Ratio Analysis 2.1

RATIO ANALYSISRATIO ANALYSIS

Mrs. Dilshad D. JalnawallaMrs. Dilshad D. Jalnawalla

Accounting ratios are Accounting ratios are relationships expressed in relationships expressed in mathematical terms between mathematical terms between figures which are connected with figures which are connected with each other in some manner.each other in some manner.

Classification of RatiosClassification of Ratios

Traditional ClassificationTraditional Classification– Trading & Profit & Loss Account Trading & Profit & Loss Account

RatiosRatios: E.g.: Gross Profit Ratio, Stock : E.g.: Gross Profit Ratio, Stock turnover Ratio, etc.turnover Ratio, etc.

– Balance Sheet RatiosBalance Sheet Ratios: Current Ratio, : Current Ratio, Debt-equity Ratio, etc.Debt-equity Ratio, etc.

– Composite Ratios or Inter-statement Composite Ratios or Inter-statement RatiosRatios: E.g.: Fixed assets turnover : E.g.: Fixed assets turnover ratio, overall profitability ratio, etc.ratio, overall profitability ratio, etc.

Functional ClassificationFunctional Classification– In order that ratios serve as a tool In order that ratios serve as a tool

for financial analysis, they are for financial analysis, they are classified according to their classified according to their functions as follows:functions as follows:

1.1. Profitability Ratios,Profitability Ratios,

2.2. Turnover Ratios, and Turnover Ratios, and

3.3. Financial Ratios.Financial Ratios.

Profitability RatiosProfitability Ratios

Profitability is an indication of the Profitability is an indication of the efficiency with which the operations of efficiency with which the operations of the business are carried on.the business are carried on.

Poor Operational performance may Poor Operational performance may indicate poor sales or lack of control over indicate poor sales or lack of control over the expenses.the expenses.

Banks, Financial Institutions, Creditors: Banks, Financial Institutions, Creditors: Earnings are more than interest on borrowed Earnings are more than interest on borrowed funds, & ultimate repayment of their debts is funds, & ultimate repayment of their debts is certain.certain.

Owners: Owners: Returns which they get on investment.Returns which they get on investment.

1. Overall Profitability 1. Overall Profitability RatioRatio Also termed as “Return on Also termed as “Return on

Investment” (ROI)Investment” (ROI) It indicates the percentage of It indicates the percentage of

return on the total capital return on the total capital employed in the business.employed in the business.

Operating Profit X 100Operating Profit X 100

Capital EmployedCapital Employed

Operating Profit Operating Profit means ‘Profit before means ‘Profit before Interest and Tax’. The term interest Interest and Tax’. The term interest means ‘Interest on long-term borrowings’means ‘Interest on long-term borrowings’

Capital Employed:Capital Employed:– Sum of all assets whether fixed or Sum of all assets whether fixed or

currentcurrent– Sum-total of fixed assetsSum-total of fixed assets– Sum of long term funds employed in Sum of long term funds employed in

the business, i.e.the business, i.e.

Share Capital+ Reserves and Surplus+ Share Capital+ Reserves and Surplus+ Long-term loans- (Non-business Long-term loans- (Non-business Assets+ Fictitious Assets)Assets+ Fictitious Assets)

Illustration 1.2Illustration 1.2ParticularsParticulars Rs.Rs. ParticularsParticulars Rs.Rs.

To Cost of goods soldTo Cost of goods sold

To Interest on To Interest on DebenturesDebentures

To Provision for TaxationTo Provision for Taxation

To Net Profit after TaxTo Net Profit after Tax

300000300000

1000010000

100000100000

100000100000

510000510000

By SalesBy Sales

By Income from By Income from InvestmentsInvestments

500000500000

1000010000

510000510000

P&L Account

LiabilitiesLiabilities Rs.Rs. AssetsAssets Rs.Rs.

Share Capital: 10% Pref.Share Capital: 10% Pref.

EquityEquity

ReservesReserves

10% Debentures10% Debentures

Profit & Loss A/cProfit & Loss A/c

Provision for TaxationProvision for Taxation

100000100000

200000200000

100000100000

100000100000

100000100000

100000100000

700000700000

Fixed AssetsFixed Assets

Current AssetsCurrent Assets

Investment in Govt. Investment in Govt. SecuritiesSecurities

450000450000

150000150000

100000100000

700000700000

Balance Sheet

Return on Capital Employed = Return on Capital Employed = Net Operating Profit before Interest and Tax X 100Net Operating Profit before Interest and Tax X 100

Total Capital employedTotal Capital employed

= 2,00,000 X 100= 2,00,000 X 100

5,00,0005,00,000

= 40%= 40%

Net Operating ProfitNet Operating Profit =Net Profit + Provision for =Net Profit + Provision for Tax-Income from Investment +Interest on Tax-Income from Investment +Interest on DebenturesDebentures

Capital EmployedCapital Employed =Fixed Assets +Current =Fixed Assets +Current Assets-Provision for TaxAssets-Provision for Tax

OrOr Share Capital +Reserves +Debentures +P&L Share Capital +Reserves +Debentures +P&L A/c Bal. -Investment in Govt. SecuritiesA/c Bal. -Investment in Govt. Securities

i. Return of Shareholders i. Return of Shareholders FundFund

Net Profit after Interest and Tax Net Profit after Interest and Tax X100X100

Shareholders FundShareholders Fund

=1,00,000 =1,00,000

5,00,000 5,00,000 X 100X 100

= 20%= 20%

ii. Return on Equity ii. Return on Equity Shareholders FundsShareholders Funds Net Profit after Interest , Tax and Preference Dividend Net Profit after Interest , Tax and Preference Dividend

Equity Shareholders FundEquity Shareholders Fund

X 100X 100

= 90,000= 90,000

3,90,000 3,90,000 X 100X 100

= 23%= 23%

iii. Return on Total iii. Return on Total AssetsAssets There are three methods:There are three methods:

(a) Net Profit after Tax(a) Net Profit after Tax

Total AssetsTotal Assets X 100X 100

= 1,00,000= 1,00,000

7,00,000 7,00,000 X 100X 100

= 14.29%= 14.29%

(b) Net Profit after Tax +Interest(b) Net Profit after Tax +Interest

Total AssetsTotal Assets X 100X 100

= 1,00,000+10,000= 1,00,000+10,000

7,00,0007,00,000 X 100X 100

==15.71%15.71%

(c) (c) Net Profit after Tax + InterestNet Profit after Tax + Interest

Total Assets excluding Fictitious Assets Total Assets excluding Fictitious Assets X X

100100

iv. Return on Gross iv. Return on Gross Capital employedCapital employed

Net Profit before Interest and Tax X Net Profit before Interest and Tax X 100100 Gross Capital employedGross Capital employed

= 2,00,000 X 100= 2,00,000 X 100 6,00,0006,00,000

= 33.33%= 33.33%InterestInterest is on both long and short term borrowings. is on both long and short term borrowings.Gross Capital EmployedGross Capital Employed= Net Fixed Assets = Net Fixed Assets

+Current Assets employed in the business.+Current Assets employed in the business.

Average Capital Average Capital EmployedEmployed

ROI=Net Profit before Interest and Tax ROI=Net Profit before Interest and Tax X100X100

Average Capital employedAverage Capital employed

= 2,00,000 X 100= 2,00,000 X 100

½(5,00,000+4,50,000)½(5,00,000+4,50,000)

= 42.11%= 42.11%

Average Capital is Average of Capital Average Capital is Average of Capital employed at the beginning and the end of employed at the beginning and the end of the accounting period.the accounting period.

Significance of ROISignificance of ROI

ROI is a concept that measures the profit which ROI is a concept that measures the profit which a firm earns on investing a unit of capital.a firm earns on investing a unit of capital.

Profit being net result of all operations, ROI Profit being net result of all operations, ROI expresses all efficiencies or inefficiencies of a expresses all efficiencies or inefficiencies of a business collectively.business collectively.

It will also show whether company’s borrowing It will also show whether company’s borrowing policy was wise economically and whether the policy was wise economically and whether the capital had been employed fruitfully.capital had been employed fruitfully.

Equity Shareholders Fund will indicate the Equity Shareholders Fund will indicate the maximum rate of dividend that might be maximum rate of dividend that might be declared.declared.

The business can survive only when return of The business can survive only when return of capital employed is more than cost of capital capital employed is more than cost of capital employed.employed.

2. Earnings per Share 2. Earnings per Share (EPS)(EPS) In order to avoid confusion on In order to avoid confusion on

account of the varied meanings of account of the varied meanings of the term capital employed, the the term capital employed, the overall profitability can also be overall profitability can also be judged by calculating EPS.judged by calculating EPS.

EPS= EPS= Net Profit after Tax & Pref. Net Profit after Tax & Pref. DividendDividend

Number of Equity SharesNumber of Equity Shares

Illustration 1.3Illustration 1.3

Calculate the earnings per share from Calculate the earnings per share from the following data:the following data:

Net Profit before Tax Rs.1,00,000Net Profit before Tax Rs.1,00,000 Taxation at 50% of Net ProfitTaxation at 50% of Net Profit 10% Pref. Share Capital (Rs.10 each) 10% Pref. Share Capital (Rs.10 each)

Rs.1,00,000Rs.1,00,000 Equity Share Capital (Rs.10 shares) Equity Share Capital (Rs.10 shares)

Rs.1,00,000Rs.1,00,000 ANSWER: Rs.4 per shareANSWER: Rs.4 per share

SignificanceSignificance

The earnings per share helps in The earnings per share helps in determining the market price of the determining the market price of the equity share of the company. A equity share of the company. A comparison of EPS of the company with comparison of EPS of the company with another will also help in deciding another will also help in deciding whether the equity share capital is whether the equity share capital is being effectively used or not. It also being effectively used or not. It also helps in estimating the companies helps in estimating the companies capacity to pay dividends to its equity capacity to pay dividends to its equity holders.holders.

EPS – AS 20EPS – AS 20

EPS is mandatory w.e.f. 1.4.2001 EPS is mandatory w.e.f. 1.4.2001 in respect of enterprises whose in respect of enterprises whose equity shares or potential equity equity shares or potential equity shares are listed on recognized shares are listed on recognized stock exchange in India.stock exchange in India.

The standard makes a distinction The standard makes a distinction between basic and diluted between basic and diluted earning per share.earning per share.

Basic Earnings Per Basic Earnings Per Share (BEPS)Share (BEPS)

Net Profit for the period attributable Net Profit for the period attributable to Equity Shareholdersto Equity Shareholders

Weighted Average Number of Equity Weighted Average Number of Equity Shares Outstanding during the yearShares Outstanding during the year


From the following compute BEPSFrom the following compute BEPS Net Profit for the year ending Net Profit for the year ending

31.12.2002 after tax & Preference 31.12.2002 after tax & Preference dividend Rs. 21,000.dividend Rs. 21,000.

Equity as on 1.1.2002 Rs.1,800.Equity as on 1.1.2002 Rs.1,800. Issued Equity Shares for Cash on Issued Equity Shares for Cash on

31.05.2002 Rs.60031.05.2002 Rs.600 Bought back Equity Shares on Bought back Equity Shares on

1.11.2002 Rs.3001.11.2002 Rs.300Answer= Rs. 10 per Share.Answer= Rs. 10 per Share.

Diluted Earnings Per Diluted Earnings Per Share (DEPS)Share (DEPS) DEPS are calculated when there are DEPS are calculated when there are

potential equity shares in the capital potential equity shares in the capital structure of the enterprise. A potential structure of the enterprise. A potential Equity Share is a financial instrument or Equity Share is a financial instrument or other contract that entitles or may entitle other contract that entitles or may entitle its holder to equity shares.its holder to equity shares.

Adjusted Net Profit for the Period Adjusted Net Profit for the Period Attributable to Equity ShareholdersAttributable to Equity Shareholders

Adjusted Weighted Average Number of Adjusted Weighted Average Number of SharesShares

3. Price Earning Ratio 3. Price Earning Ratio (PER)(PER) This ratio indicates the number of This ratio indicates the number of

times the earning per share is covered times the earning per share is covered by its market price. by its market price.

Market Price Per Equity ShareMarket Price Per Equity Share

Earning Per ShareEarning Per Share The ratio is useful in financial The ratio is useful in financial

forecasting. It also helps in knowing forecasting. It also helps in knowing whether the shares if a company are whether the shares if a company are under or over valued.under or over valued.

Significance of PERSignificance of PER

Price Earning Ratio helps the Price Earning Ratio helps the investor in deciding whether to investor in deciding whether to buy or not to buy the shares of a buy or not to buy the shares of a company at a particular market company at a particular market Price.Price.

Gross Profit RatioGross Profit Ratio

Gross Profit X 100Gross Profit X 100

Net SalesNet Sales

This ratio expresses relationship This ratio expresses relationship between gross profit and net between gross profit and net sales.sales.

Significance of Significance of G.P.RatioG.P.Ratio This ratio indicates the degree to This ratio indicates the degree to

which the selling price of goods which the selling price of goods per unit may decline without per unit may decline without resulting in losses from resulting in losses from operations to the firm.operations to the firm.

Helps in ascertaining whether the Helps in ascertaining whether the average percentage of mark up average percentage of mark up on the goods is maintained.on the goods is maintained.

Net Profit RatioNet Profit Ratio

The ratio indicates net margin The ratio indicates net margin earned on a sale of Rs.100.earned on a sale of Rs.100.

Net Operating Profit X 100Net Operating Profit X 100

Net Sales Net Sales


The ratio helps in determining the The ratio helps in determining the efficiency with which affairs of the efficiency with which affairs of the business are being managed.business are being managed.

An increase in the ratio over the An increase in the ratio over the previous period indicates improvement previous period indicates improvement in the operational efficiency of the in the operational efficiency of the business provided the gross profit ratio business provided the gross profit ratio is constant. Thus it is a effective is constant. Thus it is a effective measure to check the profitability of the measure to check the profitability of the business.business.

Operating RatioOperating Ratio

It is complementary to net profit ratio. It is complementary to net profit ratio. If net profit ratio is 20% Operating If net profit ratio is 20% Operating ratio is 80%ratio is 80%

Operating Costs X 100Operating Costs X 100

Net SalesNet Sales

Operating Cost include the cost of direct Operating Cost include the cost of direct material, direct labour and other material, direct labour and other overheads. Interest, provision for overheads. Interest, provision for taxation etc. are excluded.taxation etc. are excluded.


The ratio is the test of the operational The ratio is the test of the operational efficiency with which the business is efficiency with which the business is being carried. The operating ratio should being carried. The operating ratio should be low enough to leave a portion of sales be low enough to leave a portion of sales to give a fair return to the investors.to give a fair return to the investors.

A comparison of the operating ratio will A comparison of the operating ratio will indicate whether the cost component is indicate whether the cost component is high or low in the figure of sales. Increase high or low in the figure of sales. Increase in ratio-should be found out and in ratio-should be found out and management should be advised to check management should be advised to check the increase.the increase.

Fixed Charges CoverFixed Charges Cover This Ratio is also called as “Debt Service This Ratio is also called as “Debt Service

Ratio”.Ratio”. This ratio is very important from the This ratio is very important from the

lenders point of view. It indicates whether lenders point of view. It indicates whether the business would earn sufficient profits the business would earn sufficient profits to pay periodically the interest charges. to pay periodically the interest charges.

The higher the number, the more secure The higher the number, the more secure the lender.the lender.

Income before Interest and TaxIncome before Interest and Tax Interest Charges Interest Charges

Standard is interest charges should be Standard is interest charges should be covered 6 to 7 times.covered 6 to 7 times.

Debt Service Coverage Debt Service Coverage RatioRatio

The above ratio does not tell us anything The above ratio does not tell us anything about the ability of the company to make about the ability of the company to make payment of principal amount also on time.payment of principal amount also on time.

Net Profit before Income and TaxNet Profit before Income and Tax

Principal Payment InstallmentPrincipal Payment InstallmentInterestInterest ++

I-Tax RateI-Tax Rate The principle payment installment is adjusted The principle payment installment is adjusted

for tax effects since such payment is not for tax effects since such payment is not deductible from net profit for tax purpose. deductible from net profit for tax purpose.

The higher the ratio better it is.The higher the ratio better it is.

Payout RatioPayout Ratio

This ratio indicates what proportion of This ratio indicates what proportion of earning per share has been used for paying earning per share has been used for paying dividend.dividend.

Dividend per equity shareDividend per equity share

Earning per equity shareEarning per equity share Complementary to this ratio is Retained Complementary to this ratio is Retained

Earning RatioEarning Ratio Retained Earning per Equity Share ORRetained Earning per Equity Share OR

Earning per Equity ShareEarning per Equity Share

Retained Earnings Retained Earnings

Total EarningTotal EarningX 100X 100

SignificanceSignificance Payout Ratio and Retained Earning Ratio are Payout Ratio and Retained Earning Ratio are

indicators of the amount of earnings that indicators of the amount of earnings that have been ploughed back in the business.have been ploughed back in the business.

Lower Payout Ratio, higher earnings Lower Payout Ratio, higher earnings ploughed back and vice versa.ploughed back and vice versa.

Lower Retained Earning Ratio, lower amount Lower Retained Earning Ratio, lower amount of Earnings ploughed back and vice versa.of Earnings ploughed back and vice versa.

Lower Payout Ratio or Higher Retained Lower Payout Ratio or Higher Retained Earning Ratio means stronger financial Earning Ratio means stronger financial position of the business.position of the business.

Dividend Yield RatioDividend Yield Ratio

This ratio is particularly useful for This ratio is particularly useful for those investors who are those investors who are interested only in dividend interested only in dividend income.income.

Dividend per shareDividend per share

Market Price per share Market Price per share X 100X 100


The ratio helps an intending investor The ratio helps an intending investor in knowing the effective return on the in knowing the effective return on the proposed investment.proposed investment.

If a company declares dividend at If a company declares dividend at 20% on its shares, each having a 20% on its shares, each having a paid-up value of Rs.8 and market paid-up value of Rs.8 and market price of Rs.25, the dividend yield will price of Rs.25, the dividend yield will be only 6.4%. Thus a person can be only 6.4%. Thus a person can decide whether he wants to invest or decide whether he wants to invest or not.not.

TURNOVER RATIOSTURNOVER RATIOS

The turnover ratios or activity ratios The turnover ratios or activity ratios indicate the efficiency with which the indicate the efficiency with which the capital employed is rotated in the capital employed is rotated in the business.business.

Two factors on which overall profitability Two factors on which overall profitability depends, rate of return of capital depends, rate of return of capital employed and the turnover i.e. rate of employed and the turnover i.e. rate of rotation of capital employed. rotation of capital employed.

Higher the rate of rotation, the greater Higher the rate of rotation, the greater will be the profitability.will be the profitability.

Overall profitability ratio can classified as; Net Overall profitability ratio can classified as; Net Profit ratio and Turnover ratio.Profit ratio and Turnover ratio.

N.P. Ratio= Net Operating ProfitN.P. Ratio= Net Operating Profit

SalesSales X 100X 100

Turnover Ratio = Turnover Ratio = SalesSales

Capital EmployedCapital Employed Overall Profitability Ratio = Net Profit ratio Overall Profitability Ratio = Net Profit ratio

X Turnover X Turnover Ratio.Ratio.

= = Net Profit Sales Net Profit Sales100 X100 X

Sales Sales XX Capital employed Capital employed

= Net Profit = Net Profit

Capital Employed Capital Employed X 100X 100


Determine which company is Determine which company is more profitablemore profitable

A Ltd.A Ltd. B Ltd.B Ltd.

Net Profit RatioNet Profit Ratio 5%5% 8%8%

Turnover RatioTurnover Ratio 6 times6 times 3 times3 times

Fixed Asset Turnover Fixed Asset Turnover RatioRatio This Ratio indicates the extend to This Ratio indicates the extend to

which the investments in fixed which the investments in fixed assets contributed towards sales. It assets contributed towards sales. It is compared to the previous period is compared to the previous period it justifies whether investment in it justifies whether investment in fixed asset is judicious or not.fixed asset is judicious or not.

Net SalesNet Sales

Fixed Assets (net)Fixed Assets (net)


1997= 6,00,000 = 4 times1997= 6,00,000 = 4 times 1,50,000 1,50,000

1998= 3,00,000 = 2.67 times1998= 3,00,000 = 2.67 times 8,00,0008,00,000

This shows that there has been a decline This shows that there has been a decline in the Fixed Asset Ratio, though sales in the Fixed Asset Ratio, though sales figures have gone up. It means , figures have gone up. It means , increase in the investment in fixed increase in the investment in fixed assets has not brought about assets has not brought about commensurate gain. commensurate gain.

Working Capital Working Capital Turnover RatioTurnover Ratio The Ratio indicates whether or not The Ratio indicates whether or not

working capital has been effectively working capital has been effectively utilized in making sales.utilized in making sales.

Net SalesNet Sales

Working CapitalWorking Capital This ratio can take different forms This ratio can take different forms

for different purposes. Some of for different purposes. Some of them are explained:them are explained:

Debtors Turnover Ratio Debtors Turnover Ratio (Debtors Velocity)(Debtors Velocity)

Two Ratios are used by financial Two Ratios are used by financial analysts to judge the liquidity of a firmanalysts to judge the liquidity of a firm

Debtors Turnover Ratio and Debt Debtors Turnover Ratio and Debt collection period Ratio.collection period Ratio.

Debtors Debtors Credit Sales Credit Sales

Turnover Ratio Turnover Ratio ==

Average Accounts Average Accounts ReceivableReceivable


Sales to Accounts Receivable Ratio Sales to Accounts Receivable Ratio indicates the efficiency of the staff indicates the efficiency of the staff entrusted with collection of book debts.entrusted with collection of book debts.

The higher the ratio, the better it is, The higher the ratio, the better it is, since it would indicate that debts are since it would indicate that debts are being collected more promptly.being collected more promptly.

A standard figure should be set up.A standard figure should be set up. The ratio helps in Cash Budgeting since The ratio helps in Cash Budgeting since

the flow of cash from customers can be the flow of cash from customers can be worked out on basis of sales. worked out on basis of sales.

Debt Collection Period Debt Collection Period RatioRatio The ratio indicates the extent to which The ratio indicates the extent to which

the debts have been collected in time. It the debts have been collected in time. It gives the average debt collection period. gives the average debt collection period.

The ratio is very helpful for the lenders The ratio is very helpful for the lenders because it explains to them whether because it explains to them whether their borrowers are collecting money their borrowers are collecting money within a reasonable time. within a reasonable time.

An increase in the period will result in An increase in the period will result in greater blockage of funds in debtors.greater blockage of funds in debtors.

a.a. Months (or days) in a yearMonths (or days) in a year

Debtors TurnoverDebtors Turnover

b.b. Average Accounts Receivable X Months(or days)in Average Accounts Receivable X Months(or days)in a yeara year

Credit Sales for the yearCredit Sales for the year

c.c. Accounts ReceivableAccounts Receivable

Average Monthly or Daily Credit SalesAverage Monthly or Daily Credit Sales


It measures the quality of Debtors since it It measures the quality of Debtors since it measures the rapidity or slowness with measures the rapidity or slowness with which money is collected from them.which money is collected from them.

Shorter collection period implies prompt Shorter collection period implies prompt payment. Reduces chances of bad debtpayment. Reduces chances of bad debt

Longer collection period implies too liberal Longer collection period implies too liberal and inefficient credit collection.and inefficient credit collection.

It is difficult to provide a standard It is difficult to provide a standard collection period for the debtors. In collection period for the debtors. In general it should not exceed 3-4 months.general it should not exceed 3-4 months.

Creditors Turnover Creditors Turnover Ratio (Creditors Ratio (Creditors Velocity)Velocity) It indicates the speed with which It indicates the speed with which

the payments for credit purchases the payments for credit purchases are made to the creditors.are made to the creditors.

Credit PurchasesCredit Purchases

Average Accounts PayableAverage Accounts Payable Total PurchasesTotal Purchases

Accounts PayableAccounts Payable

Debt Payment Period Debt Payment Period Enjoyed Ratio Enjoyed Ratio (Average Age of Payables)(Average Age of Payables)

The ratio gives the average credit period The ratio gives the average credit period enjoyed from the creditor.enjoyed from the creditor.

a.a. Months (or days) in a yearMonths (or days) in a year Creditors TurnoverCreditors Turnover

b.b. Average Accounts Payable X Months (or days) in a Average Accounts Payable X Months (or days) in a yearyear

Creditors TurnoverCreditors Turnover

c.c. Average Accounts PayableAverage Accounts PayableAverage Monthly (or daily) credit PurchasesAverage Monthly (or daily) credit Purchases


Both the creditors turnover ratio Both the creditors turnover ratio and the debt payment period and the debt payment period enjoyed ratio indicate the enjoyed ratio indicate the promptness or otherwise in making promptness or otherwise in making payment of credit purchases. payment of credit purchases.

Higher CTR or Lower credit period Higher CTR or Lower credit period enjoyed ratio signifies that enjoyed ratio signifies that creditors are being paid promptly. creditors are being paid promptly.

Stock Turnover RatioStock Turnover Ratio

This ratio indicates whether investment This ratio indicates whether investment in inventory is efficiently used or not. in inventory is efficiently used or not.

Cost of Goods Sold during the yearCost of Goods Sold during the yearAverage InventoryAverage Inventory

Average Inventory is calculated by taking Average Inventory is calculated by taking stock levels at the end of each month, stock levels at the end of each month, adding them up and dividing by twelve.adding them up and dividing by twelve.

This ratio can be calculated for each This ratio can be calculated for each constituent of inventory.constituent of inventory.


It signifies the liquidity of the It signifies the liquidity of the inventory. inventory.

A high inventory turnover ratio A high inventory turnover ratio indicates brisk sales. indicates brisk sales.

A low inventory ratio results in A low inventory ratio results in blocking of funds in inventory.blocking of funds in inventory.

FINANCIAL RATIOSFINANCIAL RATIOS

Financial Ratios indicate about the Financial Ratios indicate about the financial position of the company.financial position of the company.

It is a sound principle of finance that It is a sound principle of finance that long term requirement of funds should long term requirement of funds should be met out of long term funds and short-be met out of long term funds and short-term should be met out of short term. term should be met out of short term.

Thus the financial position has to be Thus the financial position has to be judged from two angles-long-term and judged from two angles-long-term and short-term. short-term.

Fixed Assets RatioFixed Assets Ratio Fixed AssetsFixed Assets

Long-term FundsLong-term Funds The ratio should be more than 1.The ratio should be more than 1. If less than 1, it shows that a part of If less than 1, it shows that a part of

the working capital has been financed the working capital has been financed through long term funds. through long term funds.

This is sometimes desirable to some This is sometimes desirable to some extent because a part of working extent because a part of working capital termed as “core working capital termed as “core working capital” is more or less of a fixed capital” is more or less of a fixed nature. The ideal ratio is 0.67nature. The ideal ratio is 0.67

Fixed Assets include “net fixed assets” Fixed Assets include “net fixed assets” and trade investments including and trade investments including shares in subsidiaries. Long term funds shares in subsidiaries. Long term funds includes share capital, reserves and includes share capital, reserves and long term loans.long term loans.

Current RatioCurrent Ratio This ratio is an indicator of the firms This ratio is an indicator of the firms

commitment to meet its short term liabilities.commitment to meet its short term liabilities. Current AssetsCurrent Assets

Current LiabilitiesCurrent Liabilities Current Assets include cash and other assets Current Assets include cash and other assets

convertible or meant to be converted into convertible or meant to be converted into cash during he operating cycle of the cash during he operating cycle of the business. Current Liabilities mean liabilities business. Current Liabilities mean liabilities payable within a year’s time either out of payable within a year’s time either out of existing current assets or by creation of new existing current assets or by creation of new current liabilities.current liabilities.

Book debts outstanding for more than 6 Book debts outstanding for more than 6 months and loose tools should not be months and loose tools should not be included in current assets. Prepaid expenses included in current assets. Prepaid expenses should be taken.should be taken.

An ideal current ratio is 2. The ratio of 2 An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of is considered as a safe margin of solvency due to the fact that if the solvency due to the fact that if the current assets are reduced to half i.e.,1 current assets are reduced to half i.e.,1 instead of 2, then also the creditors will instead of 2, then also the creditors will be able to get their payments in full.be able to get their payments in full.

A very high current ratio is also not A very high current ratio is also not desirable since it means less efficient desirable since it means less efficient use of funds. Because very high ratio use of funds. Because very high ratio means excessive dependence on long means excessive dependence on long term sources of raising funds. Long-term sources of raising funds. Long-term liabilities are costlier than current term liabilities are costlier than current liabilities and therefore, this will result liabilities and therefore, this will result in considerably lowering down the in considerably lowering down the profitability of the concern.profitability of the concern.

It is to be noted that mere fact that It is to be noted that mere fact that current ratio is quite high does not current ratio is quite high does not mean that the company will be in a mean that the company will be in a position to meet adequately its position to meet adequately its short term liabilities. In fact the short term liabilities. In fact the current ration should be seen in current ration should be seen in relation to the components of the relation to the components of the current assets and their liquidity. If current assets and their liquidity. If a large portion of the current a large portion of the current assets comprise obsolete stocks or assets comprise obsolete stocks or debtors outstanding for a long debtors outstanding for a long time, company may fail if the time, company may fail if the current ratio is higher than 2.current ratio is higher than 2.


The current ratio is an index of the The current ratio is an index of the concern’s financial stability since it concern’s financial stability since it shows the extent of the working shows the extent of the working capital which is the amount by which capital which is the amount by which the current assets exceed the current the current assets exceed the current liabilities.liabilities.

Higher ratio will indicate inadequate Higher ratio will indicate inadequate employment of funds and poor ratio is employment of funds and poor ratio is a danger signal to the management.a danger signal to the management.

Liquidity RatioLiquidity Ratio

Also termed as ‘Acid Test Ratio’ or Also termed as ‘Acid Test Ratio’ or ‘Quick Ratio’.‘Quick Ratio’.

Liquid AssetsLiquid AssetsCurrent LiabilitiesCurrent Liabilities

Prepaid expenses and Stock are not Prepaid expenses and Stock are not taken in Liquid Assets.taken in Liquid Assets.

The ideal Ratio is 1.The ideal Ratio is 1. The ratio is an indicator of short-term The ratio is an indicator of short-term

solvency of the company.solvency of the company.

A comparison of the current ratio to A comparison of the current ratio to quick ratio shall indicate the inventory quick ratio shall indicate the inventory hold-ups. hold-ups.

For Example if two units have the same For Example if two units have the same current ratios but different liquidity current ratios but different liquidity ratios, it indicates overstocking by the ratios, it indicates overstocking by the concern having low liquidity ratio as concern having low liquidity ratio as compared to the concern which has compared to the concern which has higher liquidity ratio.higher liquidity ratio.

Debt Equity RatioDebt Equity Ratio

This ratio is determined to ascertain This ratio is determined to ascertain the soundness of the long term the soundness of the long term financial policies of the company. financial policies of the company.

It is also known as “External-internal It is also known as “External-internal equity ratio”.equity ratio”.

External equitiesExternal equitiesInternal equitiesInternal equities

In case the ratio is 1, it is considered In case the ratio is 1, it is considered quite satisfactory.quite satisfactory.

i.i. Debt equity RatioDebt equity Ratio= Total Long Term Debt= Total Long Term Debt

Total Long-term fundsTotal Long-term funds

ii.ii. Debt equity RatioDebt equity Ratio= Shareholders funds= Shareholders funds

Total Long term fundsTotal Long term funds

iii.iii. Debt equity RatioDebt equity Ratio= Total Long-term debt= Total Long-term debt

Shareholders fundsShareholders funds Ratio (i) & (ii) ideal if they are 0.5 each Ratio (i) & (ii) ideal if they are 0.5 each

while ratio (iii) ideal if it is 1.while ratio (iii) ideal if it is 1. Method (iii) is most popular.Method (iii) is most popular.


The ratio indicates the proportion of The ratio indicates the proportion of owners stake in the business. owners stake in the business.

Excessive liabilities tend to cause Excessive liabilities tend to cause insolvency. The ratio indicates the insolvency. The ratio indicates the extent to which the firm depends upon extent to which the firm depends upon outsiders for its existence.outsiders for its existence.

The ratio provides a margin of safety The ratio provides a margin of safety to the creditors. It tells the owner the to the creditors. It tells the owner the extent to which they can gain the extent to which they can gain the benefits of maintaining control with a benefits of maintaining control with a limited investment.limited investment.

Proprietary RatioProprietary Ratio

It is a variant of debt-equity ratio.It is a variant of debt-equity ratio. It establishes relationship It establishes relationship

between the proprietors or between the proprietors or shareholders funds and the total shareholders funds and the total tangible assets.tangible assets.

Shareholders FundsShareholders Funds

Total Tangible AssetsTotal Tangible Assets


The ratio focuses the attention on the general The ratio focuses the attention on the general financial strength of the business enterprise. The financial strength of the business enterprise. The ratio is of particular importance to the creditors ratio is of particular importance to the creditors who can find out the proportion of shareholders who can find out the proportion of shareholders funds in the total assets employed in the funds in the total assets employed in the business.business.

High ratio will indicate a relatively little danger High ratio will indicate a relatively little danger to the creditors, in event of forced to the creditors, in event of forced reorganization or winding up of the company. reorganization or winding up of the company.

Low ratio indicates greater risk to the creditors.Low ratio indicates greater risk to the creditors. A ratio below 50% may be alarming for the A ratio below 50% may be alarming for the

creditors since they may have to lose heavily in creditors since they may have to lose heavily in the event of company’s liquidation on account of the event of company’s liquidation on account of heavy losses.heavy losses.

Advantages of Ratio Advantages of Ratio AnalysisAnalysis

1.1. Simplifies Financial StatementsSimplifies Financial Statements

2.2. Facilitates Inter-firm ComparisonFacilitates Inter-firm Comparison

3.3. Makes Intra-firm comparison Makes Intra-firm comparison possiblepossible

4.4. Helps in planning.Helps in planning.

Limitations of Limitations of Accounting RatiosAccounting Ratios

1.1. Comparative study requiredComparative study required

2.2. Limitations of financial Limitations of financial statementsstatements

3.3. Ratios alone are not adequateRatios alone are not adequate

4.4. Window dressingWindow dressing

5.5. Problem of price level changesProblem of price level changes

6.6. No fixed standards.No fixed standards.

Documents

Ratio Analysis 2.1