RATIO ANALYSIS 3.1 INTRODUCTION OF RATIO ANALYSIS: The relationship of these two figure expressed mathematically is called a ratio.

The ratio reefers to the numerical or quantities relationship between two variables or times. A ratio is calculated by dividing one item of the relationship with the other. The ratio analysis is one of the most useful and common methods of analyzing financial statement. Ratio enables the mass of data to be summarized and simplified. Ratio analysis is an instrument for diagnosis of the financial health of an enterprise.

3.2 MEANING OF RATIO:A ratio is only a comparison of the numerator with the denominator. The tern ratio reefers to the numerical or quantitative relationship between two figures and obtained by dividing the former by the latter. Ratio analysis is the process of determining and presenting the relationship of items and group of items in the statements. According to Batty J. Management Accounting Ratio can assist management in its basic functions of forecasting, planning coordination, control and communication. Ratio analysis is an important and age old technique of financial analysis. The data given in financial statements ratio are relative form of financial data and very useful techniques to cheek upon the efficiency of a firm. Some ratio indicates the trend or progress or downfall of the firm.

3.2.1 Importance of ratio:

Ratio analysis of firms financial statement is of interest to a number of parties mainly. Shareholders, creditor, financial executives etc. shareholders are interested with earning capacity of the firm: creditors are interested in knowing the ability of firm to meet financial obligation and financial executives are concerned with evolving analytical tools that will measures and compare costs, efficiency liquidity and profitability with a view to making intelligent decisions.

 Aid to measure general efficiency: Ratios enable the mass of accounting data to be summarized and simplified Aid to measure financial solvency: They point out firms liquidity position to meet its short-term obligation and long-term solvency. Aid in forecasting and planning: ratio help to prepare the future plan of action etc. Facilitate decision-making: it throws light on the degree of efficiency of the management and utilization of the assets that is why it is called surveyor of efficiency. Aid in corrective action: the highlight the factors associated with successful and unsuccessful firms. Aids in intrude firm comparison: inter firm comparison are facilities. It is an instrument for diagnosis of financial health of enterprise. Evaluation of efficiency: ratio analysis is an effective instrument which, when properly used is useful to assess important characteristics of business liquidity, solvency, profitability etc. Effective tool: ratio analysis helps in making effective control of the business measuring performance; control of cost etc. ratio ensures secrecy.

Advantages of Ratio Analysis

The accounting ratios offer the following advantages: Help in financial statement analysis It is easy to understand the financial position of a business enterprise in respect of short term solvency, capital structure position etc., with the help of various ratios. The users can also gain by knowing the profitability rations of the firm. Help in simplifying accounting figures The single figures in terms of absolute amount such Rs. 10 lakhs income, Rs. 50 lakhs sales etc, are not of much use. But they become important when relationship are established, say for example, between gross profit and sales or net profits and capital employed and so on. Help in calculating the operating efficiency of the business enterprise Ratios enable the users of financial information to determine operational efficiency of a business firm by relating the profit figure to the capital employed for a given period.

Help in locating weak points of the firms Ratio analysis would pin-point the deficiency of various departments or a branches of a business unit even through the overall performance is satisfactory. Help in inter-firm and inter-period comparisons A firm can compare its results not only with other firms in the same industry but also its own performance over a period of time with the help of ratio. Help in forecasting Accounting ratios calculated and tabulated for a numbers of years enable the users of financial information to determine the future result on the basis of past trends

3.2.2 Limitation of ratio analysis

Ratio analysis is as already mentioned, a widely used tool of financial analysis. It is because ratios are simple and easy to understand. But they must be used very carefully. They suffer from various limitations. Some of the limitations of ratio analysis are given below: Difference in definition: comparisons are made difficult due to difference in definitions of various financial terms. Limitations of according records ratio: Ratio analysis is based on financial statement, which are themselves subject to limitations. Lack of proper standards: it is very difficult to ascertain the standard ratio in order to make proper comparison. Because it differs from firm to firm, industry to industry. Changes in accounting procedure: it different firms for their valuation follow methods then comparison will practically be of no use. Limited use of single ratio: a single ratio would not be able to convey anything. It too many ratio are calculated they are likely to confuse instead of revealing meaningful conclusions Personal bias: Ratios have to be interpreted and different people may interpret the same ratio in different ways. The analyst has to carry further investigation and exercise. His judgment in arriving at a correct diagnosis.

3.3. CLASSIFICATION BY PURPOSE:

This is a classification based on the purpose for which an analyst computes these ratios. The modern approach of classifying the ratios is according to purpose or objects of analysis. Normally, ratios are used for the purpose of assessing the profitability and sound financial position. Thus, ratios according to the purpose are more meaningful. There can be several purposes, which can be listed.

Classification by Purpose

Solvency

Profitability

Activity

Short term Long term -

Capital turnover Ratio Creditor Turnover Debtor Turnover Fixed Assets Turnover

- Current Ratio
- Cash position Ratio

- Proprietary Ratio - Debt Equity Ratio - Solvency Ratio Gross profit Ratio Net profit Ratio Expense Ratio Operating profit Ratio Return on capital employed Ratio Return on Equity Ratio

Definition of 'Weighted Average Cost of Capital - WACC'

A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. All else equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V=E+D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

DIVIDEND POLICY
The subject matter of the dividend policy is whether pay-out ratio has any impact on the market price of the share or not. In other words, if we change the pay-out ratio, whether market price of the share will change (if yes, in which direction) or not. For example, if we increase the P/O ratio, whether the market price of the share will increase or decrease or there will be no change. THERE are two theories of dividend policy. One was first suggested by Modigliani and Miller (MM) in 1961 and says dividends are irrelevant and the amounts paid (as dividends) do not affect the price of the shares of the company in long-run. The bother theory asserts that dividends are relevant and will affect the share prices. IRRELEVANCE THEORY Miller and Modigliani have opined that the price of equity shares of a firm depends solely on its earnings power and is not influenced by the manner in which its earnings are split between dividends and retained earnings. They observed under conditions of perfect capital markets, rational , absence of tax discrimination between dividend income and capital appreciation given the firms Investment policy, its dividend policy may have no influence on the market price of the shares. In other words, the price of share is not affected by the size of the dividend.

MM provide the following proof in support of their views. According to them, market price of share in beginning of a year (P) is equal to present value of sum of dividend at the end of the year (D 1) and market price of the share at the end of year (P1). Now suppose a firm requires certain amount for investment (I) at the end of first year. It will raise an amount equal to amount of investment (I) minus earnings (E) of first year plus dividend paid at the end of first year (nD1) where n = number of shares outstanding in the beginning of the year and D1 is dividend per share at the end of first year. To raise this amount, the firm will issue m shares at P1.

D1 + P1 P = 1 + Ke Where Ke = cost of equity capital. With reference to Dividend policy, it is also referred as capitalization rate/rate of capitalization/discount rate.

Walters Model
Walter has proposed a model for share valuation which supports the view that the dividend policy of a firm has a bearing on share valuation. He emphasized two factors which influence the market price on a share. The first is dividend payout ratio and the second is the relationship between internal return on retained earnings (r) and cost of equity capital (Ke ). Walter classified all the firms into three categories: (i) Growth firms, (ii) Declining firms, and (iii) Normal or constant firms. GROWTH FIRM: He refers a firm as growth firm if the rate of return on retained earnings (r) exceeds its cost of equity capital (Ke). It means if the firm retains the earnings; it can invest the retained funds at higher rate of return than the rate of return to be obtained by shareholders by investing the dividend amount in case the firm does not retain the earnings. In such a situation, the shareholders would like the company to retain maximum amount, i.e., to keep payout ratio quite low because low dividends would be more than compensated by higher returns on retained earnings. Hence in case of such firms there is negative correlation between dividend and market price of shares. Lower the dividend, higher the market price of shares. Higher the dividend, lower the market price of shares. CONSTANT FIRM: A firm is referred as constant firm if rate of return on retained earnings is equal to cost of equity capital. It means if the firm would retain the earnings it would obtain return equal to the return to be obtained by shareholders by investing dividend. In this situation, the shareholders would be indifferent about splitting off of the earnings between dividend and

retained earnings. Hence market price of share wont be influenced by dividend rate. The correlation between dividend rate and market price of the shares would be nil.

DECLINING FIRM: Walter refers a firm as declining firm if its rate of return on investments is lower than its cost of equity capital. It means if the firm retains the earnings, it can invest the retained funds at lower rate of return than the rate which can be obtained by the shareholders by investing the dividend amount (in case the firm does not retain the earnings). In such a situation, the shareholders wont like the firm to retain the profits or to retain only minimum so that they can get higher returns by investing the dividends received by them. Hence, in case of such firms there would be positive correlation between dividend size and market price of the share. Higher dividend, higher market price of the shares. Lower dividend, lower market price of the shares. Walter concludes: (i) the optimum payout ratio is nil in case of growth firm, (ii) the payout ratio of a constant firm is irrelevant, (iii) the optimum payout ratio for a declining firm is 100 per cent.

E = Earnings per share, D = Dividend per share P = Market price per share

D The first component is the present value of an infinite stream Ke Of dividends. For this component, Walter assumes (i) constant dividend per share, (ii) no earnings on retained earnings, and (iii) no increase in the value of share on account of retained earnings.

Financing working capital

Working capital management is the management of the net of current assets and current liabilities with the objective of reaching the right balance between profitability and liquidity. The aim of managing inventory (stock), trade receivables (debtors), cash, trade payables (creditors), is to obtain the right balance of all the current assets and current liabilities at any given time so that the achieve the objectives of working capital management in the form of profitability and liquidity. Working capital management is made up of so many parts, such as the management of inventory, management of trade receivables, management of cash, management of trade payables, financing of working capital. To discuss the different approaches to financing working capital, it is important to identify that ordinarily, company may use short-term sources of finance to finance its short-term activities, such as working capital activities and long-term source of finance for its capital investments in non-current assets. The choice of which source of finance a company uses to finance its working capital and other activities depend on several factors such as: availability of fund, the length of time such funds may be required for, the purpose for which the funds is required, the size of the company, the rate of interest but for the discussion of the financing of the working capital, the two main factors that needs to be considered are the risk of the finance used and the cost of finance; either by financing working capital using short or long-term source of finance. Three approaches to financing working capital 1. Aggressive approach to financing working capital The aggressive method is where a company predominantly finances all its fluctuating current assets and most of its permanent current assets using short-term source of finance and it is only a small proportion of its permanent current assets that is financed using long-term source of finance. A company that uses more short-term source of finance and less long-term source of finance will incur less cost but with a corresponding high risk. This has the effect of increasing its profitability but with a potential risk of facing liquidity problem should such short-term source of finance be withdrawn or renewed on unfavorable terms. 2. Conservative approach to financing working capital The other extreme method of financing working capital is where a company decides to use mainly long-term source of finance and very little short-term source of finance to finance its working capital. This option means that the companys finance is going to be relatively high cost

(that is sacrificing low cost finance) but low risk; this will make the companys profit to be low but does not run the risk of being faced with liquidity problem as a result of withdrawal of its source of finance. The conservative method is where a company predominantly finances all its permanent current assets and most of its fluctuation current assets using long-term source of finance and it is only a small proportion of its fluctuating current assets that is financed using short-term source of finance. 3. Moderate approach to financing working capital Between the two extreme approaches to financing working capital is the moderate (or the matching or balancing) approach. This approach makes distinction between fluctuating current assets and permanent current assets with the suggestion that to finance working capital; shortterm source of finance should be used to finance fluctuating current assets, whiles long-term source of finance should be used to finance permanent current assets. This matches the source of finance with the character of the current assets.

The financing of working capital approach adopted by a company is very important since it will have an impact on its profitability and liquidity. It is also important for companies to consider other factors apart from cost and risk in making such financing decisions with regards to its working capital financing.