The Ratio Is An Arithmetical Expression Finance Essay - Free Essay Example

Sample details Pages: 12 Words: 3508 Downloads: 9 Date added: 2017/06/26 Category Finance Essay Type Compare and contrast essay Did you like this example? The ratio is an arithmetical expression i.e. relationship of one number to another. It may be defined as an indicated quotient of the mathematical expression. Don’t waste time! Our writers will create an original "The Ratio Is An Arithmetical Expression Finance Essay" essay for you Create order It is expressed as a proportion or a fraction or in percentage or in terms of number of times. A financial ratio is the relationship between two accounting figures expressed mathematically. The financial statements, incorporating the profit and loss account statement, the balance sheet, and the cash flow statement and all of the associated notes, contain a vast amount of information. The role of ratios is to distil this information into a more usable form for the purpose of analysis. Ratios provide clues to the financial position of a concern. These are the indicators of financial strength, soundness, position or weakness of an enterprise. One can draw conclusions about the financial position of a concern with the help of accounting ratios. Liquidity Ratios The term liquidity refers to the ability of the company to meet its current liabilities. Liquidity ratios assess capacity of the firm to repay its short term liabilities. Thus, liquidity ratios measure the firms ability to fulfil short term commitments out of its liquid assets. The important liquidity ratios are (i) Current ratio (ii) Quick ratio Current ratio Current ratio is a ratio between current assets and current liabilities of a firm for a particular period. This ratio establishes a relationship between current assets and current liabilities. The objective of computing this ratio is to measure the ability of the firm to meet its short term liability. It compares the current assets and current liabilities of the firm. This ratio is calculated as under: Current ratio = Current Assets Current liabilities Current Assets are those assets which can be converted into cash within a short period i.e. not exceeding one year. It includes the following: Cash in hand, Cash at Bank, Bill receivables, Short term investment, Sundry debtors, Stock, Prepaid expenses Current liabilities are those liabilities which are expected to be paid within a year. It includes the following: Bill payables, Sundry creditors, Bank overdraft, Provision for tax, outstanding expenses. Significance It indicates the amount of current assets available for repayment of current liabilities. Higher the ratio, the greater is the short term solvency of a firm and vice a versa. However, a very high ratio or very low ratio is a matter of concern. If the ratio is very high it means the current assets are lying idle. Very low ratio means the short term solvency of the firm is not good. Thus, the ideal current ratio of a company is 2: 1 i.e. to repay current liabilities; there should be twice current assets. Quick ratio Quick ratio is also known as Acid test or Liquid ratio. It is another ratio to test the liability of the concern. This ratio establishes a relationship between quick assets and current liabilities. This ratio measures the ability of the firm to pay its current liabilities. The main purpose of this ratio is to measure the ability of the firm to pay its current liabilities. For the purpose of calculating this ratio, stock and prepaid expenses are not taken into account as these may not be converted into cash in a very short period. This ratio is calculated as under: Liquid ratio = Liquid or quick assets Current liabilities Where, liquid assets = current assets (stock + prepaid expenses) Significance Quick ratio is a measure of the instant debt paying capacity of the business enterprise. It is a measure of the extent to which liquid resources are immediately available to meet current obligations. A quick ratio of 1: 1 is considered good/favourable for a company. ACTIVITY RATIO Activity ratios measure the efficiency or effectiveness with which a firm manages its resources. These ratios are also called turnover ratios because they indicate the speed at which assets are converted or turned over in sales. These ratios are expressed as times and should always be more than one. Some of the important activity ratios are : (i) Stock turnover ratio (ii) Debtors turnover ratio (iii) Creditors turnover ratio (iv)Working capital turnover ratio Stock turnover ratio Stock turnover ratio is a ratio between cost of goods sold and the average stock or inventory. Every firm has to maintain a certain level of inventory of finished goods. But the level of inventory should neither be too high nor too low. It evaluates the efficiency with which a firm is able to manage its inventory. This ratio establishes relationship between cost of goods sold and average stock. Stock Turnover Ratio =Cost of goods sold = Sales Gross Profit Average stock = Opening stock + Closing stock 2 (i) If cost of goods sold is not given, the ratio is calculated from the sales. (ii) If only closing stock is given, then that may be treated as average stock. Inventory/stock conversion period It may also be of interest to see average time taken for clearing the stocks. This can be possible by calculating inventory conversion period. This period is calculated by dividing the number of days by inventory turnover. Inventory conversion period = Days in a year I nventory turnover ratio (times) Significance The ratio signifies the number of times on an average the inventory or stock is disposed of during the period. The high ratio indicates efficiency and the low ratio indicates inefficiency of stock management. Debtors Turnover ratio This ratio establishes a relationship between net credit sales and average account receivables i.e. average trade debtors and bill receivables. The objective of computing this ratio is to determine the efficiency with which the trade debtors are managed. This ratio is also known as Ratio of Net Sales to average receivables. It is calculated as under Debtors Turnover Ratio = Net credit annual sales Average debtors In case, figure of net credit sale is not available then it is calculated as if sales are credit sales: Average debtors = Opening Debtors + Closing Debtors 2 Note: If opening debtors are not available then closing debtors and bills receivable are taken as average debtors. Debt collection period This period refers to an average period for which the credit sales remain unpaid and measures the quality of debtors. Quality of debtors means payment made by debtors within the permissible credit period. It indicates the rapidity at which the money is collected from debtors. This period may be calculated as under : Debt collection period = Average Trade Debtors Average Net credit sales period Significance Debtors turnover ratio is an indication of the speed with which a company collects its debts. The higher the ratio, the better it is because it indicates that debts are being collected quickly. In general, a high ratio indicates the shorter collection period which implies prompt payment by debtor and a low ratio indicates a longer collection period which implies delayed payment for debtors. Creditors Turnover Ratio It is a ratio between net credit purchases and average account payables (i.e creditors and Bill payables). In the course of business operations, a firm has to make credit purchases. Thus a supplier of goods will be interested in finding out how much time the firm is likely to take in repaying the trade creditors. This ratio helps in finding out the exact time a firm is likely to take in repaying to its trade creditors. This ratio establishes a relationship between credit purchases and average trade creditors and bill payables and is calculated as under Creditors turnover ratio = Net credit purchases Average trade creditors Average creditors = Creditors in the beginning + Creditors at the end 2 Significance Creditors turnover ratio helps in judging the efficiency in getting the benefit of credit purchases offered by suppliers of goods. A high ratio indicates the shorter payment period and a low ratio indicates a longer payment period. Working Capital Turnover Ratio Working capital of a concern is directly related to sales. The current assets like debtors, bill receivables, cash, stock etc., change with the increase or decrease in sales. Working capital = Current Assets Current Liabilities Working capital turnover ratio indicates the speed at which the working capital is utilised for business operations. It is the velocity of working capital ratio that indicates the number of times the working capital is turned over in the course of a year. This ratio measures the efficiency at which the working capital is being used by a firm. A higher ratio indicates efficient utilisation of working capital and a low ratio indicates the working capital is not properly utilised. This ratio can be calculated as Working Capital Turnover Ratio = Cost of sales working capital SOLVENCY RATIOS The term solvency refers to the ability of a concern to meet its long term obligations. The long-term liability of a firm is towards debenture holders, Financial institutions providing medium and long term loans and other creditors selling goods on credit. These ratios indicate firms ability to meet the fixed interest and its costs and repayment schedules associated with its long term borrowings. The following ratios serve the purpose of determining the solvency of the business firm. Debt equity ratio Proprietary ratio Debt-equity ratio It is also otherwise known as external to internal equity ratio. It is calculated to know the relative claims of outsiders and the owners against the firms assets. This ratio establishes the relationship between the outsiders funds and the shareholders fund. Thus, Debt-equity ratio = Outsiders funds Share holders funds The two basic components of the ratio are outsiders funds and shareholders funds. The outsiders funds include all debts/liabilities to outsiders i.e. debentures, long term loans from financial institutions, etc. Shareholders funds mean preference share capital, equity share capital, reserves and surplus and fictitious assets like preliminary expenses. This ratio indicates the proportion between shareholders funds and the long-term borrowed funds. In India, this ratio may be taken as acceptable if it is 2: 1. If the debt-equity ratio is more than that, it shows a rather risky financial position from the long term point of view. Significance The purpose of debt equity ratio is to derive an idea of the amount of capital supplied to the concern by the proprietors. This ratio is very useful to assess the soundness of long term financial position of the firm. It also indicates the extent to which the firm depends upon outsiders for its existence. A low debt equity ratio implies the use of more equity than debt. Proprietary ratio It is also known as equity ratio. This ratio establishes the relationship between shareholders funds to total assets of the firm. The shareholders fund is the sum of equity share capital, preference share capital, reserves and surpluses. Out of this amount, accumulated losses should be deducted. On the other hand, the total assets mean total resources of the concern. The ratio can be calculated as under: Proprietary ratio = Shareholders funds Total assets Significance Proprietary ratio throws light on the general financial position of the enterprise. This ratio is of particular importance to the creditors who can ascertain the proportion of shareholders funds in the total assets employed in the firm. A high ratio shows that there is safety for creditors of all types. Higher the ratio, the better it is for concerned. A ratio below 50% may be alarming for the creditors since they may have to lose heavily in the event of companys liquidation on account of heavy losses. PROFITABILITY RATIOS The main aim of an enterprise is to earn profit which is necessary for the survival and growth of the business enterprise. It is earned with the help of amount invested in business. It is necessary to know how much profit has been earned with the help of the amount invested in the business. This is possible through profitability ratio. These ratios examine the current operating performance and efficiency of the business concern. These ratios are helpful for the management to take remedial measures if there is a declining trend. The important profitability ratios are: (i) Gross profit ratio (ii) Net profit ratio (iii) Operating profit ratio (iv) Return on investment ratio Gross profit ratio It expresses the relationship of gross profit to net sales. It is expressed in percentage. It is computed as Gross profit ratio = Gross profitÃÆ'Æ’-100 Net sales where Net sales = Total sales (sales returns + excise duty) Gross profit = Net sales Cost of goods sold. Significance Gross profit ratio shows the margin of profit. A high gross profit ratio is a great satisfaction to the management. It represents the low cost of goods sold. Higher the rate of gross profit, lower the cost of goods sold. Net profit ratio A ratio of net profit to sales is called Net profit ratio. It indicates sales margin on sales. This is expressed as a percentage. The main objective of calculating this ratio is to determine the overall profitability. The ratio is calculated as: Net profit ratio = Net profit ÃÆ'Æ’-100 Net sales Significance Net profit ratio determines overall efficiency of the business. It indicates the extent to which management has been effective in reducing the operational expenses. Higher the net profit ratio, better it is for the business. Operating profit ratio Operating profit is an indicator of operational efficiencies. It reveals only overall efficiency. It establishes relationship between operating profit and net sales. This ratio is expressed as a percentage. It is calculated as: Operating profit = Operating profit ÃÆ'Æ’-100 Net sales Operating Profit = Gross Profit (Administration expenses + selling expenses) Significance It helps in examining the overall efficiency of the business. It measures profitability and soundness of the business. Higher the ratio, the better is the profitability of the business. This ratio is also helpful in controlling cash. Return on investment ratio (ROI) ROI is the basic profitability ratio. This ratio establishes relationship between net profit (before interest, tax and dividend) and capital employed. It is expressed as a percentage on investment. The term investment here refers to long-term funds invested in business. This investment is called capital employed. where Capital employed = Equity share capital + preference share capital + Reserve and surplus + long term liabilities fictitious assets Non trading investment OR Capital employed = (Fixed asset depreciation) + (Current Asset- Current liabilities) OR Capital employed = (Fixed Assets Depreciation) + (Working capital) This ratio is also known as Return on capital employed ratio. It is calculated as under ROI = Net profit before interest, tax and dividend ÃÆ'Æ’-100 Capital employed Significance ROI ratio judges the overall performance of the concern. It measures how efficiently the sources of the business are being used. In other words, it tells what is the earning capacity of the net assets of the business. Higher the ratio the more efficient is the management and utilisation of capital employed. LEVERAGE RATIO Leverage ratio is otherwise known as capital structure ratio. The term capital structure refers to the relationship between various long term forms of financing such as debentures (long term), preference share capital and equity share capital including reserves and surpluses. Financing the firms assets is a very crucial problem in every business and as a rule there should be a proper mix of debt and equity capital in financing the firms assets. Leverage or capital structure ratios are calculated to test the long term financial position of a firm. Generally capital gearing ratio is mainly calculated to analyse the leverage or capital structure of the firm Capital gearing ratio The capital gearing ratio is described as the relationship between equity share capital including reserves and surpluses to preference share capital and other fixed interest bearing loans. If preference share capital and other fixed interest bearing loans exceed the equity share capital including reserves, the firm is said to be highly geared. The firm is said to be low geared if preference share capital and other fixed interest bearing loans are less than equity capital and reserves. Capital gearing ratio = Equity share capital reserves and surpluses Preference share capital + long term debt bearing fixed interest Significance Capital gearing ratio is very important ratio. Gearing should be kept in such a way that the company is able to maintain a steady rate of dividend. High gearing ratio is not good for a new company or a company of which future earnings are uncertain. LIMITATION OF ACCOUNTING RATIOS Accounting ratios are very significant in analysing the financial statements. Through accounting ratios, it will be easy to know the true financial position and financial soundness of a business concern. However, despite the advantages of ratio analysis, it suffers from a number of disadvantages. The following are the main limitations of accounting ratios. Ignorance of qualitative aspect The ratio analysis is based on quantitative aspect. It totally ignores qualitative aspect which is sometimes more important than quantitative aspect. Ignorance of price level changes Price level changes make the comparison of figures difficult over a period of time. Before any comparison is made, proper adjustments for price level changes must be made. No single concept In order to calculate any ratio, different firms may take different concepts for different purposes. Some firms take profit before charging interest and tax or profit before tax but after interest tax. This may lead to different results. Misleading results if based on incorrect accounting data Ratios are based on accounting data. They can be useful only when they are based on reliable data. If the data are not reliable, the ratio will be unreliable. No single standard ratio for comparison There is no single standard ratio which is universally accepted and against which a comparison can be made. Standards may differ from Industry to industry. Difficulties in forecasting Ratios are worked out on the basis of past results. As such they do not reflect the present and future position. It may not be desirable to use them for forecasting future events. BALANCE SHEET OF TAJ GROUP OF HOTELS INDIA (RS IN MILLIONS) LIABLITIES MARCH-2011 MARCH-2010 SHARE CAPITAL 62034.50 62033 RESERVES SURPLUS 235011.50 210974.30 NETWORTH SECURED LOANS UNSECURED LOANS 297046 39130.50 230331.30 273007 35205.80 145011.10 TOTAL LIABLITIES 566507.80 453224.20 ASSETS MARCH 2009 MARCH 2008 GROSS BLOCK 200570.10 164795.90 (-)ACC. DEPRECIATION NET BLOCK (A) 90624.70 109945.40 82324.80 82561.10 CAPITAL WORK IN PROGRES (B) 34876.80 43674.50 INVESTMENTS 423717.80 41031.90 INVENTORIES 34804.70 26049.80 SUNDRY DEBTORS 6359.80 5434.80 CASH AND BANK 15906 4650.40 LOANS AND ADVANCES 58846 345828.40 (1) 115916.60 381963.40 CURRENT LIABLITIES 89657.60 684222.60 PROVISIONS 29341.90 29135.20 (2) 118999.50 97557.80 NET CURR ASSETS (1-2) -3082.90 284405.60 MISC. EXPENSES 1050.70 1551.10 ANNUAL PROFIT AND LOSS STATEMENT TAJ GROUP OF HOTELS INDIA( RS IN MILLIONS) MARCH- 2009 MARCH-2008 SALES 243483.20 196544.10 OTHER INCOME 3053.60 3472.80 TOTAL INCOME 246536.80 200016.90 RAW MATERIAL COST 82794.40 60248 EXCISE 24952.10 25370.20 OTHER EXPENCES 43972.30 28480.50 OPERATING PROFIT 91764.40 82445.40 INTREST NAME 14895 9290.30 GROSS PROFIT 76869.40 73155.10 DEPRECIATION 9734 8346.10 PROFIT BEF TAX 70189 68281.80 NET PROFIT 49040.30 44479 OTHER NON RECURRING INCOME 2977.10 2391 REPORTED PROFIT 52017.40 46870.30 EQUITY DIVEDEND 11689.50 11689.30 ANALYSIS FOR FINANCIAL RATIOS FOR 2011 RATIO PARTICULARS VALUE CRITIQUE Net Working Capital = Current assets-Current liabilities Current Assets = 115,916.60 Current Liabilities =118,999.50 3082.9 Liquidity available is less 2 Current Ratio =Current Assets Current Liabilities Current Assets = 115,916.60 Current Liabilities = 118,999.50 0.97 It is not safe. Acid test or Quick ratio =Quick Assets Current Liabilities Quick Assets = 81111.9 Current Liabilities =118,999.50 0.68 It is not safe. Debt-Equity Ratio = Long term debt Shareholders Equity Total debt = 269461.8 Shareholder Equity = 297,046.00 0.91 It is good. Interest Coverage = Operating Profit Interest Operating Profit = 91,764.40 Interest = 14,895.00 6.16 It is not safe. Operating Profit margin = Operating Profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Sales Operating Profit = 91,764.40 Sales = 243,483.20 37 % It is good. Gross Profit margin = Gross Profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Sales Gross Profit = 76,869.40 Sales = 243,483.20 31.57 % It is good. Net Profit margin = Net profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Sales Net Profit = 52,017.40 Sales =243,483.20 21.36% It is not good. Return on Assets = Operating Profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Average Assets Operating Profit = 91,764.40 Average Assets = 616843.75 14.87% It is not good. Return on Investments =Profit Before Tax ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Net worth Profit Before Tax = 70189 Net Worth = 297046 23.62% It is not satisfactory Return on Net Worth =Net Profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Average Net worth Net profit = 49040.30 Average Net Worth = 285026.65 17.20% It is not good. Return on Capital Employed = Operating Profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Average Capital Employed Operating Profit = 91,764.40 Avg. Capi tal Employed = 725122.4 12.65% It is not good. Operating Ratio = Cost of Goods sold + other Expenses Sales Other Expenses = 43,972.30 0.52 0.52 It is not satisfactory Fixed Assets turnover = sales Fixed assets Fixed Assets = 568540 Sales = 243,483.20 0.42 It is satisfactory ANALYSIS FOR FINANCIAL RATIOS FOR 2010 RATIO PARTICULAR VALUE CRITIQUE Net Working Capital = Current assets-Current liabilities Current Assets = 381963.40 Current Liabilities = 97557.80 284405.6 Liquidity position is good. Current Ratio = Current Assets Current Liabilities Current Assets = 381963.40 Current Liabilities = 97557.80 3.92 It is safe Acid test or Quick ratio = Quick Assets Current Liabilities Quick Assets = 355913.6 Current Liabilities = 97557.80 3.64 It is satisfactory Debt-Equity Ratio = Long term debt Shareholders Equity Total debt = 180216.9 Shareholder Equity = 273007.30 0.66 It is not safe Interest Coverage = Operating profit Interest Operating Profit = 82445.40 Interest = 9290.30 8.87 It is not satisfactory Operating Profit margin = Operating profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Sales Operating Profit = 82445.40 Sales = 196544.10 41% It is satisfactory Gross Profit margin = Gross profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Sales Net Profit = 46870.30 Sales =196544.10 23.8% It is not satisfactory Return on Assets = Operating profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Average Assets Operating Profit = 82445.40 Average Assets = 433708.7 19 % It is not safe. Return on Investments = profit before Tax ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Net worth Profit Before Tax = 68281.80 Net Worth = 273007.30 25.01% It is not good Return on Net Worth = Net profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Average Net worth Net profit = 44479 Average Net Worth = 206984.4 21.48% It is not satisfactory Return on Capital Employed = Operating profit ÃÆ' ¢Ãƒâ€¹Ã¢â‚¬  - 100 Average Capital Employed Operating Profit = 82445.40 Avg. Capital Employed = 523886.1 15.73% It is not safe Cost of Goods Sold Ratio =Cost of Goods Sold Sales Cost of goods sold = 60248 Sales = 196544.10 0.30 It is not satisfactory Operating Ratio = Cost of Goods sold + other Expenses Sales Other Expenses = 28480.50 0.45 It is not satisfactory Fixed Assets turnover = sales Fixed assets Fixed Assets = 167267.5 Sales = 196544.10 1.17 It is not safe