Financial Ratios And Their Interpretation Pdf
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Ratio analysis can be defined as the process of ascertaining the financial ratios that are used for indicating the ongoing financial performance of a company using few types of ratios such as liquidity, profitability, activity, debt, market, solvency, efficiency, and coverage ratios and few examples of such ratios are return on equity, current ratio, quick ratio, dividend payout ratio , debt-equity ratio, and so on. Ratio analysis is a process used for the calculation of financial ratios or in other words, for the purpose of evaluating the financial wellbeing of a company. The values used for the calculation of financial ratios of a company are extracted from the financial statements of that same company.
- Ratio Analysis Types
- UNIT 10 FINANCIAL STATEMENTS: ANALYSIS AND INTERPRETATION (Accounting Ratios
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- Financial Ratios and The Analysis of Marketing Policy
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Ratio Analysis Types
This aspect has been discussed in detail in this unit. Profitability 2. Financial soundness Analysis and interpretation of financial statements, therefore, refers to the treatment of the information contained in the income statement and the balance sheet so as to afford full diagnosis of the profitability and the financial soundness of the business.
A distinction here can be made between the two terms-'analysis' and 'interpretation'. The term 'analysis' means the methodical classification of the data given in the financial statements. The figures given in the financial statements will not help one unless they are put in a simplified form. For example, all items relating to 'Current Assets' are put at one place, while all items relating to 'Current Liabilities' are put at another place. The term 'interpretation' means 'explaining the meaning and significance of the data so simplified'.
However, both 'analysis' and 'interpretation' are complementary to each other. Interpretation requires analysis, while analysis is useless without interpretation. Most of the authors have used the term 'analysis' to cover the meanings of both analysis and interpretation, since analysis involves interpretation.
According to Myers, 'financial statement analysis is largely a study of the relationship among the various financial factors in a business as disclosed by a single set of statements and a study of the trend of these factors as shown in a series of statements.
Each of the above steps has been explained in the following pages: 1 Methodical Classification. In order to have a meaningful analysis it is necessary that figures should be arranged properly.
Usually, instead of the two-column T form statements, the statements are prepared in single vertical column form 'which should throw up significant figures by adding or subtracting. Obviously, no purpose will be served by comparing two sets of figures which are not at all connected with each other. Moreover, absolute figures are also unfit for comparison.
Traditional Classification. This classification has been on the basis of the financial statements to which the determinants of a ratio belong. On this basis, the ratios could be classified as Profit and Loss Account Ratios, i. Balance Sheet Ratios, i. Composite Ratios or Inter-statement Ratios, i. Functional Classification. The traditional classification has been found to be too crude and unsuitable because analysis of balance sheet and income statement cannot be done in isolation. They have to be studied together in order to determine the profitability and solvency of the business.
In order that ratios serve as a tool for financial analysis, they are classified according to their functions as follows Profitability Ratios 2. Turnover Ratios 3. Financial Ratios In the following pages we will explain the ratios covered by each of the above categories in detail.
Poor operational performance may indicate poor sales and hence poor profits. A lower profitability may arise due to the lack of control over the expenses.
Bankers, financial institutions and other creditors look at the profitability ratios as an indicator of whether or not the firm earns substantially more than it pays interest for the use of borrowed funds, and whether the ultimate repayment of their debt appears reasonably certain. Owners are interested to know the profitability as it indicates the return which they can get on their investments. The following are the important profitability ratios.
Overall Profitability Ratio. It indicates the percentage of return on the total capital employed in the business. It is calculated on the basis of the following formula:Operating Profit Capital EmployedThe term capital employed has been given different meanings by different accountants. Some of the popular meanings are as follows: i Sum-total of all assets, whether fixed or current ii Sum-total of fixed assets In management accounting, the term 'capital employed' is generally used in the meanings given in the point iii above.
The term 'operating profit' means 'profit before interest and tax'. The term 'interest' means 'interest on long-term borrowings'. Interest on short-term borrowings will be deducted for computing operating profit. Non-trading incomes such as interest on government securities or non-trading losses or expenses such as loss on account of fire, etc. Significance of ROI. The return on capital invested is a concept that measures the profit which a firm earns on investing a unit of capital.
It is desirable to ascertain this periodically. The profit being the net result of all operations, the return on capital expresses all efficiencies or inefficiencies of a business collectively and, thus, is a dependable measure for judging its overall efficiency or inefficiency. On this basis, there can be comparisons of the efficiency of one department with that of another, of one plant with that of another, one company with that of another and one industry with that of another.
For this purpose, the amount of profits considered is that before making deductions on account of interest, income tax and dividends and capital is the aggregate of all the capital at the disposal of the company, viz.
Return on capital, as explained, may also be calculated on equity shareholders' capital. In that case, the profit after deductions for interest, income tax and preference dividend will have to be compared with the equity shareholders' funds. It would not indicate operational efficiency or inefficiency, but merely the maximum rate of dividend that might be declared. A business can survive only when the return on capital employed is more than the cost of capital employed in the business.
Earning per share helps in determining the market price of the equity share of the company. A comparison of earning per share of the company with another will also help in deciding whether the equity share capital is being effectively used or not.
It also helps in estimating the company's capacity to pay dividend to its equity shareholders. This ratio indicates the number of times the earning per share is covered by its market price. This is calculated according to the following formula:Market price per equity share Earning per shareFor example, the market price of a share is Rs 30 and earning per share is Rs 5, the price earning ratio would be 6 i.
It means the market value of every one rupee of earning is six times or Rs 6. The ratio is useful in financial forecasting. It also help in knowing whether the shares of a company are under or overvalued. For example, if the earning per share of AB Limited is Rs 20, its market price Rs and earning ratio of similar companies is 8, it means that the market value of a share of AB Limited should be Rs i.
The share of AB Limited is, therefore, undervalued in the market by Rs Price-earning ratio helps the investor in deciding whether not to buy the shares of a company at a particular market price. Gross Profit Ratio. This ratio expresses the relationship between gross profit and net-sales. This ratio indicates the degree to which the selling price of goods per unit may decline without resulting in losses from operations to the firm. It also helps in ascertaining whether the average percentage of mark up on the goods is maintained.
There is no norm for judging the gross profit ratio, therefore, the evaluation of the business on its basis is a matter of judgment. However, the gross profits should be adequate to cover the operating expenses and to provide for fixed charges, dividends and building up of reserves. Net Profit Ratio. This ratio indicates the net margin earned on a sale of Rs Illustration This ratio helps in determining the efficiency with which affairs of the business are being managed.
An increase in the ratio over the previous period indicates improvement in the operational efficiency of the business, provided the gross profit ratio is constant. The ratio is thus an effective measure to check the profitability of a business. An investor has to judge the adequacy or otherwise of this ratio by taking into account the cost of capital, the return in the industry as a whole and market conditions such as boom or depression period.
No norms can be laid down. However, constant increase in the above ratio year after year, is a definite indication of improving conditions of the business. Operating Ratio. This ratio is a complementary of net profit ratio. In case the net profit ratio is 20 per cent, it means that the operating ratio is 80 per cent. Financial charges such as interest, provision for taxation, etc. This ratio is the test of the operational efficiency with which the business is being carried.
The operating ratio should be low enough to leave a portion of sales to give a fair return to the investors. A comparison of the operating ratio will indicate whether the cost component is high or low in the figure of sales. In case the comparison shows that there is an increase in this ratio, the reason for such increase should be found out and the management advised to check the increase.
Fixed Charges Cover. This ratio is very important from the lender's point of view.
UNIT 10 FINANCIAL STATEMENTS: ANALYSIS AND INTERPRETATION (Accounting Ratios
Business owners tend to dislike the financial management of their firm. Who can blame them!? But, there is one thing about learning about the financial management of your business firm. It is absolutely necessary. So, you gotta suck it up and learn it.
Financial ratios are relationships determined from a company's financial information and used for comparison purposes. Examples include such often referred to measures as return on investment ROI , return on assets ROA , and debt-to-equity, to name just three. These ratios are the result of dividing one account balance or financial measurement with another. Financial ratios can provide small business owners and managers with a valuable tool with which to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful means of identifying trends in their early stages.
The main purpose of this ratio is to control the gross profit or cost of goods sold of the entity. These ratios basically show how well companies can achieve profits from their operations. First, a Profitability ratios Profitability Ratios Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income profit relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific period of time. These ratios indicate the ease of turning assets into cash. Used with care and imagination, the technique can reveal much about a company and its operations. But there are a few things to take in mind about ratios. Balance Sheet Ratio Analysis.
The current ratio is a popular financial ratio used to test a company's liquidity a complete profit margin analysis that there are several income and expense.
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Discusses the analysis that financial ratios have won lots of attention in the accounting and financial literature. Demonstrates how financial ratios can be used in order to analyse certain aspects of a firm's marketing policy. Adopts the idea that accounting ratios are affected by the firm's marketing management philosophy. Validates results obtained for the ratios supposedly being affected by the firm's consumer service policy and uses other accounting figures, e.
Financial Ratios and The Analysis of Marketing Policy
Even if you usually get financial ratio figures from your broker or a financial website, you still ought to know what they represent and what they can tell you about a business in which you're considering investing. Otherwise, you could make a mistake such as buying into a company with too much debt or paying too much for a stock with meager earnings growth potential. Some investors prefer to focus on a financial ratio known as the price-to-cash-flow ratio instead of the more well-known price-to-earnings ratio. It's calculated by dividing a company's market capitalization by its cash flow from operations or dividing its share price by its cash flow from operations per share. It's a quick and easy way to determine how cheap or expensive the stock is compared with its peers. You have to consider whether that amount is too high, a bargain, or somewhere in between.
Solvency Ratios. A summary of the key points and practice problems in the CFA Institute multiple-choice format n Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed. It needs to meet the requirement of the business concern. Accounting Ratios: Importance and Limitations! By digging deeper into the current assets, you will gain a greater understanding of a company's true liquidity. So the first thing to do is decide which ratios to spend your time focusing on. Financial ratio analysis analyzes specific financial line-items within a company's financial statements to provide insight as to how well the company is performing.