## Ratio Analysis

Introduction

Financial statement gives us clear idea about the financial position of the company. It will help the proprietor whether to continue the business or closed down or to make changes in working style of the business. Every businessman is interested in profit margin only. Financial statement gives the clear idea of the profit margin in amounting term. But with the help of ratio, we get the clear idea of comparison and with the help of ratio we are able to express the relationship between different figures.

Meaning

Ratios express the relationship between two number as well as accounting figures. It shows the process of computing and presenting the relationship between items of the financial statement.

Types of Ratio

It is possible to look at the financial health of a corporation by looking at some of its key financial ratios. Ratio analysis can also be used as a diagnostic tool to find the sources of financial trouble at a company.

The ratios may be divided into these types:

1. Liquidity ratios, that look at the availability of cash for operations.

It measures the short-term solvency, i.e., the firm’s ability to pay its current dues. They comprise of Current Ratio and Liquid Ratio.

Current Ratio or Working Capital Ratio is a relationship of current assets to current liabilities.

Current Assets are the assets that are either in the firm of cash or cash equivalents or can be converted into cash or cash equivalents in a short time (say, within a year’s time) and Current Liabilities are repayable in a short time. It is calculated as follows:

Significance:

The objective of calculating Current Ratio is to assess the ability of the enterprise to meet its short-term liabilities promptly. It shows the number of times the current assets can be converted into cash to meet current liabilities. As a normal rule current assets should be twice the current liabilities.

Low ratio indicates inadequacy of the enterprise to meet its current liabilities and inadequate working Capital.

High Ratio is an indication of inefficient utilization of funds. An enterprise should have a reasonable current ratio. Although there is no hard and fast rule yet a current ratio of 2:1 is considered satisfactory. Current Ratio is calculated at a particular date and not for a particular period.

The following items are included in current assets and Current Liabilities:

Important Points:

1.Working Capital =Current Assts – Current Liabilities.

2.Total Debt =Total Outsider Liability = Long term Liability+ short term Liability (current Liability)

3.Total assets=fixed assets + investment +Current assets

Liquidity Ratio or Liquid Ratio or Quick Ratio or Acid Test Ratio:

Liquidity Ratio is a relationship of liquid assets with current liabilities and is computed to assess the short- term liquidity of the enterprise in its correct form.

This is calculated as follows:

Liquid assets are the assets, which are either in the form of cash or cash equivalent or can be converted into cash within a very short period. Liquid assets include cash, bills receivable, marketable securities and debtors (excluding bad and Doubtful debts), etc. Stock is excluded from liquid assets as it may take some time before it is converted into cash. Similarly prepaid expenses do not provide cash at all and are thus excluded from liquid assets.

A quick ratio of 1:1 is usually considered favorable, since for every rupee of current liabilities, there is a rupee of current assets.

A high liquidity ratio compared to current ratio may indicate under stocking while a low liquidity ratio while a low liquidity ratio indicated overstocking.

2. Asset management ratios evaluate the efficient utilization of the resources.

3. Debt management ratios keep track of debt to be within reasonable bounds, and keep the debt level at its optimal level.

4. Profitability ratios measure the degree of accounting profits.

5. Market value ratios help investors discriminate between overvalued and undervalued securities while making investment decisions.

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