Interpretation Of Financial Statement Using Simple Ratio SS2 Financial Accounting Lesson Note

ACCOUNTING RATIOS

Once the financial statements of an organization are prepared they then need to be analyzed. One such tool to analyze and assess the financial situation of a firm is Ratio Analysis. It allows the stakeholder to make better sense of the accounts and better understand the current fiscal scenario of an entity. Let us take an in-depth look at ratio analysis.

MEANING OF RATIO ANALYSIS

Now, we have previously learned what ratios are. They are a comparison of two numbers concerning each other. Similarly, in finance, ratios are a correlation between two numbers or rather two accounts. So two numbers derived from the financial statement are compared to give us a clearer understanding of them. This is an accounting ratio.

Let us take an example. The income for the year from operations is let us say 1,00,000/- for a given year. The Purchases and other direct expenses cost around 75,000/-. So the Gross Profit of the year is 25,000/-. Now it can be said that the Gross Profit is 25% of the Operations Revenue. We calculate this as:

G.P. Ratio = GP Sales ×100

                    Revenue 

G.P.Ratio = 25,000  ×100

                  1,00,000 

G.P. Ratio = 25%

One factor to be kept in mind is that ratio analysis is used only to compare numbers that make sense and give us a better understanding of the financial statement. Comparing random financial accounts should be avoided.

OBJECTIVES OF RATIO ANALYSIS

Interpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfils.

1] Measure of Profitability: Profit is the ultimate aim of every organization. So, if I say that ABC firm earned a profit of 5 lakhs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratios, Expense Ratios etc. provide a measure of the profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.

2] Evaluation of Operational Efficiency: Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. Assets and financial resources must be allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets.

3] Ensure Suitable Liquidity: Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So, the liquidity of a firm is measured by ratios such as the Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.

4] Overall Financial Strength: Some ratios help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage ratios etc.

5] Comparison: The organizations’ ratios must be compared to the industry standards to get a better understanding of their financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratios to see the progress of the company. This is known as trend analysis.

ADVANTAGES OF RATIO ANALYSIS

When employed correctly, ratio analysis throws light on many problems of the firm and also highlights some positives. Ratios are essentially whistleblowers, they draw the management’s attention towards issues needing attention. Let us take a look at some advantages of ratio analysis.

1. Ratio analysis will help validate or disprove the financing, investment and operating decisions of the firm. 
2. They summarize the financial statement into comparative figures, thus helping the management to compare and evaluate the financial position of the firm and the results of their decisions.
3. It simplifies complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency, long-term positions etc.
4. Ratio analysis helps identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the complex accounting statements, and ratios will help pinpoint such problems.
5. Allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons etc. This will help the organization better understand its fiscal position in the economy.

 LIMITATIONS OF RATIO ANALYSIS

While ratios are very important tools of financial analysis, they have some limitations, such as:

1. The firm can make some year-end changes to their financial statements, to improve their ratios. Then the ratios end up being nothing but window dressing.
2. Ratios ignore the price level changes due to inflation. Many ratios are calculated using historical costs, and they overlook the changes in price levels between the periods. This does not reflect the correct financial situation.
3. Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration the monetary aspects (quantitative)
4. There are no standard definitions of the ratios. So firms may be using different formulas for the ratios. One such example is the Current Ratio, where some firms take into consideration all current liabilities but others ignore bank overdrafts from current liabilities while calculating the current ratio
5. And finally, accounting ratios do not resolve any financial problems of the company. They are a means to the end, not the actual solution

TYPES OF RATIOS

There are two ways in which financial ratios can be classified. There is the classical approach, where ratios are classified based on the accounting statement from where they are obtained. The other is a more functional classification, based on the uses of the ratios and the purpose for which they are calculated.

TRADITIONAL CLASSIFICATION

Traditional Classification has three types of ratios, namely:

i. Profit and Loss Ratios

ii. Balance Sheet Ratios

iii. Composite Ratios

i. Profit and Loss Ratios: When both figures are derived from the statement of Profit and Loss A/c we will call it a Profit and Loss Ratio. It can also be known as Income Statement Ratio or Revenue Statement Ratio. One such example is the Gross Profit ratio, which is the ratio of Gross Profit to Sales or Revenue. As you will notice, both these amounts will be derived from the Profit and Loss A/c. Other examples include the Operating ratio, Net Profit ratio, Stock Turnover Ratio etc.

ii. Balance Sheet Ratios: Just as above, if both variables are obtained from the balance sheets, it is known as a balance sheet ratio. When such a ratio expresses the relation between two accounts of the balance sheet, we also call them financial ratios (other than accounting ratios).

Take for example: The current ratio that compares current assets to current liabilities, both derived from the balance sheet. Other examples include Quick Ratio, Capital Gearing Ratio, Debt-Equity ratio etc.

iii. Composite Ratios: A composite ratio or combined ratio compares two variables from two different accounts. One is taken from the Profit and Loss A/c and the other from the Balance Sheet. For example the ratio of Return on Capital Employed. The profit (return) figure will be obtained from the Income Statement and the Capital Employed is seen in the Balance Sheet. A few other examples are Debtors Turnover Ratio, Creditors Turnover ratio, Earnings Per Share etc.

FUNCTIONAL CLASSIFICATION

Then we move onto the functional classification. These help us group the ratios according to the functions they perform in our understanding and analysis of financial statements. This is a more accurate and useful classification of ratios, and hence more commonly used as well. The types of ratios according to the functional classification are:

1. Liquidity Ratio
2. Leverage Ratios
3.  Activity Ratios
4. Profitability Ratios
5. Coverage Ratios

1. Liquidity Ratios

A firm has assets and liabilities to its name. Some are fixed in nature and then there are current assets and current liabilities. These are short-term in nature and easily convertible into cash. The liquidity ratios deal with the relationship between such current assets and current liabilities.

Liquidity ratios evaluate the firm’s ability to pay its short-term liabilities, i.e. current liabilities. It shows the liquidity levels, i.e. how many of their assets can be quickly converted to cash to pay off their obligations when they become due.

It is not only a measure of how much cash there is but also how easily current assets can be converted to cash or marketable securities. Now let us look at some of the important liquidity ratios.

a) Current Ratio: The current ratio is also known as the working capital ratio. It will measure the relationship between current assets and current liabilities. It measures the firm’s ability to pay for all its current liabilities, due within the next year by selling off all its current assets. The formula is as follows

Current Ratio =   Current assets

                           Current liabilities

Current Assets include:

1. Stock
2. Debtors
3. Cash and Bank Balances
4. Bills receivable
5. Accruals
6. Short-term loans that are given
7.  Short-term Securities
8. Current Liabilities include
9. Creditors
10. Outstanding Expenses
11. Short Term Loans that are taken
12.  Bank Overdrafts
13. Provision for taxation
14. Proposed Dividend

The ideal current ratio, according to the industry standard, is 2:1. That means that a firm should hold at least twice the amount of current assets than it has current liabilities. However, if the ratio is very high it may indicate that certain current assets are lying idle and not being utilized properly. So, maintaining the correct balance between the two is crucial

b) Quick Ratio: The other important one of the liquidity ratios is the Quick Ratio, also known as a liquid ratio or acid test ratio. This ratio will measure a firm’s ability to pay off its current liabilities (minus a few) by only selling off its quick assets.

Now Quick assets are those which can be easily converted to cash with only 90 days’ notice. Not all current assets are quick assets. Quick assets generally include cash, cash equivalents, and marketable securities. The formula is:

Quick Ratio 

=            Quick assets

Current liabilities quick liabilities

Quick Assets 

= All Current Assets – Stock – Prepaid Expenses

Quick Liabilities = All Current Liabilities – Bank Overdraft – Cash Credit

The ideal quick ratio is considered to be 1:1, so that the firm can pay off all quick assets with no liquidity problems, i.e. without selling fixed assets or investments. Since it does not take into consideration stock (which is one of the biggest current assets for most firms) it is a stringent test of liquidity. Many firms believe it is a better test of liquidity than the current ratio since it is more practical.

c) Absolute Cash Ratio: This is an even more rigorous liquidity ratio than a quick ratio. Here we measure the availability of cash and cash equivalents to meet the short-term commitment of the firm. We do not consider all current assets, only cash. Let us see the formula,

Absolute Cash ratio =   Cash + Bank balance + Marketable securities

d) Current liabilities: As you can see, this ratio measures the cash availability of the firm to meet the current liabilities. There is no ideal ratio, it helps the management understand the level of cash availability of the firm and make any changes required.

However, if the ratio is greater than 1 it indicates poor resource management and very high liquidity. And high liquidity may mean low profitability.