INSTITUTE-UNIVERSITY SCHOOL OF

BUSINESS
DEPARTMENT-MBA
Master of Business Administration
Financial Reporting and Analysis
24BAT622
Dr. Charu Saxena
Associate Professor

RATIO ANALYSIS
DISCOVER . LEARN . EMPOWER
Ratio Analysis

Dr. Charu Saxena

 Ratio Analysis
• Ratio-analysis means the process of
computing, determining and presenting the
relationship of related items and groups of
items of the financial statements.
• They provide in a summarized and concise
form of fairly good idea about the financial
position of a unit. They are important tools for
financial analysis.
 Ratio Analysis
• Ratios are easy to understand and simple to compute.

• They can also be used to compare different companies in different

industries.

• Since a ratio is simply a mathematically comparison based on

proportions, big and small companies can be use ratios to compare
their financial information.
• These relationships between the financial statement accounts help
investors, creditors, and internal company management understand
how well a business is performing and of areas needing improvement
 It’s a tool which enables the banker or
lender to arrive at the following factors :

 Liquidity position
 Profitability
 Solvency
 Financial Stability
 Quality of the Management
 Uses of Ratio Analysis
1. Simplification of mass of accounting data- provides
summarized and simplified data.
2. An invaluable aid to management- helps in planning,
forecasting and control of the business
3. Facilities better coordination and control- informing the
position and performance of the business to the
management.
4. A tool to access important characteristics of business- like
liquidity, solvency and profitability of the business.
5. An effective tool for intra firm and inter-firm comparison-
identify the strengths and weaknesses of the firm
Classification of Ratios
 Classification of Ratios
Classification on the Basis of Financial Statement

Balance Sheet Ratios: Ratios calculated from taking various

data from the balance sheet are called balance sheet ratio. For
example, current ratio, liquid ratio,

Income Statement Ratio: Ratios calculated on the basis of

data appearing in the trading account or the profit and loss
account are called income statement ratios. For example,
operating ratio, net profit ratio,

Mixed or Composite Ratio: When the data from both balance

sheet and revenue statements are used, it is called mixed or
composite ratio. For example, working capital turnover ratio
 Classification on the Basis of
Financial Aspects

• Liquidity Ratios: to find out the short-term paying

capacity of a firm, to comment short term solvency of
the firm, or to meet its current liabilities.

• Long-Term Solvency and Leverage Ratios

• Debt equity ratio and interest coverage ratio are
calculated to know the efficiency of a firm to pay long-
term debts and to meet interest costs. Leverage ratios
are calculated to know the proportion of debt and equity
in the financing of a firm.
Activity Ratios
• Activity ratios are also called turnover ratios.
• Activity ratios measure the efficiency with which the
resources of a firm are employed.

Profitability Ratios
• The results of business operations can be calculated
through profitability ratios.
• These ratios can also be used to know the overall
performance and effectiveness of a firm.
• Two types of profitability ratios are calculated in relation
to sales and investments.
Classification on the Basis of time
1. Structural ratios- quarterly, biannually or
annually
2. Trend ratios- for a period of 5 years

Classification on the Basis of Importance

1. Primary Ratios: related to primary objectives
of the business, sales, revenue and profit.
2. Secondary Ratios: ratios calculated to explain
the primary ratios
Liquidity
 Current Ratio
1. Current Ratio : It is the relationship
between the current assets and current
liabilities of a concern.
Current Assets
Current Ratio =
Current Liabilities

Objective: The objective is to measure the ability of the firm to

meet its short – term obligations and to reflect the short – term
financial strength/ solvency of a firm. It suggests whether firm
can meet its short term obligation from short – term Assets.
 Current Assets include,

• Stock
• Debtors
• Cash and Bank Balances
• Bills receivable
• Accruals-Pre-paid Expenses
• Short term loans that are given
• Short term Securities
 Current Liabilities include

• Creditors
• Outstanding Expenses
• Short Term Loans that are taken
• Bank Overdrafts
• Provision for taxation
• Proposed Dividend
If the Current Assets and Current Liabilities
of a concern are Rs.4,00,000 and
Rs.2,00,000 respectively, then the Current
Ratio will be?
 4,00,000
• =2:1
2,00,000
Interpretation: It indicates rupees of current assets
available for each rupee of current liability.

Higher the ratio, greater is the margin of safety for

short–term creditors and vice versa.
However, too high/too low ratio calls for further
investigation since the too high ratio may indicate the
presence of idle funds with the firm and too low ratio
may indicate problem of short-term insolvency.

It is suggested that the ideal Current Ratio is 1.5:1

to 2:1
 KEY TAKEAWAYS

• The current ratio compares all of a company’s current

assets to its current liabilities.
• These are usually defined as assets that are cash or will
be turned into cash in a year or less, and liabilities that
will be paid in a year or less.
• The current ratio is sometimes referred to as the
“working capital” ratio and
• helps investors understand more about a company’s
ability to cover its short-term debt with its current
assets.
 ACID TEST or QUICK RATIO
It is the ratio between Quick Current Assets and Current
Liabilities. The should be at least equal to 1.

Quick Current Assets

Acid Test or Quick Ratio =
Current Liabilities
 Quick Assets
• Quick assets are those which can be easily
converted to cash with only 90 days notice.
• Not all current assets are quick assets.
• Quick assets generally include cash, cash
equivalents, and marketable securities.

Quick Assets = All Current Assets – Stock – Prepaid

Expenses
• Quick Liabilities = All Current Liabilities – Bank
Overdraft – Cash Credit

• Liquid Ratio= Quick or Liquid Assets/

Quick or Liquid Liabilities

The ideal quick ratio is considered to be 1:1, so that the

firm is able to pay off all quick assets with no liquidity
problems, i.e. without selling fixed assets or investments.
• Objective: The objective is to measure the
ability of the firm to meet its short – term
obligations as and when due without relying
upon the realization of stock.

• Interpretation : It indicates rupees of quick

assets available for each rupee of liability due
on short term notice.
EXERCISE 1

LIABILITES ASSETS

Capital 180 Net Fixed 400

Assets
Reserves 20 Inventories 150

Term Loan 300 Cash 50

Bank Credit 200 Receivables 150

Trade Creditors 50 Goodwill 50

Provisions 50

800 800
 Also
• Liquid ratio or Quick ratio or Acid
Test Ratio=
Liquid Assets/ Liquid Liabilities
 ABSOLUTE CASH RATIO
• This is an even more rigorous liquidity ratio than quick
ratio. Here we measure the availability of cash and cash
equivalents to meet the short-term commitment of the
firm. We do not consider all current assets, only cash.
Let us see the formula,

Cash+Bank Balance+
Absolute Cash ratio = Marketable Securities
Current Liabilities
 Absolute Cash Ratio
• As you can see, this ratio measures the cash availability
of the firm to meet the current liabilities.
• There is no ideal ratio, it helps the management
understand the level of cash availability of the firm and
make any changes required.
• However, if the ratio is greater than 1 it indicates poor
resource management and very high liquidity.
• And high liquidity may mean low profitability.
 Q: Given Below is the Balance sheet of ABC Co. Analyze the Balance
Sheet and Calculate the Current Ratio.

Liabilities Amount Assets Amount

Share Capital 50,000 Fixed Asset 1,24,000

Preference Share Capital 30,000 Short Term Capital 10,000

General Reserve 40,000 Debtors 95,000

Debentures 60,000 Stock 50,000

Trade Payable 10,000 Cash and Bank 15,000

Bank Overdraft 20,000 Discount on Share Issue 6,000

Provision for Tax 40,000

Provision for Depreciation 20,000

 Solution:

• Current Ratio = Current Assets/Current Liabilities

• Current Assets = Debtors + Stock + Cash + Short term

Capital = 1,70,000

• Current Liabilities = Trade Payables + Bank Overdraft +

Provision for Taxes + Provision for Depreciation =
90,000

• Current Ratio = 170000/90000 = 1.889 : 1

Poll Question:
Calculate Quick Ratio from the given details.
Current Liabilities 65,000

Current Assets 85,000

Stock 20,000

Advance Tax 5,000

Prepaid Expense 10,000

A) 0.84:1
B 0.80:1
C) 0.77:1
• Solution:
Quick Ratio = Quick Assets/ Current Liabilities

Quick Assets = All Current Assets – Stock – Prepaid

Expenses = 85000 – (20000+5000+10000) = 50,000

Quick Liabilities = All Current Liabilities – Bank Overdraft –

Cash Credit = 65,000

Quick Ratio = 50000/65000 = 0.77:1

 Solvency Ratios
• Capacity or ability of the business to meet its long term
obligations or to repay its loan and interest.

• When an organization's assets are more than its

liabilities is known as solvent organization

• Share holder's, debenture holders and long term

creditors like financial institutions are interested in
these ratios.
 Solvency Ratios/
Leverage Ratios

• Debt-Equity Ratio

• Debt Ratio

• Proprietary Ratio

• Capital Gearing Ratio

• Interest Coverage Ratio

 DEBT-EQUITY RATIO
It is calculated to measure the relative claims of
outsiders and the owners against the firm assets.
Objective :The objective is to measure the relative
proportion of debt and equity in financing the
assets of a firm.
𝐷𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
𝐸𝑞𝑢𝑖𝑡𝑦
or
Outsiders’ Funds
𝐷𝑒𝑏𝑡 − 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 =
Shareholders’ Funds
Outsiders’ Funds= short-term debt, long-term debt and other
fixed payment obligations of a business that are incurred
while under normal operating cycles.

Shareholders Funds/Equity =
Equity Share Capital + Preference Share Capital + Reserves
and Surpluses
 Debt-Equity Ratio

Debt to equity ratio = Long term debt /

shareholder’s funds
Or

Debt to equity ratio = total liabilities /

shareholders’ equity
• For instance, if the Firm is having the
following :

Share Capital = Rs. 200 Lacs

Reserves & Surplus = Rs. 300 Lacs
Long Term Loans/Liabilities= Rs. 800 Lacs
Interpretation:-
• Analyses the long term financial performance
of the business
• It indicates the margin of safety to long –
term Debt.
• A low debt equity ratio implies the use of more
equity than debt which means a larger safety
margin for Debt.
• An acceptable norm for this ratio is considered
to be 1:1
 Calculate Debt-Equity Ratio
• Preference Share Capital= 3,00,000
• Equity Share Capital=11,00,000
• Capital Reserve= 5,00,000
• Profit= 2,00,000
• Debentures= 5,00,000
• Sundry Creditors= 2,40,000
• Bills Payable= 1,20,000
• Provision for Taxation= 1,80,000
• Outstanding Creditors= 1,60,000
 Debt Ratio
• Debt ratio is a financial ratio that is used in measuring a
company’s financial leverage. It is calculated by taking
the total liabilities and dividing it by total capital. If the
debt ratio is higher, it represents the company is riskier.
• The long-term debts include bank loans, bonds payable,
notes payable etc.

Debt Ratio = Long Term Debt / Capital Employed

Or Debt Ratio= Long Term Debt/ Total Assets

Capital Employed = Long Term Debt + Shareholders Funds

• Low debt to capital ratio is indicative of a
business that is stable
• while a higher ratio casts doubt about a firm’s
long-term stability.
• Trading on equity is possible with a higher
ratio of debt to capital which helps generate
more income for the shareholders of the
company.
 Proprietary Ratio
• Indicates the long term or the future solvency
position of the business
• This ratio relates the shareholders’ funds to total
assets
Equity Ratio = Shareholder’s funds / Capital
Employed
or
Shareholder’s funds / Total Assets

• Shareholders’ Funds include Equity and preference share

capital plus all reserves and surplus items
• Capital Employed = Long Term Debt + Shareholders Funds
 Proprietary Ratio
Objective:
The objective is to find out how much the
proprietors have financed for the purchases of
assets.
Interpretation:
This ratio indicates the extent to which the assets
of the firm have been financed out by proprietors’
fund.
 Calculate Proprietary Ratio
• Preference Share Capital= 3,00,000
• Equity Share Capital=11,00,000
• Capital Reserve= 5,00,000
• Profit and loss Account= 2,00,000
• Debentures= 5,00,000
• Sundry Creditors= 2,40,000
• Bills Payable= 1,20,000
• Provision for Taxation= 1,80,000
• Outstanding Creditors= 1,60,000
• Shareholders’ Funds= 21,00,000

• Total Liabilities (Total Assets)=

33,00,000

21,00,000
𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑜𝑟𝑦 𝑅𝑎𝑡𝑖𝑜 = = 0.64 or 7:11
33,00,000
 Proprietary Ratio
• Proprietary Ratio: Ideal ratio : 0.5:1

• Higher the ratio better the long term solvency

(financial) position of the company.

• This ratio indicates the extent to which the

assets of the firm have been financed out by
proprietors’ fund.
 Capital Gearing Ratio
Objective: The objective is to find proportion of fix return
(interest/ dividend) bearing security to equity share capital in
total capital of firm.

𝑫𝒆𝒃𝒕+𝑷𝒓𝒆𝒇. 𝑺𝒉𝒂𝒓𝒆𝒔
Capital Gearing Ratio =
𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
Interpretation:-Gearing should be kept in such a way that
the company is able to maintain a steady rate of dividend.
High gearing ratio is not good for a new company or a
company in which future earnings are uncertain.

Highly Geared: Low equity share capital

Low Geared: High equity share capital

Calculate Capital Gearing Ratio for the
year 2010 and 2011
2010 2011

Equity Share Capital 5,00,000 4,00,000

Reserves and Surplus 3,00,000 2,00,000

Preference Share Capital 2,50,000 3,00,000

Debentures 2,50,000 4,00,000

 Interest Coverage Ratio
• To measure the debt servicing capacity of a firm so far
fixed interest on long – term
debt and debenture is concerned.
Interest Coverage Ratio =
PBIT/ Interest On Loan

• Higher the ratio, greater the firm’s ability to

pay interest but very high ratio may imply
lesser use of debt and very efficient
operations.
• Interest coverage ratio shows the number of times the
amount of interest on long – term debt is covered by
the profits out of which that will be paid.

• It indicates the limit beyond which the ability of the firm

to service its debt would be adversely affected.

• Higher the ratio, greater the firm’s ability to pay interest

but very high ratio may imply lesser use of debt and
very efficient operations.
ROE has been defined as :

ROE = Net Income

Average net worth

Now this can be written as a combination of the:

•Margin on sales ratio,

•Assets efficiency ratio,
•Financial leverage ratio.
ROE =

Net Income x Sales x Total Assets

Sales Total Assets Average Net Worth

ROE= NPM X Total Assets turnover X Equity Multiplier

NPM stand for Net profit margin

TAT stand for Assets Efficiency
EM stands for Equity Multiplier
 DuPont Anaysis

The Du Pont break up conveys that one can maximize profitability (ROE)
by focusing on Playing a margin based game, assets utilization and financial
leverage game.

It helps in identifying & pinpointing the reasons behind high or low

profitability of a firm with its competitors or industries or economies.

Profitability = Margin game x

Volume Game x
Financial leverage game.
Banking Industry = Deposits & Loans (Focus on
financial leverage game)

Automobile sector= Margin based &

Volume based.

FMCG Sector= Margin games

Calculate Solvency Ratios
Calculate (a) Current Ratio (b)Liquid Ratio (c)Debt-
Equity Ratio (d)Proprietary Ratio (e)Capital Gearing
Ratio
Liabilities Rs Assets Rs
Equity Share 5,00,000 Land & Building 6,00,000
Capital
Preference Share 2,00,000 Plant and Furniture 5,00,000
Capital
Reserves and 3,00,000 Stock 2,40,000
Surplus
Debentures 4,00,000 Sundry Debtors 1,95,000
Sundry Creditors 1,50,000 Cash in Hand 60,000
Bank Overdraft 50,000 Prepaid Expenses 5,000
 Profitability
• Profitability is a measure of efficiency and Control

• Profitability measures look at how much profit the

firm generates from sales or from its capital
assets

• Measures efficiency of business operations

 Types of Profitability Ratio

In relation to Sales In relation to Investment

a) Gross profit ratio a) Return on Cap. Employed
b) Net profit Ratio b) Return on Equity
c) Operating Ratio c) Return on equity shareholder
fund
d) Return on equity share capital
e) Earning per share
f) Return on total assets
 Gross Profit Ratio
• to determine the efficiency with which production and/or
purchase operations are carried on.
Interpretation:
This ratio indicates (a) an average gross margin
earned on a sale of Rs. 100,
(b) the limit beyond which the fall in sales prices
will definitely result in losses.
(c) what portion of sales is left to cover operating
expenses and non – operating expenses like to pay
dividend and to create reserves.
 Gross Profit Ratio
Higher the ratio, the more efficient the
production and /or purchase management. This
ratio may increase due to one of the following
factors:
(i) Higher Sales Prices with constant Cost of
Goods Sold;
(ii) Lower Cost of Goods Sold with constant
Sales Prices;
(iii) A combination of aforesaid two factors.
 Calculate Gross Profit Ratio:

• Opening Stock = 25,000

• Purchases= 80,000
• Closing Stock= 35,000
• Purchase Returns= 2000
• Sales= 1,05,000
• Sales Returns= 5,000
 Net Profit Margin
The objective is to determine the overall profitability due to
various factors such as operational efficiency.

• After considering all non operating incomes such

as interest on investments, dividend received,
etc.
• All the non-operating expenses such as loss on
sale of assets, provision for contingent liabilities,
etc.
Interpretation:
• This ratio indicates
(a) an average net margin earned on a sale of Rs.
100
(b) what portion of sales is left to pay dividend
and to create reserves, and
(c) firm’s capacity to withstand adverse economic
conditions when selling price is declining.
 Operating Profit Ratio
• This ratio helps to analyze a firm’s operational efficiency

Operating Profit Ratio=

Operating Profits/ Net Sales *100

• Operating Profit = Gross profit + Other Operating

Income – Other operating expenses
• Revenue From Operations (Net Sales) = (Cash
sales + Credit sales) – Sales returns
High – A high ratio may indicate better management of
resources
• i.e. a higher operational efficiency leading to higher
operating profits in the company.

Low – A low ratio may indicate operational flaws and

improper management of resources,
Example
Ques. Calculate Operating profit ratio from the below information

Sales 6,00,000

Sales Returns 1,00,000

Operating Profit 1,00,000

• Operating Profit Ratio = (Operating Profit/Net
Sales)*100
• (1,00,000/5,00,000)*100
• = 20%

This means that for every 1 unit of net sales the

company earns 20% as operating profit.
 Operating Ratio
To determine the operational efficiency with which production
and /or purchases and selling operations are carried on.
Also called Operating Cost Ratio or Operating Expenses Ratio

Operating Cost
Operating Ratio = ∗ 𝟏𝟎𝟎
Net Sales

• Operating Cost= Cost of Goods Sold + Operating

Expenses
• Operating expenses include
A. Office and Administration Expenses
B. Selling and Distribution Expenses
Interpretation:-
• This ratio indicates an average operating cost
incurred on sales of goods worth Rs. 100.

• Lower the ratio, greater is the operating profit

to cover the non – operating expenses, to pay
dividend and to create reserves and vice–
versa.
Compute the Operating Ratio

• Total Sales= 2,65,000

• Sales Returns=15,000
• Cost of Goods Sold= 1,75,000
• Administrative Expenses= 15000
• Selling & Distribution Expenses= 10,000
 Return on Capital Employed/
Return on Investment
The objective is to find out how efficiently the
long – term funds supplied by the Debenture
holder and shareholders have been used.

Higher the ratio, the more is the efficient the management

and utilization of Capital Employed.
 Return on Equity
The objective is to find out how efficiently the
funds belonging to the shareholders (equity and
preference) have been used.

This ratio indicates the firm’s ability of generating

profit per 100 rupees of shareholders’ funds.
Higher the ratio, the more efficient the
management and utilization of shareholders’
funds is.
 Return on Equity Shareholder
fund
The objective is to find out how efficiently the
funds supplied by the equity shareholders have
been used.

This ratio indicates the firm’s ability of generating

profit per 100 rupees of equity share capital.
Higher the ratio, the more efficient the management
and utilization of equity shareholders’ Capital is.
 Earning Per Share
The objective is to measure the profitability of
the firm on per equity share basis.

A higher EPS indicates more value because

investors will pay more for a company with
higher profits.
It also helps in estimating the company’s capacity
to pay dividend.
 PRICE EARNING RATIO
• The price-earnings ratio, often called as P/E
ratio is the ratio of company’s stock price to
the company’s earnings per share.
𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
P/E Ratio =
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝑷𝒆𝒓 𝑺𝒉𝒂𝒓𝒆

• It is a market prospect ratio which is useful in

valuing companies.
• Market Price per Share: is the price of each
share in the open market or how much it
would cost to buy a share of stock.
 Activity Ratios
Activity ratios are also called turnover ratios.
Activity ratios measure the efficiency with which
the resources of a firm are employed.

• Capital Turnover Ratio

• Fixed Assets Turnover
• Stock Turnover Ratio
• Debtor Turnover Ratio
• Creditor Turnover Ratio
 Capital Turnover Ratio
• It is the relationship between cost of goods
sold and the capital employed.
• to determine the efficiency with which the
capital employed is utilized.
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝑹𝒂𝒕𝒊𝒐 =
(𝑨𝒗𝒈. )𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅

Interpretation:
• It indicates the firm’s ability to generate sales
per rupee of capital employed.
• Higher the ratio, the more efficient the
management and utilization of capital
employed is.
 Fixed Asset Turnover
• To determine the efficiency with which the
fixed assets are utilized.
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔
𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑨𝒗𝒈. 𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔

Interpretation
• It indicates the firm’s ability to generate sales
per rupee of investment in fixed assets.

• Higher the ratio, the more efficient the

management and utilization of fixed assets is
and vice versa.
 Stock Turnover Ratio
• To determine the efficiency with which the inventory is
utilized.

• Stock Turnover Ratio = COGS

• Average Stock

Interpretation:-
• It indicates the speed with which the inventory is
converted into sales.
• a high ratio indicates efficient performance. However,
too high ratio and too low ratio should be called for
further investigation.
 Stock Turnover Ratio
• A too high ratio may be the result of a very low
inventory levels which may result in frequent stock –
outs and thus the firm may incur high stock – out costs.
• On the other hand, a too low ratio may be the result of
excessive inventory levels, slow moving or obsolete
inventory and thus, the firm may incur high carrying
costs.
• Thus, a firm should have neither very high ratio nor low
ratio.
• (Stock out means customer going out of shop due to
unavailability of stock.)
 Debtors’ Turnover Ratio/
Accounts receivable turnover
• It is an efficiency ratio or activity ratio that measures how
many times a business can turn its accounts receivable into
cash during a period.
• In other words, the accounts receivable turnover ratio
measures how many times a business can collect its average
accounts receivable during the year.
ART = Net credit sales
Avg (Debtors + Bills Receivables)
or

ART = Net credit sales

Avg (Account Receivables)
 High and Low Debtor’s Turnover Ratio

A high ratio may indicate

• Low collection period allowed to customers.
• The company may operate majorly on the cash basis.
• Company’s collection of accounts receivable is efficient.
• A high proportion of quality customers pay off their debt quickly.
• The company is conservative with regard to the extension of
credit.

A low ratio may indicate

• • High collection period allowed to customers.
• Good credit period availed by the company from its suppliers.
• The company may have a high amount of cash receivables for
collection.
Debtors Collection Period

= 1/ART *365 days

• Calculate debtor’s turnover ratio from the
information provided below;
• Total Sales – 5,00,000
• Cash Sales – 2,00,000
• Debtors (Beginning of period) – 50,000 &
Debtors (End of period) – 1,00,000
Debtor’s turnover ratio or Accounts receivable turnover
ratio = (Net Credit Sales/Average Trade Receivables)

Net Credit Sales = Total Sales – Cash Sales

• = 5,00,000 – 2,00,000
• Net Credit Sales = 3,00,000
Average Trade Receivables = (Opening Trade
Receivables + Closing Trade Receivables)/2
• = (50,000 + 1,00,000)/2
• = 75,000
• Ratio = (3,00,000/75,000) => 4/1 or 4 times
Calculate Receivables Turnover Ratio
in times and days
• Gross Credit Sales= 1,00,000
• Returns= 10,000
• Account Receivables, Beginning of the year=
10,000
• Account Receivables, End of the year= 15,000
 Creditors Turnover Ratio
or
Accounts Payable Turnover Ratio
• Accounts payable are short-term debt that a company
owes to its suppliers and creditors.
• The accounts payable turnover ratio shows how efficient
a company is at paying its suppliers and short-term
debts.
Creditors turnover ratio=
Net credit purchase / Average (Accounts Payable)
or
Creditors turnover ratio=
Net credit purchase / Creditors + Bills Payable
 Creditors’/ Average Payment
Period
• Average Payment Period =
Average (Accounts Payable) * 365 days
Net credit purchase
 High and Low Creditor’s Turnover Ratio

• A high ratio may indicate

• Low credit period available to the business or early
payments made by the business.
• The company may operate majorly on the cash
basis.
• The company is not availing full credit period.

• A low ratio may indicate

• • Creditors are not paid in time.
• Increased credit period is allowed to the business.
• Calculate creditor’s turnover ratio from the
information provided below;
• Total Purchases – 5,00,000
• Cash Purchases – 2,00,000
• Creditors (Beginning of period) – 50,000 &
Creditors (End of period) – 1,00,000
• Net Credit Purchases = Total Purchases – Cash
Purchases = 5,00,000 – 2,00,000

Net Credit Purchases = 3,00,000

Average Trade Payables = (Opening Trade Payables +
Closing Trade Payables)/2
• = (50,000 + 1,00,000)/2
• = 75,000
Ratio = (3,00,000/75,000) => 4/1 or 4:1
Accounts Payable Turnover Ratio
for ABC company
• Total supplier purchases: $1,00,000
• Beginning A/P balance: $25,000
• Ending A/P: $50,000
 Total Asset Turnover Ratio
• How efficiently assets are employed in
business.

Interpretation:
• This ratio suggests how a rupee of asset
contributes to earn sales more the ratio more
efficiently assets are used in gainful operation.
 Working capital turnover
It measures how efficiently a company is using its working
capital (current assets minus current liabilities) to support
a given level of sales.
Also referred to as net sales to working capital, work
capital turnover shows the relationship between the funds
used to finance a company's operations and the revenues
a company generates as a result.

Working capital turnover ratio =

Net sales / Working capital
Opening Stock Rs. 76,250,
Closing stock Rs. 98,500,
Gross Profit Rs. 200000,
Net Profit Rs. 84000, and
Sales Rs. 500000.

Calculate a) Gross Profit Ratio

b) Net Profit Ratio and
c) Stock Turnover Ratio.
Calculate debt equity ratio from the
following values:

• Short-Term Liabilities Rs. 25,000,000,

• Long-Term Liabilities Rs. 50,000,000,
• Equity Rs. 300,000,
• Paid In Capital Rs. 22,000,000,
• and Retained Earnings Rs. 6,250,000.
 Interest Coverage Ratio
• To measure the debt servicing capacity of a firm so far
fixed interest on long – term
debt and debenture is concerned.
Interest Coverage Ratio =
PBIT/ Interest On Loan

• Higher the ratio, greater the firm’s ability to

pay interest but very high ratio may imply
lesser use of debt and very efficient
operations.
• Interest coverage ratio shows the number of times the
amount of interest on long – term debt is covered by
the profits out of which that will be paid.

• It indicates the limit beyond which the ability of the firm

to service its debt would be adversely affected.

• Higher the ratio, greater the firm’s ability to pay interest

but very high ratio may imply lesser use of debt and
very efficient operations.
• Expenses Ratio=
Operating Expenses/ Net Sales
*100
 Working capital turnover
It measures how efficiently a company is using its working
capital (current assets minus current liabilities) to support
a given level of sales.
Also referred to as net sales to working capital, work
capital turnover shows the relationship between the funds
used to finance a company's operations and the revenues
a company generates as a result.

Working capital turnover ratio =

Net sales / Working capital
 Total Asset Turnover Ratio
• How efficiently assets are employed in
business.

Interpretation:
• This ratio suggests how a rupee of asset
contributes to earn sales more the ratio more
efficiently assets are used in gainful operation.
 Interest Coverage Ratio
• To measure the debt servicing capacity of a firm so far
fixed interest on long – term
debt and debenture is concerned.
Interest Coverage Ratio =
PBIT/ Interest On Loan

• Higher the ratio, greater the firm’s ability to

pay interest but very high ratio may imply
lesser use of debt and very efficient
operations.
• Interest coverage ratio shows the number of times the
amount of interest on long – term debt is covered by
the profits out of which that will be paid.

• It indicates the limit beyond which the ability of the firm

to service its debt would be adversely affected.

• Higher the ratio, greater the firm’s ability to pay interest

but very high ratio may imply lesser use of debt and
very efficient operations.
• Expenses Ratio=
Operating Expenses/ Net Sales
*100
Calculate debt equity ratio from the
following values:

• Short-Term Liabilities Rs. 25,000,000,

• Long-Term Liabilities Rs. 50,000,000,
• Equity Rs. 300,000,
• Paid In Capital Rs. 22,000,000,
• and Retained Earnings Rs. 6,250,000.
Before looking at the ratios there are a number of cautionary points
concerning their use that need to be identified :

a. The dates and duration of the financial statements being compared

should be the same. If not, the effects of seasonality may cause
erroneous conclusions to be drawn.

b. The accounts to be compared should have been prepared on the same

bases. Different treatment of stocks or depreciations or asset
valuations will distort the results.

c. In order to judge the overall performance of the firm a group of ratios,

as opposed to just one or two should be used. In order to identify
trends at least three years of ratios are normally required.
 LIMITATIONS

Comparative study required:

• Ratios are useful in judging the efficiency of the business
only when they are compared with the past results of the
business or with the results of a similar business.
• Also forecasts for future may not be correct since several
other factors like market conditions, management policies,
competition, local factors etc., may affect the future
operations.
Ratios alone are not adequate:
• Ratios are only indicators; they cannot be taken as final
judgment 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
current assets mostly comprise of outdated stocks.
Window dressing:
• The term window dressing means manipulation of
accounts in a way so as to conceal vital facts and
present the financial statements in a way to show a
better position than what it actually is,
• On account of such a situation, presence of a particular
ratio may not be a definite indicator of 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 of closing stock or failure
to maintain proper stock of goods.
4. Problems of price level changes:
• Financial analysis based on accounting ratios will give
misleading results if the effects of changes in price level
are not taken into account.

• For example, two companies set up in different years,

having plant and machinery of different ages, cannot be
compared, on the basis of traditional accounting
statements. This is because the depreciation charged on
plant and machinery in case of old company would be at
a much lower figure as compared to the company which
has been se up recently.
No fixed standards:
• No fixed standards can be laid down for ideal ratios. For
example,
• current ratio is generally considered to be ideal if
current assets are twice the current liabilities. However,
in case of those concerns which have adequate
arrangements with their banks for providing funds when
they require, it may be perfectly ideal if current assets
are equal to slightly more than current liabilities.
• It is therefore necessary to avoid many rules of thumb.
Inaccurate base:
• The accounting ratios can never be more correct than the
information from which they are computed. If the
accounting data is not accurate, the accounting ratios
based on these figures would give misleading results.
Investigation necessary:
• It must be remembered that accounting ratios are only a
preliminary step in investigation. They suggest areas
were investigation or inquiry is necessary. It can never
be used as conclusion.
Rigidity harmful:
• If in the use of ratios, the manager remains rigid and
sticks to them, it will lead to dangerous situation.
• For example, if the manager believes the current ratio
should not fall below 2: 1, then many profitable
opportunities will have to be foregone.