The relation between two numerical figures expressed mathematically is known as ratio. Similarly, analysis of the relationship between various items of financial statements is called financial ratio analysis which helps to summarize the large quantity of financial data and to make quantities judgments about the firm’s financial performance. Financial ratio reflects the quantitative relationship which helps the manager to take qualitative judgment. It can be expressed in terms of percentage, times and proportion or quotient (Barnas, 2007). For example, return is expressed in percentage; turnover is explained in times and so on.
Ratio is very useful for the purpose of taking decision from simple analysis to empirical research in predicting the performance of the company to show the direction of success or failure. The ratio analysis involves comparison of various ratios of the firm with industry average at the same time or with the previous year’s ratio of the firm. It is necessary for useful interpretation of the financial statements. A single ratio in itself does not give any base for managerial decision. To determine the financial condition and performance of the firm, its ratio may be compared with average ratio to the industry of which the firm is involved (Clausen, 2009). Another way of ratio analysis is comparison of the current ratios with the past ratios or with the future or the projected ratios.
1. Liquidity Ratios
Liquidity ratios measure the firm’s ability to satisfy its short terms commitments out of current or liquid asserts. These ratios focuses on current assets and liabilities and are used to ascertain the short term solvency position of the firm. The two primary tests of liquidity are current ratio and quick ratio.
- Current Ratio
A current ratio CR is the quantitative relation between current asserts (CA) and current liabilities (CL). Here, current asserts are those, which can normally be converted into cash within a year. They include cash, inventories, receivables, bank balance, prepaid expenses, and marketable securities and so on.
Current ratio is calculated as follow:
CR = Current asserts/ Current liabilities
Example, For Annapurna Textile Inc. the current asset is Rs. 750000 and the current liabilities is Rs. 700000 hence, the current ratio of the year 2018 is
CR = Rs. 750000/Rs. 700000
= 1.07
The current ratio, 1.07 times indicate that the current asserts of Annapurna Textiles is 1.07 times of its current liabilities.
- Quick Ratio
Quick ratio (QR), also termed as acid - test ratio or liquid ratio, is another measure of short - term solvency of a firm. Quick ratio is defined as the quantitative relationship between quick the
QR = Quick assert/ Current liabilities
Example, For Annapurna Textile Inc. quick assert is Rs. 555000 (CA - Inventory = Rs. 750000 - Rs. 200000) hence the quick ratio for the year 2018 is:
QR = Rs. 550000/ Rs. 700000
= 0.79 times
The quick ratio of 0.79 times that Annapurna Textile’s quick asserts are 0.79 times of current liabilities.
2. Debt - equity ratio
Dept- equity ratio (DE) is the most widely used widely used leverage ratio to equivalent the long term solvency of a firm. The ratio expresses the relationship between debt capital and equity capital, and reflects the relative claim of them on the asserts of the firm. It is simple calculated by dividing total dept by total equity:
DE ratio = Total dept/ Total equity
In the above relationship total dept includes all items of depts, viz., long - term dept and current liabilities. The shareholders’ equity include common equity, preferred stock, and any balance of undistributed profits net of fictitious asserts.
Example, For Annapurna Textile Inc., dept - equity ratio for the year 2018 is
DE ratio = Rs. 1000000/ Rs. 1100000
= 0.9091 times or 90.91 %
Dept - Equity ratio is used as a tools for analyzing financial risk both by creditors as well as by the firm. A higher the dept - equity ratio indicates greater contribution at a firm’s financing by dept holders than those of equity holders.
Profitability Ratios
Profitability is the end result of a number of corporate policies and decisions. It measures how effectively the firm is being operated and managed. Besides owners and managers, creditors are also interested to know the financial soundness of the firm. Owner are eaged to know their returns whereas managers are interested in their operating efficiency. So they calculate profitability ratios because expectations of both owners and managers are evaluated in terms of profit earned by the firm. Following are the major ratios used to measure the profitability of the firm:
Net Profit Margin
Gross Profit Margin
Ø Net profit margin
Net profit margin is the ratio between net income and sales of a firm. It shows the firm’s ability to generate net income per rupee of sales and is calculate as
Net Profit Margin = Net Income/ Sales
Example, For Annapurna Textile Inc., the net profit margin is:
It means Annapurna Textiles has been able to earn 13.35 percent net profit on its sale. Higher net profit margin is preferred by the owners, the management as well as the creditors.
Ø Gross Profit margin
It is the ratio between gross profit and sales of a firm and is calculated as:
Gross Profit margin = Gross profit/ Sales
Example, the gross profit margin of Annapurna Textile is:
Gross profit margin = Rs 600000/ 1500000
=0.4 or 40%
It means Annapurna Textile earned, after meeting cost of goods sold, 40 percent on its sales. Higher gross profit margin is preferred as it allows greater cushion to absorb other expenses.
References
Barnas, P. (2007). The Analysis and Use of Financial Ratio. Journal of Business Finance & Accounting.
Clausen, J. (2009). Accounting 101 - Financial Statement Analysis in Accounting: Liquidity Ratio Analysis Balance Sheet Assets and Liabilities. Journal of a financial statement
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The relation between two numerical figures expressed mathematically is known as ratio. Similarly, analysis of the relationship between various items of financial statements is called financial ratio analysis which helps to summarize the large quantity of financial data and to make quantities judgments about the firm’s financial performance. Financial ratio reflects the quantitative relationship which helps the manager to take qualitative judgment. It can be expressed in terms of percentage, times and proportion or quotient (Barnas, 2007). For example, return is expressed in percentage; turnover is explained in times and so on.
Ratio is very useful for the purpose of taking decision from simple analysis to empirical research in predicting the performance of the company to show the direction of success or failure. The ratio analysis involves comparison of various ratios of the firm with industry average at the same time or with the previous year’s ratio of the firm. It is necessary for useful interpretation of the financial statements. A single ratio in itself does not give any base for managerial decision. To determine the financial condition and performance of the firm, its ratio may be compared with average ratio to the industry of which the firm is involved (Clausen, 2009). Another way of ratio analysis is comparison of the current ratios with the past ratios or with the future or the projected ratios.
1. Liquidity Ratios
Liquidity ratios measure the firm’s ability to satisfy its short terms commitments out of current or liquid asserts. These ratios focuses on current assets and liabilities and are used to ascertain the short term solvency position of the firm. The two primary tests of liquidity are current ratio and quick ratio.
- Current Ratio
A current ratio CR is the quantitative relation between current asserts (CA) and current liabilities (CL). Here, current asserts are those, which can normally be converted into cash within a year. They include cash, inventories, receivables, bank balance, prepaid expenses, and marketable securities and so on.
Current ratio is calculated as follow:
CR = Current asserts/ Current liabilities
Example, For Annapurna Textile Inc. the current asset is Rs. 750000 and the current liabilities is Rs. 700000 hence, the current ratio of the year 2018 is
CR = Rs. 750000/Rs. 700000
= 1.07
The current ratio, 1.07 times indicate that the current asserts of Annapurna Textiles is 1.07 times of its current liabilities.
- Quick Ratio
Quick ratio (QR), also termed as acid - test ratio or liquid ratio, is another measure of short - term solvency of a firm. Quick ratio is defined as the quantitative relationship between quick the
QR = Quick assert/ Current liabilities
Example, For Annapurna Textile Inc. quick assert is Rs. 555000 (CA - Inventory = Rs. 750000 - Rs. 200000) hence the quick ratio for the year 2018 is:
QR = Rs. 550000/ Rs. 700000
= 0.79 times
The quick ratio of 0.79 times that Annapurna Textile’s quick asserts are 0.79 times of current liabilities.
2. Debt - equity ratio
Dept- equity ratio (DE) is the most widely used widely used leverage ratio to equivalent the long term solvency of a firm. The ratio expresses the relationship between debt capital and equity capital, and reflects the relative claim of them on the asserts of the firm. It is simple calculated by dividing total dept by total equity:
DE ratio = Total dept/ Total equity
In the above relationship total dept includes all items of depts, viz., long - term dept and current liabilities. The shareholders’ equity include common equity, preferred stock, and any balance of undistributed profits net of fictitious asserts.
Example, For Annapurna Textile Inc., dept - equity ratio for the year 2018 is
DE ratio = Rs. 1000000/ Rs. 1100000
= 0.9091 times or 90.91 %
Dept - Equity ratio is used as a tools for analyzing financial risk both by creditors as well as by the firm. A higher the dept - equity ratio indicates greater contribution at a firm’s financing by dept holders than those of equity holders.
Profitability Ratios
Profitability is the end result of a number of corporate policies and decisions. It measures how effectively the firm is being operated and managed. Besides owners and managers, creditors are also interested to know the financial soundness of the firm. Owner are eaged to know their returns whereas managers are interested in their operating efficiency. So they calculate profitability ratios because expectations of both owners and managers are evaluated in terms of profit earned by the firm. Following are the major ratios used to measure the profitability of the firm:
Net Profit Margin
Gross Profit Margin
Ø Net profit margin
Net profit margin is the ratio between net income and sales of a firm. It shows the firm’s ability to generate net income per rupee of sales and is calculate as
Net Profit Margin = Net Income/ Sales
Example, For Annapurna Textile Inc., the net profit margin is:
Net Profit margin = Rs. 203000/ Rs. 1500000
= 0.1353 = 13.53%
It means Annapurna Textiles has been able to earn 13.35 percent net profit on its sale. Higher net profit margin is preferred by the owners, the management as well as the creditors.
Ø Gross Profit margin
It is the ratio between gross profit and sales of a firm and is calculated as:
Gross Profit margin = Gross profit/ Sales
Example, the gross profit margin of Annapurna Textile is:
Gross profit margin = Rs 600000/ 1500000
=0.4 or 40%
It means Annapurna Textile earned, after meeting cost of goods sold, 40 percent on its sales. Higher gross profit margin is preferred as it allows greater cushion to absorb other expenses.
References
Barnas, P. (2007). The Analysis and Use of Financial Ratio. Journal of Business Finance & Accounting.
Clausen, J. (2009). Accounting 101 - Financial Statement Analysis in Accounting: Liquidity Ratio Analysis Balance Sheet Assets and Liabilities. Journal of a financial statement