Ratio Analysis in Financial Accounting

Ratio Analysis in Financial Accounting

To see whether the business has improved its profitability or not, the ratio can be calculated for a number of years. Return on equity (ROE) is widely used to measure the overall profitability of the company from preference and common stockholders’ view point. The ratio also indicates the efficiency of the management in using the resources of the business. Higher ratio means high return on shareholders’ investment. Investors always search for the highest return on their investment and a company that has higher ROE ratio than others in the industry attracts more investors.

Fixed assets ratio If fixed assets to stockholders’ equity ratio is more than 1, it means that stockholders’ equity is less than the fixed assets and the company is using debts to finance a portion of fixed assets. If the ratio is less than 1, it means hat stockholders’ equity is more than the fixed assets and the stockholders’ equity is financing not only the fixed assets but also a part of the working capital. Different industries have different norms. Generally a ratio of 0. 60 to 0. 70 (or 60% to 70%, if expressed in percentage) is considered satisfactory for most of the industrial undertakings.

Debt to equity ratio A ratio Of 1 or 1 : 1 means that creditors and stockholders equally contribute to the assets of the business. A less than 1 ratio indicates that the portion of assets provided by stockholders is greater than the portion of assets provided y creditors and a greater than 1 ratio indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stockholders. Creditors usually like a low debt to equity ratio because a low ratio (less than 1) is the indication of greater protection to their money.

But stockholders like to get benefit from the funds provided by the creditors therefore they would like a high debt to equity ratio. Debt equity ratio vary from industry to industry. Different norms have been developed for different industries. A ratio that is ideal for one industry may be worrisome for another industry. A ratio of 1 : 1 is normally considered satisfactory for most of the companies. Current ratio is a useful test of the short-term-debt paying ability of any business.

A ratio of 2:1 or higher is considered satisfactory for most of the companies but analyst should be very careful while interpreting it. Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal. It requires a deep analysis of the nature of individual current assets and current liabilities. A company with high current ratio may not always be able to pay its current abilities as they become due if a large portion of its current assets consists of slow moving or obsolete inventories.

On the other hand, a company with low current ratio may be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets I. E. , cash, bank balance, marketable securities and fast moving inventories. Consider the following example to understand how the composition and nature of individual current assets can differentiate the liquidity position of two companies having same current ratio figure. Quick ratio is considered a more reliable test of short-term solvency than current ratio because it shows the ability of the business to pay short term debts immediately.

Inventories and prepaid expenses are excluded from current assets for the purpose of computing quick ratio because inventories may take long period of time to be converted into cash and prepaid expenses cannot be used to pay current liabilities. Generally, a quick ratio of is considered satisfactory. Like current ratio, this ratio should also be interpreted carefully. Having a quick ratio of or higher does not mean that he company has a strong liquidity position because a company may have high quick ratio but slow paying debtors.

On the other hand, a company with low quick ratio may have fast moving inventories. The analyst, therefore, must have a hard kick on the nature Of individual assets. The reason of computing absolute liquid ratio is to eliminate accounts receivables from the list of liquid assets because there may be some doubt about their quick collection. This ratio is useful only when used in conjunction with current ratio and quick ratio. An absolute liquid ratio of 0. 5:1 is noninsured ideal for most of the company sees. This ratio is very helpful when used in conjunction with short term solvency ratios I. . , current ratio and quick ratio. Short term solvency ratios measure the liquidity of the company as a whole and accounts receivable turnover ratio measures the liquidity of accounts receivables. Generally, a high ratio indicates that the receivables are more liquid and are being collected promptly. A low ratio is a sign of less liquid receivables and may reduce the true liquidity of the business in the eyes of the analyst even if the current and quick ratios are satisfactory. A short collection period means prompt collection and better management of receivables.

A longer collection period may negatively effect the short-term debt paying ability of the business in the eyes of analysts. Whether a collection period is good or bad, depends on the credit terms allowed by the company. For example, if the average collection period of a company is 50 days and the company allows credit terms of 40 days then the average collection period is worrisome. On the other hand, if the company’s credit terms are 60 days then the average collection period of 50 days would be noninsured very good. Inventory turnover ratio vary significantly among industries.

A high ratio indicates fast moving inventories and a low ratio indicates slow moving or obsolete inventories in stock. A low ratio may also be the result of maintaining excessive inventories needlessly. Maintaining excessive inventories unnecessarily indicates poor inventory management because it involves tiding up funds that could otherwise be used in other business operations. Accounts payable turnover ratio indicates the creditworthiness of the company. A high ratio means prompt payment to suppliers for the goods researched on credit and a low ratio may be a sign of delayed payment.

Accounts payable turnover ratio also depends on the credit terms allowed by suppliers. Companies who enjoy longer credit periods allowed by creditors usually have low ratio as compared to others. A high ratio (prompt payment) is desirable but company should always avail the credit facility allowed by the suppliers. A shorter payment period indicates prompt payments to creditors. Like accounts payable turnover ratio, average payment period also indicates the creditworthiness of the company. But a very short payment period may be an indication that the company is not taking full advantage of the credit terms allowed by suppliers.

The interest coverage ratio is very important from the lender’s point of view. It indicates the number of times interest is covered by the profits available to pay interest charges. It is an index of the financial strength of an enterprise. A high debt service ratio or interest coverage ratio assures the lenders a regular and periodical interest income. But the weakness of the ratio may create some problems to the financial manager in raising funds from debt sources. Operating ratio shows the operational efficiency of the business. Lower operating ratio shows higher operating profit and vice versa.

An operating ratio ranging between 75% and 80% is generally considered as standard for manufacturing concerns. This ratio is considered to be a yardstick of operating efficiency but it should be used cautiously because it may be affected by a number of uncontrollable factors beyond the control of the firm. Moreover, in some firms, non-operating expenses from a substantial part of the total expenses and in such cases operating ratio may give misleading results. The earnings per share is a good measure of profitability and when compared tit PEPS of similar companies, it gives a view of the comparative earnings or earnings power of the firm.

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