Meaning, objectives, and nature of ratio analysis.

A ratio expresses the numerical relationship between two numbers. In the words of Kennedy and McMullen, “the relationship of one item to another expressed in simple mathematical form is known as a ratio”. Thus, the ratio is a measuring device to judge the growth, development and present condition of concern. It plays an important role in measuring the comparative significance of the income and position statement. Accounting ratios are expressed in the form of time, proportion, percentage, or per one rupee. Ratio analysis is not only a technique to point out the relationship between two figures but also points out the devices to measure the fundamental strengths or weaknesses of a concern.

Net Profit Ratio – meaning and formula.

Net profit is a good indicator of the efficiency of a firm. The net profit ratio or net profit margin ratio is determined by relating net income after taxes to net sales. Net profit here is the balance of profit and loss account which is arrived at after considering all non-operating incomes such as interest on investments, dividends received, etc. And non-operating expenses like loss on the sale of investments, provisions for contingent liabilities, etc.

Financial Leverage Ratio – meaning and formula.

Financial leverage results from the presence of fixed financial charges in the firm’s income stream. These fixed charges do not vary with the earnings before interest and tax (EBIT) or operating profits. They have to be paid regardless of the amount of earnings before interest and taxes available to pay them. After paying them, the operating profits (EBIT) belong to the ordinary shareholders. Financial leverage is concerned with the effects of changes in earnings before interest and taxes on the earnings available to equity holders. It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the firm’s earning per share. Financial leverage and trading on equity are synonymous terms. The EBIT is calculated by adding back the interest (interest on loan capital + interest on long term loans + interest on other loans) and taxes to the amount of net profit. Financial leverage ratio is calculated by dividing EBIT by EBT (earnings before tax). Neither a very high leverage nor a very low leverage represents a sound picture. (EBIT ÷ EBT).