Users of Ratio Analysis

Ratio analysis plays a significant role in ascertaining the financial performance of concern. The following are the various users of ratio analysis.

(i) Management

Ratio analysis helps management to reap many managerial uses from it. They are.

• Ratio analysis helps management assess the financial position of the firm and make necessary decisions from the information available in the financial statement.
• It facilitates financial forecasting and financial planning.
• It helps in communicating the financial strength and weakness of a firm in a more easy and understandable form.
• It helps in the coordination of activities which is the most important functions of business management.
• It facilitates in effective control of the business by revealing the loop holes in it.
• Ratio analysis also serves many other purposes to the management by becoming an essential part in budgetary control and standard costing.

(ii) Investors/Shareholders

Ratio analysis helps investors or a shareholder to assess the financial position of the concern in which he is going to invest It warns him in making up his mind whether the present financial position of the concern warrants him for further investment or not The calculation of various ratios help him to do this.

(iii) Creditors/Suppliers

Ratio analysis helps the creditors or suppliers who extend short-term credit to the concern: to know whether the financial position of the concern warrants their payment at a specified time or not.

(iv) Employees

Ratio analysis also helps the employees who are interested in knowing the financial position of the concern. Various profitability ratios facilitate them to know for the increase of their wages and other benefits.

(v) Government

Ratio analysis aids the government in assessing the financial health of different industries and preparing its future policies. With all the utilities to various users, ratio analysis serves as a powerful tool for ascertaining the financial position of a concern.

Advantages of Ratio Analysis

Following are the advantages of ratio analysis:

1. Ratio analysis simplifies the understanding of financial statements.
2. Ratio bring out the inter relationship among various financial figures and bring to light their financial significance and it is a device to analyze and interpret the financial health of the enterprise.
3. Ratios contribute significantly towards effective planning and forecasting.
4. Ratios facilitate inter-firm and intra-firm comparisons.
5. Ratios serve as effective control tools.
6. Ratios cater to the particular information need of a particular person.

Limitations of Ratio Analysis

Following are the limitations of ratio analysis.

• Ratio may not prove to be the ideal tool for interfirm comparisons. When two firms adopt different accounting policies.
• A study of ratios in isolating, without studying the actual figures may lead to wrong conclusions.
• Ratios can be calculated based on the data. If the original data is not reliable: then ratios will be misleading.
• Ratio analysis suffers from lack of consistency.
• In the absence of well accepted standards: interpretation of ratios become subjective.
• Ratios fail to reflect the impact of price level changes, and hence can be misleading.
• Ratios are only tools of quantitative analysis and fail to take into account the qualitative aspects of a business.
• Ratios are based on past data and hence cannot be reliable guide to future performance.
• Ratios are volatile and can be influenced by a single transaction with extreme value.
• Ratios are only indicators. They need a proper analysis by capable management, they are only the means, and not an end, in the interpretation of financial statements

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Profit maximization is the traditional and narrow approach. As per traditional theories, maximization of profit is considered to be the sole objective of a business organization. This theory is also called as cashing per share maximization. As per the requirement of the firm, the product price and output are placed under competition to maximize profit. Profit maximization is said to be the maximization of returns by the firm in terms of monetary resources and increasing the earnings per share of the shareholders. Firms often select investment proposals which suit their profit maximization criterion. The firm selects only those investment projects which provide excess profit and reject projects which provide comparatively less profit. Maximizing of profit by a firm, is often influenced by the input-output relationship, where firms tend to lower their cost of capital and try to achieve maximum profit and shareholders’ wealth maximization. Thus, with the right selection of project, the firm can maximize its productivity and efficiency in the operation activities.

Features of Profit Maximization

Profit is one of the most significant measures for assessing the efficiency of any business or economic activity. The survival and growth of a business concern also depend on its profit-earning capacity. Traditional theories like, profit maximization is the sole objective of a business concern. Some of the salient features of profit maximization objective are as follows:

1. Profit maximization is related to the maximization of earnings per share of the firm.
2. An increase in profitability is one of the foremost concerns of every business organization and thus involves various procedures and methods to maximize profits.
3. Profit is one of the benchmarks of operational efficiency, survival and well being of a business organization, as it reflects its business decisions and policies.
4. The objective of profit maximization minimizes the risk and uncertainty factors in business decisions and operations.

Arguments in Favor of Profit Maximization

Some of the arguments in favor of the objective of profit maximization are as follows:

1) Measure of Financial Stability: The profitability of a firm is an important indicator of its financial stability as well as economic well-being.

2) Promotes Socio-Economic Welfare: Increased profit, promotes the socio-economic welfare of various stakeholders associated with the firm. It aids in shareholders’ wealth maximization, increased incentives and benefits to employees, better and improved products to customers, employment generation, etc.

3) Retained earnings: Retained profit acts as a major source of long-term finance for a company. Retained earnings with a low cost of capital, can be utilized for fixed assets acquisition. expansion and modernization projects of the firm. Thus, outside funding’s not required.

4) Increases Competitiveness: Maximization of profit by a firm helps it to sustain competition from its competitors. With increased profits, a firm is more capable to sustain its growth and development amongst severe competition, through product development, market development and gaining market share.

5) Decision-Making: Increased profitability strengthens the foundation for sound managerial decision-making and also helps to solve agency issues in an organization, through optimum utilization of funds for business expansion as well as increased returns to shareholders.

6) Desire for Controls: When the company earns huge profit, the entry of the shareholders is restricted subject to internal use of funds for expansion and modernization. And this in turn leads to full control of the company to the existing shareholders.

Limitations of Profit Maximization

However, the objective of profit maximization has been questioned and criticized on several grounds. Some of the limitations that are associated with the objective of profit maximization are as follows:

1) Ambiguity: The complexity of the profit maximization criterion for financial decision-making is that the term profit is an ambiguous and confusing concept. It has no specific implication. It is open to different understandings by different individuals. For example, profit may be short-term or long-term: ît may be total profit or rate of profit margin; profit after tax or profit before tax; return on capital employed or assets or return on equity. Thus, as an objective of profit maximization, the issue arises as to which variant of profit a business concern should try to maximize.

2) Timing of Benefits: A more significant limitation to the objective of profit maximization is that it ignores the differences in timings of the benefits received over the working life of the asset, irrespective of when they were received. The profit maximization criterion does not consider the time value of money.

4) Impact on Social Welfare: Increased profits may often lead to the organization producing such products or services which may not be beneficial and useful to the society at large. Thus, such objective may sometimes fail to optimize social welfare.

5) Ignores Financing and Dividend Aspects: Another limitation of the profit maximization objective is that the effects of financing and dividend decision areas on market price of shares are often ignored while pursuing the objective of profit maximization.

6) Change in Organization Structure: Earlier, an owner manages the business alone because at that time the competition was too less. The organization structure that has single owner is referred as sole proprietor. The whole profits and liability belongs to him. But now, all the businesses are transforming their structure to compete.

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Another way of looking it is as

“the time required for a proposal to ‘break-even’ on the net investment of the project”.

In simple words, payback period refers to the period of time in which the projects cash outflows can be recovered from the project cash inflows or investment.

Calculation of Payback Period

The calculation of payback period is carried out in different methods under two different situations as under:

Equal Annual Cash Inflows: When the revenue generated (cash inflows) during the implementation of a project remains same every year or in other words the cash inflows are in the form of an annuity, computation of the payback period is simple; it can be arrived at by dividing the ‘cash outflow’ by ‘cash inflow per annum’ (the amount of annuity).

The formula used in this situation are as under:

\[\text{Payback Period}=\frac{\text{Initial out flow of the Project}}{\text{Annual Cash In flow}}\]

For example, initial investment in a proposal involves a cash outflow of $10,00,000 and the revenue generation (cash inflow) is projected at $2,00,000 p.a. for 8 years. in this case, the payback period would be 5 years i.e., 10,00,000/2,00,000. The initial cash outflow of  $10,00,000 will be fully recovered within a period of 5 years and the cash inflows accruing thereafter (6^th year and onwards) is ignored.

Unequal Annual Cash Inflows: When the revenue generated (cash inflows) during the implementation of the project is different every year (not in annuity form), then the cumulative figure of annual cash inflows are taken for calculating the payback period. The concept would be clear from the following example:

For example, in a proposal, there is a cash outflow of $2,00,000 and the projected level of revenue generation (cash inflow) is not equal year after year. it is $80,000, $60,000, $40,000, $20,000 and $20,000 over next 5 years respectively. The payback period would be 4 years as illustrated below

In the above example, the cash inflow exactly equals to cash-outflow at the end of 4^th year, making the calculation of payback period easy. However, in those cases wherein the cumulative cash inflows do not exactly equal to the cash outflow of the project, the computation of payback period is a bit complicated. In the above case, if the cash outflow is  $1,85,000 then the payback period would be calculated as follows:

The required cumulative cash inflow now would be $l,85,000. At the end of 3^rd year, the cumulative cash inflow is  $1,80,000. For the 4^th year, the annual cash inflow is 20,000. Therefore, cash inflow of $5,000 would be required during the 4^th year to make the cumulative cash inflows to be $1,85,000. The precise period required to earn a cash inflow of $5,000 during 4th year may be computed (on the assumption that the cash inflows are even throughout the year) by applying the technique of ‘‘Linear Interpolation”, i.e., the payback period is 3 years + (5,000/20,000) = 3.25 years or 3 years and 3 months. However, the above calculation is theoretical only, as the cash inflows take place at the year-end only. In such cases, the payback period of 3.25 years may be increased to next full year, i.e., 4 years

Decision Rule

The payback period, on its own is not indicative of the decision rule. It is not helpful in taking decisions unless there is a standard target period for each industry/business, with whom the computed payback period of a particular project may be compared. If the computed payback period is less than the standard target period, then the project may be considered favorable, otherwise (if the computed payback period is more than the standard target period) the proposal may be rejected. In the absence of any yardstick (standard payback period), the calculated payback period for a project remains an absolute figure with nothing to compare with, and the decision taken on its basis would be biased and illogical, lacking objectivity. However, if there is a series of proposals and ranking is required to be done in respect thereof the proposal with lowest payback period will be ranked first.

Advantages of Payback Period

Despite certain shortcomings in the ‘Payback Method’, it has an many advantage over other methods in view of the following:

1. No Expertise Operation: Calculation of the payback period in respect of any project is simple and uncomplicated as compared to other advanced techniques. It is very convenient for small business houses having a limited workforce with little or no competence in respect of other advanced but complex techniques.
2. Liquidity Indication: As the payback method prioritize an early cash inflow, it is the most appropriate method for an organization facing liquidity problems. During the implementation of a project, the liquidity position remains under close monitoring and a corrective measure may be taken by the organization in case it is needed.
3. Lower Level of Risk: Under the payback method of capital budgeting, more emphasis is given on early cash inflows. In other words, the projects with short payback period are preferred and are considered less risky, when compared to the projects with a longer payback period. Thus, in an indirect manner, adoption of payback method results in lower level of risk (risk mitigation) for the company.

Disadvantages of Payback Period

There are certain drawbacks of using payback method for capital budgeting, some of which are as follows:

1) Overlooks Cash inflows: Under the ‘Payback Method’, cash inflow accrued after the ‘payback period’ is not given any attention. The fact that in some projects, cash inflows are substantial after the payback period is completely overlooked. This could be false and may result in discrimination against those proposals which generate substantial cash inflows during post-payback period.

2) Equal Importance to all Cash Flows: Under this method, the ‘time value of money’, is not taken into consideration. It does not discriminate between the cash inflow of certain amount at present and the cash inflow of the same amount after two years. This approach is flawed, because a certain amount received today cannot be equal to the same amount received after a gap of some years. Also the cash inflows occurring after payback period are immaterial under this method.

3) Overlooks Salvage Value: The salvage value and the total economic life of a project are totally overlooked under the payback period method. The total emphasis is on fast cash inflow so as to recover the initial investment. A project having substantial salvage value and economic life span may be kept aside in favor of a project with higher inflows in previous years. By ignoring such important aspects, this method cannot be considered as an effective tool for assessing the economic feasibility of a project. Decisions taken only on the basis of single criteria (faster and early cash inflow), avoiding other crucial aspects, may perhaps not be appropriate.

4) Method of Capital Recovery: The payback period method is more concerned with the recovery of initial investment rather than assessing the profitability and other benefits of a project. Recovery of the investment should be one of the criteria but not the sole criterion. Other aspects like profitability and other benefits likely to accrue in the long run also need to be taken into account.

Example 1: A project costs 1,00,000 and yields an annual cash inflow of 20,000 for 8 years. Calculate its payback period.

Solution: The Payback period for the project is as follows:

\[\text{Payback Period}=\frac{\text{Initial out flow of the Project}}{\text{Annual Cash In flow}}\]

\[=\frac{\text{1,00,000}}{\text{20,000}}\]

\[=\text{5 years}\]

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Shareholders being the true owners of the firm are entitled to the residual profit only. After meeting the commitment to all other stakeholders they get the remaining. Shareholders claim cannot precede that of any other stakeholders. Thus, by maximization of residual as the objective of the firm, it can safely be stated that all preceding commitments have been adequately satisfied. Pursuit of these all-encompassing goals by the firm ensures that the interest of all the different stakeholders is taken care of in the process as this wealth maximization as a goal is in congruence with the objectives of the varied stakeholders. No firm can bring about sustained increase in the wealth of its owners without taking care of the interest of its other stakeholders. For example, the deteriorating liquidity position of a firm makes the lenders, current and prospective, worried about its creditworthiness, which eventually gets reflected in its share prices and consequently the wealth of the shareholders. Similarly, a firm that cannot retain its existing customers will witness a decline in its sales and consequently the market price of shares. The wealth maximization approach can he more explicitly defined in the following ways:

\[W=\frac{{{A}_{1}}}{{{\left( 1+K \right)}^{1}}}+\frac{{{A}_{2}}}{{{\left( 1+K \right)}^{2}}}+….+\frac{{{A}_{n}}}{{{\left( 1+K \right)}^{n}}}-C\]

\[W=\sum\limits_{t=1}^{n}{\frac{{{A}_{t}}}{{{\left( 1+K \right)}^{t}}}}-C\]

Where,

W = Net present worth

A₁, A₂, …… A_n = Streams of benefits expected/Future cash flows

C = Cash outlay or cost of action/Cost of project

K = Discount rate/Capitalization rate

Features of Wealth Maximization

Wealth maximization criterion has a far and wide range of acceptance because of its following salient features:

1. The idea and notion of wealth is distinct and simple to understand.
2. It serves as an important aid to investment decisions.
3. It refers to the time adjusted present value of benefits, thereby reducing the cost of investment.
4. Maximizing economic well being of its shareholder is one of the parameters of wealth maximization.
5. Wealth maximization takes into concern both the quantity and quality standards of benefits.
6. It also integrates the time value of money, risk and uncertainty factors.
7. It considers that the shareholder’s wealth is maximized only when the market price per share is maximized.
8. It also avoids agency issues in an organization, as it encompasses the personal goals of executives, such as recognition, power, status, personal wealth, etc.
9. It eliminates the associated limitations of the profit maximization objective of financial management.

Arguments in Favour of Wealth Maximization

The following arguments can be given in favor of wealth maximization as the objective of business:

1. Wealth maximization is advanced and can be better compared to the objective of profit maximization since the sole endeavor of the business firm is to enhance the value or wealth of the shareholders.
2. Wealth maximization involves the comparison of the value to cost associated with the company.
3. Wealth maximization takes into concern both time value and risk factors of the firm.
4. Wealth maximization promotes and improves optimum and efficient utilization of resources.
5. It aims to achieve and fulfill economic obligations of (lie society.

Limitations of Wealth Maximization

Issues involved in implementing the goal of maximization of shareholder’s wealth:

1. Incorrect Assumptions: The Maximization of Shareholder’s wealth wrongly presumes that there is an efficient capital market. In reality, the Share Price in the market is subject to extensive fluctuations.
2. Speculation: Speculative business activities lead to variations in price of shares. Since, an investor is more concerned about the safety and security of his investment whereas a speculator is interested in appreciation of his capital and profits.
3. Varied Objectives: In every organization, there are three basic stakeholders namely Shareholders, Professional Managers and Creditors. Thus, agency problem may arise, i.e., managers may place personal goals ahead of corporate goals.
4. Justice to All Social Groups: It is widely reasoned that a business organization is not concerned with shareholders only. Employees, customers, creditors, local societies at lame are also associated with the company. A business thin has to function in the social context responsibly. Obligations of the company towards different social groups should be honored.

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