3. Effects of Price Level Changes: Price levels changes often make the comparison of figures difficult over a period of time. Changes in price affect the cost of production, sales and also the value of the assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison.
4. Quality factors are ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision-making. For example, an average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis.
5. Effect of window dressing: In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way.
6. Costly Techniques: Ratio analysis is a costly technique and can be used by big business houses. Small business units are not able to afford it.
7. Misleading Results: In the absence of absolute data, the result may be misleading. For example, the gross profit of two firms is 25% whereas, the profit earned by one is just U.S.$5,000 and sales are U.S.$20,000 and profit earned by the other one is U.S.$10,000 and sales are U.S.$40,000. Even the profitability of the two firms is same but the magnitude of their business is quite different.
8. Absence of Standard University accepted terminology: There are no standard ratios, which are universally accepted for comparison purposes. As such, the significance of ratio analysis technique is reduced.
Financial Ratio Analysis and Formulas
Universal Teachers Publications (2010) outlines and explains the meaning, objective and method of calculation of the financial ratios as follows:-
(a.) Gross Profit Ratio:
This ratio shows the relationship between Gross Profit of the concern and its Net Sales; and it can be calculated as follows:-
Gross Profit Ratio = Gross Profit/Net Sales*100 whereby; Gross Profit = Net Sales
Cost of Goods Sold; and the Net Sale = Total Sales -- Sales Return.
Cost of Goods Sold = Opening stock + Net purchases + Direct Expenses -- Closing
According to Universal Teachers Publications (2010), the Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses; and is able to cover its fixed expenses. Universal Teachers Publications claims that the gross profit ratio of current year is compared to the previous year's ratios of the other concerns; hence, the minor change in the ratio knows about any departure from the standard mark-up and would indicate losses on account of theft, damage, bad stock system, bad sales policies and other reasons. However, Universal Teachers Publications advises that it is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realization of fixed expenses of the business.
(b.) Net Profit Ratio:
According to Universal Teachers Publications (2010), the Net Profit Ratio shows the relationship between Net Profit of the concern and its Net Sales. Universal Teachers Publications decrees that Net Profit Ratio can be calculated in the following manner:-
Net Profit Ratio = Net Profit / Net Sales *100 whereby
Net Profit -- Selling and Distribution Expenses -- Office and Administration Expenses
- Financial Expenses -- Non-Operating Expenses + Non-Operating Income; and Net Sales = Total Sales -- Sales Return
In order to workout overall efficiency of the concern, Universal Teachers Publications (2010) claims that Net Profit Ratio is calculated. This ratio is helpful to determine the operational ability of the concern. When comparing the ratio to the previous years' ratios, the increment shows the efficiency of the concern.
(c.) Operating Profit Ratio
Operating profit means earned profit by the concern from its business operation and not from the other sources. While calculating the net profit of the concern all incomes either they are not part of the business operation like Rent from tenants, interest in Investment etc. are added and all non-operating expenses are deducted. Therefore, while calculating operating profits these all are ignored and the concern comes to know about its business income from its business operations. Meaning, Operating Profit Ratio shows the relationship between Operating Profit and Net Sales; and it can be calculated as follows:
Therefore, Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earnings from the order sources; hence it shows whether the businesses is able to stand in the market or not.
(d.) Operating Ratio
Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means cost of goods sold plus Operating Expenses.
Operating Cost = Operating Cost / Net Sales*100 whereby
Operating Cost = Cost of Goods Sold + Operating Expenses
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses -- Closing
Operating Expenses = Selling and Distribution Expenses, Office and Administration
Expenses, Repair and Maintenance
Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percent of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage; therefore, less percentage of cost means higher margins to earn profit.
(e.) Return on Investment or Return on Capital Employed
This ration shows the relationship between the profits earned before interest and tax and the capital employed to earn such profit.
Return on Capital Employed = Net Profit before Interest, Tax, and Dividend / Capital Employed*100 whereby Capital Employed (Equity + Preference) + Reserves and Surplus + Long-term Loans -- Fictitious Assets
Capital Employed = Fixed Assets -- Current Liabilities
Returns on capital employed measures the profit, which a firm earns on investing a unit capital. The profit being net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.
Return of Equity
Return on Equity is also known as shareholder's investment; and the ratio establishes relationship between profits available to equity shareholders with equity shareholder's funds.
Return on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders' Funds * 100 whereby;
Equity Shareholder's Funds = Equity Share Capital + Reserve and Surplus -- Fictitious Assets
Therefore, Return on Equity judges the profitability from the point-of-view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of Equity funds invested in the firm. The investors favor the company with higher ROE.
(g.) Earning Per Share
Earnings per share are calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares. Therefore,
Earnings per share = Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares.
Otherwise, Earnings per share help in determining the market price of the Equity share of the company. I t also helps to know whether the company is able to use it equity share capital effectively which compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.
According to Credit and Finance Risk Analysis (2010), the CAMELS approach was developed by bank regulators in the United States as a means of measurement of the financial condition of a financial institution. (Uniform Financial Institutions Rating System established by the Federal Financial Institutions Examination Council). Hence, Credit and Finance Risk Analysis (2010) declares that the acronym CAMELS stands for Capital Adequacy; Asset Quality; Management; Earnings (Profitability); Liquidity and Funding Sensitivity to Market Risk (losses arising from changes in market prices). Further, the Credit and Finance Risk Analysis claims that CAMELS analysis requires financial statements (the last three years and interim statements for the most recent 12-month period); cash flow projections; portfolio aging schedules; funding sources; information about the board of directors; operations/staffing; and macroeconomic information.
Recommendations and Conclusion
Personally, I recommend that both investors, financial institutions and department should analyze their financial statements in four stages i.e. (1) preliminary data adjustments; (2) ratio analysis; (3) assessment of accounting quality; and (4) valuation as recommend by De Mello-e-Souza and…