Ratio Analysis is the basic tool of financial analysis and Financial analysis itself is an important part of any business planning process as SWOT (Strengths, Weaknesses, Opportunities and Threats), being the basic tool of the strategic analysis plays a vital role in a business planning process and no SWOT analysis would be complete without an analysis of companies financial position. In this way Ratio Analysis is very important part of whole business strategic planning. There are mainly six types of ratios :
1) Return On Capital Employed: This ratio helps to examine the figure for profit earned in relation to the money invested (Capital Employed) in the business. It is generally acceptable to use either Net Profit Before Tax or Net Profit After Tax.
(a) ROCE= (Net Profit / Capital Employed)*100
2)Profit Ratio: This ratio is helpful to assess the adequacy of profit earned and their trends in comparision with the past.
(a) Gross Profit Margin= (Gross Profit/ Sales)*100
(b) Net Profit Margin= (Net Profit/ Sales) *100
Eeaning Per Share = Profit After Tax/ Number of Equity Shares
3) Solvency Ratio: In order to maintain the status of going concern a business must be able to meet its debts for which it should have enough working capital. The working capital ratio helps to examine secuted financial position of a business.
(a) Working Capital Ratio= Current Asset/ Current Liability
(b) Liquidity Ratio= Liquid Asset/ Liquid Liability
4)Asset Turn Over Ratio: Figure arrived from this calculation helps management to ensure efficient utilization of resources applied.
(a) Rate of Stock Turnover (in number)= Cost of Goods Sold/ Average Stock Level
(b) Stock Turnover (in days)= (Average Stock/ Cost fo Goods Sold)*365
(c) Rate of Collection of debtors (in days)= (Average Trade Debtors/ Credit Sales)*365
(d) Rate of Payment to creditors (in days)= (Average Trade Creditors/ Credit Purchases)*365
(e) Cash operating Cycle (in days)= Stock Holding Period + Debt Collection Period- Creditors Payment Periods
(f) Total Asset Turnover= Sales/ Aerage Total Assets
5) Gearing or Levearage Ratio: This ratio defines capital structure of gearing.
(a) Debt Equty Ratio= Total Financial Debt/ Shareholders Equity
6)Cash Flow Statement Ratio: This is a ratio of cash inflow and outflow. It helps in examining sources and uses of cash and their net effect. This ratio is calculated in percentage and the percentages can be used to show the relative balance between the inflows and outflows of cash, with the choice of which figure to use as a lease (i.e. which one equals 100%) depending on the purpose of the analysis.
(a) Cash Flow Ratio= (Cash inflow/ cash outflow )* 100 or ( Cash Outflow / Cash Inflow) *100.
Limitations of Ratio Analysis:
1) It helps in finding out the changes in financial results but they don’t explain the reason of such changes.
2) Deterioration is accounting ratios does not always indicate poor management e.g. a decline in stock turnover ratio may seem unhealthy sign for a business but a further investigation may reveal that reason is accumulation of scarce raw material that enable a plant to continue working when competitiors are forced to suspend production.
3) Too much significance to indivisual ratio cannot result in good decision. eg. Sometimes higher ROCE may be accompanied with low liquidity.
