• PAGE ONE
• INDEX
• HOME

The basics of ratio analysis

N. R. Parasuraman

WHILE the profit and loss (P&L) account of a company essentially contains revenue items, appropriation and provisions, the balance-sheet lists out the assets and liabilities.

While it is useful to understand the absolute quantum of each asset, liability and revenue item in isolation, far greater understanding of its implication with respect to the trend and performance of the company can be achieved by a `relationship' study. For instance, if one studies profits in relation to sales for the current year and compares it with the same relationship for a series of years, a greater understanding of the trend and performance can be had.

The `relationship' study referred has two facets: i) the relationship of one item to another for the current or previous years, but in respect of the same company, and ii) the relationship of these parameters with industry figures or representative figur es of competitors or of firms of similar size and operations. The first set enables one to understand the performance of the company in isolation, while the second gives an insight as to where the company stands vis-a-vis the industry or competition.

The intuitive way of arriving at a `relationship' is to develop ratios among key parameters. After the finalised statement of accounts is ready, one ascertains the ratio of one key parameter to another. A large number of ratios are in common use, but som e of these are useful only for specific end uses such as project appraisal, working capital analysis, securities analysis, and so on. This discussion is restricted to only those ratios which are universal in nature and which can be computed easily.

The liquidity ratios give a clear indication of the extent to which a company is liquid. Liquidity and profitability are two separate yardsticks to gauge a company's performance. The current ratio gives an indication of the number of times by which the c urrent assets multiply the current liabilities. In a healthy industry, the current ratio should be upwards of 1.75. A figure of less than 1.25 would indicate that the company's working capital management has to be pretty rigid to keep the liquidity afloa t. The quick or acid test ratio is a modification of the current ratio in that only the `quick' assets are considered in the numerator, and inventory, which is the slowest of the current assets, is ignored. The measure gives the extent of fast liquidity enjoyed by the company.

Just as important as liquidity is the level of profitability. While absolute figures of profitability may be adequate for some cases, a better understanding of the performance of a company can be had by studying the profits in relation to select paramete rs such as sales, capital employed and equity capital. These relationships are covered under profitability ratios. It may be noted that for return on equity, only the net income after interest is taken, whereas for return on assets, the net income before interest. This is because, in the latter ratio we are looking at what the total investment fetched and not what is left for the equity holders.

The debt ratio can ascertain the extent of reliance of external financing. The debt-equity ratio gives the proportion of debt to equity. In capital-intensive industries, this ratio can be as high as four -- that is, debt can be up to four times the equit y portion. Normally, a debt-equity ratio of two is considered acceptable. The `times interest earned ratio' is a matter or reassurance to the lenders that their interest dues are protected. If the company is doing well in terms of having a high times int erest earned ratio, it means that the interest liability is only a relatively small portion of the company's net surplus. However, if the ratio is small, there is cause for concern for the lender.

Only the most essential and fundamental ratios are considered here. Depending on the specific needs of the user, more ratios can be utilised.

By comparing the various ratios with those of the previous year or years, the areas where the company has improved can be identified; as also the spheres where finances display a fall in the performance. This will act as a good planning tool.

Ratios have far greater utility if compared with those of the industry as a whole and those of the competitors. Specific areas which need improvement can be identified and corrective action initiated.

Concept check

* A high profit-to-sales ratio means that the return on assets is also high. Do you agree?

* Suppose you are viewing key ratios of a company from the angle of a term-lending institution, and find that the quick ratio is less than one but the current ratio and the times interest earned ratio are 1.2 and 2 respectively, what will be your assessm ent about the interest and principal repayment capacity of the company?