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Meaning of Ratio Analysis

A tool used to conduct a quantitative

analysis of information in a company's

financial statements.

Ratios are calculated from current year

numbers and are then compared to previous

years, other companies, the industry, oreven the economy to judge the performance

of the company.

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Uses of accounting ratios

Enable comparison of the performance of

the company

- in different years

- with its budgets and forecasts

- with other companies in similar trades

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Uses of accounting ratios

Provide information of the company in respect of

the liquidity, profitability, use of assets and capital

structure Eliminate the effects of the scale and size of

different companies or different years of the same

company so comparison can be provided.

Appraise the performance of the company, make

predictions for future performance and assist in

future planning

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Accounting ratios and

interpretation Liquidity

- current ratio / working capital ratio

- acid test ratio / quick ratio / liquid ratio

- stock turnover rate

- stock turnover period - debtors collection period

- creditors payment period

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Liquidity

Liquidity is a measure of the amount of

funds a company can quickly use to settle

its debts.

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Liquiditycurrent ratio

This ratio indicates the ability of a business tomeet its short-term liabilities from its currentassets.

FormulaCurrent assets/Current liabilities

The norm is 2:1.

If the ratio is too high, the company may be

holding too many idle short-term assets. (Theymay be used in a more profitable way.)

If the ratio is too low, the company may not havesufficient funds to meet its short-term liabilities.

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Liquidityacid test ratio

This ratio indicates the ability of the business to

meet its short-term liabilities from its quick assets.

Formula- Quick Assets/Current Liabilities The norm is 1:1.

If the ratio is too high, the company may be

holding excessive liquid assets. If the ratio is too low, the company may have a

liquidity problem / cash flow problem.

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Liquiditystock turnover rate

It shows the number of times that a business

can sell its average stock in a period.

FormulaCOGS/Average Stock

A high ratio means high sales, fast stock

turnover and a low stock level.

A low ratio means low sales, low stock

turnover and a high stock level. (goods may

become obsolete, high storage cost)

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Liquiditydebtors collection

period This ratio measures the debt collection

period of a business.

FormulaCredit Sales/Average Debtors

A low ratio means debtors pay back their

debts in a short period of time. The

company may have sufficient liquid fund.

A high ratio indicates a poor credit control

and a high risk of bad debts.

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Liquiditycreditors payment

period This shows the length of time taken to pay

the creditors.

FormulaCredit Purchases/Average

Creditors

A long payment period may indicate that

the company has a liquidity problem. Therelationship between the company and the

suppliers may be affected.

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Examples of interested group

Liquidity

- shareholders

- suppliers

- creditors

- competitors

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Limitations of ratio analysis

Differences in management and background of

various businesses may affect the comparison.

Different accounting definitions, methods,techniques and policies used by various businesses

may affect the comparability.

It is difficult to set up a proper standard for good

performance.

Short term fluctuations may not be reflected.

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Thank You

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