Tuesday, September 15, 2009

RATIO ANALYSIS

RATIO ANALYSIS OR ACCOUNTING RATIOS

01. Ratio Analysis:
v A ratio is simply a quotient of two numbers.
v This is an instrument for diagnosis of the financial health of an enterprise.
v It does by evaluating important aspects of the conduct of business like liquidity, solvency, profitability, capital gearing, etc.
v It is an invaluable aid to management in the discharge of basic functions of forecasting, planning, co-ordination, communication, and control.
v The technique used by Accountants to facilitate the discussion of the questions ( a few are listed below) listed below is Ratio analysis -

-
Profitability Are the profits adequate for the capital employed?
Solvency Can the concern repay its creditors?
Ownership What extent of the business is financed by its creditors?
Financial Strength Has it got sufficient resources to enable it to expand?
Trend Are the profits on a rising scale or Are they falling away?
Gearing How certain are dividends?

02. What they are:
v Pure ratios - (e.g. = 2:1) (Current Assets: Current Liabilities).
v No. of times -(e.g. : Stock Turnover being 6 times a year)
v Percentages - (e.g.: 30% Gross profit on Sales).
03. Handling of Ratios:
By itself may be meaningless unless it is interpreted against some standard and analysed on a comparative basis.
v Usefulness depends upon the ingenuity and experience of the analyst who employs them.
v Properly used, can assist for improving efficiency. In the wrong hands, may mislead.
04. Why Ratios?
v Absolute figures are often misleading.
v The value of absolute figures increases manifold if they are studied with ratio analysis.
v Ratios enable mass of data to be summarised and simplified for presentation to management for decision making.
v "Time series analysis" - the comparison of ratios of the same company over a period of time for evaluating the CO's financial condition and profitability.
v "Cross Sectional Analysis" an analysis of the future based on projected financial statements. It may also be in comparison with those of similar companies in the same line of business and with an industry average.
v Past ratios indicate trends in costs, sales, profit and other relevant facts. For forecasting likely events, they may be very useful.
v By accounting ratios, the plans made can be 'signposted'.
v To establish the desirable co-ordination or balance they may be used.
v Control of performances (e.g. Sales quotas) as well as control of costs may be materially assisted by the use of ratios.
v Ratios may be used as measures of efficiency for inter-firm and intra-firm comparisons.
v Ratios can play a vital role in informing what has happened.
v If properly selected, correctly calculated, and timely presented, accounting ratios often prove very handy and useful tools for helping the management to have a clear grasp of the trend of the business resulting from the policy followed so far.

05. Limitations
Ratio analysis has a number of pitfalls:
v Ratios are calculated from the data drawn from accounting records. As such, it suffers from the inherent weakness of the accounting system itself which is the source of data.
v Ratios compared from single set of figures will not have much significance. They must be compared with independent standards. But, as ratios share with other statistical concepts the fact that all the limitations of the latter in the determination of a proper standard for comparison can't be ignored
v Ratios are clues, not bases for immediate conclusions. They are only the means to reach conclusions and not conclusion in themselves. They give just a fraction of information needed for decision making.
v Conclusions from analysis of statements are not sure indicators of bad or good management. They give room to suspicion and should be carefully looked into. For example, a high inventory turnover generally considered to be indication of operating efficiency may be temporarily achieved by unwarranted price reduction or failure to maintain stock-in-hand.
v As ratios are simple to calculate and easy to understand, there is a tendency to employ them profusely. When too many ratios are calculated, they are likely to confuse instead of revealing meaningful conclusions.
v Different agencies adopt different definitions, thereby making the ratios non-comparable.

06. Classification of Ratios:

Structural point of view Balance sheet ratios, Profit & Loss Account ratios, Composite Ratios.
Functional point of view - Solvency Ratios, Profitability Ratios, Efficiency & performance Ratios.

STRUCTURAL POINT OF VIEW
RATIO ANALYSIS
BALANCE SHEET RATIOS
PROFIT & LOSS ACCOUNT RATIOS
COMPOSITE RATIOS
Current (or 2 to 1) Ratio.
Gross Profit Ratio
Return on Proprietor's Fund.
Quick Ratio or Liquid Ratio or Acid Test Ratio.
Net Profit Ratio
Return on Proprietor's Equity.
Proprietory Ratio.
Expense Ratio
Return on Equity Share Capital
Assets Proprietorship Ratio.
Operating Ratio
Return on Capital Employed.
Debt-Equity Ratio.
Stock Turnover Ratio
Return on total Assets
Capital gearing Ratio.
Turnover of Fixed Assets.
Turnover of Total Assets.
Turnover of Working Capital.
Debtors' Turnover
Creditors' Velocity

FUNCTIONAL POINT OF VIEW
RATIO ANALYSIS
SOLVENCY
PROFITABILITY
EFFICIENCY
&
PERFORMANCE
SHORT TERM
IMME-DIATE
LONG TERM
Gross Profit Ratio
Solvency Ratio

Current
Ratio
Quick
Ratio
Proprietory
Ratio
Net Profit Ratio
Capital Gearing Ratio



Dividend Per Share Ratio
Stock Turn Over Ratio
Return on Capital Employed
Operating Ratio
Return on Equity
Expense Ratio


Return on total assets etc.
Turnover of Total assets etc.
07. Operating Ratio - in Management Accounting:-
v This is obtained by dividing the total of the cost of goods sold plus operating expenses by the amount of sales. Lower the ratio the better it is! The ratio is calculated as
Cost of goods Sold + Manufacturing, Administrative, Selling Expenses and financial Expenses
X
100
Net Sales

v A comparison of operating ratio would indicate whether the cost content is higher or low in the figure of sales.

v A rise in the operating ratio indicates decline in efficiency;

Net Profit Ratio + Operating Ratio = 100

v This is the most general measure of operating efficiency and is important to managements in judging its operations.

v In general, for manufacturing concerns, operating ratio is expected to touch a percentage of 75 to 85.

v The difference between the operating ratio and 100 is the ratio of operating profit to net sales. Lower the operating ratio, higher the margin of profit.

v While this ratio serves as an index of overall efficiency, its usefulness is limited by its vulnerability to changes resulting from management decisions.

08. Inventory Turnover Ratio (or Stock turnover Ratio or Inventory Ratio). (in Management Accounting).

v It shows the number of times the stock is turned over during the accounting period. It is the ratio between the average stock (i.e. Closing Stock + Opening Stock divided by 2) held and the cost of sales (Opening Stock + Purchases - Closing Stock).

v For Example, the opening stock, purchases and closing stock of a company are Rs.18, 000/-, Rs.3, 44,000/-, Rs.20, 000/- respectively. The Stock turnover ratio is worked out as
X
= 18 timesCost of Goods Sold 3, 42,000
Average Stock 19,000

v High inventory turnover indicates that more sales are being produced by a unit of investment in stocks and thus reflects an effective inventory management.

v A low turnover ratio may indicate that the concern has accumulated unsaleable goods or may be the inventories are over valued.

v It affords useful information whether capital is being locked-up in slow moving stocks or whether Gross Profit may be increased by reducing prices in order to induce a rapid rate of turnover. Therefore, an increase in the ratio may indicate expansion of the business and a decrease the opposite.

v This ratio can be improved in one of the three ways.
By keeping sales at the same level, while reducing the stock of finished goods.
By increasing sales, while keeping the stock of finished goods at the same level.
By increasing sales, while at the same time reducing the stock of finished goods.
v This ratio also shows whether the concern is indulging in overtrading or undertrading. A sharp increase in this ratio along with sharp increase in the ratio of inventory to working capital may indicate over trading, and a sharp fall in this ratio may indicate undertrading.

09. Return on Capital Employed [or on investment (ROR)]
Ratio - 1
v
Return of Capital Employed
=
Profits
X
100
Capital Employed

Ratio - 2
v Return on Capital Employed
=
Profit
X
Sales
X
100
Sales
Capital Employed

v Ratio 1 -reveals the efficiency of trading operation of the business. It is a profitability ratio.

v Ratio 2 -reveals the degree, of success in the utilization of capital used in the business. It is a capital-turnover ratio

v A business might be efficient in trading operations, showing a high profitability ratio. But this may be accompanied by excessive employment of capital in relation to the value of sales achieved by the business.

10. Common standards:

v Ratios in themselves are meaningless unless they are compared to some appropriate standard.

v What is an appropriate standard? It is very difficult to answer. It is only mental generalisation of what is adequate and normal. There are four common standards used in this connection. They are as follows:

1. Absolute Standards.
2. Historical Standards
3. Horizontal Standards.
4. Budgetted Standards.

v 1. Absolute Standards are those which become generally recognised as being desirable regardless of type of company. However, there can hardly be an independent absolute standard which is desirable in all cases.

v 2. Historical Standards (also known as Internal Standards) involve comparing a company's own past performance as a standard for the present or future. It simply shows that the current period is better or worse than the past. However, it does not provide a sound basis for judgement, as historical standard may not have represented an acceptable standard.

v 3. Horizontal Standards (also known as External Standards) compared one company with another company or companies of the same nature. We know that no two companies are similar variations in accounting methods lead to significant differences in ratios. Such industry standards are periodically published in the Reserve Bank of India Bulletin and other financial dailies.

v 4. Budgeted Standard is arrived at after preparing the budget for a period. Such standards may be set by management as goals. They can be very useful because they are evolved after taking into account the prevailing conditions and the specific company situation. In fixing the budgeted standards, the management has to pay due attention to historical as well as horizontal standards.

11. Railway Financial Ratios:

v Financial Ratios: - The financial efficiency of operating an enterprise can best be seen from the 'financial ratios' which are worked out from the Statement of Profit and Loss for the year and the Balance Sheet (of Assets and Liabilities) as at the end of the year. The glossary of terms which should be used in Railway Estimates and Financial statements is given in para 308-F.
v The important financial ratios, applicable to Indian Railways, may now be described as shown below: -

(a) Operating Rate, i.e., percentage of gross working expenses [item (xiii) of para 308-F] to gross earnings [item (vi)] of para 308-F).

(b) Return on Capital -
(i) Percentage of (revenue) surplus (item xxi of Para 308-F) to Capital-at-charge (item xxii of para 308-F).

(ii) Percentage of net receipts (item xix of para 308-F_ to Capital-at-charge.

(c) Current Assets/Liabilities -
(i) Stores in stock in terms of month's consumption.
(ii) Work-in-progress (workshops) as a percentage of the value of workshop outturn.
(iii) Stores Inventory (stores, 'purchases', 'sales', and miscellaneous advance, capital, etc.,) as percentage the total issue of stores.
(iv) Unrealised earnings at the year-end in terms of number of days, earnings.

v The above ratios, compared from year to year, provide useful information for judging the financial performance of the Railways.

v Glossary of terms used

(i) Coaching Earnings (less refunds)

(ii) Goods Earnings (less refund)

(iii) Traffic Earnings = (i) + (ii)

(iv) Sundry Other Earnings (Less refunds) = Other than Traffic Earnings.

(v) Gross Earnings = (iii) +) iv) = true or accrued earnings in an accounting period whether or not actually realised.

(vi) Suspense.

(vii) Gross Receipts = (v) + (vi) = Earnings actually realised during an accounting period.

(viii) Miscellaneous Receipts = Guarantee recoverable from State governments + Other Miscellaneous Receipts, such as Government share of surplus profits, sale of land of subsidized companies, receipts from surcharge on Passenger fares, etc.

(ix) Total Revenue receipts = (vii) + (viii)

(x) Ordinary Working Expenses = Expenses booked under final heads, excluding appropriation to Depreciation Reserve Fund, and Pension Fund. (Payments on account of accident compensation and Pensionary payments should also be excluded).
(xi) Appropriation to Depreciation Reserve Fund.

(xii) Appropriation to Pension Fund.

(xiii) Gross Working Expenses = (x) + (xi) + (xii) = True expenses in an accounting period whether or not actually disbursed.

(xiv) Suspense.

(xv) Gross Expenditure = (xiii) + (xiv) = Working, Expenses actually disbursed during an accounting period.

(xvi) Miscellaneous expenditure = surveys + Land for subsidized companies; subsidy + other Miscellaneous Railway Expenditure. Appropriations to Pension Fund relating to Railway Board and Miscellaneous establishments booked under grants 1 & 2 and Accident Compensation, Safety and Passenger Amenities fund and Open Line Works (Revenue_ expenditure, and payments to worked lines.

(xvii) Total Revenue Expenditure = (xv) + (xvi)

(xviii) Net earnings = (v) - (xiii)

(xix) Net Receipts = (ix) - (xvii)

(xx) Payments to General Revenues.

(xxi) Surplus/Shortfall = (xix) - (xx).

Note: The "Surplus or Shortfall" shown in item (xxi) differs from the "gain or loss" given in Account No.110 of the Finance and Revenue Accounts of the Government of India, as besides dividend, the former takes into account all the Miscellaneous Receipts (viii) and Expenditure (xvi) attributable to a Railway, whereas the latter does not.

(xxii) Capital-at-charge represents the Central Government's investment in the Railways by way of Loan Capital and value of the assets created therefrom.

12. Railway Operating Ratio: (Time series analysis)
Year @
Indian Railways
Southern Railway
1991-92
89.5%
117.81 %
1992-93
87.4%
118.51 %
1993-94
82.9%
110.60 %
1994-95
82.6%
109.47 %
1995-96
82.5%
105.62%
1996-97
86.2%
106.98 %
1997-98
90.9%
111.81 %
1998-99
93.3%
114.29 %
1999-2000
93.3%
114.29%
2000-01(RE)
98.5%
-
2001-02 (BE)
98.8%
-

v Cross Sectional Analysis

RAILWAYS
INDIAN ZONAL RAILWAYS
1992-93
1993-94
1994-95
1995-96
1996-97
Central
76.51
74.33
77.97
80.79
84.38
Eastern
98.40
93.49
91.79
95.83
97.71
Northern
86.51
81.65
83.25
80.45
83.56
North Eastern
182.67
174.06
177.39
158.21
164.74
North East Frontier
187.88
186.70
186.51
196.01
210.74
Southern
118.51
110.60
109.47
105.62
106.98
South Central
85.76
81.98
84.03
78.98
80.96
South Eastern
69.00
65.18
62.75
63.93
68.73
Western
70.87
67.83
64.90
64.66
69.52
Total Indian Rlys.
*87.36
*82.93
*82.64
*82.45
*86.22



13. Ratio of net revenue to capital-at-charge:
(Please see annexure enclosed)


14. Railway inventory turnover ration (Excl. Fuel)

Year
Indian Railways
Southern Railway
Central Railway
1991-92
20.97 % (RE)
24.19 %
-
1992-93
21.93 % (BE)
36.53 %
-
1993-94
-
22.34 %
28.15 %
1994-95
-
16.81
22.54 %
1995-96
-
12.80 %
17.77 %
1996-97
12.00 %
9.69 %
16.00 %
1997-98
11.00 %
10.58 %
13.35 %
1998-99
-
13.12 %
-
1999-2000
11.00 %
14.33 %
-
2000-2001(RE)
14.00 %
-
-
2001-2002 (BE)
14.00 %
-
-

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