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RATIO ANALYSIS AND BREAK-EVEN POINT

Meaning of Ratio

Absolute numbers tell very little. Assume that two companies A and B, operating
within the same industry supply the information:

One can easily say that Company B makes the most profit. But which company is
most profitable? The answer for this will naturally call for further additional
information relating to profit such as size of the company, the total sales it generates
or to how much capital is invested in it. Hence, an assessment or a judgment is made
based on making some sort of comparison. Extending the example,

If net profit is compared with Sales, an assessment can be made on which company
generates the most net profit per Re.1 received from customers. Company A : Net
Profit/ sales * 100 i.e. 5 percent and Company B it is 20 percent. If the net profit is
expressed in terms of investments made by the owners in each company, it is Net
Profit / Net worth *100. For Company A, it is 10% and for it is 25%. It is also known
as Return on Capital Employed. ROCE. Ratios are useful in two ways:

1. To make inter-business comparisons

2. To make comparisons across financial periods

A ratio is simply one number expressed in terms of another. It is a means of

highlighting in arithmetical terms the relationship between figures drawn from
various financial statements. Therefore, it refers to the numerical or quantitative
relationship between two variables or items. A ratio expresses simply in one number
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the result of comparison between two figures. It is calculated by dividing one figure
by the other. The quotient so obtained is the ratio of the figures.

Ratio can be expressed in the following three forms: 1. As proportion

2. As percentage

3. As turnover or rate

The Dictionary meaning of Analysis is “separation or breaking up of anything into its

elements or component parts”. Ratio Analysis is, therefore, a technique of analysis
and interpretation of financial statements. Ratio analysis is the process of establishing
and interpreting various ratios for helping in making certain decisions. It involves the
methods of calculating and interpreting financial ratios to assess the firm’s
performance and status.

Meaning Of Ratio Analysis

The Dictionary meaning of Analysis is “separation or breaking up of anything into its

elements or component parts”. Ratio analysis is therefore a technique of analysis and
interpreting various ratios for helping in making certain decisions. It involves the
methods of calculating and interpreting financial ratios to assess the firm’s
performance and status

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Scope

The ratio analysis is one of the most powerful tools of financial analysis. The firm is
answerable to the owners, the creditors and employees. The firm can reach a number
of parties. On the other hand, parties interested in the business can compute ratios
based on the financial statements of the firm. The analysis is not restricted to any one
aspect but takes into account all aspects such as earning capacity of the firm, financial
obligation, liquidity and solvency aspects, liquidity and profitability concepts.

Objectives of Ratio Analysis

Interpreting the financial statements and other financial data is essential for all
stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial
analysis and financial management. Let us take a look at some objectives that ratio
analysis fulfils.

What Does Ratio Analysis Tell You?

Investors and analysts employ ratio analysis to evaluate the financial health of
companies by scrutinizing past and current financial statements. Comparative data
can demonstrate how a company is performing over time and can be used to telegraph
likely future performance. This data can also compare a company's financial standing
with industry averages while measuring how a company stacks up against others
within the same sector.

Advantages

The various advantages of ratio analysis are as follows:

a) Financial Forecasting and Planning

Ratio analysis helps in the financial forecasting and planning activities.

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Ratios based on the past sales are useful in planning the financial position . Based on
this, future trends are set.

b) Decision Making

Ratio analysis throws light on the degree of efficiency. It is also concerned with the
management and utilization of the assets. Thus, it enables for making strategic
decisions.

c) Comparison

With the help of ratio analysis, ideal ratios can be composed. These can be used for
comparison in respect of the firm’s progress and performance, inter-firm comparison
with industry average.

d) Financial Solvency

Ratios are useful tools. It indicates the trends in the financial solvency of the firm.
Long term solvency refers to the financial liability of a firm. It can also evaluate
the short term liquidity position of the firm. .

e) Communication

The financial strength and weaknesses of a firm are communicated in a more easy
and understandable manner by the use of ratios. The information contained in the
financial statements is conveyed in a meaningful manner. It, thus, helps in the
communication and enhance the value of the financial statements.

f) Efficiency Evaluation

It evaluates the overall efficiency of the business entity. Ratio analysis is an effective
instrument which, when properly used, is useful to assess important characteristics of
business liquidity, solvency, profitability. A critical study of these aspects may enable
conclusions relating to capabilities of business.

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g) Control

It helps in making effective control of the business. Actual results can be compared
with the established standard and to take corrective action at the right time.

h) Other uses

Financial ratios are very helpful in the early and proper diagnosis and financial health
of the firm.

Classifications Of Ratios

The diagrammatic representation of ratios are as follows : Liquidity Ratio

It means the liquidity of the firm. Liquidity is the ability of the firm to meet its
current liabilities as they fall due. Since the liquidity is basic to continuous operations
of the firm, it is necessary to determine the degree

of liquidity of the firm. These are important because liquidity is close to the heart of
the firm. A firm may have a high level of long term assets and substantial net income,
but if they do not have enough cash on hand or assets that can be turned into cash
fairly quickly, they will not be able to operate day to day. The liquidity ratios examine

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the current portion of the balance sheet : current assets and current liabilities. The
implicit assumption is that current assets will be used to pay off current liabilities.
This makes sense due to the matching principle (match the maturity of the debt with
the duration of the need) e.g. one would not take a five year bank loan to pay off an
account payable due in thirty days.

There are two ratios that determine how liquid a firm is : the current ratio and quick
ratio.

1) Current Ratio

It is one of the popular financial ratios. It measures the firm’s ability to meet its short
term obligations. This is achieved by comparing the current assets of a business with
its current liabilities.. The formula for current ratio is :

Current Ratio = Current Assets / Current Liabilities Example:

Current Assets

Stock

Debtors

Cash

Current Liabilities Creditors

Bank Overdraft

AB Rs. Rs. 3,000 60,000 16,000 Nil 5,000 Nil

24,000 Nil Nil 10,000

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The liquidity of the firms are determined by the amount of working capital available
to the business. This is defined as current assets minus current liabilities. The current
ratio is not expressed as a percentage but as a proportion. The current ratio of the
above two firms are: 1 for A and 5 for B. The ratio reveals a considerable difference
between the two companies. Company B is five times more liquid than company A.
Company A can only just cover its obligations to creditors in the short term, yet
Company B can cover its obligation to the bank five times over.

Although company A would be less vulnerable if its ratio was higher, it can be argued
that to have a ratio that is too high indicates inefficiency, in that too much working
capital is available, which might be better invested in fixed assets. However, it is
important to identify the specific types of current assets that are excessive such as

1. Excessive stock levels, indicating poor stock control or a decline in sales

volume

2. Excessive debtors, indicating poor credit control and an increasing risk of bad
debts

3. Excessive cash or near cash equivalents, indicating a lack of suitable

investment opportunities in capital projects.

A rule of thumb is that a ratio of 2 : 1 (Rs.2 in current assets for every Re.1 of current
liabilities) is acceptable. However, the current ratio may vary from less than one in
such industries as fast foods to more than two in the telephone apparatus
manufacturing industry. Consequently, it is important too utilize the industry
averages.

A ratio that is much higher than the industry average indicates that the firm may have
excessive current assets. Further investigation may demonstrate the cause of the
excess. One reason may be that the firm is having trouble in the collection of its
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debtors or has high inventory, both of which will be identified through the use of
other ratios. Another reason may be that the firm is holding too much cash or short
term investments which could be earning more money if they were invested in long
term instruments. Still another reason for a high ratio is that the firm may be at a
specific point in its business cycle. The company that sells woolen goods in winter is
expected to have high inventory in November, December, January and high debtors in
February.

A ratio which is much lower than the industry average indicates that the firm is
having liquidity problems, meaning that it may not be able to meet its short term
obligations. Accordingly, an extremely low current ratio should be a red flag to the
company being analysed.

The components of current assets and current liabilities are:

Current Assets: Cash in hand, cash at bank, trade debtors, bills receivable, stock,
prepaid expenses, trade investments, marketable securities

Current Liabilities: Trade creditors, bills payable, bank overdraft, outstanding or

accrued expenses, tax payable, provision for tax, dividends payable.

2) Liquid Ratio

It is also known as Quick Ratio or Acid test Ratio. It is similar to current ratio except
that it excludes inventory which is generally the least liquid current asset. The reason
for eliminating inventory may be due to two primary factors

a. Many types of inventory cannot be easily sold because they are partially
completed items, obsolete items, special purpose items.

b. The items are typically sold on credit. This results in the creation of trade
debtors or bills receivables before being converted into cash.

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Citing the example, in the case of company B, the only current asset that it carries is
stock. The question must be asked : is this level of stock too high or might it be
essential to this type of business ?

As stock is the least liquid of the current assets, prudence requires that liquidity be
looked at in another way. If current assets excluding stock are compared with current
liabilities, a more cautious assessment of the liquidity of the two companies is given..
This ratio is calculated as follows:

Acid Test Ratio = Current assets less Stock / current liabilities The quick
ratios for companies A and B are as follows :

A = 24,000 – 3,000 / 24,000 = 0.875

B = 50,000 – 50,000 / 10,000 = 0

This time the quick ratio indicates that company A has a considerably better liquidity
from this point of view and company B is dangerously insolvent.

Solvency Ratios

The ratios are analysed on the basis of long term financial position of a firm. It is also
known as test of solvency or analysing the debt. Many financial analysts are
interested in the relative use of debt and equity in the firm. Debt refers to outside
borrowings by the firm.

The debt position of a firm indicates the amount of other people’s money being used
in attempting to generate profits. The long term debts are of much importance to the
firm since a firm is expected to commit the payment of periodic interest over the long
run. In addition, repayment of loan after the expiry of maturity date has to be planned.

Since the creditor’s claims must be satisfied before the distribution of earnings to
shareholders, present and prospective shareholders pay close attention to the degree
of indebtedness and ability to repay the debts. Lenders are also equally concerned
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about the indebtedness and the repayment modes. Hence, the solvency of the firm in
particular needs consideration.

1) Debt Ratio

Debt ratios are important because debt is widely considered to be a measure of the
health of the firm and the risk associated with it. If a firm has high debt, they have
fixed payments which must be made. This means that limited funds may be directed
to debt payment (either principal or interest or both) instead of investments. .

The debt ratio is :

Total Liabilities / total assets

This ratio tells you how much of the firm’s assets are financed with debt. A high debt
ratio indicates that the firm may be carrying too much debt. This is of concern to the
firm because it may not be able to repay the debt nor to borrow additional funds they
are needed. Accordingly, a firm in this situation is considered risky because short
term financing is limited and may not be available in an emergency.

A low debt means that the firm has a low level of liabilities compared to its total
assets. Such a ratio indicates that the firm is not risky because it has plenty of
financing available when compared to its need. However, a low ratio may also
indicate that the firm should take on more debt. The reason for this is that the ability
to borrow is considered a resource and a firm with low debt may not be taking
advantage of this resource.

2) Debt : Equity Ratio

The debt : equity ratio is :

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Long term Debt / Shareholder’s equity

The debt-equity ratio deals with the long term liabilities and equity portion of the
balance sheet. Note that shareholders’ equity includes retained earning (Equity may
also be known as net worth). The debt-equity ratio provides information on the
capital structure (relationship between debt and equity) of the firm. Such information
is important because it affects the value of the firm. The value of the firm is important
because it has an impact on the ability to raise funds., either through increased
borrowing or the sale of shares or both.

A high debt-equity ratio indicates a poor capital structure because it signifies that the
firm has high debt in comparison to its level of shareholders’ equity. This means that
the firm’s creditors may be concerned about the repayment of debt, which in turn
leads to high interest rates, which in turn leads to higher required returns on the firm’s
potential investments..

A low debt equity ratio is an indication that the firm is in sound financial position and
therefore is not considered risky. Normally, the debt equity ratio vary tremendously
from industry to industry.

Profitability Ratios

A firm’s profitability can be assessed relative to sales, assets, equity or share value.
The profitability ratios are important because they indicate whether the firm is doing
what it set out to do : make a profit and provide a return to its investors. There are
many measures of profitability. Each relates the returns of the firm with regard to the
sales, assets, equity or share value. As a group, these measures enable to evaluate the
firm’s earnings. The criteria for earnings can be related to a given level of sales,. A
certain level of assets, the owner’s investment or share value.

Earnings result in profits. Without profits, a firm may be handicapped to attract

outside capital. The income statement of the firm shows the total profits earned by the

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firm during the preceding fiscal period. The important ratios which highlight the
profitability of a firm would be as follows:

1) Gross Profit Ratio

It measures the percentage of each sales value remaining after the firm has paid for its
goods. The higher the gross profit margin, the better and lower the relative cost of
merchandise sold. Thus, it serves an important tool in shaping the pricing policy of
the firm. The formula is :

Gross Profit = (Gross Profit / Sales) x 100

Where Gross profit = Sales minus Cost of goods sold (COGS) Net Sales = Cash Sales
+ Credit Sales minus Sales Returns

It is normally expressed as a percentage. If we deduct gross profit ratio from 100, the
ratio of COGS is obtained..

2) Expenses Ratio

These ratios indicate the relationship of various expenses to net sales. Individual
expenses are calculated based on the net sales and indicated as a percentage to net
sales.

3) Net Profit Ratio

It is also known as Net Profit Margin. It measures the percentage of each sales in
rupee after all expenses including taxes have been deducted This ratio provides
considerable insight into the overall efficiency of the business. A higher ratio speaks
about the overall efficiency of the business. It also focuses the attention of the better
utilization of total resources. A lower ratio would mean a poor financial planning and
low efficiency. A net profit margin of 1 percent or less would be unusual for a grocery
store which a net profit margin of 10 percent would be low for a retail stores. It is
divided by net income by net sales. The formula is :
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Net Profit Ratio = (Net Profit after taxes / Net Sales ) x 100

The net profits are calculated after excluding the income tax, the nonoperating
incomes and non-operating expenses. It is expressed as a percentage on net sales..

Activity Ratios

These are used to measure the speed with which various accounts are converted into
sales or

cash. Measures of liquidity are generally inadequate due to the composition of the
firm’s current assets and current liabilities. The activity ratios are also known as
turnover ratios. Some of the turnover ratios are as follows :

Stock Turnover Ratio : STO Debtors Turnover Ratio : DTO Creditors Turnover Ratio
: CTO

1) Stock Turnover Ratio

It commonly measures the activity or liquidity of the firm’s stock.. The STO is also
known as stock velocity. Velocity refers to “speed” with which an object travel. Here,
it is the speed on converting the stock into sales then to cash. It indicates the number
of times the stock has been turned over as cash during a given period of time. It
evaluates the efficiency with which a firm is able to manage its stock.

If the cost of goods sold )COGS) is known, the STO can be calculated as

follows: STO = COGS / Average stock at cost Where COGS

= Net Sales – Gross Profit

Average Stock = Opening + Closing Stock / 2

If COGS is not known, it can be computed as follows: STO = Net Sales / Stock

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2) Debtors Turnover Ratio: DTO

It is also known as Debtors velocity. The birth of debtor comes from credit sales.
Total debtors include the Bills Receivable also. The Bills receivables are written
promise of trade debtors. Trade debtors are normally provided with 3 months credit
time. After the expiry, they will pay cash. Thus, debtors are expected to be converted
into cash within a short period.

Therefore, it is included in the current assets. It is calculated as follows :

DTO = ( Debtors + BR / Net credit sales) x Number of working days

DTO indicates the velocity of debt collection of firm. It indicates the number of times
average debtors convert themselves over into cash during a year. Debtors care should
always be taken on gross value/ Do not deduct the bad debts or provision for doubtful
debts. It is expressed as the number of times.

If DTO is given in months, convert it into a common base period. If it is given

as a number of times, do not reduce it to a base period.

3) Creditors Turnover Ratio : CTO

Creditors come into being out of credit purchases. Creditors include both trade
creditors and bills payables. It is included in the current liability since the payment
has to be made within three months normally. The formula is as follows :

CTO = ( Creditors + Bills Payable / Credit purchases ) x 100

Where credit purchases = Total purchases minus cash purchases.

Leverage Ratio

A firm’s capital structure is the relation of debt to equity as sources of the firm’s
assets.. Normally both the owners and the creditors of the business will be interested
in analysing its capital structure. The ratios that deal with the leverage are as follows :
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1) Capital Gearing Ratio:

It denotes the extent of reliance of a company on the fixed cost bearing securities viz.
the preference share capital and the debentures as against the equity funds provided
by the equity shareholders. The ratio is calculated as:

Capital Gearing Ratio: Fixed cost bearing capital / variable cost bearing
capital

Where fixed cost bearing capital = preference share capital, debentures, long term
bank borrowings.

Variable cost bearing capital = equity share capital, reserves and surplus.

If fixed cost bearing capital is more than the equity capital, i.e. if the ratio is more
than 1, the firm is said to be highly geared. On the reverse, it is low geared.

2) Debt-equity Ratio:

The ratio compares the debt with equity. Debt refers to long term loans and liabilities.

Redeemable Preference shares are also considered as debt. This measure is helpful to
assess the soundness of the long-term financial policies. It determines the relative
stake of outsiders and shareholders in the company Lower the ratio, it is considered
more comfortable for the creditors financial position. 2: 1 is taken as a satisfactory
debt – equity ratio. However, it is not a very satisfactory measure. since the nominal
values may bear very little relationship to their current market values. The calculation
is as follows:

Debt – equity Ratio = Long term debts / Shareholders’ funds + Long term
debts

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Limitations Of Ratio Analysis

Undoubtedly, ratios are precious tools in the hands of the analyst. But its significance
comes from proper use of these ratios. Misuse or mishandling of these ratios and
using them without proper context may lead the analyst or management to a wrong
direction. The person who uses these ratios should be well versed and should possess
expertise knowledge about making proper use of these ratios. Like all tools, ratios
also suffer from several ‘ifs’ and ‘buts’ and for a thorough understanding of proper
use of these ratios. There are certain limiting factors in the case of ratio analysis.

These limiting factors are:

1. The user should possess the practical knowledge about the concerns and the
industry in general.

2. Ratios are not an end. They are only means to an end.

3. A single ratio in itself is not important. The trend is more significant in the
analysis. Comparison of ratios should be made.

4. For comparative purposes, there should be a standard ratio. There are no such
standards prescribed for the ratios.

5. The accuracy and correctness of ratios are totally dependent upon the reliability
of the data contained in the financial statement on the basis of which ratios are
calculated.

6. To use ratios, first of all there should be uniformity in the accounting plan used
by both the firms. In addition. There must be consistency in the preparation of
financial statement and recording the transactions from year to year within that
concern.

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7. Ratios become meaningless if detached from the details from which they are
derived. They should be used as supplementary and not substitution of the
original absolute figures.

8. Time lag in calculation and communicating the same should not be unnecessarily
too much.

9. The method of presentation should be precise and without any ambiguity.

10. Price level changes make the ratio analysis meaningless.

11. Inter-firm comparison should never be undertaken in the case of concerns which
are not associated or comparable.

12. All techniques concerning the ratio analysis should be taken into account.

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 BREAK EVEN POINT

The break-even point (BEP) is where the total money coming into your business

(revenue) matches what’s leaving (expenses).

It’s the tipping point where you’re no longer losing money, but are not yet making

a profit.

Reaching your break-even point is one of the first major milestones for any

successful business. It shows that your business model is viable and can sustain

itself without dipping into reserves or raising venture capital funding.

Once you reach this point, you’re usually ready to scale toward profitability—and

that’s exciting.

Calculating your break-even point is relatively straightforward. Just use the

following break-even point formula:

Break-even point = Total fixed costs / (unit sales price - variable cost per unit)

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 FIXED AND VARIABLE COST

• Fixed cost: Think rent, salaries, and your monthly cloud hosting fees.

These total costs don’t change much, regardless of how much you sell.

• Unit selling price: This one’s easy—it’s how much you charge for your

product.

• Variable cost per unit: These costs change depending on how much you

produce or sell. This could be things like materials and labour—if you

make more products, these costs go up.

• Financial insights: No more guesswork. Break-even analysis tells you

exactly how much revenue you need to cover your costs and start turning a

profit.

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 • Decision-making: Want to make a business pivot, invest in new equipment,

or hire more staff? Break-even analysis estimates the potential and

consequences. Knowing this number lets you see the financial impact of

different strategies.

• Risk management: Whether it’s a sudden drop in sales or unexpected cost

increases, your break-even point gives you the know-how to weather the

storm and keep your business afloat.

• Performance evaluation: Are you crushing sales or barely keeping your

head above water? Break-even analysis lets you compare actual sales and

expenses to see if you’re on track to meet your financial targets.

How to use your break-even point

Calculating your break-even point isn’t just a tick on your to-do list—it’s a

number you should reference often. Here’s how to use your break-even point to

guide decisions:

1. Pricing strategy: Your break-even point helps you set smarter prices. If

you’re not hitting your break-even point, you might need to up your pricing

or find ways to lower costs.

2. Financial planning: The break-even point gives you a clear target to aim

for each month. Knowing how much you need to sell helps you better

manage free cash flow and plan for future investments.

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 3. Product viability: If the volume of sales required to break even is

unrealistically high, it might be a sign that your product isn’t priced

correctly (or the cost structure needs adjustment).

4. Risk management: Your break-even point helps you understand the

minimum performance required to sustain operations.

5. Goal setting: The break-even point provides a clear goal for your sales

team to aim for each month. It’s a baseline measure of success that

everyone in the company can rally behind.

6. Benchmarking: Your break-even point helps evaluate the success of new

products and services compared to established operations.

Limitations and considerations of break-even analysis

Break-even point analysis can do a lot for your business. However, this financial

metric comes with a few limitations.

Let’s take a look at the benefits and drawbacks before you over-rely or

misinterpret this number:

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 Considerations for break-even analysis

• Regular updates: Your break-even point metric won’t do much good if it’s

not accurate. You’ll need to regularly update it to reflect changes in costs,

prices, and market dynamics.

• Use with other metrics: The break-even point shouldn’t be used in

isolation. Look at it alongside other financial metrics like ROI, cash flow

analysis, and net profit margins.

• Understand its scope: Break-even analysis isn’t the end-all-be-all metric.

It’s simply an introductory tool for financial insight and should be used as a

starting point for deeper financial investigation.

• Context is key: Consider the broader economic and sector-specific context

when interpreting break-even analysis results. External factors can impact

the applicability of any of your findings.

Limitations of break-even analysis

• Static assumptions: Break-even analysis assumes that prices and costs

don’t change, but that’s not always the case—especially in dynamic market

conditions where material costs and product prices fluctuate frequently.

• Simplifies complex variables: The model reduces complex business

realities to simple numbers, but there’s a lot more going on. You have

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 qualitative factors like market conditions, competitor actions, and changes

in consumer behaviour.

• Overlooks economies of scale: As production increases, unit costs may

decrease due to economies of scale—but break-even analysis often doesn’t

consider this.

• No profit guarantee: Reaching the break-even point doesn’t guarantee

profitability—it just means you’re not losing. However, this doesn’t

necessarily mean you have a sustainable solution.

• Ignores capital costs: Break-even analysis often excludes the cost of

capital (such as interest on loans or the opportunity cost of investment).

How market changes affect your break-even analysis

Your break-even point isn’t set in stone. Market changes (outside of your control)

fluctuate all the time, and they can influence your metrics.

For example, variable costs may decrease during an economic downturn due to

lower material costs. Or, fixed costs might increase due to higher interest rates

and inflation.

Changing industry regulations or compliance requirements might force you to

change operations or invest in different technology or infrastructure. These costs

can add to your overall expenses, pushing your break-even point further out.

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You’ll also need to keep an eye on technological advancements. You might find

new software or cloud hosting solutions that dramatically lower your costs, or you

may be able to incorporate new features or integrations into your products—

allowing you to raise the price per unit.

Supply and demand play an important role, too.

If you’re a latecomer to a market, there might be too much supply, and you might

not be able to break even without economies of scale. However, if you jump on a

trend early, you might be able to command market share and price to accelerate

toward your break-even point.

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