Interpretation of Financial Ratios

Interpretation of Financial Ratios

Broadly speaking, ratios may be interpreted n four different ways as follows:
1. An individual ratio may have significance of its own. For example a ratio of 25% of net profit on capital employed shows a satisfactory return.

2. Ratios may be interpreted by making comparison over time. For example, ratio of net profit on capital employed is 25%. This ratio may be compared with same ratio of a number of past years.

Such a comparison will indicate the trend of rise, decline or stability of the profitability.


3. Ratios of any one firm may be compared with ratios of other firms in the same industry. This is known as inter-firm comparison. Such a comparison shows the efficiency of a firm as compared to other firms.

4. The interpretation of financial ratios is a group of several related ratios. For example, the utility of current ratio is enhanced if it is used along with other related ratios like quick ratio or acid test ratio, stock turnover ratio, etc. Similarly various profitability ratios may be considered in relation to each other.

Types of Ratios

Ratios may be classified as given below:
(A) Classification based on the nature of accounting statement through which the types of ratios tend to be derived

1. Balance Sheet Ratios. These ratios deal with the relationship between two items appearing in the balance sheet, e.g., current ratio, liquid ratio, debt equity ratio, etc.

2. Profit and Loss Account Ratios. This type of ratios show the relationship between two items which are in the profit and loss account itself, e.g. gross profit ratio, net profit ratio, operating ratio , etc.

3. Combined or Composite Ratios. These ratios show the relationship between items one of which is taken from Profit and Loss Account and the other from the Balance Sheet, e.g., Rate of return on capital employed, debtors turnover ratio, stock turnover ratio, capital turnover ratio, etc.

(B) Classification from the point of view of financial management or objective
1. Liquidity Ratios.
2. Capital Structure Ratios.
3. Turnover Ratios.
4. Profitability Ratios.
In this Book, discussion of ratios is on the basis of this classification according to objectives.

Liquidity Ratio Analysis

(Short Term Solvency)

Liquidity Ratio Analysis Liquidity signifies ability of a company to meet its existing liabilities. A liquidity ratio analysis, therefore, attempt to establish a connection between current liabilities, which can be the obligations quickly becoming due and current assets, that presumably offer the source from where these obligations is going to be met. In short, the liquidity ratios answer the question: Will the organization probably be in a position to meet its obligations any time they become due?
The failure of an organization to meet its obligations because of lack of adequate liquidity will lead to bad credit ratings, loss in creditor's confidence as well as in law suits against the business. The following ratios are generally used to show the liquidity of business.

Change in price levels makes ratio analysis formula ineffective. Adjustments in price levels usually make comparison of figures for several years difficult. For instance, the ratio of sales to set assets in 2003 will be much higher compared to 1995 due to growing prices because fixed assets remain being expressed about the basis of cost incurred several years ago while sales are getting expressed at their existing prices.

There is no single standard for comparison. Ratios of an organization have meaning only if they are compared with a few standard ratios. Circumstances vary from firm to firm and the character of each industry is various. Therefore, the standards will vary for every industry and the situations of each company will need to be kept in mind. It is hard to find out a correct basis of comparison. As a result, the efficiency of one industry may not be correctly comparable with that of another. Generally it is recommended that ratios ought to be compared with the average of the industry. However the industry averages aren't easily available.

Important Liquidity Ratio Analysis

1. Current ratio.
2. Quick ratio.
3. Absolute liquid ratio

1. Current Ratio (Working Capital Ratio)
This ratio is mostly used to do the short-term financial evaluation. In the interpretation of financial ratios it is referred to as the working capital ratio, this ratio suits the current assets of the company to its current liabilities.

Significance and Objective

Existing ratio throws good light around the short-term policy and financial position. It is actually an indicator of a company’s ability to rapidly meet its short-term liabilities. A relatively higher current ratio indicates how the firm is liquid and gets the ability to meet its existing liabilities. However, a relatively lower current ratio indicates how the firm will find it hard to pay its charges normally a current ratio of 2: 1 is known as satisfactory.

In other words, existing assets ought to be twice the amount of existing liabilities. When the current ratio is actually 1: 1, it signifies that funds yielded through current assets are only sufficient to pay the amounts because of various creditors and you will see nothing left to fulfill the expenses that are being currently incurred. Therefore the ratio should usually be more than 1: 1. An extremely high current ratio is also not desirable due to it indicates idleness of funds that is not a sign of effective financial management.

2. Quick Ratio
This ratio is also called liquid ratio or acid test ratio. It can be a more severe analyze of liquidity of an organization. It exhibits the ability of a company to meet its instant financial commitments. It is utilized to supplement the details given by the present ratio.

What are Assets and Liabilities

The quick assets contain cash, debtors (excluding negative debts) and securities which could be realized without trouble. Stock is not included within quick assets for that purpose of this ratio. In the same way prepaid expenses will also be excluded as they can't be converted into cash. Quick or liquid liabilities reference all current liabilities other than bank overdraft.

Generally a quick ratio of 1: 1 is considered to represent a satisfactory current financial position. In the illustration 14.2 above, the quick ratio of 0.47: 1 is not at all satisfactory because it is, less than 1: 1. On account of such a low ratio, the business may find itself in serious financial difficulties.