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What is Ratio Analysis?

Ratio: It shows relationship between two numbers. A single ratio does not show any result unless it compares with other ratio.

Type of Ratios:
·         Liquidity ratio
·         Solvency ratio
·         Activity turnover ratio
·         Profitability ratio

Current ratio: It shows the ability of a company to pay its short term liabilities in a year. 2:1 is an ideal ratio. Higher the ratio better for the company.
Current ratio = Current assets/current liabilities

Current assets = Cash in hand + cash at bank + prepaid expense + stock (includes finished goods, raw material, work-in-progress) + bill receivable + debtors + accrued income

Current liabilities = creditors + bills payable + outstanding expenses + bank overdraft + provision for debt + provision for tax + unclaimed dividend

Quick ratio: It shows that company is able to pay its debt in a month. 1:1 is an ideal ratio and more than that is good for the company. Quick asset does not include prepaid expenses and stock.
= quick assets / current liabilities

Example: Find out the current ratio of company X if the current asset is Rs.2,00,000 and current liabilities is Rs.1, 80,600.If the company mention the purchases amount is Rs.10, 000 instead of Rs. 30, 000.

Solution: Current ratio = Current assets/current liabilities
= 2, 00,000 + 20,000 / 1, 80,600
= 1.21:1
It shows that company’s short term liquidity position is not good because the ideal ratio is 2:1.

Example: Which of the following items help to increase the current ratio if a current asset is Rs.5, 56,000 and a current liability is Rs. 3, 00,000?
·         Rs.20,000 Profit adding in current assets only
·         Payment to creditors Rs 2,000 is deducted from current assets and liabilities
·         Rs,12, 000 loss deducted from current liabilities

Solution:
·         Rs.20,000 Profit adding in current assets only
= 5, 56,000 + 20,000 / 3, 00,000
= 1.92:1
·         Payment to creditors Rs 2,000 is deducted from current assets and liabilities
= 5, 56,000 – 2,000/3, 00,000 – 2,000
= 1.85:1
·         Rs,12, 000 loss deducted from current liabilities
= 5, 56,000 / 3, 00,000 -12,000
= 1.93:1
So, by adding Rs.20, 000 profit and deducting Rs. 2,000 from current and current liabilities increases the current ratio.

Example: Find out the acid test ratio if liquid asset is Rs. 95,000 and current liabilities Rs.62, 000. There is another more information given by company that the stock is not included in assets which is Rs.8, 000.

Solution: quick assets / current liabilities
= 95,000 / 62,000
= 1.45:1
It shows that the company is able to pay its short term liabilities within a month.

Solvency ratio: It includes debt-equity ratio, proprietary ratio and total assets to debt ratio.

Debt-Equity ratio: It shows that the company is able to pay its long term debt. 2:1 is an ideal ratio if the ratio goes beyond this it will become risky for the company to pay its debt.
Debt-Equity ratio = Debt / Shareholders funds (Equity)
Debt = It includes all long term debt like debenture, mortgage, public deposits, Long term loan.
Equity = share capital + preference share capital + reserves + Profit & loss a/c (profit) + securities premium + capital reserve

Total Assets to Debt ratio: The total assets of a company act as a security with the help of it company raises long term loan. Higher the total assets in comparison to debt better for company. The total assets to debt ratio show the relationship of total assets and debt. If this ratio is higher than it is good for the company and vice versa.

Total assets = Fixed assets + current assets (not included fictitious assets like preliminary expenses, loss on sale of asset, discount on issue of share)
Total Assets to Debt ratio = Total Assets / Debt

Proprietary ratio: It shows that how many total assets are financed by equity capital. Higher the ratio better for the company and vice versa.
Proprietary ratio = Equity / Total assets

Example: Find out debt equity ratio, total assets to debt ratio and proprietary ratio:
·         Shareholders fund Rs. 6, 50,000 and issue of shares expenses Rs.10, 000.
·         Total intangible assets Rs. 9, 50,000.
·         Long term loan Rs. 5, 29,000.

Solution:
Debt-Equity ratio = Debt / Shareholders funds
= 5, 29,000 / 6, 50,000 -10,000
= 0.82:1
It is lower than ideal ratio that is 2:1 which shows that company is able to pay its long term debt.

Total Assets to Debt ratio = Total Assets / Debt
= 9, 50,000 / 5, 29,000
= 1.79:1
It shows that 1.79 times more than debt which is good for the company.

Proprietary ratio = 6, 40,000 / 9, 50,000
       = 0.67:1
      It shows that company’s financial position is not good.




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