Ratio Analysis

Ratio is an arithmetical relationship between two or more numbers.

Accounting Ratio is a relationship between two or more numbers taken from financial
statements.

Ratio analysis means calculation of accounting ratios for proper interpretation of

financial statements.

Accounting Ratios are calculated to measure ………..

1. Solvency Position
2. Level of Efficiency
3. Profitability
4. Liquidity
5. Capital Structure of Business Organisation

Accounting Ratios can be expressed in three different ways……

1. Pure Ratio : It is the ratio where second digit in the ratio is always 1.
2. Percentage Ratio : It is the ratio expressed in terms of %.
3. Rates : It is the ratio expressed in No. of times.

Depending upon financial statements form where the figures are taken, there are three types
of Accounting Ratios……..

RATIOS
│
↓ ↓ ↓
BALANCE SHEET REVENUE STATEMENT COMPOSITE
RATIOS RATIOS RATIOS

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I. BALANCE SHEET RATIOS:
1. CURRENT RATIOS (WORKING CAPITAL RATIO)

A. FORMULA:

Current Assets
Current Liabilities

B. MEANING:

Current assets are short term assets i.e. ability of the assets to generate cash within a
short period of time which is less than one year.
Similarly, current liabilities are short term liabilities which become payable within a year’s
time.

C. SIGNIFICANCE:

By comparing current assets with current liabilities, an attempt is made to find out whether or
not company has enough liquidity to meet its obligations.

D. GENERAL STANDARD: 2:1

Current assets must be at least twice the current liabilities which will suggest a comfortable
position. Higher the current ratio better the financial position.

E. WINDOW DRESSING

It is a deliberate manipulation in the books of accounts to improve upon an

unfavourable Current Ratio.

e.g. Let current assets be Rs. 25,000 and current liabilities be Rs. 15,000 and therefore,
Current Ratio = 1.67 : 1 (Unfavourable).

To improve the above current ratio, a fictitious payment of Rs. 5,000 shall be shown in the
books of accounts which will affect the current ratio in the following manner……

Current Assets
= 25,000 – 5,000
= 20,000

Current Liabilities
= 15,000 – 5,000
= 10,000

Therefore,

Current Ratio = 2 : 1 (Favourable)

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2. QUICK RATIO (LIQUID RATIO / ACID TEST RATIO)

A. FORMULA:

Quick Assets
Quick Liabilities

B. MEANING:

Quick Assets means such current assets which can realised cash at a short notice while
Quick liabilities are such current liabilities which become due at a short notice.

C. SIGNIFICANCE:

This ratio is calculated to find out whether or not company has the ability to meet its
current obligations at a very short notice. In other words, Quick ratio tests company’s
solvency position.

Quick Assets = Current Assts – Stock – Prepaid Expenses

Quick Liabilities = Current liabilities – Bank overdraft – Income received in advance

D. GENERAL STANDARD: 1:1

For every Rupee 1 of Quick liabilities, Quick assets must also be equal to Rupee 1.

3. DEBT EQUITY RATIO

A. FORMULA:

Debt
Equity

B. MEANING:

Debt means borrowed fund while Equity means shareholders fund.

C. SIGNIFICANCE:

This ratio indicates extent of company’s dependence on share holders for the funds
employed. Since, there is not General Standard, following possibilities may arise….

If the ratio is < 1, it means that company has shown greater dependence on share holders.
This will provide financial stability but returns to share holders will be poor.

If the ratio is > 1, it means that company has shown greater dependence on outsiders. This
will affect financial stability. However, returns to share holders will be high.

II. REVENUE STATEMENT RATIOS

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1. GROSS PROFIT RATIO

A. FORMULA:

Gross Profit x 100

Net sales

B. SIGNIFICANCE:

This ratio indicates profitability of the Product.

2. EBIT MARGIN RATIO

A. FORMULA:
EBIT x 100
Net sales

B. MEANING;

EBIT= Net Profit before Tax + Interest on Borrowed funds

C. SIGNIFICANCE:

This ratio indicates the level of profitability before Interest and Tax burden with reference
to net sales.

3. NET PROFIT RATIO

A. FORMULA;

Net profit After Tax x 100

Net Sales

B. SIGNIFICANCE;

This ratio indicates profitability of Business.

4. STOCK-TURNOVER RATIO OR INVENTORY TURNOVER RATIO

A. FORMULA:

Cost of Goods Sold

Average Stock

B. MEANING;

Average Stock = Opening Stock + Closing Stock

2.

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Note: When opening stock is not given, closing is taken as Average Stock.

C. SIGNIFICANCE:

This ratio indicates the No. of times, stock is getting converted into sales during. The rapidity
with which stock gets converted into sales depends upon demand for company’s product. A
highly efficient management will be successful in sustaining demand for the product at a
constant rate. It means that any fluctuation in stock-turnover will indicate lack of efficiency..

5. STOCK-VELOCITY OR INVENTORY HOLDING PERIOD

A. FORMULA:

Average Stock X 365 days

Cost of Goods Sold

B: SIGNIFICANCE:

This ratio indicates the No. of times, stock is getting converted into sales during. The rapidity
with which stock gets converted into sales depends upon demand for company’s product.
Higher the Stock-turnover better will be the liquidity of company which depends on Stock
holding period or stock velocity

6. OPERATING CYCLE TIME

A. FORMULA:

= IHP + DCP - CPP

OR

= SV + DV - CV

IHP = INVENTORY HOLDING PERIOD OR STOCK VELOCITY

DCP = DEBTORS COLLECTION PERIOD OR DEBTORS VELOCITY

CPP = CREIDTORS PAYMENT PERIOD OR CREDITORS VELOCITY

B: SIGNIFICANCE:

This ratio indicates the liquidity available with company for business operations

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III. COMPOSITE RATIOS
1. RETURN ON CAPITAL EMPLOYED (RETURN ON INVESTMENT – ROI )

A. FORMULA:

EBIT x 100
Capital employed

B. MEANING

EBIT = Earnings Before Interest and Tax.

In other words, it means Net Profit Before Tax + Interest on Borrowed Fund

Interest on Borrowed Fund will include interest on debentures, interest on secured and
unsecured loans. Interest on Bank Overdraft is not considered since, Bank Overdraft is
current liability.

C. SIGNIFICANCE:

This ratio indicates profitability with reference to total funds invested.

2. RETURN ON PROPRIETOR’S FUNDS (RETURN ON NET WORTH)

A. FORMULA:

Net Profit After Tax x 100

Proprietor’s Fund

B. SIGNIFICANCE:

This ratio indicates profitability with reference to shareholders fund.

3. RETURN ON EQUITY SHARE CAPITAL

A. FORMULA:

Net Profit After Tax – Preference Dividend x 100

Equity share capital

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B. SIGNIFICANCE;

This ratio indicates profitability with reference to Equity share capital.

EARNING PER SHARE (EPS)

This ratio is a variant of Return on Equity share capital. Return is calculated not as a
percentage but, in the form of profit earned per share.

EPS = Net Profit After Tax – Preference Dividend

No. of Equity shares

4. DEBTORS TURNOVER RATIO

A. FORMULA:

Credit sales
Debtors + B/R

B. MEANING:

Debtors will always be taken at ‘Gross’ i.e. before deducting provision for doubtful debts.
Similarly, Debtors will include Trade Debtors only.

C. SIGNIFICANCE:

This ratio indicates No. of times amount is realised from debtors in a year. The rapidity with
which debtors will realise cash will depend upon period of credit allowed to debtors.
Such a credit period is called as ‘Debtors Velocity’. (Speed)

Debtors Velocity is calculated as follows………

Debtors Velocity = 12months / 52weeks / 365 days

Debtors Turnover

= 12months / 52weeks / 365 days

Credit sales
Debtors + B/R

= Debtors + B/R x 12months / 52weeks / 365 days

Credit Sales

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5. CREDITORS TURNOVER RATIO

A. FORMULA:

Credit purchases
Creditors + B/P

B. MEANING:

Creditors will include Trade Creditors only.

C. SIGNIFICANCE:

This ratio indicates No. of times amount is paid to creditors in a year. No. of payments made
to the creditors will depend upon period of credit allowed by creditors. Such a credit period is
called as ‘Creditors Velocity’. (Speed)

Creditors Velocity is calculated as follows………

Creditors Velocity = Creditors + B/P x 12months / 52weeks / 365 days

Credit purchases

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FUNCTIONAL CLASSIFICATION OF RATIOS

I) SOLVENCY POSITION

1. Current Ratio (Short-Term)

2. Quick Ratio (Immediate)

II) LEVEL OF EFFICIENCY

1. Stock Turnover Ratio (Efficiency in Stock Management)

2. Debtors Turnover Ratio (Efficiency in Debtors Management)

III) LIQUIDITY

1. Stock Turnover Ratio

2. Debtors Turnover Ratio

IV) PROFITABILITY
A. With reference to Sales
1. Gross Profit Ratio
2. EBIT margin Ratio
3. Net Profit Ratio

B. With reference to funds employed

1. Return on Capital Employed
2. Return on Proprietors Fund
3. Return on Equity share Capital

V) CAPITAL STRUCTURE
1. Debt Equity Ratio

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ADDITIONAL RATIOS
1. Earning Per Share (EPS)

A. FORMULA:

Net profit After Tax – Preference Dividend

No. of Equity shares

B. SIGNIFICANCE:

This ratio indicates the profit available for distributing among the Equity shareholders. In other
words, this ratio indicates the profit that can be distributed per Equity share among
shareholders.

2. Dividend Per Share (DPS)

A. FORMULA:

Actual Equity dividend paid

No. of Equity shares

B. SIGNIFICANCE:

This ratio indicates the profits i.e. actually distributed among the Equity shareholders with
reference to No. of Equity Shares.

3. Dividend Pay-out Ratio

A. FORMULA:

DPS x 100
EPS

B. SIGNIFICANCE:

This ratio indicates the relationship in terms of % between the profits that can be distributed
and the profits actually distributed among the share holders.

4. Price Earning Ratio

A. FORMULA:

Market Value Per share

EPS

B. SIGNIFICANCE:

In this ratio, the Earning per share is compared with market value per share.
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5. Debt Service Coverage Ratio.

A. FORMULA:

Earnings Before Interest and Tax (EBIT)

Interest on Borrowed Funds + Preference Dividend + Principal amt. of loan repayment

B. SIGNIFICANCE:

This ratio verifies the capacity of company to repay its borrowed funds alongwith interest
thereon. Higher ratio indicates that the company has enough liquidity to pay interest and
repay principal amount of loan.

6. Debt Service Ratio.

A. FORMULA:

Earnings Before Interest and Tax

Interest on Borrowed Funds

B. SIGNIFICANCE:

This ratio verifies the capacity of company to pay interest on borrowed funds.

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