6.1 Introduction. 6.2 Meaning of Ratio

Transcription

1 6.1 Introduction Ratio analysis has emerged as the principal technique of analysis of financial statements. The system of analysis of financial statements by means of ratio was first made in 1919 be Alexander wall. It is an attempt to present the information of the financial statements in simplified, systemized and summarized by establishment the quantitative relationship of the items or group of items of financial statements. 6.2 Meaning of Ratio A ratio is a sample arithmetical expression of the relationship of one number to another and is obtained by dividing the former by the later, In other words, ratios are simply a means of highlighting, in arithmetical terms, the relationship between figure drawn from financial statements, whereas ratio analysis if the process of determining and presenting the relationship of items or groups of items in financial statements. A ratio may be defined as the indicated quotient of two mathematical expressions. According to accountant s handbook by Wixon, Kell and Bedford, a ratio is an expression of the quantitative relationship between two numbers. Ratio analysis is a process of determining and presenting the relationship of items or group of items in the financial statements. The relationship may be of two types: i) Associate relationship and ii) Cause / effect relationship For example there is an associate relationship between cost of goods sold and cost of raw material, whereas, there is cause/ effect relationship between sales and profits, both the relationship are expressed in terms of ratios. Normally, the ratios may be expressed in percentage, in times and in proportion. In financial analysis, these ratios highlight the financial position of the business, and hence known as financial ratios, they are also called structural ratio because they measure relative importance of the items expressed in financial statements. 206

2 6.3 Steps in Ratio analysis The ratio analysis requires two steps: i) Calculation of ratios ii) Comparing the ratio with some predetermined standard The standard ratio may be the past ratio of the same firm industry s average ratio of a projected ratio or the ratio of the most successful firm in the industry. 6.4 Importance of Ratio The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyze and interpret the financial health of enterprise. A ratio is known as a symptom like blood pressure, the pulse rate of the temperature of an individual. It is with help of ratios that the financial statements can be analysed more clearly and decision made from such analysis. The use of ratios is not analysis for knowing financial position of a firm like supplier, banks, investors, shareholders, financial institutions etc. The ratio analysis provides guides and clues especially in spotting trends towards better or poor performance. In the words of J. Batty ratio can also assist management in its basic functions of foresting, planning, co-ordination control and communication. The important / objectives of ratios analysis is discussed below: 1. Simplifies accounting figures Accounting figures in many cases fail to provide information in a desired way. Ratios simplify, summarize and systematize accounting figures which can easily be understood by those do not know the language of accounting. 2. Measures liquidity position Ratio analysis helps in measuring the liquidity position of the firm. Liquidity position of firm is said to be satisfactory if it is able to meet its current obligation as and when they mature. Various liquidity ratios are used for the purpose of credit analysis by banks and short term lenders. 3. Measuring long-term solvency Ratio analysis is equally important in evaluating the long term solvency of the firm. It is measured by capital structure of leverage ratios. 207

3 4. Measures operational efficiency Ratios are useful tools in the hands of management to evaluate the firm s performance over a period of time by comparing the present ratios with the past ratios. Various activity or turnover ratio measure the operational efficiency of the firm. These ratios are used, in general, by bankers, investors and other supplier of credit. 5. Measures profitability The management as well as owners of firm is primarily concerned with the overall profitability of the firm. Profit and loss amount reveals the profit earned or loss incurred during a period but fails to convey the capacity of the firm to earn in terms of per rupee invested or per rupee of sales. By calculating various profitability ratios an analyst can measure earning capacity of the firm. 6. Facilities inter firm and intra firm compositions Ratio analysis is the basis for comparing the efficiency of various firms in the industry and various division of a business firm. 7. Trend analysis Ratio analysis enables a firm to take the time dimensions into account. Trend analysis of ratios revels whether financial position of the firm is improving or deteriorating over years. With the help of such analysis, one can ascertain whether the trend is favorable or adverse. For example any particular ratio may be less than general ratio but the trend may be increasing. On the contrary, present level may be satisfactory but trend may be declining. 8. Managerial uses Ratio analysis is an invaluable aid to management is discharging its basis function such as planning, communication, control co-ordination and decision making. 6.5 Limitations Ratio analysis is one of the most powerful tools of financial evaluation of business firms. But it should be kept in view that ratios are only guide in analyzing the financial statements, and not conclusive end in themselves. If these ratios are misused, the results will be incorrect and misleading. Therefore, the analyst should be aware of the weaknesses and limitations of ratio analysis while analyzing financial statements on the basis of these ratios. The important limitations are as follows. 208

4 1. Limited use of a single ratio A single ratio would not be able to convey anything, as the single ratio in itself is meaningless, it does not furnish a complete picture. Neither it can be explained, nor can any decision be taken on this basis. Hence, it is essential to ponder over all relating ratios while drawing inferences. 2. Lack of standard ratios In practice, there is no uniformity in the definition of various terms used in ratio analysis. For example, some companies treat net current assets (current assets- current liabilities) as working capital, while others only current assets. There are no well accepted standard or rules of thumb for all ratios which can be accepted as norms. 3. Inherent limitations of according Ratios are calculated from accounting records which are subject to accounting principles, conventions, concepts and personal judgments. Any ratio based on the facts and figures of such financial statements suffers from inherent limitations. 4. Window dressing Windows dressing means manipulation of accounts in a way so as to present a better picture than what is actually it. By doing so, it is possible to cover up bad financial position. One should be very careful in making a decision from ratios calculated from such financial statements. 5. Difference in accounting methods and systems Comparability of financial statements is affected when differences are traced out in accounting methods and systems followed by different firms. 6. Price level change Changes in price level affect the comparability of ratios. A change in price level can seriously affect the validity of comparison of ratio for different years. 7. Personal bias Ratios have to be interpreted, but different people may interrupt the same ratios in different way. Ratios are only means of financial analysis, but not an end in them. It should be clearly noted that ratios are only tools and personal judgment of the analyst is more important. 209

5 8. No substitute for sound judgment Ratios analysis is one of the methods of interpretation and drawing inferences. It only provides little information for decision making conclusions drawn from ratio analysis are not sure indicators of bad or good management. 9. Qualitative factors ignored Ratios are arithmetical expressions, so the qualitative aspects cannot be presented through ratios. Normally qualitative factors that may influence the conclusion drawn are ignored while computing ratios. 10. Incomparable Not only industries differ in their nature but also the firms of the similar business widely differ in their size and accounting procedure etc. It makes comparison of ratios difficult and misleading. 6.6 Classification of Ratios Ratios analysis is the process of determining and interpreting numerical relationship based on financial statements. The technique is getting wider acceptance in account and mathematical world. The ratios have analysis provides guides and clues especially in spotting trends towards better or poor performance. Figure 6.1 : Classification of Ratios Each business entity has its own problems. Different ratios are computed to analyze these problems. Ratio expert Spencer A. Trickers P.E. has analysed such 429 ratio is his book, successful management control by ratio analysis. Calculation and application of all these 210

6 ratios is quite difficult and not feasible. Different kinds of accounting ratio are selected for different types of situations. Ratio may be classified into three broad categories. In traditional classification ratios are classified on the basis of information given in the financial statements, i.e. balance-sheet and profit and loss account to which the determinants of ratios belong. This classifications, however, in rather since it leads one to think that analysis of the income statements or the balance-sheet can be attempted in isolation. To get a correct idea about the profitability and financial strength of a concern, it is necessary that an opinion can only be framed after a detailed study of various statements in relation to each other. Now-a-days functional classification is the most popular mode of classifying the ratios. Accordingly, the ratio may be grouped on the basis of certain tests which satisfy the needs of the parties having financial interest in the business concern. The British Institute of Management has recommended classification of ratios according to important for inter-firm comparison. The institute has suggested the following categories. a) Primary ratios b) Secondary ratios The primary ratios are those which are of prime importance to a concern. The other ratios which support or explain the primary ratios are called secondary ratios. This ratio are classified with different point of views, but from analytical point of view, the functional classification is more important appropriate as it highlights the utility of different ratios. In this study functional classification of ratios is used to calculate profitability ratios of all selected public sector units. 6.7 Ratios Analysis Ratio analysis is a very powerful analytical tool useful for measuring performance of an organization. The ratio analysis helps the managements to analyze the past performance of the firm and to make future projections. Ratio analysis is extremely helpful in providing a business strength and weakness in two ways. Ratio provide as easy way to compare present performance with past. 211

7 Ratio depict the areas in which a particular business is completely advantaged or disadvantaged through comparing ratios to those of other business of the some size within the same industry. In this study to measure profitability of selected Public Sector Units following profitability ratios have been calculated Profitability Ratio The primary objective of a business undertaking is to earn profits. Profits earning is considered essential for survival of the business. In the words of Lord Keynes, Profit is the engine that drives the business enterprise. The firm s ability to earn maximum profit by the best utilization of its resource is called profitability. Profit refers to absolute quantity of profit whereas profitability refers to ability to earn profit. The profitability of a firm can easily be measured by its profitability ratios. These ratios indicate overall managerial efficiency. Generally profitability ratios are calculated either in relation to sales or in relation to investment. The profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflect the final results of business operations. The results of the firms can be evaluated in terms of its earnings with references to a given level of assets or sales or owners interest etc. In this study to measure profitability of selected public sector units following ratios are used for the purpose of analysis. They are; 1. Gross Profit Ratio 2. Net Profit Ratio 3. Return on Capital Employed. 4. Earnings Per Share 5. Payout Ratio 1) Gross Profit Ratio This ratio expresses the relationship of gross profit on sales to net sales in terms of percentage. Expressed as a formula, the gross profit ratio is: Gross Profit Gross Profit Ratio = x 100 Net Sales 212

8 This ratio measures the trading effectiveness and basic profit earning potentiality of a firm. The higher the ratio the greater will be the margin and that is why it is also called margin ratio. The low gross profit ratio is the indication of the fact that profits are declining in comparison to sales. Table 6.1 : Gross profit ratio of public sector units for the period to (In percentage) Name of the companies Mean GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Mean of Public Sector Source: Annual Reports. Graph 6.1 : Gross profit ratio of public sector units for the period to Gross Profit Ratio 100 % Year GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Table 6.1 indicates gross profit ratio of selected public sector units for the period to The average gross profit ratio of public sector enterprises was which 213

9 indicates good performance. GSPL and GFL had excellent performance because both had registered gross profit ratio more than double to the mean size of industry. Whereas GSFC, GAIL, GNFC, GBL and GAEL had average performance since their performance was below the mean size of industry. GIPCL and GACL had good performance because their performance is more than mean size of industry. RMGL is loss making unit which had average gross profit ratio is Table 6.2 : Descriptive statistics of GPR 95% Confidence Name of the Std. Std. Interval for Mean N Mean Companies Deviation Error Lower Upper Minimum Maximum Bound Bound GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Total The table of descriptive statistics verifies what the graph shows; that the gross profit ratio of GSPL was highest whereas lowest gross profit ratio indicated by GAEL and RMGL. 2) Net Profit Ratio This ratio measures the relationship between net profit and sales of a firm. The net profit is determined by dividing the net profit by sales and expressed as a percentage. The formula used is as follows: Net Profit After Tax Net Profit Ratio = x 100 Net Sales Thus ratio is the indication of overall profitability and efficiency of the business. It not only reveals the recovery of costs and expenses from the revenue of the period but also to leave a margin of reasonable compensation to the owners for providing capital at their risk. A 214

10 high net profit ratio would only mean adequate return to the owners. A low net profit ratio on the other hand would only indicate adequate returns to the owners. Table 6.3 : Net profit ratio of public sector units for the period to (In percentage) Name of the companies Mean GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Mean of Public Sector Source: Annual Reports. Graph 6.2 : Net profit ratio of public sector units for the period to Net Profit Ratio 60 % Year GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Table 6.3 indicates net profit ratio of selected public sector units for the period to The average net profit ratio of public sector enterprises was which indicate good performance. GSPL and GFL had excellent performance because both had registered net profit ratio twice to the mean size of industry. Whereas GSFC, GNFC, GBL and GAEL 215

11 had average performance since their performance was below the mean size of industry. GAIL, GIPCL and GACL had good performance because their performance was more than mean size of industry. RMGL is loss making unit which had average net profit ratio Table 6.4 : Descriptive statistics of NPR 95% Confidence Name of the Std. Std. Interval for Mean N Mean Companies Deviation Error Lower Upper Minimum Maximum Bound Bound GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Total The table of descriptive statistics verifies what the graph shows; that the net profit ratio of GFL was highest whereas lowest net profit ratio indicated by GSFC, GBL, GAEL and RMGL. 3) Return on Capital Employed The primary objective of making investment in any business is to obtain adequate return on capital invested. Therefore, to measure the overall profitability of the firm, it is essential to compare profit with capital employed. With the objective return on capitals employed is calculated. It is also called return on investment (ROI). This ratio expresses the relationship between profit and capital employed and is calculated in percentage by dividing net profit by capital employed. The formula used is as follows: Net Profit before Interest and Tax Return on Capital Employed = x 100 Capital Employed 216

12 It is the only measure which indicates the overall profitability and efficiency of the business concern. It facilitates inter-firm comparison. It enables the management to know whether the investment made is utilized productively or not. It enables the management to take sound financial decisions. A fair return on capital employed will enable the management to pay regular dividends to shareholders, create adequate reserve and enhance goodwill of the firm. Table 6.5 : Return on capital employed of public sector units for the period to (In percentage) Name of the companies Mean GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Mean of Public Sector Source: Annual Reports. Graph 6.3 : Return on capital employed of public sector units for the period to Return on Capital Employed GSFC GAIL 60 GNFC % GIPCL GSPL GACL 0 GBL YEAR GAEL GFL RMGL 217

13 Table 6.5 indicates return on capital employed of selected public sector units for the period to The average return on capital employed of public sector enterprises was which indicate good performance. GACL had excellent performance because it had registered return on capital employed thrice to the mean size of industry. Whereas GIPCL, GBL and GAEL had average performance since their performance was below the mean size of industry. GSFC, GAIL, GNFC, GSPL and GFL had good performance because their performance was more than mean size of industry. RMGL was loss making unit which had average return on capital employed Table 6.6 : Descriptive statistics of ROCE 95% Confidence Name of the Std. Std. Interval for Mean N Mean Companies Deviation Error Lower Upper Minimum Maximum Bound Bound GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Total The table of descriptive statistics verifies what the graph shows; that the return on capital employed of GACL were highest whereas lowest return on capital employed indicated by RMGL. 4) Earnings Per Share (EPS) The rate of dividend on share depends upon the amount of profits earned by the firm. Whatever profits remains, after meeting all expenses and paying preference share dividend, belongs to equity shareholders. These are the profits earned on equity share capital. The earnings per share (EPS) is calculated by dividing the profits available to equity shareholders by the number of shares issued. Thus, 218

14 Profit After Tax Earnings Per Share (EPS) = Number of Equity Shares The earnings per share help in determining the market price of the equity share of the company. A comparison of dividend pay-out ratio of the company with another will also help in deciding whether the equity share capital is being effectively used or not. It also helps in estimating the company s capacity to pay dividend to its equity shareholders. Table 6.7 : Earning Per Share (EPS) of public sector units for the period to (In Rs.) Name of the companies Mean GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Source: Annual Reports. Mean of Public Sector Graph 6.4 : Earning Per Share (EPS) of public sector units for the period to Earning Per Share Rs Year 219 GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL

15 Table 6.7 indicates earning per share of selected public sector units for the period to The average earning per share of public sector enterprises was which indicate good performance. GSFC and GFL had excellent performance because both the company had registered earning per share more than double to the mean size of industry. Whereas GIPCL, GSPL, GACL, GBL, GAEL and RMGL had average performance since their performance was below the mean size of industry. GAIL and GNFC had good performance because their performance was more than mean size of industry. Name of the Companies N Mean Table 6.8 : Descriptive statistics of EPS Std. Deviation Std. Error % Confidence Interval for Mean Lower Bound Upper Bound Minimum Maximum GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Total The table of descriptive statistics verifies what the graph shows; that the earning per share of GSFC was highest whereas lowest earning per share indicated by GSPL, GBL, GAEL and RMGL. 5) Dividend Pay-Out Ratio It is the ratio calculated to determine the relationship between dividend per equity share and earnings per share. In other words, it is calculated to know the amount earnings retained in the business which reduces the cost of capital and increase the rate of dividend payable to equity shareholders. This ratio can be expressed as: Dividend Per Equity Share Dividend Pay-out Ratio = Earning Per Equity Share

16 Dividend pay-out ratio is indicators of the amount of earnings that have been ploughed back in the business. The lower the pay-out ratio, the higher will be the amount of earnings ploughed back in the business and vice versa. Table 6.9 : Dividend pay-out ratio of public sector units for the period to (In percentage) Name of the companies Mean GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Mean of Public Sector Source: Annual Reports. Graph 6.5 : Dividend pay-out ratio of public sector units for the period to Dividend Pay Out Ratio 150 % Year GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL 221

17 Table 6.9 indicates dividend pay-out ratio of selected public sector units for the period to The average dividend pay-out ratio of public sector enterprises is which indicate good performance. GBL had excellent performance because it had registered dividend pay-out ratio more than thrice to the mean size of industry. Whereas GSFC, GAIL, GACL and GFL had average performance since their performance was below the mean size of industry. GNFC, GIPCL, GSPL and GAEL had good performance because their performance was more than mean size of industry. RMGL is loss making unit which had not distributed dividend in any year. Table 6.10 : Descriptive statistics of DPOR 95% Confidence Name of the Std. Std. Interval for Mean N Mean Companies Deviation Error Lower Upper Minimum Maximum Bound Bound GSFC GAIL GNFC GIPCL GSPL GACL GBL GAEL GFL RMGL Total The table of descriptive statistics verifies what the graph shows; that the dividend pay-out ratio of GBL was highest whereas lowest dividend pay-out ratio indicated by GACL. And RMGL had not paid dividend during the study period. 222

18 Profitability Ratios Sources of Variation Table 6.11 : ANOVA of profitability ratios Sum of Squares df Mean Square F P-value GPR Between Groups Within Groups Total NPR Between Groups Within Groups Total ROCE Between Groups Within Groups Total EPS Between Groups Within Groups Total Payout Ratio Between Groups Within Groups Total The p-value is less than (0.05), shows that all the above ratios (gross profit ratio, net profit ratio, return on capital employed, earning per share and dividend pay-out ratio) are significant for profitability analysis of selected public sector units. 6.8 Testing of Hypothesis H 0 = There is no significance difference in mean profitability ratio between selected public sector enterprises. H 1 = There is significance difference in mean profitability ratio between selected public sector enterprises. Table 5.10 depicts data relating to ANOVA of profitability ratios among 10 public sector enterprises. In ANOVA table p value was less than Hence we reject the null hypothesis i.e. there is no significance difference in mean profitability ratio between selected public sector enterprises and we accept alternative hypothesis i.e. there is significance difference in mean profitability ratio between selected public sector enterprises. 223

19 References: Books 1. Gupta, Shashi K. and Sharma, R. K., (2006), Financial Management, Kalyani Publishers, New Delhi. 2. Khan, M. Y. and Jain, P. K., (2000), Financial Management, Tata McGraw Hill Publishing Company Limited, New Delhi. 3. Kishore, Ravi M., (2005), Cost Accounting and Financial Management, Taxmann Allied Services (P.) Ltd., New Delhi. 4. Kulkarni, P. V., Satyaprasad, B. G., (2007), Financial Management, Himalaya Publishing House, Mumbai. 5. Maheshwari, S. N., (2004), Fundamentals of Financial Management, Sultan Chand & Sons, New Delhi. 6. Sharma, N. K., (1994), Financial Management and Appraisal, Arihant Publishing House, Jaipur. Annual Reports 1. Annual Reports of GSFC from to Annual Reports of GAIL from to Annual Reports of GNFC from to Annual Reports of GIPCL from to Annual Reports of GSPL from to Annual Reports of GACL from to Annual Reports of GBL from to Annual Reports of GAEL from to Annual Reports of GFL from to Annual Reports of RMGL from to Website