Ratio Analysis

Ratio analysis

ratio analysis basics


Ratios act as a useful tool to measure business performance. Ratios are a quotient of two numbers and the relation expressed between the two accounting figure is known as ‘Accounting Ratio’. There will be a natural difference between ratios according to the nature of the business, the size of the business, its age and the industry within which it operates.Ration analysis is a very important part of the accounting services, bookkeeping services. Different reports can be prepared and memorized for future use, using QuickBooks Statement writer which is part of QuickBooks Accountants edition. They are generally assessed in relation to a comparator or benchmark such as
• Analyzing the past performance of the Firm
• The budget
• Internal division of department
• A competitor
Ratios are useful in a way that
i. They provide an easy way to estimate the present performance with the past.
ii. They depict the areas in which a particular business is competitively advantaged or disadvantaged through comparing ratios to those of the other businesses of the same size within the same industry.
A few limitations could be
i. Ratios do not provide answers to every question and their interpretation can be subjective.
ii. They are calculated on the basis of historic accounting information which may itself include assumptions and interpretations.
The ratio analysis could be made under a few broad categories.
A. Measuring short term solvency / liquidity
Short term solvency is the ability of the firm to meet its short term debts from its liquid assets. These could include cash in hand cash at bank trade receivables, but not inventories since they can’t be converted quickly into cash.
1) Current Ratio:Current assets are assets that can be converted into cash within a year. Current liabilities and provisions are those that are payable within a year. A current ratio of 2:1 indicates a high solvency of the company. This ratio can be calculated as
Current assets / Current liabilities

B. Measuring Long term solvency through leverage ratios:Long term solvency ratios measure the risk a business faces from its debt burden. It is essentially the proportion of the business financed via debt compared to equity.
1. Debt – equity ratio: It indicates the relationship between the loan funds and the net worth of the company, which is known as the ‘gearing’. If the proportion of debt to equity is low,a company is said to be low geared and the vice- versa. The formula used to impute the debt – equity ratio is
Long term debts / Shareholder’s Fund

2. Net Debt to EBITDA: Although not a traditional measure of long term solvency, the net debt to EBITDA ratio has become popular with banks as a measure of Gearing. Banks will typically lend a business up to five times its earnings. Hence, Cash generated from operations can be substituted for EBITDA. (EBITDA stands for Earnings before Interest, Tax, Depreciation and Amortization.)
Net Debt to EBIDTA (tines) = Interest bearing Debt – Cash/ EBITDA
3. Interest Coverage Ratio
This ratio measures how many times a business can pay its interest charges from its operating profit. Ideally a business should be able to cover its interest at least or more times. The formula used to compute this ratio is

Interest Cover [times] = Operating Profit (i.e. Profit before interest, depreciation, and Tax) / Interest (Finance expenses)

C. Investor Ratios

These ratios are used mostly by existing and potential investors of mostly publically listed companies. They can be obtained or calculated where necessary from publically available information.

1. Earnings per Share:-

The EPS is an important measure of economic performance of a corporate entity. The flow of capital to the companies under present imperfect capital market conditions would be made on the evaluation of EPS. It measures the net profit measured per share. It is one of the major factors that effect’s the dividend policy of the firm and the market prices of the companies. A steady growth in EPS year after year indicates a good track of profitability. Investors who lack inside and detailed information of a company can always look at the EPS, as their best base to take their investment decisions. A higher EPS means better capital productivity.
Its can be measured as
Net profit after tax and preference Dividend / No. of equity shares

2. Dividend Payout Ratio

Dividend payout indicates the extent of net profits distributed to the shareholders as dividend. A high payout signifies a liberal distribution policy and a low payout reflects a conservative dividend policy. It is the dividend per share by earning per share; written as

Dividend per Share / Earnings per share

3. Book Value

This ratio indicates net worth per equity share. The book value is the reflection of the past earnings and the distributed policy of the company. A huge book value indicates that a company has huge reserves whereas a lower book value suggests a liberal distribution policy of bonus and dividends, or alternatively a poor track record of profitability.
Book value is considered to be less significant than the EPS, as it reflects the past records, whereas the market discounts the future prospects. The book value of a company can be derived from

Equity Capital + Reserves – Profit and Loss A/c Debit Balance / Total No. of Equity Shares

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