RATIO ANALYSIS

Accounting ratios are relationships between accounting figures which

are connected with each other in some manner.
CLASSIFICATION OF RATIOS
Accounting ratios can be classified on the following basis:
Traditional Classification
The traditional classification has been on the basis of the financial
statements. The ratios could be classified as:
(i) Profit and loss account ratios, i.e., ratios calculated on the basis of
the profit and loss account only
(ii) Balance sheet ratios, i.e. ratios calculated on the basis of the figures
of balance sheet only.
(iii) Composite ratios or inter-statement ratios, i.e. ratios based on
figures of profit and loss account as well as the balance sheet.

Functional Classification
When ratios serve as a tool for financial analysis, they are now classified
as:
(i) Profitability Ratios,
(ii) Turnover or activity ratios, and
(iii) Financial or solvency ratios.
Financial ratios may be further classified into two categories:
(a) Short-term Solvency Ratios are the ratios that disclose the financial
position or solvency of be firm in the short period. Called as 'Liquidity
Ratios'.
(b) Long-term Solvency Ratios are the ratios that disclose the financial
position or solvency of the firm in the long period. Called as 'Solvency
Ratios'.

USES OF ACCOUNTING RATIOS

(i) Simplify financial statements
(ii) Facilitate inter-firm comparison
(iii) Facilitate intra-firm comparison
(iv) Help in planning: Ratios help in planning and forecasting.

LIMITATIONS OF ACCOUNTING RATIOS

• Ratios provide a glimpse of the past performance and forecasts for
future which may not prove correct, since several other factors like
market conditions, management policies, etc. may affect the future
operations.
• Limitations of financial statements: Ratios are based only on the
information which has been recorded in the financial statements. As
indicated in the preceding pages, financial statements suffer from a
number of limitations. The ratios derived from there, therefore, are
also subject to those limitations. For example, non-financial charges,
change in management of the company etc
• Ratios alone are not adequate: Ratios are only indicators; they cannot
be taken as final regarding good or bad financial position of the
business. Other things have also to be seen. For example, a high
current ratio does not necessarily mean that the concern has a good
 liquid position, in case the current assets mostly comprise of outdated
stocks.
• Window Dressing: On account of such a situation, the presence of
particular ratio may not be a definite indicator of a good or bad
management. For example, a high stock turnover ratio is generally
considered to be an indication of operational efficiency of the
business. But this might have been achieved by unwarranted price
reductions or failure to maintain proper stock of goods.
• Problems of price level changes: Financial analysis, based on
accounting ratios, will give misleading results if the effects of changes
in the price level are not taken into account.
• No fixed standards: No fixed standards can be laid down for ideal
ratios.

CACULATION AND INTERPRETATION OF VARIOUS

RATIOS

Solvency Ratios
A company is considered to be solvent or financially sound if it is in a
position to carry on its business smoothly and meet all obligations, both
long-term as well as short-term, without strain.

Short-term Solvency Ratios/ Liquidity Ratios

Current Ratio: This ratio is an indicator of the firm's commitment to meet
its short-term liabilities.
Current assets / Current liabilities
An ideal current ratio is 2. A very high current ratio is also not desirable
since it means inefficient use of funds.

Liquidity Ratio/ 'Acid test ratio' or 'quick ratio'

This is ratio of quick assets and current liabilities. This ratio measures the
capacity of the firm to pay off the current liabilities of the urgent nature
immediately.
Liquid assets (Quick Assets)/ Current liabilities

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

of the company.

Long-term Solvency Ratios/ Leverage Ratios/

Solvency Ratios
Fixed Assets Ratio
This ratio is calculated as:
Fixed Assets/ Long Term Funds
Fixed assets include net fixed assets and trade investments and Long-
term funds include capital, reserves and long term outside liabilities.

* The ratio should not be more than 1. If it is less than 1, it shows that a
part of the working capital has been financed through long-term funds.
Debt-equity Ratio
The debt-equity ratio is calculated to ascertain the soundness of the
long-term financial policies of the company. It shows dependence of the
unit on the outside long-term finance.

Debt-equity ratio = External equities / Internal equities

OR
Long Term Outside Liabilities/ Tangible Net worth

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

Excessive liabilities tend to cause insolvency. The ratio indicates the
extent to which the firm depends upon outsiders for its existence.
The ratio provides a margin of safety to the creditors. It tells the owners
the extent to which they can borrow, to increase the profits, with a
limited investment.

DEBT SERVICE COVERAGE RATIO (DSCR)

The Debt Service Coverage Ratio (DSCR) measures the ability of a
company to use its operating income to repay all its debt obligations,
including repayment of principal and interest on both short-term and
long-term debt.
(Profit After tax (PAT) + Depreciation + Annual Interest on term loans)
/ (Annual Interest on long term loans & liabilities + Annual Instalment
payable on long term loans)
(Benchmark DSCR Ratio 2)

Turnover Ratios/ Activity Ratios

Stock Turnover Ratio: This ratio indicates whether the investment in
inventories is efficiently used or not. It, therefore, explains whether
investment in inventories is within proper limits or not.
Cost of goods sold during the year/ Average inventory
OR
Sales/ Average Inventory

• The average inventory be computed on the basis of the average of

inventory at the beginning and at the end of the accounting period.
• The inventory turnover ratio signifies the liquidity of the inventory.

Debtors' Turnover Ratio (Debtors Velocity): Debtors are an important

constituent of current assets
and, therefore, the quality of debtors, to a great extent, determines a
firm's liquidity. Two ratios are used by financial analysts to judge this.
They are:
(i) Debtors, turnover ratio, and
(ii) Debt collection period ratio.
Debtors' turnover ratio =
Credit sales/ Average accounts receivable

The term Accounts Receivable' includes 'Trade Debtors' and 'Bills

Receivable.
In case, details regarding opening and closing receivables and credit sales
are not available, the ratio may be calculated as follows:
Total sales / Accounts receivables

"Sales to Accounts Receivable Ratio” indicates the efficiency of the staff

entrusted with collection of book debts. The higher the ratio, the better
it is.
Debt Collection Period Ratio: The ratio indicates the extent to which the
debts have been collected in time. It gives the average debt collection
period.

Average accounts receivable x Months (or days) in a year/ Credit sale

for the year

it measures the rapidity or slowness with which money is collected from

them. A shorter collection period implies prompt payment by debtors. It
reduces the chances of bad debts.
Profitability Ratios
Overall Profitability Ratio (Return on Investment/ Return on Capital
Employed)
It indicates the percentage of return on the total capital employed in the
business. It is calculated on the basis of the following formula:
= Operating profit (PBIT) / Capital employed x 100

Here return is profit before interest and tax and capital employed means
the tangible net worth or shareholder’s funds and outside term liabilities

Earnings per Share (EPS)

EPS tells about the earning per equity share. It can be computed as
follows:
Earnings per Share = Net profit after tax and preference dividend /
Number of equity shares
EPS helps in determining the market price of the equity share of the
company.

Price Earning (P/E) Ratio

This ratio indicates the number of times the earning per share is covered
by its market price. This is calculated according to the following formula:
Market price per equity share/ Earning per share

Operating Profit Ratio

It denotes the margin on the profits arising from the main business
revealing the operational efficiency of the unit.
Operating Profit/ Sales X 100

Gross Profit Ratio

This ratio expresses the relationship between the gross profit and the net
sales. Its formula is:
Gross profit / Net sales

Net Profit Ratio

Net profit is surplus of Gross Profit after the meeting other expenses.
This can be before tax or after tax.
Net profit / Net sales X 100

Return on Equity
This ratio provides information about the earnings which the funds put
in the business by the owners/ promoters and retained, earns.
ROE = Net Profit/ Tangible Net Worth x 100

DIFFERENT USERS AND THEIR USE OF RATIOS

(i) Accounting ratios used by a long-term creditor:
• Fixed charges cover = Income before interest and tax/ Interest
charges
 • Debt service coverage ratio = Cash profit available for debt service/
Interest + Principal payments instalment
(ii) Accounting ratios used by a bank granting a short-term loan:
• Quick ratio = Quick assets/ Current liabilities
• Current ratio = Current assets / Current liabilities

(iii) Accounting ratios used by shareholders:

• Earnings per share = Profit available for equity shareholders / No.
of equity shares
• Dividend yield ratio = Dividend per share / Market price per share

(i) Payment of current liability: On payment of a current liability out of

current assets, working capital will remain unchanged. However, current
ratio will improve.
(ii) Purchase of fixed assets: On purchase of fixed assets in cash, current
assets will decrease without any change in current liabilities. Thus, the
transaction will result in decline of current ratio.
(iii) Cash collected from customers: Collection of debtors, results in the
conversion of one current asset, viz., debtors into another current asset,
viz., cash. Hence, amount of current assets and current liabilities remain
unchanged.
(iv) Bills receivable dishonoured: When a bill receivable is dishonoured,
it cannot always be presumed that the customer has become insolvent.
Hence, if the customer is solvent, the amount of bills receivable will get
reduced and the amount due from debtors will increase. There will be no
change in the amount of current liabilities.
However, if it is anticipated that the debt becomes bad and it is recorded
as such, it will result in the reduction of current assets resulting in fall in
the current ratio from 2:1.

(v) Issue of new shares: If issue of new shares is for cash it will result in
an increase in the current assets. Hence, there will be consequential
improvement in current ratio as there will be no change in current
liabilities.
However, if issue is in consideration of conversion of debentures, there
will be no change in current assets or current liabilities and, therefore,
no change in current ratio.

Solve the Following

1 unsecured loan long term 80 LTL
2 Goodwill 30 IA
3 Sundry debtors 160 CA
4 plant & Machinery 250 FA
5 Bills Payables 120 CL
6 Reserves 100 NW
7 Sundry creditors 20 CL
8 land and Building 150 FA
9 CC Limit/ OD 140 CL
10 Prepaid expenses 20 CA
11 Stock 200 CA
 12 Preliminary expenses 20 IA
13 Shared Capital 200 NW
14 cash in hand 20 CA
15 provision for expenses 20 CL
16 machinery 100 FA
17 unquoted investments 30 NCA
18 Term loans including installment 200 LTL
19 Security Deposit 20 NCA
20 Bonds/ Debentures 120 LTL

Profit and Loss Items

21 Sales 1000
22 Net Profit 50
23 Interest on term loan 30
24 Depreciation 20

Others
Installment per month 4

Liabilities Assets
Net worth Fixed Assets
13 capital 200 16 Machinery 100
6 reserves 100 4 Plant & Machinery 250
Long term Liabilities 8 Land or Building 150
1 unsecured loans 80 Non-Current Assets
18 Term Loans 200 17 unquoted Investments 30
20 Bonds 120 19 Security Deposit 20
Current Liabilities Current Assets
15 Provisions for expenses 20 14 Cash 20
7 sundry creditors 20 3 Sundry Debtors 160
5 bills payables 120 11 Stocks 200
9 CC Limit 140 10 Prepaid Expenses 20
Intangible Assets
2 Goodwill 30
12 Preliminary Expenses 20
Total 1000 Total 1000
 1 LONG TERM LIABILITY 80+120+200 400
2 CURRENT LIABILITY 300
3 OUTSIDE LIABILITY LTL+CL 700
4 NET WORTH 300
5 INTANGIBLE ASSETS 50
6 TANGIBLE NETWORTH NW-IA 250
7 SHORT TERM SOURCES 300
8 LONG TERM SOURCES 700
9 LONG TERM USES 600
10 WORKING CAPITAL (GROSS) CA 400
11 NET WORKING CAPITAL CA-CL 100
12 QUICK ASSETS 180
13 SHORT TERM USES CA 400
14 CURRENT ASSETS 400

CURRENT RATIO CA/CL 400/300 1.33

QUICK RATIO QA/CL 180/300 0.6
NWC CA – CL 400-300 100
DER LTL/TNW 400/250 1.6
DSCR (PAT + Dep + Intt)/(Installment + intt) 50+20+30/78 1.28
STOCK TURNOVER RATIO Sales/ stock 1000/200 5
DEBTOR TURNOVER RATIO Sales/ sundry debtors 1000/160 6.25
NET PROFIT Ratio NP/Sales x 100 50/1000 x 100 5%
RETURN ON EQUITY NP/TNW x 100 50/250 x 100 20%
Q3893: To calculate quick assets, which of the following is not reduced
from current assets:

A.) Stocks
B.) inventories
C.) pre-paid expenses
D.) trade debtors

Q3897: Net working capital of a firm is 80 and current ratio is 1.5:1. Its
current liabilities and assets are:

A.) 80,120
B.) 160,240
C.) 240,320
D.) 120,200

Q3900: The debt equity ratio is 3:1 and current ratio is 1.5:1. If current
assets are 45 and long-term liabilities are 45, which of the following is
correct:

A.) current liabilities are 15 and tangible net worth 30

B.) current liabilities are 30 and tangible net worth 15
C.) current liabilities are 30 and tangible net worth 30
D.) current liabilities are 15 and tangible net worth 15
current liabilities = 45/1.5 and tangible net worth = 45/3

Q3903: DSCR coverage ratio is used for which of the following

purposes:

A.) to calculate the amount of term loan

B.) to calculate working capital limits
C.) to decide whether to sanction a term loan and fix instalments
D.) all the above

Q3898: capital of a firm is 35 reserves 11, its debentures are 80 and

preliminary expenses 6. The debt equity ratio will be:

A.) 0.5:1
B.) 02:01
C.) 1.7:1
D.) none of the above

Q3905: Firm-A has sales of 5000 and stocks of 400.Firm-B has stocks of
600 and sales of 7200.in this connection which of the following is not
correct :

A.) stock turnover ratio of Firm-A=12.5

B.) stock turnover ratio of Firm-B=12
C.) stock turnover ratio of Firm-A is better than of Firm-B
D.) stock utilisation of Firm-B is better than of Firm-A

Q3919: The net profit before tax of a firm is 200.The interest amount is
20. The tangible net worth is 300 and long-term liabilities of 400.The
return on investment shall be:

A.) 29.50%
B.) 29.40%
C.) 25.71 %
D.) 32.80%

Q3902: net profit of a firm is 45, depreciation 20 and term loan interest
15, If term loan instalment is 25, what will be DSCR:

A.) 1.5
B.) 2
C.) 2.5
D.) 3

Q3892: The formula for which of the following ratios is not correct:

A.) current ratio=current assets/current liabilities

B.) quick ratio = quick assets/quick liabilities
C.) net working capital=current liabilities + current assets
D.) none of the above
Q3901: Debt service coverage ratio is calculated as:

A.) (net profit + depreciation + term loan interest)/term loan instalment

B.) (net profit + depreciation + term loan instalment)/term loan interest
C.) (net profit + depreciation + term loan interest)/ (term loan
instalment + term loan interest)
D.) (net profit + depreciation + term loan interest)/(term loan
instalment + depreciation)

Q3896: current ratio of a firm was 1.33:1 in the previous year which
continues to be same. But the quick ratio has changed from 0.69:1 to
0.97:1. The change will be on account of:

A.) %age of stocks in total current assets increased

B.) %age of quick assets in total current assets increased
C.) %age of stocks in total current assets increased slightly
D.) %age of quick assets in total current assets decreased

Q3918: The return on investment is calculated as:

A.) net profit before interest and tax/ (tangible net worth + long term
liabilities)
B.) net profit after interest and tax/ (tangible net worth + long term
liabilities)
C.) net profit before interest and tax/ (tangible net worth + outside
liabilities)
D.) net profit before interest and tax/ (net worth + long term liabilities)

Q3894: A firm has stocks of 10, debtors 12, trade creditors of 7, cash 1,
bank overdraft 4, prepaid expenses 2 and expenses outstanding 2.
Which of the following is not correct?

A.) quick assets=12

B.) current assets = 25
C.) current liabilities = 13
D.) quick ratio = 1:1

Q3906: which of the following is correct with regard to debtor turnover

ratio:

A.) ratio is calculated as = sales/ avg debtors

B.) ratio indicated credit period extended by the firm to its customer
C.) ratio indicates the inefficiency of recovery of debtors
D.) debt velocity ratio is another variant of this ratio

Q3910: sales of a firm are 6000 and its debtors 300. Debtor velocity of
the firm in the previous year was 0.8 months. Which of the following
statements is not correct?

A.) debtor turnover ratio is 20 times

B.) debtor velocity ratio is 0.6 months
C.) debt collection has improved over the previous year
D.) debt collection has shown deterioration over the previous year
 FINAL ACCOUNTS OF
BANKING COMPANIES
Banks and Banking activities are mainly regulated under banking
regulation act 1949.
Definition (Section 5 of BR Act): accepting of deposits of money from the
public, for the purpose of lending or investment and the deposits are
repayable on demand or otherwise by cheque, draft, order or otherwise
In addition to banking business, a bank is permitted to perform some
other functions as per section 6(1) of the BR Act.

CONSTITUTION OF BANKS
Banks in India fall under one of the following categories:
1. Body corporate constituted under special act of parliament
2. Company registered under the Companies Act. 1956 (Companies Act
2013) or a foreign company,
3. Co-operative society registered under a central or state enactment on
co-operative societies.

REQUIREMENTS OF BANKING COMPANIES AS TO

ACCOUNTS AND AUDIT
Preparation of Financial Statements and Accounting Date (Section 29)
A Company registered under the Companies Act, 2013 is required to
present its financial statements, i.e. balance sheet and profit and loss
account in the formats laid down in the Schedule III annexed to the
Companies Act.
The Banking Regulation Act gives the format of the balance sheets and
the profit and loss account in the third schedule of the Act, form A
(proforma balance sheet) and form B (proforma profit and loss account)
The Government has notified that accounts of the banking companies
shall be closed on 31st March every year.
Signatures (Section 29)
The financial statements of banking companies incorporated in India
should be signed by the manager or principal officer of the banking
company and by at least three directors (or all the directors in case the
number is less than three).
The financial statements of a foreign banking company are to be signed
by the manager or agent of the principal office in India.
The provisions of section 29 are also applicable to nationalised banks,
State Bank of India, its subsidiaries, and regional rural banks.

Audit (Section 30)

• Accounts must be audited by a person, duly qualified under any law,
for the time being in force, to be an auditor of companies.
• Every banking company is, before appointing, reappointing or
removing any auditor, required to obtain the prior approval of the
Reserve Bank of India.
Submission of Accounts (Secs 31 and 32)
• Three copies of the balance sheet and profit and loss account
prepared under Section 29 together with auditors' report under
Section 30 must be submitted to the Reserve Bank of India within
three months from the end of the period to which they refer.
• it can be extended up to a further period of three months by RBI
(Section 31).
• Section 32 of the Act requires a banking company (but not other types
of banks) to furnish three copies of its annual accounts and auditor's
report thereon to the Registrar of Companies at the same time when
it furnishes these documents to the RBI.

Publication of Accounts
Rule 15 of the Banking Regulating (Companies) Rules, 1949 prescribes
that accounts and auditors' report shall be published in a newspaper
circulating in a place where a banking company has its principal office,
within six months from the end of the period to which they relate.

Display of Balance Sheet by Foreign Banks

Every Banking Company incorporated outside India shall not later than
first Monday in August of any year in which it carries on business, display
in a conspicuous place in its principal office and in every branch office in
India a copy of its last audited balance sheet and profit & loss account
prepared under section 29.
SIGNIFICANT FEATURES OF ACCOUNTING SYSTEMS OF
BANKS
• Banks follow the mercantile system of accounting.
• Banks need to post the entries in ledger accounts, especially those of
customers, being accurate and up-to-date.
• It is therefore necessary to keep the customers’ accounts up to date
and check them regularly.
• In the case of banks, relatively lesser emphasis is placed on books of
prime entry such as cash books or journals.
Bankers' Books
According to Section 2 (3) of the Bankers' Books Evidence Act, Bankers'
Books' include ledgers, day book, cash books, account books and all
other books used in the ordinary business of a bank.

Cash Book
• All cash receipts and payments are recorded in the receiving cashier
's cash book.
• After this, on the basis of pay-in slips received by the receiving cashier
and cheques and withdrawals slips by the paying cashier, these
transactions are entered first in the accounts of customers and after
that Day Books are written. This is called the 'Slip System' of posting.

Ledger Book
General Ledger contains the total accounts of each ledger. Besides the
GL, the following ledger books are maintained:
• Current Accounts Ledger
• FD Accounts Ledger
• RD Accounts Ledger
• Loan Ledger
• Investment Ledger
• Bills discounted and purchased Ledger

Other Books
• Clearing Register
• Securities Register
• Draft Register
• Bills for collection Register
• Safe deposit vault Register
• Dishonoured cheques Register
• Letter of credit Register