (i) Net Profit Ratio =Interpretation Net Profit ratio finds the proportion of revenue that finds its way into profits. A high net profit ratio will ensure positive returns of the business. (c) Operating Profit Ratio: Operating profit ratio is also calculated to evaluate operating performance of business. Operating Profit *100 Sales Operating Profit Ratio = or, Earnings before interest and taxes (EBIT) 99 Sales Where, Operating Profit = Sales — Cost of Goods Sold (COGS) - Expenses Interpretation Operating profit ratio measures the percentage of each sale in rupees that remains after the payment of all costs and expenses except for interest and taxes. This ratio is followed closely by analysts because it focuses on operating results. Operating profit is often referred to as earnings before interest and taxes or EBIT. (d) Expenses Ratio: Based on different concepts of expenses it can be expresses in different variants as below: (i) Cost of Goods Sold (COGS) Ratio £065 500 Sales — Administrative exp.+ Selling & Distribution OH, «gg (i) Operating Expenses Ratio Sales COGS+Operating expenses sales Gi) Operating Ratio = 100 Financialexpenses* *100 Sales iv) Financial Expenses Ratio = “It excludes taxes, loss due to theft, goods destroyed by fire etc.Administration Expenses Ratio and Selling & Distribution Expenses Ratio can also be calculated in similar ways. 3.3.4.2 Profitability Ratios related to Overall Return on Assets/ Investments (a) Return on Investment (ROI): ROI is the most important ratio of all. It is the percentage of return on funds invested in the business by its owners. In short, this ratio tells the owner whether or not all the effort put into the business has been worthwhile. It compares earnings/ returns/ profit with the investment in the company. The RO! is calculated as follows: Return /Profit /Earnings Investment Or, = Return/Profit/Eamings | _ Sales Sales Investment Return on Investment = 100 Return /Profit /Earnings Sales = Profitability Ratio Sales Investment Turnover Ratio = ————__ Investments So, ROI = Profitability Ratio x Investment Turnover Ratio. RO! can be improved either by improving Profitability Ratio or Investment Turnover Ratio or by both.3.3.4.3 Profitability Ratios Required for Analysis from Owner's Point of View (a) Earnings per Share (EPS): The profitability of a firm from the point of view of ordinary shareholders can be measured in terms of earnings n per share basis. This is known as Earnings per share. It is calculated as follows: Netprofitavailable to equity shareholders Earnings per Share (EPS) = Number of equity shares outstanding (b) Dividend per Share (DPS): Earnings per share as stated above reflects the profitability of a firm per share; it does not reflect how much profit is paid as dividend and how much is retained by the business. Dividend per share ratio indicates the amount of profit distributed to equity shareholders per share. It is calculated as: Total Dividend paid to equity shareholders Number of equity shares outstanding Dividend per Share (DPS) = (©) Dividend Payout Ratio (DP): This ratio measures the dividend paid in relation to net earnings. It is determined to see to how much extent earnings per share have been retained by the management for the business. It is computed as: Dividendper equity share(DPS) idend payout Rati mend’ payout Ra Earning perShare(EPS) 3.3.4.4 Profitabi These ratios involve measures that consider the market value of the company's shares. Frequently share prices data are punched with the accounting data to generate new set of information. These are (a) Price- Earnings Ratio, (b) Dividend Yield, (c) Market Value/ Book Value per share, (d) Q Ratio. (a) Price- Earnings Ratio (P/E Ratio): The price earnings ratio indicates the expectation of equity investors about the earnings of the firm. It relates earnings to market price and is generally taken as a summary measure of growth potential of an investment, risk characteristics, shareholders orientation, corporate image and degree of liquidity. It is calculated as Market Price perShare(MPS) Earning perShare(EPS) Ratios related to market/ valuation/ Investors Price-Earnings per Share (P/E Ratio) = Interpretation It indicates the payback period to the investors or prospective investors.G 3.5 APPLICATION OF RATIO ANALYSIS IN FINANCIAL DECISION MAKING A popular technique of analysing the performance of a business concern is that of financial ratio analysis. As a tool of financial management, they are of crucial significance. The importance of ratio analysis lies in the fact that it presents facts on a comparative basis and enables drawing of inferences regarding the performance of a firm. Ratio analysis is relevant in assessing the performance of a firm in respect of following aspects: 3.5.1 Financial Ratios for Evaluating Performance (a) Liquidity Position: With the help of ratio analysis one can draw conclusions regarding liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its obligations when they become due. This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans. (b) Long-term Solvency: Ratio analysis is equally useful for assessing the long- term financial viability of a firm. This aspect of the financial position of a borrower is of concern to the long term creditors, security analysts and the present and potential owners of a business. The long term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and operating efficiency. The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or whether heavily loaded with debt in which case its solvency is exposed to serious strain. Similarly, the various profitability ratios would reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved. (©) Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilisation of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets — total as well as its components.(d) (e) Overall Profitability: Unlike the outside parties which are interested in one aspect of the financial position of a firm, the management is constantly concerned about the overall profitability of the enterprise. That is, they are concerned about the ability of the firm to meet its short-term as well as long- term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum utilisation of the assets of the firm. This is possible if an integrated view is taken and all the ratios are considered together. Inter-firm Comparison: Ratio analysis not only throws light on the financial position of a firm but also serves as a stepping stone to remedial measures. This is made possible due to inter-firm comparison/comparison with industry averages. A single figure of particular ratio is meaningless unless it is related to some standard or norm. One of the popular techniques is to compare the ratios of a firm with the industry average. It should be reasonably expected that the performance of a firm should be in broad conformity with that of the industry to which it belongs. An inter-firm comparison would demonstrate the relative position vis-a-vis its competitors. If the results are at variance either with the industry average or with those of the competitors, the firm can seek to identify the probable reasons and, in the light, take remedial measures. Ratios not only perform post mortem of operations, but also serve as barometer for future. Ratios have predictor value and they are very helpful in forecasting and planning the business activities for a future. It helps in budgeting. Conclusions are drawn on the basis of the analysis obtained by using ratio analysis. The decisions affected may be whether to supply goods on credit to a concern, whether bank loans will be made available, etc. Financial Ratios for Budgeting: In this field ratios are able to provide a great deal of assistance. Budget is only an estimate of future activity based on past experience, in the making of which the relationship between different spheres of activities are invaluable. It is usually possible to estimate budgeted figures using financial ratios.Ratios also can be made use of for measuring actual performance with budgeted estimates. They indicate directions in which adjustments should be made either in the budget or in performance to bring them closer to each other. G 3.6 LIMITATIONS OF FINANCIAL RATIOS The limitations of financial ratios are listed below: @ (i) (iii) (iv) w™) (wi) Wii) Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons. Financial data are badly distorted by inflation: Historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios. Seasonal factors :it may also influence financial data. Example: A company deals in cotton garments. It keeps a high inventory during October - January every year. For the rest of the year its inventory level becomes just 1/4th of the seasonal inventory level. So liquidity ratios and inventory ratios will produce biased picture. Year end picture may not be the average picture of the business. Sometimes it is suggested to take monthly average inventory data instead of year end data to eliminate seasonal factors. But for external users it is difficult to get monthly inventory figures. (Even in some cases monthly inventory figures may not be available). To give a good shape to the popularly used financial ratios (like current ratio, debt- equity ratios, etc.): The business may make some year-end adjustments. Such window dressing can change the character of financial ratios which would be different had there been no such change. Differences in accounting policies and accounting period: \t can make the accounting data of two firms non-comparable as also the accounting ratios. No standard set of ratios against which a firm’s ratios can be compared: Sometimes a firm’s ratios are compared with the industry average. But if a firm desires to be above the average, then industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high a standard to achieve. Difficulty to generalise whether a particular ratio is good or bad: For example, a low current ratio may be said ‘bad’ from the point of view of low liquidity, but a high current ratio may not be ‘good’ as this may result from inefficient working capital management.(ili) Financial ratios are inter-related, not independent: Viewed in isolation one ratio may highlight efficiency. But when considered as a set of ratios they may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis. Financial ratios provide clues but not conclusions. These are tools only in the hands of experts because there is no standard ready-made interpretation of financial ratios. @ 3.7 FINANCIAL ANALYSIS Horizontal and vertical: It may be of two type Horizontal Analysis: When financial statement of one year are analysed and interpreted after comparing with another year or years, it is known as horizontal analysis. It can be based on the ratios derived from the financial information over the same time span. Vertical Analysis: When financial statement of single year is analyzed then it is called vertical analysis. This analysis is useful in inter firm comparison. Every item of Profit and loss account is expressed as a percentage of gross sales, while every item on a balance sheet is expressed as a percentage of total assets held by the firm.