Ratio Analysis - Looking beyond the Ratios

If interpreted carefully, Ratio analysis will provide adequate source of information for the lending banker in taking the credit decision. But the decision need not and should not be based purely on Ratio analysis.

What appears to be a strong case can actually be a very weak case if reckoned with non financial and physical factors and vice versa. Ability to look at times beyond this and to look to super sensitive areas can help us to make meaningful decision

Some live cases where the bank had to look beyond the figures/ratios are given below.

Y Ltd, one of the leading exporters of minerals, was sanctioned by us in 2019 .export credit limit of Rs. 400 lacs (Packing credit Rs. 250 lacs and foreign bills purchase Rs. 150 lacs)as applied in its renewal proposal. During 2021, the company requested us to grant adhoc enhancement in packing credit limit by Rs. 100 lacs with 'nil' margin. The company's request was not based on projected financial statements. But the company produced copies of export orders on hand in support of its request.

Important financial indicators were as under

The overall financial position as revealed by the financial statements appeared sound. We were curious to know why the company wanted the bank to consider the additional packing credit with 'nil' margin, despite good current ratio indicating comfortable liquid position. This query resulted in a detailed probe of physical factors contributing to financials which revealed that bulk of the stocks held were quarried items and rejected as not fit for export. However, it was found that the company continued to include the rejections in the build up of current assets. Besides, the company's receivables portfolio revealed amounts deducted from the invoices by the buyers, to be settled later. Subsequently, Account sales were submitted and further claims on the company were made by the buyers. In fact, the company should not have shown the amounts of claims as receivables, but should have indicated the claims as current liabilities. If the company had given the proper accounting treatment, the current ratio would be less than one indicative of its liquidity strain. Perhaps, the liquidity constraints faced by the Company, necessitated it to approach the bank for additional finance with "nil' margin. The moral from this account is that not only sound current ratio is important but also the quality of current assets that go to compile the ratio is more relevant.

We received a proposal from one of our branches for take-over of the account of ABC Ltd, a trading unit, from some other bank and grant additional working capital facilities.

Our analysis of the financial statements of the company revealed that the company's financial position was fairly satisfactory. It had strong networth and good current ratio with profits earned purported to have been retained in the business. Despite good financial position, additional working capital to support the projected increase in the volume of business was sought for, pointing out that growth in turnover was a routine phenomenon.

The financial position was so impressive that the company's request can be passed on for consideration. But our detailed investigation of the proposal revealed that the company had four associates viz. M, N, O & P and all of them enjoyed credit facilities. For all the five units, there was only a single investment (Rs. 10 laks) towards capital. The annual make-up of accounts of these units was so manipulated that while the parent unit closed its accounts on 31st December, the four associates M, N, O & P closed their accounts on 31st March, 30th June, 30th September and Diwali date respectively.

The parent unit, before closing its accounts transferred funds (Rs. 10 laks) to the associate unit M. The account of M was shown in the books of the parent unit as an item of sundry debtors. M treated the funds received form the parent unit as capital contribution. Similarly, the same amount of funds was transferred from M to N, N to O and O to P before closing of accounts of the transferor unit towards capital contribution of the transferee unit. With a single investment which was shown a long term funds in all the units, bank finance wa~. availed of by all the units disproportionate to the size of the investment.

The manipulations made in the accounts came to light when we collected the balance-sheets of all the five units as on a particular date and prepared the consolidated balance-sheet. When we were carrying out the above exercise, the company under the pretext that the bank had called for too many particulars,went to some other bank where it exploded.

XYZ Ltd was sanctioned credit facilities based on certain level of current assets and current liabilities to support the projected level of sales turnover. After a lapse of about six months from the date of sanction, the company requested us to grant additional working capital limit towards build up of inventories beyond the assessed levels. As the reasons given by the company for the proposed higher holding of inventories were not acceptable to us, we did not agree to the company's request for additional limit. However, it was observed at the end of the year, the company achieved the projected level of sales turnover availing of full credit limits sanctioned by us.

For the following year, the company projected substantial increase in sales turnover and also in the level of current assets in tune with the projected sales turnover. When that financial year ended and the relative financial statements submitted, it was observed that the company achieved the sales turnover as projected with a steep rise in the level of current assets.

The profit and loss account was subjected to critical scrutiny by us. It was observed that despite steep increase in sales turnover, the overall profitability was only marginally higher. We were curious to know whether there was increase in input costs without matching increase in selling price. It was noticed that the figures of various expenses were more or less comparable with that of the previous year and there were no abnormalities.

Our detailed probe indicated that the company had an associate company and we casually called for its latest financial statements. The company representative mentioned that the associate company did not enjoy any creditfacilities but was engaged only in some trading and that the bank was not right in asking for its financial statements. However, the financial statements of the associate company were obtained finally and they were critically examined.

The trading account of the associate company indicated that the items of sales and closing stock were bracketed and only a single figure was shown there against. Simultaneous examination of the balance-sheet did not show any closing stock figure. For a going concern, even if it was a trading unit, this was an abnormal situation indicating that the entire stocks purchased were sold. The sales shown by the associate company was about Rs. 3 crores, but the profit arrived at was much less when compared with profit declared by the parent company for its turnover. Our analysis revealed that the parent company in order to book sales turnover, passed on the entry to the associate company which after holding the purchase entry for sometime gave it back to the parent company. By this method the parent company could show increased sales turnover in its books including sales turnover which was not actually achieved, and thereby it was in a position to negotiate a larger credit facility with the bank. This shows that purchases and sales accounts also need be critically examined in the analysis of financial statements.

The sales turnover and profits achieved by PQR Ltd, engineering contractors, over a three year period were as under:

While there was steady increase in the sales turnover achieved, a declining trend in profits attained was observed. General conclusion would be that the profits had fallen on account of any one or more of the following factors.

1) Increase in input costs without matching increase in selling price.

2) Increase in selling and Administration expenses not absorbed.

3) deliberate reduction in margin to improve the sales turnover.

4) Loss in a particular division

For the declining trend in profits, the company, however, came out with an acceptable explanation., saying that it consistently maintained a uniform accounting policy, namely, booking the sales only on realisation basis. While all the revenue expenses were booked in the same year in which they were incurred, sales was booked only on realisation which on distribution released the profits and the revenue expenses already met were back in the system.

Infact, proper evaluation in such cases, should be on the basis of data obtained relating to annual contracts executed and aggregate profits earned over a five year period to examine whether there is increasing or decreasing trend, before we come to the adverse conclusions.

On account of distortion which might appear in the final accounts due to change in accounting policies the financial indicators, more particularly, the current ratio, are also likely to undergo a total distortion.

For instance, at the time when credit facilities were sanctioned to KLM Ltd, the summary of the balance sheet

KLM Ltd

Balance Sheet

On the basis of projected increase in sales turnover from Rs. 200 lacs to Rs. 275 lacs, we had sanctioned enhancement in working capital limit from Rs. 40 lacs to Rs.50 lacs. After twelve months, the financial statements were submitted, a summary of which is qiven below.

KLM Ltd

Balance Sheet

When the financial statements were tendered, it was observed that the company achieved a sales turnover of only Rs. 225 lacs as against the projected turnover of Rs. 275 lacs, but it fully utilised the enhanced working capital limit. It was also observed that net pi of it had declined as compared with the previous year. Normally, this is a serious anomaly. But it came to light that due to change in the accounting policy ,the company had not booked sales worth Rs. 50 lacs and it had also made higher provision for bad and doubtful debts on a conservative basis. On account of the above, the profit had declined and the current ratio slipped to1.21 :1 as against 1.33.1 as at the end of the previous year.

This indicates that we should have open mind and examine the change in accounting policies, if any and study their implications.

SM textiles Ltd is engaged in the production of cotton yarn and its entire credit needs are met by our bank. A summary of the financial statements submitted alongwith the renewal proposal, is given below

SM Textiles Ltd

Balance Sheet

It was observed that Net Profit after tax as compared with 1990-91 was down by Rs.one crore during 1991 - 92 though.

1. Sales was up

2. Selling prices were favourable

3. Input costs remained static

It was further observed that the current ratio also, which stood at 1.39:1 declined to the minimum required level of 1.33:1. While the market information obtained on the company was very satisfactory, we were surprised why the financial statements, did not indicate a favourable trend. In order to ascertain the reasons, we called the company representative for a discussion. He informed that the company had replaced some ring frames during 1991-92 by utilising the surplus funds available in the system which was the cause for the decline in the current ratio. Although, the existing ring frames replaced by the company were useful, they were not efficient to produce the desired quantity and quality of cotton yarn. When the new ring frames were purchased, the company had the option of treating the purchase, either as a capital item or as a revenue item. The company decided to charge off 100% of the purchase made to the profit and loss account under the head "Renewals, Repairs & maintenance" instead of treating it as an addition to fixed assets. If the company treated the purchase as capital item, it could have claimed only 25% depreciation during the first year. By treating it as revenue as pemitted under the Income - Tax act, the company could show lesser profits and thereby arrest the tax

This case study amply illustrates the need for seeking detailed information and analysing the information gathered beyond the ratios obtained from the financial statements to draw correct conclusions.

VRS Ltd., engaged in the manufactureof suiting materials applied to us for sanction of working capital limits. The company's financial statements revealed that it incurred administrative and selling expenses to the tune of Rs. 2 crores, Rs. 2.25 crores and Rs. 3 crores during the immediate three years preceding to the year when the application was received. The profit before depreciation and tax was just sufficient to absorb the depreciation and the net profit after tax declared was meagre in all the three years. The projected increase in sales turnover and the quantum of working capital limit asked for were not supported by comparative financial ratio analysis.

The company representative when called for a detailed discussion, produced evidence of advertisements given by the company in various popular dailies, weeklies and monthly magazines published from India and also in some of the popular magazines from abroad. The company representative pointed out that the selling prices of the company's products were well above the cost of production and the profit margin was high during the last three years but for the large advertisement expenses booked under the selling and administrative expenses. He further advised that in view of the large advertisement expenses incurred, the company had made meagre profits in the past three years, but the company had already started reaping the benefit of the advertisement expenses incurred, from the current year. Infact.the sales turnover declared sofarinthe current year was more than double that of the sales turnover achieved during the corresponding period in the previous year. In view of the fact that the total advertisement expenses would be 50% less than that of the previous year and coupled with increase in sales turnover,the company would make sizable profits in the current year. The company was poised for very rapid growth in the coming years.

The moral from this illustration is that while analysing profits, it may be necessary for us to go back to the various components of revenue expenses and perhaps, invite the company officials for discussion before coming to any rash conclussions.

X Ltd is a transport company which follows the accounting practice of booking revenue expenses as and when incurred but crediting the income by way of freight charges into profit and loss account only when it is received.

Invoices on each of the company's customers, which are generally big companies, covering the services rendered during the course of a month are drawn at the end of the month with a stipulation that the payment for which shall be made before the close of next month. As a result, receivables representing 1 1/2 to 2 months freight charges are usually outstanding but such receivables are not reflected in the financial statements due to accounting of freight charges on cash basis. Bank finance by way of advance against receivables is extended to the company based on submission of periodical statement of receivables certified by the company's auditors.

As a method of tax-planning, the company defers incidence of advance-tax and income-tax on the income deferred by following the above accounting practice. For financing the company's receivables, which are not reflected in the books, the bank has to go behind the financial statements.

From a study of the above illustrations, it may be inferred that a banker has to look beyond the ratios and seek other sources of information to ensure a comprehensive credit analysis leading to the decision making. Some of the important infomation that may be gathered for the purpose of credit analysis is listed below.

1. Calling for the past financial statements to ascertain the background and trend of business in the past.

2. Accounting procedure followed by the borrower.

3. Auditors report on the financial statements and qualifications made if any, in the report.

4. Notes on accounts furnished in the financial statements.

5. Details of liabilities not acknowledged as debts by the borrower.

6. Details of guarantees issued towards disputed excise, customs, sales-tax liabilities and what would be the impact on the financial position of the borrower, if they are invoked?

7. Details of guarantees furnished by the borrower in support of credit facilities granted to the associates.

8. Comparison of the borrower's financial position and performance with that of similar companies in the same industry or line of business.

9. Details of revaluation if any on the fixed assets and the effect of the same on networth.

10. Particulars of business/credit facilities enjoyed by the associates.

1. This note proposes to discuss the use of ratio analysis, as an instrument of Management control. Management may be described as the function of administering capital and man power in the production and distribution of goods and services. The primary aim of all management functions is to maximise output at a minimum cost within a given economic environment. This aim can be largely achieved by the main instruments of business control, namely properly drawn balance sheets and profit and loss statements. The financial control on any enterprise involves fundamentally in the control of costs and finances. The balance sheet helps to control finances, and the profit and loss statement helps to control costs. When costs and finances are efficiently controlled, both can help to maximise output at minimum cost and locate trouble spots and suggest courses for effective action. The society values an enterprise in relation to the contribution it makes towards general welfare. The society has no use from an inefficient enterprise. Such an enterprise has generally inbuilt sources of decay, and would make it perish in course of time. Enterprises which are efficient, perform useful service in society and have inbuilt positions of growth in their making. What are the sources of strength and what are the sources of decay could be evaluated by the process of ratio analysis.

2. The term ratio applies to any calculation expressing the numerical relationship between two numbers. It is measured by the number of times one number is contained by the other, either integrally or fractionally. The ratio analysis of financial statements means the process of calculating structural relations of different items and groups in the financial statements. These relations may be expressed in three different ways as follows :-

a) Ratio : a simple division of one number by another.

b) Rate : a ratio between two numerical facts over a period of time

c) Percentage : a special type of rate which expresses reltionships in hundredths.

It would be advantageous to divide the more desirable by the less desirable, so that a favourable change gives an increase in ratio, and may be immediately perceptible.

3. A single balance sheet tells how a business stands at a particular point of time. A related profit and loss statement sums up the results of operations till that time. A single balance sheet is like the opening chapter of a book. It indicates a theme. It shows how the capital is distributed, how much of it is in various accounts, and how much surplus exists of assets over liabilities. Any profit and loss statement indicates the volume of sales for a given peirod of time, the amount of costs incurred and the amount earned after allowing for all costs. When a series of balance sheets at regular intervals, say at the end of each fiscal year are arranged in vertical columns, and related items are compared, the changes in these items either increasing or decreasing may disclose trends. For example, a management decision to increase holding of basic inventories may be perceived by the growing quantities of merchandise held year by year. Successive increase of receivables in the context of steady sales may indicate that credits to customers are relaxed and collections are also delayed. If expansion is undertaken, debts may remain high, and if losses are sustained the net worth would decline. What is the cumulative effect of these changes on the enterprise ? where did the money come from and how exactly was it spent is a prime management problem for ascertainment. Similarly, from an examina tion of the profit and loss statement, any increase or decrease in sales, increase or decrease in purchasing and manufacturing costs, increase or decrease in overheads and financing charges, indicate important changes. Whether these changes_or variations have remained in proper proportion or balance to each other, is another important management problem for determination. The different items of any profit and loss statement should be in meaningful relationship to each other. Problems such as whether the business was overstocked or the stock turnover was as fast as before or whether there was a fall due to accumulation of unsaleable stocks, may possibly be assessed from subtle changes perceptible by these comparisons. Thus it may be seen that apart from comparing assets and liabilities, something more becomes necessary ie. to compare the year by year changes in the balance sheet and profit and loss statement, making on the whole the evaluation of changes meaningful for assessment of the financial position of an enterprise.

4. The computation of ratios assists the anylyst in this assessment in disclosing significant relationships in financial statements as instruments of managerial control. These calculations help the busy executives to locate trouble spots and assess trends in which the business is moving. Generally, the ratios are of three kinds. They are:

1) Balance sheet ratios indicating the relationship between various balance sheet items.

2) The operating ratios which show the relationship of expense accounts to income.

3) The inter-statement ratios show the relationship of balance sheet items to income and expense accounts.

Ratios may also be broadly classified into three different categories, namely, structural ratios, profitability ratios, and turnover ratios.

5. How the ratios are calculated and interpreted could be better illustrated by a practical example given below :-

ABC LTD 31.12.1993 (Rs. in lacs)

BALANCE SHEET

Profit and Loss Account for the year ending 31.12.1993

Now we shall endeavour to calculate the most important ratios in relation to the above simple balance sheet.

6. We shall commence this analysis by the examination of different structural ratios in a balance sheet. The most important of these ratios are enumerated below :-

1) CURRENT RATIO :

Computation : Current Ratio is obtained by the division of total current assets by total current liabilities. In the above balance sheet, current assets aggregate to Rs. 1.50 lacs and current liabilities to Rs. 1 lac. The current ratio is 1.50/1.00 or more simply as 1.50:1 (i.e). in this particular balance sheet, for every 1.50 units of current assets, there is one unit of current liability. As current liabilities maturing day by day are to be met only from current assets, the relationsip is significant. If for example, the current ratio of this same company were to move as under:

an inference is possible that the capacity of the enterprise to meet current debt is slowly receding. This should put the management on guard about the weakness in credit strength slowly emerging. Though this inference is possible, any ratio by itself however is not able to tell us precisely why ft is so. We will then have to go and evaluate the component factors constituting the ratios and ascertain why the regressive trend has been noticed. In this particular case, the fall of the ratio might have been brought about by either a progressive fall of current assets or increase of current liabilities, The ratio however by itself is not able to tell us which of the two possibilities has actually happened.

2) QUICK RATIO :

Computation : Cash, marketable securities and account receivables divided by current liabilities. In the above case (Rs. 0.10 + nil + 0.40) 0.50 divided by 1.00 i.e. 0.5 :1. This ratio indicates the extent to which current liabilities could be met without relying on the sale of inventories. Inventories take time to get themselves converted into cash. Cash, marketable securities and accounts receivables may be considered as immediately available to discharge current obligations. The size of the aggregate of these liquid assets in relation to the size of the total current liabilities is a significant relationship. Just as in the interpretation of current ratio, a rise indicates improved credit strength and a fall, a deteriorating credit strength.

3) PROPRIETARY OR EQUITY ASSET RATIO :

Computation : By dividing total shareholders' funds by total assets. In the above balace sheet 1.50/5.00 or more simply 0.30 : 1. The ratio indicates the portion of shareholders funds in any asset holding and indicates the degree of safety or margin of protection available to the creditors. If in an enterprise, the proprietary ratio turns out as shown below :-

It is possible to surmise that for every unit of asset held by the enterprise, shareholders' contribution towards the holding has increased year by year. Increase in the ratio is a sign of increasing financial strength and of good management.

4) FIXED ASSETS TO TANGIBLE NET WORTH PLUS TERM DEBT :

Computation : Net fixed assets divided by net worth plus term debt. In the above case 3.50/4.00 or simply 0.87:1. The ratio indicates the size of long term funds invested in fixed assets. If for an enterprise, this ratio shows a position of 0.87 :1 as above, a reasonable inference is possible that the enterprise would be having a working capital of 0.13 at that time. If the ratio moves for example in the following manner:

an inference is possible that the working capita! retained in the enterprise is being slowly eroded away. An increase in this ratio is undesirable. This ratio should not exceed 1:1 for a manufacturing concern and 0.75 :1 for wholesaler. If the ratio increases, the margin of operating funds become too narrow, and may expose the enterprise to hazards of unexpected developments.

5) CURRENT DEBT TO TANGIBLE NET WORTH :

Computation : Current liabilities divided by tangible net worth. A business may begin to pile up trouble if this ratio exceeds 0.80:1. In the above balance sheet the ratio is 1/1.50 or 0.6:1. If the ratio moves for example in the following manner.

indicates increasing stake of the creditors and probably generation of debt pressures and insufficiency of own capital.

6) TOTAL DEBT TO TANGIBLE NET WORTH :

Computation : Obtained by dividing the long and short term debt by net worth. In the above balance sheet, yie ratio is 3.50/1.50 or 2.3 :1. Generally, total debt to own worth should not be more than 2.50:1. If for exam

the position may indicate that the business is being exposed to hazards of greater and greater borrowings which may millitate against its survival, cloud business judgemet of the entrepreneur and sap Management energies. The enterprise may not be able to cover the risk of unexpected contingencies, sudden downward trends in sales, changes in style, and customer preferences. In other words, the enterprise may lose flexibility, and pressure of top heavy liabilities may undermine business judgement.

7) INVENTORY TO NET WORKING CAPITAL

Computation : Inventory divided by net working capital. In the above balance sheet, inventory is 1.00 and net working capital 0.50. The ratio therefore is 2:1. Ordinarily in a healthy balance sheet, inventory should not exceed 80% of the working capital. If excessive percentage of net working capital is reflected by unsold inventory, difficulty may be felt in meeting current obligations.

8) CURRENT DEBT TO INVENTORY :

Computation : By dividing current liabilities by inventory. In the above balance sheet, the ratio would work up to 1:1. A steady increase in ratio year by year may indicate the increase of current debt or decrease of inventory. Generally, the trend is not favourable.

1) NET PROFIT ON NET SALES (Net profit after tax)

Computation : Division of net profits by net sales. In the above profit and loss account the ratio is 0.20/10.25 or 0.02: 1 or 2:100. This ratio would be an important yard stick for measuring profitability. The ratio indicates the ability to provide profits from sales. Higher the ratio, more rewarding be the investment.

2) NET PROFFT ON TANGIBLE NET WORTH (Net profit after tax)

Computation : Division of net profit by tangible net worth. In the above profit and loss account, the ratio is 0.20/1.50 or 2:15 or 0.13:1 or 13:100. This ratio indicates the rate of return on owners'investment. The modern tendency is to look more and more to this ratio rather than to sales as a final criterion for profitability. At least 10% is regarded as a necessary objective for providing dividends plus funds for future growth.

3) GROSS PROFIT TO NET SALES :

Computation : Net annual gross profits divided by total sales. In the profit and loss account, the ratio is 1.20/10:25 or 0.1:1. This ratio is a test of the management's pricing policies. It is however necessary to compare this ratio of two similar businesses or between different periods in the same business. Several factors contribute towards a change in this ratio, such as increase in expenses, fall in prices of commodity produced, fall also in total production, variations in wages, freight, and many other factors.

4) NET PROFIT TO TOTAL ASSETS :

Computation: Annual net profit divided by total assets. In the above case 0.20/5.00 or 0.04:1. Indicates rate of return on resources commited to the operations of the firm. This is another test for ascertaining growing or declining efficiency.

1) SALES TO RECEIVABLES

Computation : Net annual sales divided by trade receivables. In the above case, 10.25/0.40 i.e. 25. Indicates relationship of volume of business to uncollected receivables. A higher ratio indicates more rapid collection and greater liquidity of receivables. Divide 360 by the above answer, and you wil get the number of days of sales represented by the amout of receivables. In this particular case, 360/25 = 15 days sales approximately may be taken as the amount represented by the receivables.

2) SALES TO INVENTORY

Indicates the velocity with which the goods are sold. In the above case, the ratio is 10.25/1.00 i.e. 10.25 times. The quality of inventory turnover is indicatd by this ratio.

3) SALES TO TOTAL ASSETS

Computation : Divide sales by total assets 10.25/5.00 i.e. 2.05:1. It is a rough measure for the efficient use of funds.

5. Corporate practices in U.S.A. and U.K. widely differ. However comparisons made and ratios computed of financial statements of a wide range of enterprises have generally indicated, that liquidity of firms or enterprises is slightly higher in the U.S.A. than in the U.K. enterprises. American inventories are generally smaller, and turnover in relation to equity are faster than in U.K. However, profit after tax in the U.K. produced somewhat a higher ratio than in U.S.A. It is therefore not possible to set down a hard and fast rule as to within what range a particular ratio should lie. Out of an assessment of a large number of ratio studies made in the U.S.A and United Kingdom, the following ratios are indicated as lying within safety norms.

The following procedure for comparison and evaluation of any balance sheet is suggested,

a) Calculate the ratios of balance sheet under study for 3 or 5 years.

b) Compare the ratios with the published ratios, if any of the industry as a whole.

c) In case of large deviations - ascertain the factors involved.

d) Consider what financial adjustments are necessary to bring the ratio within the average range.

6. A comparative ratio analysis of a sample of companies in the public and private sector in India, is given below.

Public and Private Sector Enterprises: a Comprative Analysis

7. Analysts have devised innumerable ratios in the course of the past few years. Only a few of them have important significance and these have been detailed above. Each ratio when computed and interpreted may tell a story, and in conjunction with other ratios may tell a supplemental story. But it is necessary to recognise only a few having managerial and financial significance. Even though variations in ratios may disclose a trend, any particular ratio by itself and detached from the setting in which it has been determined has little independent significance.

If any lending decision is to be properly made, the risk involved in the transaction should be properly evaluated. Risk evaluation primarily consists in the ascertainment of the ability of the prospective borrower to repay the proposed loan. To ascertain this ability, apart from financial analysis many other vital considerations such as character of the borrower, his managerial ability, technical and operational skill and the productive use to which the funds would be applied would come into operation. The computation of ratio assists any analyst to evaluate significant relationships in financial statements. How this is done is explained in the example given below:

A and B are two small scale units. Both seek bank finance. The problem for determination is to ascertain which of them is more eligible and why? The Balance Sheet and profit and loss accounts of both are given below. They almost appear similar. How to choose the one most desirable?

BALANCE SHEET

PROFIT AND LOSS ACCOUNT FOR THE CORRESPONDING YEAR

3. We shall attempt to evaluate here below the points of financial strength and weakness of the enterprise for credit purposes:

This ratio indicates credit strength by indicating how much of current assets are available for meeting each rupee of liability. A has only 54 paise for each Rupee of liability and B 93 paise. In between A & B, B may be persumed to have greater credit strength. Normal ratio however is 2:1 and any position below this should be considered as sub-normal.

2) Liquidity ratio also called Acid test

This ratio in its application is more stringent than the previous one. It indicates the size of the liquid assets which can be readily converted into cash in relation to the total liability. Increase in this ratio means greater credit strength and greater ability to meet maturing liabilities. In the above cases, A has 31 paise for each Rupee liability and B 27 paise. In between the two, A is preferable. But the normal ratio is 1:1 and from this standpoint both the above companies may be considered below standard.

This ratio indicates the dependance of any company upon its creditors for working. In the first case 61 paise and in the second 70 paise in every rupee of asset holding has been contributed by the creditor. In between A and B, B appears to depend upon creditors more than A. A is therefore preferable. Over a period of time increase or decrease of this ratio indicates a trend analysis - showing to what extent debt pressure increases or decreases. Increase of this ratio indicates decrease of debt and decrease of this ratio indicate increase of debt.

4) Rate of earning on total assets employed

This ratio gives the percentage of return from business production on every rupee of asset employed. An increase in this ratio indicates increase in earning power and financial efficiency. A decrease in this ratio means decrease in earning power and decrease in financial efficiency. The increase or decrease in ratio of the same company over a period of time provides a trend analysis about the increase or decrease of financial efficiency and earning power.

5) Operating Ratio

This ratio indicates the proportion of each Rupee of sales needed to meet the cost of production and operation. It may be seen that the greater the ratio lesser is the profit and lesser the ratio greater is the profit. In the above cases, A indicates a net profit of Rs. 8.50 for every Rs. 100 sales and B Rs. 6.80 for every Rs. 100 of sales. Over a period of time increase or decrease in this ratio for a particular company would indicate the increase or decrease of profitability and evaluation of a trend.

6) Turnover of capital

Greater the ratio - greater would be the efficiency of turnover of capital, lesser the ratio lesser would be the efficiency. Over a period of time increase or decrease in ratio would indicate flow of a trend, whether the management efficiency increases or decreases.

7) Merchandise turnover

This ratio shows the number of times the inventory is replaced during a given period of time. Increase or (here in the absence of an average inventory figure, the inventory on the date of the Balance sheet is taken as the average inventory for the year.) decrease in these ratios shows efficiency in merchandising and turnover. Greater the ratio greater is the efficiency and lesser the ratio lesser the efficiency. Once again calculation of the same ratio over a period of time may indicate the emergence of a trend.whether the efficiency in management increases or decreases.

Ratios helpful in control of internal operations.

8) Margin percentage

For every Rs. 100 sales recorded, A records a gross profit of Rs. 19.3 and B Rs. 18.3. In between A and B, A is preferable. The gross profit must be large enough to cover every other item of expenditure in order to be profitable in its overall operations. Increase or decrease in this ratio helps management in cost control, and considered over a period of time calculation for contiguous profit and loss accounts may indicate the emergence of a trend indicating increase or decrease in gross profit on sales and may help management in the control of internal operations.

9) Net Profit Ratio

This ratio could better be expressed as a percentage. In between A and B, A earns a net profit of Rs. 8.7 and B Rs. 6.4 for every Rs. 100 sales effected. A is preferable to B. Over a period of time, for a number of successive profit and loss accounts changes in percentages may indicate profitability trends.

10) Number of days sales in receivables.

This is a collection ratio, and shows the average length of time accounts are outstanding. In the case of A, receivables are collected after a 12 day period and in B after a 9 day period, a fall in the number of days shows increased efficiency in debt collection and increase, in lesser efficiency. Ratios calculated over a period of time indicates trends in the credit management of the enterprise.

4. We shall summarise here below the significant relationships which we have located in the Balance Sheets and profit and loss accounts of the above enterprise and endeavour to evaluate the overall financial strength. The following points may be noted:

It may be seen from the above that except for the current ratio and the number of days sales in receivables where B is having a slight edge over A, in all other cases A appears to have a favourable position over B. This analysis has been made on the basis of credit strength as measured by liquidity and capacity to pay debts as and when maturing, credit strength as measured by magnitude of own liabilities in relation to own worth, profitability and earning power, and lastly financial efficiency and efficiency of management. Modern practices involve in budgeting for better turnover, better profits, and better return on investment by planning for better ratios.