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What is Ratio Analysis? (Part 1)

Amit: Uncle, we have discussed many topics on stock market/share market right from basics i.e. what is share market, key fac­tors affect shares/stock, How to read Balance sheet, P&L A/c then fundamental analysis, Macro economic analysis, industry analysis and finally company/corporate analysis. During discussing these topics, you said “RATIO ANALYSIS”. What is ratio analysis? How we use ratio analysis for analyzing company? Is it very difficult? I am scared actually.

Sarvajeet: Relax Amit. You were scared when we started discussing about share market. Ratio analysis is a yardstick for evaluating the financial condition and performance of a firm. Analysis and interpretation of various accounting ratios gives a better understanding of financial condition and performance of the firm in a better manner than the perusal of financial statements.

Uncle: Yes Sarvajeet. You are spot on. Let’s simplify this. Let’s start with basics.

Now Amit tell me what do we check for assessing health of any individual?

Amit: Normally we check blood pressure, ECG, pulse or temperature of an individual. While taking Life insurance policy for myself, Insurance Company had checked above parameters and issued life insurance policy after analyzing above parameters.

Uncle: Now, here Insurance company has checked whether you are fit or not. They issued insurance policy only after analyzing parameters (blood pressure, ECG, pulse or temperature). Same goes with our investment also.

 Ratio Analysis

Ratios are the symptoms or indication or sign of health of an organization like blood pressure, pulse or temperature of an individual. Ratios are the indicators for further investigation. Ratio analysis is a method of analyzing data to determine the overall financial strength of a business. A ratio or financial ratio is a relationship between two accounting figures, expressed mathematically. Financial ratios help to summarize large quantities of financial data to make qualitative judgment about the firm’s financial performance.

Sarvajeet: Uncle, A single ratio is not meaningful. For proper interpretation and understanding, ratios are to be compared.

Uncle: Yes Sarvajeet. You are right. Now comparison can be with:

-          Past ratios i.e. ratios from previous years’ financial statements of the same firm.

-          Competitors’ ratios i.e. similar ratios of the nearest successful competitors.

-          Industry ratios i.e. ratios of the industry to which the firm belongs to.

-          Projected ratios  i.e. ratios developed by the firm which were prepared, earlier, and projected to achieve

Now we will understand about various types of ratios.

Types of Ratio Analysis

Now these are various types of ratios. Now before starting discussing about above types, it is important to understand that only Ratio Analysis is not enough, you have to interpret this analysis.  Analysis means methodical classification of data and presentation in a simplified form for easy understanding. Interpretation means assigning reasons for the behavior in respect of the data, presented in the simplified form.

Liquidity Ratios

It measures the ability of the firm to meet its short-term obligations, i.e. capacity of the firm to pay its current liabilities as and when they fall due.  Thus these ratios reflect the short-term financial solvency of a firm.

A firm should ensure that it does not suffer from lack of liquidity. The failure to meet obligations on due time may result in bad credit image, loss of creditors confidence, and even in legal proceedings against the firm on the other hand very high degree of liquidity is also not desirable since it would imply that funds are idle and earn nothing.  So therefore it is necessary to strike a proper balance between liquidity and lack of liquidity.

The various ratios that explains about the liquidity of the firm are

  1. Current Ratio
  2. Acid Test Ratio / quick ratio
  3. Absolute liquid ration / cash ratio

Current ratio

Current ratio is defined as the relationship between current assets and current liabilities. It is also known as working capital ratio. This is calculated by dividing total current assets by total current liabilities.

cr

Current assets (Debtors- [Debtors are people who "owe" you], stock, cash) are those that can be realized within a short period of time, generally one year. Similarly, current liabilities (creditors, bank overdraft, short term loan) are those that are to be paid, within a period of one year.

Interpretation

Current ratio represents a margin of safety for creditors. Realization of assets may decline. However, all the liabilities have to be paid, in full. As a conventional rule, a current ratio of 2:1 is considered satisfactory. The rule is based on the logic that in the worst situation, even if the value of current assets becomes half, the firm will be able to meet its obligations, fully.

A current ratio of 1.33: 1 is considered as the minimum acceptable level by banks for providing working capital finance. Looking at the mere ratio in figures, no conclusion is to be arrived at. Current ratio is a test of quantity, not test of quality. It is essential to verify the composition and quality of assets before, finally, taking a decision about the adequacy of the ratio.

Amit: Uncle, this means high current ratio is favorable? Correct?

Uncle: Generally is it favorable. But a high current ratio, due to the following causes, may not be favorable:

1. Slow-moving or dead stock/s, piled up due to poor sales.

2. Figure of debtors may be high as debtors are not capable of paying or debt collection system of the firm is not satisfactory

3. Cash or bank balances may be high, due to idle funds.

On the other hand, a low current ratio may be due to the following reasons:

1. Insufficiency of funds to pay creditors.

2. Firm may be trading beyond resources and the resources are inadequate to the high volume of trade.

Quick Ratio

It has been an important indicator of the firm’s liquidity position and is used as a complementary ratio to the current ratio Liquid assets are those that can be converted into cash, quickly, without loss of value. Cash and balance in current account with bank are the most liquid assets. Other assets that are considered, relatively, liquid are debtors, bills receivable and marketable securities (temporary, quoted investments purchased, instead of holding idle cash). Inventories and prepaid expenses [Prepaid expense is expense paid in advance but which has not yet been incurred ] are excluded from this category.

quick ratio

Interpretation

Liquid ratio of 1:1 is, normally, considered satisfactory. However, firms with the ratio of more than 1:1 need not be liquid and those having less than the standard need not, necessarily, be illiquid. It depends more on the composition of liquid assets.

Debtors, normally, constitute a major part in liquid assets. If the debtors are slow paying, doubtful and long outstanding, they may not be totally liquid. So, firms even with high liquid ratio, containing such type of debtors, may experience the problem in meeting current obligations, as and when they fall due.

On the other hand, inventories may not be, totally, non-liquid. To a certain extent, they may be available to meet current obligations. So, all firms not having the liquid ratio of 1:1 may not experience difficulty in meeting the current obligations, depending on the efficient realization of inventories.

Cash Ratio or Absolute Liquid Ratio

It shows the relationship between absolute liquid or super quick current assets and liabilities.  Absolute liquid assets include cash, bank balances, and marketable securities.

cash ratio

Leverage or solvency Ratio

The solvency or leverage ratios throws light on the long term solvency of a firm reflecting its ability to assure the long term creditors with regard to periodic payment of interest during the period and loan repayment of principal on maturity or in predetermined installments at due dates.

Leverage ratios indicate the mix of debt and owners’ equity in financing the assets of the firm. These ratios measure the extent of debt financing in a firm.

To whom these ratios are important?:

Short-term creditors like suppliers of raw materials and banks that provide working capital are concerned with short-term solvency of the firm.

On the other hand, long term-creditors like debenture holders, financial institutions that provide long term capital are concerned with long-term solvency

Debt Equity ratio

Debt-Equity Ratio is also known as External-Internal Equity Ratio. This ratio is calculated to measure the relative claims of outsiders and owners against the firm’s assets. The ratio shows the relationship between the external equities (outsiders’ funds) and internal equities (shareholders’ funds).

Debt equity ratio

* Net Worth = Equity Share Capital + Preference Share Capital + Reserves and Surplus

Interpretation

Debt-Equity Ratio indicates the extent to which debt financing has been used in business. This ratio shows the level of dependence on the outsiders.

As a general rule, there should be a mix of debt and equity. The owners want to conduct business, with maximum outsiders’ funds to take less risk for their investment. At the same time, they want to maximise their earnings, at the cost and risk of outsiders’ funds. The outsiders (lenders and creditors) want the owners’ share, on a higher side in the business and assume lower risk, with more safety to their funds.

Total debt to net worth of 1:1 is considered satisfactory, as a thumb rule. In some businesses, a high ratio 2:1 or even more may be considered satisfactory, say, for example in the case of contractor’s business. It all depends upon the financial policy of the firm, risk bearing profile and nature of business.

Amit: What is impact of high ratio?

Uncle: A high debt-equity ratio may be unfavorable as the firm may not be able to raise further borrowing, without paying higher interest, and accepting stringent conditions. This situation creates undue pressures and unfavorable conditions to the firm from the creditors.

Debt Service (Interest Coverage) Ratio

Debt ratio is static and fails to indicate the ability of the firm to meet interest obligations. The interest coverage ratio is used to test the firm’s debt-servicing capacity. This shows the number of times the earnings of the firms are able to cover the fixed interest liability of the firm.

As taxes are computed on earnings after deducting interest, earnings before taxes are taken.  Depreciation is a non-cash item. Therefore, funds equal to depreciation are also available for payment of interest charges. So, the interest coverage ratio is computed by dividing the earnings before depreciation, interest and taxes (EBDIT) by interest charges.

interest coverage

Interpretation

This ratio indicates the extent to which earnings can fall, without causing any embarrassment to the firm, regarding the payment of interest charges. The higher the IC ratio, better it is both for the firm and lenders.   For the firm, the probability of default in payment of interest is reduced and for the lenders, the firm is considered to be less risky. However, too high a ratio indicates the firm is very conservative in not using the debt to its best advantage of the shareholders. On the other hand, a lower coverage ratio indicates the excessive use of debt.

Debt Service Coverage Ratio (DSCR)

Now in Debt Service (Interest Coverage) Ratio, repayment of installment liability is not included.

Debt service coverage ratio (DSCR) essentially calculates the repayment capacity of a borrower. DSCR less than 1 suggests inability of firm’s profits to serve its debts whereas a DSCR greater than 1 means not only serving the debt obligations but also the ability to pay the dividends. This ratio suggests the capability of cash profits to meet the repayment of the financial loan. DSCR is very important from the view point of the financing authority as it indicates repaying capability of the entity taking loan.

DSCR

To be Continued ……… 

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