Ratio analysis: ratio is an expression of quantitative
relationship between two figures or numbers. It is expressed when one figure is
compared with another. Ratio analysis determines and interprets the numerical
relationship between figures of financial statements. Hence ratio is used for
evaluating the financial positions and performance of a firm.
Importance of ratio analysis
a. Financial positions analysis:
accounting ratio reveal the financial position of a concern
b. simplifying accounting figures: accounting ratios
simplify ,summarize and systematize the accounting figures to make them
understandable
c. assess the operational efficiency : it helps to
assess the operational or working efficiency of a concern
d. forecasting :it is useful in financial forecasting
and planning
e. comparing performance between companies
limitations
of ratio analysis
1.based on historical information
2. ignore qualitative aspects
3. fails to disclose current worth of enterprise
4.not free from bias
5.arthematical window dressing
Types of ratio
A. liquidity ratio: liquidity ratios measure the
short term solvency or liquidity of a firm .liquidity is the ability of a firm
to meets it short term obligations. they reflect the short term financial
strength of business. Current ratio and quick ratios are calculated under
leverage ratio.
Current ratio = current
assets
Current liabilities
Quick ratio
=current assets-prepaid expenses-closing stock
Current liabilities
B. leverage ratio: leverage ratio shows the long term
solvency or liquidity of a firm. they indicate whether firm is financially
sound or solvent in relation to its long term obligations. they show firms
ability to pay interest regularly and repay the principal on the due date. long term solvency of a firm can be measured
through debt equity ratio and debt to total capital ratio.
C. Turnover ratio: activity or turnover ratios
describes the relationship between the firm’s level of activity assets employed
to generate the activity. they are also used to forecast a firm’s capital
requirement both operating and long term. Inventory turnover, fixed assets
turnover ,total assets turnover, capital employed turnover are the activity
ratio.
D. Profitability ratio : the sustainability of a firm
depends on income earned and profit earned. moreover, a firm should earn sufficient
profit on each rupee of sales to meet the operating expenses and to avail returns to the owners. Gross profit
margin , net profit margin , return on assets , return on shareholders equity ,
return on capital employed ,earning per share are the profitability ratios
