Once the financial statements of the business are prepared, the next task is to analyze the business performance as to whether the performance of the business has improved, deteriorated, or remain the same. If the performance has improved, what caused the improvement, if the performance has deteriorated what went wrong. If the performance has remained constant, why is there no improvement?
Ratio Analysis is done to compare the current year performance of the business with its past year's performance, the company’s current year's performance with its expected or budgeted performance, and the company’s current year's performance with the competitor’s current year performance until and unless performance appraisal is done the standing of the company cannot be known.
In order to have a 360 degrees analysis of the business ratios are divided into the following categories:
1. Profitability Ratios
2. Liquidity Ratios
3. Resource Utilization Resource ratios
4. Investment Ratios
5. Cash Flow Ratios
Note: Profitability and Liquidity Ratios are part of the syllabus.
It helps in identifying the earning capacity of the businesses to how much revenue is generated and through what sources and how much expenses are incurred and by what means and thus, what is the profitability. It also helps in identifying whether the business can control its expenses effectively and efficiently or not. Good control over expenses has a huge impact on delivering the profitability position of the business. These are some basic formulas and equations to help you calculate the profitability ratios easily:
Turnover, also termed in the exam as, Net Sales = Sales – Sales Return
Cost of Sales = Cost of Turnover = Cost of goods sold: Opening inventory +Net Purchase- Closing inventory
Gross Profit= Sales- Cost
Sales = Gross Profit+ Cost
Cost = Sales – Gross Profit
Gross Profit – Expenses = Net Profit
Gross Profit= Net Profit + Expenses
Expenses = Gross Profit- Net Profit
Owner’s Capital = Total Assets – Total Liabilities
Non-current assets + current assets – current liabilities – noncurrent liabilities
Capital Employed: Non-current asset + Current asset – Current liabilities
• Total Assets – Current liabilities
• Non-current asset + Working capital
• Opening capital + Net profit – Drawings + Non-current liabilities
• Owner capital + Non-current liabilities
*Profitability Ratios are as follows:
Gross Profit Markup: Gross profit as a percentage of cost = Gross profit/ cost * 100
Gross Profit Margin: Gross Profit as a percentage of sales = Gross profit/ sales*100
Net Profit Margin: Net profit as a percentage of sales = Net profit/sales *100
The expense to sales ratio: Expense/ sales * 100
• GP Margin – NP Margin
Return on Capital Employed (ROCE): Net Profit before interest tax/capital employed *100
Equity= Capital Owner’s share capital + all reserves
• Owners share capital + preference share capital + all reserves
• Equity + preference share capital
Liquidity is the ability of the business to convert its assets into cash. Liquidity ratios help us in identifying whether the business has enough resources to pay off its debts. Liquidity plays a vital role in the survival of the business. A business can survive without making huge profits, but it cannot survive without paying off its debts. These are some formulas and equations to help you calculate liquidity ratios:
Working capital = Current assets – Current liabilities
• If positive = net current assets
• If negative, then net current liabilities
Liquidity Ratios are as follows:
Current ratio: Current assets/Current liabilities (where ideal ratio = 1.5:1 – 2:1)
Quick Ratio/ Acid Test Ratio: Current assets – Closing inventory / Current liabilities
Average inventory: opening inventory + closing inventory / 2
Rate of inventory turnover(times): Cost of sales / Average inventory
- The value obtained from this formula would be in times.
Inventory turnover (days): Average inventory/loss of sales * 365
Trade receivable turnover(days): Receivables / credit sales * 365
- Also known as the receivable collection period.
Trade payable turnover(days): payables/credit purchases * 365
Working capital cycle: inventory turnover days + receivables collection period – payables payment period
• Working capital at any point in time should always be positive. When it is negative, it indicates that the business is suffering from a liquidity crisis and is on the urge of bankruptcy.
• Current and quick ratios should be closed to ideal ratios. If they are below the ideal ratio, it shows liquidity crises and financial crunch, but if they are more than the ideal ratio, then it is not a good sign as it reflects under-utilization of resources as the amount which should have been invested elsewhere is stuck into the business.
• Rate of inventory turnover indicates the rapidity with which inventory is being sold; the higher the rate of inventory turnover, the better the performance of the business is. Inventory turnover days, on the other hand, indicates how many days does it take for the inventory to be sold completely; the earlier the inventory is sold, the better the performance.
• The receivables collection period indicates the number of days it takes for the receivable to pay back the amount that they are. The payables payment period, on the other hand, indicates the number of days it takes for the business to pay off its payables.
• Working capital cycle help in identifying the number of days it takes for the working capital to be recovered; the shorter the working capital cycle, the better the liquidity.
How to Comment Ratios:
When commenting, it must be kept in mind that we will never comment in a haphazard manner whatever the sequence in which ratios are calculated. Instead, we will first comment on all profitability ratios then on all liquidity ratios, and, finally, on all resource utilization ratios. When commenting, we will not state that the ratio has increased or decreased; instead, we will identify whether the change in ratio shows improvement in performance or deterioration in performance. Moreover, we will also try and identify what caused the improvement and deterioration and suggest reasons for further improvement. Finally, we will give a concluding remark, to sum up, the comments we have made.