Financial Accounting and Ratio Analysis

J.V. GURURAJ

Financial Accounting is now a days a very deep rooted subject.  It has only two wheels – Debit and Credit.  The whole system of accounting is completely rested on these two wheels.  It has got such a scope these days that even it is impossible to imagine our economy without the use of financial accounting.  From Petty Pan Shop to a billionaire company needs accounting.  The accountants do play a vital role in maintaining and reporting the accounting system.

A Ratio is a statistical Yard stick to measure relationship between two accounting figures.  It is used mainly to analyse trend and static of business.   It is very useful for the investors, suppliers, creditors.  It is used as a mirror to reflect financial status of a particular company or group of company, firms, business houses.  The manager or owner of the company use the tool to rectify or diversity or fine tune their transactions in accordance with ratio pointing analysis.  The investor will think of investing or disinvesting in the company based on the positions revealed by ratio analysis.  The  suppliers will know the position of turn over trend and the creditors will know the profit ability to get their return.

Classification of Ratios :   The Classification of ratio is based on the statement from which the ratios are calculated.  There are three categories:

I) Balance Sheet Ratio :  Balance Sheet is the product of accounting system – extracting all debits and all Credits naming as Assets and Liabilities accordingly.  Balance Sheet always reveals the true figures which will be final and moves further to next  continuation.  The Manager or owner or investor or creditors etc.  will use ratios of the followings to analyse whether the company is potential or not.

a)   Working Capital Ratio or current ratio :  Simple formula is current assets divided by current Liabilities  eg : 100/50 = 2 : 1  double assets to single liability.  Bankers always  prefer this.

b) Liquid Ratio or Quick Ratio or Acid Test Ratio :  The formula is : Quick current assets / Quick  current Liabilities  100/100 = 1 : 1  equal assets and equal quick liabilities  Quick Current Assets are : Cash bills receivables, debtors , quick current liabilities are : Short Term Creditors , Hand Loans, Usls etc.  usually proprietors prefers this.

c)  Return on proprietory fund Ratio :  This shows  return on proprietors capital .  The formula is Net Profit after tax x 100/  proprietors capital = NP 100 X 100 /102 =98.03 return usually investors or proprietors prefers.

d) Proprietor fund ratio :   This ratio actually shows how much proprietory fund has earning capacity over fixed assets.

Formula :  Fixed Assets / Proprietary Fund = 100/100 = 1: 1

II) The second Category of ratio is Profit and Loss account : The financial accounting before extracting Balance Sheet will first extract Mfg. trg. Profit and Loss A/c.  All the debits in Profit & Loss are sucked out by all  credits and final by products is Net Profit.   In trading and Manufacturing account we know exact T.O.,  Sales, purchases stock , G.P.  There are five main types of ratios based on Profit and Loss .

a)  Gross Profit Ratio : Usually Gross Profit constitutes the difference between  cost of goods brought in and the cost at which they are sold.  The suppliers of the goods will first see the G.P. Ratio to get their money back.  Formula is G.P. x 100 / Sales TO.  If G.P. is 10000/- and sales is 100000 then 10000 x 100/100000 = 10%.

b)  Net Profit Ratio :  Net Profit is out come of G.P. –  Expenses.  All indirect expenses are deducted or debited in accounting system.  The more percentage of N.P. shows healthy earning capacity of the company.  The Bankers or the investors mainly attracted by this.  The formula is NP x 100/10 .  If TO is 5000000 N P is 5,00,000 = 5,00,000 x 100/50,00,000 = 10%.

c)  Expenses Ratio :  The Selling expenses can be controlled by analyzing P & L by this method.  It is very useful for the managers of the company to curb unnecessary expenditure.  The formula is Expenses x 100 / Total Sales.

                    If Sales is 1,00,000 and expenses is 1000 :

                    1000 x 100 / 100000 = 1%.

d) Inventory to Ratio :  It is computed by dividing the cost of sales by average  inventory of the period.  A low ratio indicates slow moving of inventory.  Formula : Avg. Inventory / cost of sales .  If inventory is 20 cost of sale is 100 = 20 / 100 = 1 : 50 or 20%.

e)  Operating Ratio :  This indicates relation between operating profit and sales.  It is worked out by dividing operating profits by net sales.  We can Judge the managerial capability.  The high percentage proves the efficient management.

III. The Third category of ratio is Balance Sheet and Profit and Loss Statement Ratio :   It is calculated by referring both Balance Sheet and Profit and Loss.

a) Return on total resources Ratio :  This ratio is an indicator of the earning capacity of the total resources employed in the business.  Total resources not only includes share capital but also includes fixed liabilities i.e. borrowed money, reserves un distributed profits etc.  It is calculated as  : Total resources x NP /Capital employed.  If total resources is 100, NP  80, Capital is 100 = 100 x 80 / 100 = 80% NP to total resources.

b) Return on Capital Ratio :  This is calculated in the same way as  ( a)  is calculated.  Here Capital can include of a proprietory level where there are no reserves made obligatory.  Any how while calculating this ratio we should see capital employed and share capital, P. Shares, borrowed liabilities, reserves.  The formula is : Capital employed  = NP x 100 / Capital employed.

c)  Turn Over of Fixed assets ratio :  This ratio expresses the number of times fixed assets are being Turn Over in a stated period.  It is calculated as : Fixed assets ratio = Sales / Net Fixed assets ( Less Depreciation).

 For eg: Sales is 100 net fixed asset is 80 = 100 / 80 = 1.25 : 1  The ratio         shows     how well the fixed assets are being used in the business.  The lower the ratio shows that fixed assets are inefficiently used in business.

d)  Turn Over of Debtors Ratio : This ratio measures the accounts receivables in terms of number of days of credit sales during a particular period .  This ratio is calculated as :

Debtors Turn Over ratio =   Net credit sales / Average Debtors

The ratios can be  calculated in various forms like:

Pure ratios: which are arrived at by simple division of one number by another i.e. current assets to current liabilities.

Rate: which is the ratio between two numerical factors. it is expressed over a period of time i.e.  stock turnover is three times a year

Percentage: which is a special type rate expressing the relation in hundredth. i.e.  GP is 25% of sales

In conclusion we can say that the accounting system creates life of business; the ratios check up the health of business. To get best advantages, the ratios should be rightly used. If wrongly used ratios may create havoc and financial crisis in the company or business houses. Very much care is needed in applying ratios to different purposes especially in bigger investments, lending decisions from banks, fore warning of sickness of the company etc.

 Article written by-  J.V. GURURAJ ,Accounts & Tax consultant, Ph 9849291424 , [email protected]