Accounting Ratios & Ratio Analysis

Accounting Ratios are the expression of mathematical relationships between various figures
of items represented in the financial statements of a Company as a ratio or percentage.

The financial statements mainly used for calculating ratios are Balance Sheet, Profit and
Loss Account, Cash Flow statements.

Ratio Analysis is one of the tools used to evaluate the financial condition and performance of
any business or Corporate. It is the calculation and comparison of ratios which are derived
from the data given on the Financial Statements.

“Ratio Analysis of financial statements is a study of relationship among various financial

factors in a business as disclosed by a single set of statements and a study of trend of these
factors as shown in a series of statements.”

- -- Myers

Classification of Accounting Ratios

• Based on Financial Statements used.

1) Balance Sheet Ratios

Indicates financial positions

2) Profit and Loss Account Ratios

Indicates Profitability and cost efficiencies

3) Inter-Statement Ratios

Indicate Operating Efficiencies or effective use of facilities and resources.

• Based on the financial aspects which it measures

1. Profitability Ratios

Measures the Profitability of the business – its capacity to generate profits. Figures from the
P & L account helps generate the ratios.

2. Performance Ratios
Also known as turnover ratios helps the business to know the rapidity with which a unit of
investment generates sales or how well the resources of a Company are utilized.

3. Liquidity Ratios

Measures the short –term solvency of a business.

4. Solvency Ratios

Measures the long-term solvency of a business

5. Valuation Ratios

Helps us with the evaluation of performance of the equity stock of a company in the stock
market. Price Earnings ratio is an important Valuation Ratio.

Advantages of Ratio Analysis Limitations of Ratio Analysis

Performance (Profitability& Operating Reliability of Data: The data on which ratios

Efficiency)and Financial position(Financial are worked should be absolutely reliable. If
Capability) can be properly judged by a the data itself is incorrect one may arrive at
complete and correct analysis totally misguiding ratios

Can identify the causes for the current Comparability: a) A ratio alone on its own is
position of the Company to further improve of little help. It should be compared with a
performance or maintain the good results base year or a standard year , the
computation of which is very difficult.

b) When the ratio of two firms who are

following different accounting standards are
arrived the results are erratic since the basic
data itself are not comparable. Similarly
ratios of Companies of different Industry
cannot be compared.

Trend Analysis based on a number of years Changes in price levels over different periods
data helps in decision –making, forecasting makes comparison difficult. Change in cost of
and structuring financial strategies and production or price of fixed assets makes it
budgets. difficult for comparison without making
 adjustment of price level changes.

Simplifies accounting information. Instead of Qualitative factors are not reflected for
studying detailed information it gives a brief example for e.g.Administrative expenses
and concise report of complicated and may show a very high figure due to huge
detailed calculations salary for qualified foreign professionals. A
significant improvement in the process of
production and zero rejections in products
would have brought in huge savings in cost
of goods which will amply compensate for a
compartively higher Administrative expenses
ratio.

Absolute figures are useful but they do not Ratios of irrelevant figures may be
communicate detailed meaning. Comparison misleading. For e.g. Ratio of sales and
of accounting ratios makes them more ordinary investments. Therefore, ratios
meaningful and gives a better should be worked out for only significant
understanding. items.

Sometimes ratios without the absolute

figures may be misguiding. For example a
company selling products at the intiial stage
will show a high percentage increase while
those at the saturation stage will show a
lesser percentage increase although the
absolute figures may show a very huge
profit.

Formula for a few common Ratios

Profitability Ratio

a) Return on capital employed

Net Operating Profit /Capital employed in business * 100

Also represented as

Net Profit before Interest, tax & dividends/capital employed in

business

b) Gross Profit Ratio

Gross Profit / Sales * 100

Gross Profit = Net Sales – Cost of Goods sold

Cost of Goods sold = Opening stock + Net Purchases + Direct

Expenses – Closing Stock
 Net Sales = Total Sales – Sales Return

c) Net Profit Ratio

Net Operating Profit/Net Sales * 100

Operating Profit = Gross Profit – Operating Expenses

d) Fixed Assets Charges Cover

Profit before Interest and Income Tax/Total Interest Charges

Performance Ratios

A. Stock Turnover Ratio

Cost of Goods sold / Average Stock carried

Cost of Goods sold = Opening Stock + Net Purchases + Direct

Expenses – Closing Stock

Avg Stock - Last Year’s closing stock + current year’s closing stock /2

Liquidity Ratios

a. Current Ratio

Current Assets / Current Liabilities

b. Liquid Ratio

Liquid Assets/ Current Liabilities

Liquid Assets includes all current assets other than stock & prepaid
expenses

Solvency Ratios

I. Fixed Assets Ratio

Fixed Assets/Long Term Funds(includes capital , reserves & debenture &

long term loans-Fictitious Assets)
II. Debt Equity Ratio

Long Term Debt/Shareholder funds

Please note to remove maturities falling due within a year from the long term
Debts

III. Capital Gearing Ratio

Funds bearing Fixed Cost/Funds belonging to Shareholders

Funds bearing fixed cost include Preference shares, debentures, Long Term
Debts

Shareholders funds include Capital, reserves less set off items & other
liabilities for write-off

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