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Ratio Analysis Measures Company Financial Position From Past Data Essay Sample

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Introduction of TOPIC

A ratio is numeric or arithmetic relation between two numbers. It is simply one number expressed in terms of another. The two numbers used in the ratio can both be taken from income statement or position statement or one number from income statement and one number from position statement. Ratio analysis measures company financial position from past data. Ratio analysis is based on company balance sheet and income statement. There are various types in ratio analysis.

1. Profitability Ratio:

Profitability Ratio can measure the profitability of organization. It also measure firm ability of making profit. A high profitability ratio is good for the firm.

a) Gross Profit Ratio: Gross profit ratio describe gross profit margin of the firm over sales. Sales minus cost of goods sold are equal to the gross profit.

Gross Profit Ratio =

In 2008 Gross Profit Ratio =

= 20%

In 2009 Gross Profit Ratio =

= 16.67%

In 2010 Gross Profit Ratio =

= 14.94%

Profitability has gone down from 20% to 14.94%. Total sales have increased by 57.50% in 2009 cost of goods sales also increased high proportion by 64.06% in 2009. Huge increase of cost of sales effect the gross profit ratio. Management should look for the cheaper source of raw material. They should look for alternative suppliers from some other country.

b) Net Profit Ratio: This ratio indicates the relationship between net profit (before interest and tax) and net sales. Higher the net profit ratio is good for the firm.

Net Profit Ratio =

In 2008 Net Profit Ratio =

= 10%

In 2009 Net Profit Ratio =

= 8.73%

In 2010 Net Profit Ratio =

= 8.05%

Net profit Ratio has decreased from 10% to 8.05% in 2008 to 2010. Although sales has increased but net profit has decreased because of increasing cost of goods sold. In 2010, firm took loan and increased in expenses for processing the loan. Firm should look for other form of capital i.e. issuing share, partnerships. Firm should try to decrease account receivable.

c) Return on Capital Employed (ROCE): Return of capital employed measure the net profit over total capital employed. Higher ROCE indicates more efficient use of capital employed. Capital employed includes owner’s capital and loans and retain earnings.

Return on Capital Employed (ROCE) Ratio =

In 2008 ROCE =

= 22.71%

In 2009 ROCE =

= 31.38%

In 2010 ROCE =

= 20.62%

ROCE has increased 22% to 31% from 2008 to 2009. But it has been gone down because of large amount of loan in 2010. Firm has taken large portion of loan in 2010. Firm should look for other sources of finances.

2. Liquidity Ratios

Liquidity ratios measure a firm’s ability to meet its current obligations. Liquidity determines company’s capability to pay off short terms liabilities. If ratio value is higher, then firm can meet more swiftly liabilities.

(i) Current Ratio

Current Ratio will measure firm’s ability of paying short term liabilities. Higher current ratio will better for the firm. Low current ratio suggest that company are not good for meet their current obligation.

Current Ratio =

In 2008 Current Ratio =

=1.19 : 1

In 2009 Current Ratio =

=1.05 : 1

In 2010 Current Ratio =

=1.38 : 1

Firm’s current ratio has decreased from 2008 to 2009. Firm don’t have any cash in bank. Account receivable has increased. Bank overdraft has also increased year by year.

(ii) Acid Test Ratio: Acid test ratio is also known as quick test. Acid test ratio includes all the current assets except stock/ inventory. If it is higher, either firm have too much cash or poor collection of accounts receivable. If it is lower, it shows firm maintain large inventory to meet its obligation.

Acid Test Ratio =

In 2008 Acid Test Ratio =


= = 0.79 : 1 In 2009

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Acid Test Ratio =

= 0.71 : 1

In 2010 Acid Test Ratio =

= 0.97: 1

Acid test ratio has increased from 2008 to 2010. Firms account receivable has increasing more than 50% each year. That is not good for the firm. It should try to reduce account receivable and try to recover those account receivable.

(iii) Net Working Capital is also known as working capital. If we deduct total current assets from total current liability, we will get firm net working capital.

Net Working Capital (Net Working Capital) = Current Assets – Current Liability

In 2008 NWC = Current Assets – Current Liability

= 23971 + 47943 – 53696 – 6791


= 11427

In 2009 NWC = Current Assets – Current Liability

= 47943 + 100679 – 107391 – 34108

= 148622-141499

= 7123

In 2010 NWC = Current Assets – Current Liability

= 95885 + 230,124 – 159,169-77,155

= 326,009 – 236,324

= 89685

Net working capital has decreased from 2008 to 2009. From 2009 to 2010 NWC has increased more. In 2010 Current asset has increased to more than double from 2009.

3. Gearing Ratio

Gearing ratio will shows percentage of long term debt in total capital employed in the business

(a) Gearing Ratio = x 100

In 2010 Gearing Ratio = x 100

= X 100

= X 100

= 51 %

Before 2010 there is no loan for the firm. In 2010 firm takes a loan amount of � 95,885.

(b) Gearing Ratio = x 100

In 2010 Gearing Ratio = x 100

= X 100

= 105.78%

Portion of loan are higher than equity. For sole trader firm owner is personally liable for the loan.

(c) Interest Cover:

Interest cover shows firm ability to pay interest on loan.

Interest Cover =

In 2010 Interest Cover =

= 0.24

In 2010 firm took loan. Interest rate of loan is around 10%. It is too high. Firm should look for other sources of capital such as partnership.

4. Efficiency Ratios:

Efficiency ratio measures firm’s efficiency of utilising internal assets and liabilities.

(a) Stock turnover ratio shows how long it will take for converting inventory into cash. Higher turnover is good for the firm.

Stock turnover ratio =

Here average stock =

Inventory Holding Period =

In year 2008 Stock turnover ratio =

= 7.33 Times

Inventory holding Period =

= 1 month 18 days

In year 2009 Stock turnover ratio =

= 8 Times

Inventory holding Period =

= 1 month 15 days

In year 2010 Stock turnover ratio =

= 5.65 Times

Inventory holding Period =

= 2 month 4 days

Inventory turnover was good in 2008. But in 2010 inventory turnover has gone down. Inventory holding period is increased. Firm should try to increase stock turnover by making good prediction about sales and buy goods when they required. Firm should not hold too much inventory.

(b) Debtor Turnover Ratio

Debtor turnover ratio shows how quickly their credit sale has recovered. Lower debtor turnover is good for the firm.

Debtor Turnover Ratio = x 365 days

In 2008 Debtor Turnover Ratio = x 365 days

= x 365 days

= 80 days

In 2009 Debtor Turnover Ratio = x 365 days

= x 365 days

= 106 days

In 2010 Debtor Turnover Ratio = x 365 days

= x 365 days

= 176 days

Firm debtor turnover has increased for 80 days to 176 days for 2008 to 2009. It is not good for the firm. Firm policy regarding debt collection is not efficient. Firm should pay attention to recover their debt.

(c) Creditor Turnover Ratio

Creditor turnover ratio measures the average number of days firm pay any money to its suppliers.

Creditor Turnover Ratio = x 365 days

Here, we assume all purchases are made on credit.

Purchase = Cost of Goods Sold + Closing Stock – Opening Stock

In 2008 Purchase = Cost of Goods Sold + Closing Stock – Opening Stock

= 175794 + 23971-0

= 199765

Creditor Turnover Ratio = x 365 days

= x 365 days

= 98 days

In 2009 Purchase = Cost of Goods Sold + Closing Stock – Opening Stock

= 288413+47943-23971

= 312385

Creditor Turnover Ratio = x 365 days

= x 365 days

= 125 days

In 2010 Purchase = Cost of Goods Sold + Closing Stock – Opening Stock

= 288413+47943-23971

= 312385

Creditor Turnover Ratio =x 365 days

= x 365 days

= 176 days

Firm credit turnover ratio has been increased over the year. That is good for the business. Firm try to maintain higher ratio.

Limitation of Ratio Analysis

* Past Data

Ratio analysis is based on past years balance sheet and income statement. It is not future oriented.

* Financial statement Errors

If there is error in balance sheet or income statement, then ratio analysis result will be incorrect.

* No Ideal Definition

There is no standard definition or formula for ratio analysis. So result of ratio analysis will not same. Decision on based ratio will not be vary.

* Difference Currency

In the real world each country has own currency. If two companies operating different country have different currency in balance sheet or income statement, by ratio analysis we can compare them.

* Comparison of performance over time

Ratio analysis we compare performance over years. Each year company faces new challenges, new technological changes, price changes, which have no consideration in ratio analysis.

Other Methods

There are many other method by which we can analyse financial statement.

* Balance Scorecard

* Trend Analysis

* Common Size Ratio

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