Question 2a: Discuss the importance of ratio analysis for inter-firm and intra-firm comparisons including circumstances responsible for its limitations .If any Answer: Ratio analysis implies the systematic use of ratios to interpret the financial statements so that the strength and weaknesses of a firm as well as its historical performance and current financial position can be determined. With the help of ratio analysis conclusion can be drawn regarding several aspects such as financial health, profitability and operational efficiency of the undertaking. Ratio analysis is very useful in making inter-firm comparison as it helps to draw a comparisonbetween the entities within the same industry or otherwise following the same accounting procedure. It provides the relevant financial information for the comparative firms with a view to improving their productivity & profitability. Ratio analysis helps in intrafirm comparison by providing necessary data. An interfirm comparison indicates relative position. It provides the relevant data for the comparison of the performance of different departments. If comparison shows a variance, the possible reasons of variations may be identified and if results are negative, the action may be initiated immediately to bring them in line. However, in spite of being such a useful tool, it is not free from its limitations. A single ratio is of a limited use and it is essential to have a comparative study. The base used for ratio analysis viz: financial statements have their own limitations. Also, they consider only the quantitative aspects of business transactions where as there are various other non-quantitative aspects such as quality of work force which considerably affect profitability and productivity. Also, ratio analysis as a tool is also limited by changes in accounting procedures/policies.
Question 2b: Why do you understand by the term ‘pay-out ratio’? What factors are taken into consideration while determining pay-out ratio? Should a company follow a fixed pay-out ratio policy? Discuss fully. Answer: Pay-out Ratio means the amount of earnings paid out in dividends to shareholders. Investors can use the payout ratio to determine what companies are doing with their earnings. It can be calculated as: A very low payout ratio indicates that a company is primarily focused on retaining its earnings rather than paying out dividends. The pay-out ratio also indicates how well earnings support the dividend payment. The lower the ratio, the more secure the dividend because smaller dividends are easier to payout than larger dividends. The major factor to be considered in determining the payout ratio is the dividend policy of the company. Young, fast-growing companies are typically focused on reinvesting earnings in order to grow the business. As such, they generally sport low (or even zero) dividend payout ratios. At the same time, larger, more-established companies can usually afford to return a larger percentage of earnings to stockholders. Also, another factor to be considered is the type of industry in which the company is operating. For example, the banking sector usually pays out a large amount of its profits. Certain other sectors like real estate investment trusts are required by law to distribute a certain percentage of their earnings. Funds requirement of the company and its available liquidity is another factor which is considered while determining the pay-out. Some companies prefer to follow a fixed pay-out ratio policy irrespective of the earnings made. This is a welcome policy from the point of view of the investors. But, the company should take into account various important factors such as its need for future investment and growth, cash requirements and debt obligations.