Ratio Analysis

Meaning of Ratio Analysis :

Ratio analysis is the most widely used technique for interpreting and comparing financial
reports. It analyses financial data from the firm’ s profit and loss account and Balance
sheet. Accounting ratios show relationship among items in financial statements. These are
used in the assessment of profitability, liquidity, activity and the capital structure of the
Enterprise.
Classification of Ratio :
1. Liquidity Ratio
(i) Current Ratio
(ii) Liquid Ratio/ Quick Ratio/ Acid test Ratio
2. Solvency Ratio
(i) Debt Equity Ratio
(ii) Total Assets to Debt Ratio
(iii) Proprietory Ratio
(iv) Interest – Coverage Ratio
3. Activity Ratio
(i) Inventory Turnover Ratio
(ii) Debtors Turnover Ratio
(iii) Creditors Turnover Ratio
(iv) Working capital Turnover Ratio
(v) Total Assets Turnover Ratio
(vi) Fixed Assets Turnover Ratio
4. Profitability Ratio
(i) Gross profit Ratio
(ii) Net profit Ratio
(iii) Return on Capital Employed/ Investment
(iv) Operating Ratio
(v) Return on Networth
(vi) Price Earning Ratio
 (vii) Earnings per share
(viii) Dividend yield Ratio

(ix) Gearing Ratio

1. Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its short- term obligations.
Short-term is conventionally viewed as a period up to one year.
(i) Current Ratio : Current Ratio is the relationship between current assets and current
Liabilities. Ideal current ratio is 2:1.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
Current Ratio =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

Examples of current Assets are : cash in hand ; cash at bank ; cash equivalents ; trade
debtors ; bills receivables , accrued income , prepaid expenses , inventories , advance tax;
short-term investments.

Examples of Current Liabilities are : Trade creditors ; bills payable ; liability for taxes ;
outstanding expenses ; income received in advance ; provision for taxation ; proposed
dividend ; short-term bank loan .
(ii) Liquid Ratio : The quick ratio is the relationship between quick assests and current
Liabilities. A quick ratio of 1: 1 is considered satisfactory.
𝑸𝒖𝒊𝒄𝒌 𝑨𝒔𝒔𝒆𝒕𝒔
Liquid Ratio :
𝑸𝒖𝒊𝒄𝒌 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 𝑩𝒂𝒏𝒌 𝑶𝒗𝒆𝒓𝒅𝒓𝒂𝒇𝒕

Quick Assets = Current Assets – Inventories – Prepaid expenses

2. Solvency Ratios
Solvency means that a business is able to pay its liabilities as they become due.
Insolvency means the business is unable to do so. Solvency usually refers to the firm’ s
Ability to meet Long- term liabilities.

(i) Debt Equity Ratio : It is the ratio between long-term debts and shareholders’ funds.
Long –term debts include debentures, loan from financial institutions.
Shareholders’ funds = Equity shares capital + preference shares capital + Reserves and
surplus – Fictitious assets (e.g. debit balance of the profit & loss,
, preliminaries expenses , discount on issue of shares etc.)

𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕𝒔

Debt Equity Ratio =
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝑭𝒖𝒏𝒅𝒔
(ii) Total Assets to Debt Ratio : This ratio shows the relationship between total assets
And long-term debts. This ratio measures the proportion of the firm’ s total assets
That are financed by long-term debts.

𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
Total Assets to Debt Ratio =
𝑳𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝑫𝒆𝒃𝒕

(iii) Proprietory Ratio : It is the ratio between shareholders’ funds and total assets. This
Ratio shows the proportion of total assets of a business financed by shareholders’ fund.

𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝑭𝒖𝒏𝒅𝒔
Proprietory Ratio =
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

(iv) Interest – Coverage Ratio : This ratio reflects the number of times that a company’ s
Interest charges are covered by its earnings before interest and taxes (EBIT).

𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝑻𝒂𝒙

Interest- coverage Ratio =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒄𝒉𝒂𝒓𝒈𝒆𝒔

3. Activity Ratios
Activity ratios show the degree of assets utilization of a business. Activity ratios are the
Ratios of cash elasticity of current assets, i.e., how quickly various current assets are
Converted into sales and cash.

(i) Inventories / Stock Turnover Ratio : It is the ratio of cost of goods sold to average
Inventories. The inventories turnover ratio measures how quickly inventory is sold.

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅

Inventory turnover Ratio = = Number of Times
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
Notes :
1) Cost of goods sold = Sales – Gross profit
Or
= Opening stock + purchases + carriage Inwards + Direct Expenses-
Closing stock
𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝑪𝒍𝒐𝒔𝒊𝒏𝒈 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
2) Average Inventory =
𝟐

(ii) Debtors Turnover Ratio : This is the between the credit sales and average debtors
Plus average bills receivable.

𝑪𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔
Debtors Turnover Ratio =
𝑻𝒓𝒂𝒅𝒆 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆𝒔 ( 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑩𝒊𝒍𝒍𝒔 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆)

𝟑𝟔𝟓
Debt collection Period = = Number of Days
𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
𝟏𝟐
Debt collection period = = Number of Months
𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
(iii) Creditors Turnover Ratio : This is the between the credit purchases and average
Creditors Plus average bills payable.

𝑪𝒓𝒆𝒅𝒊𝒕 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔
Ceditors Turnover Ratio =
𝑻𝒓𝒂𝒅𝒆 𝒑𝒂𝒚𝒂𝒃𝒍𝒆𝒔 ( 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒄𝒓𝒆𝒅𝒊𝒕𝒐𝒓𝒔 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑩𝒊𝒍𝒍𝒔 𝒑𝒂𝒚𝒂𝒃𝒍𝒆𝒔)

𝟑𝟔𝟓
Debt payment Period = = Number of Days
𝑪𝒓𝒆𝒅𝒊𝒕𝒐𝒓𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
𝟏𝟐
Debt payment period = = Number of Months
𝑪𝒓𝒆𝒅𝒊𝒕𝒐𝒓𝒔 𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓

(iv) working capital Turnover Ratio : This is the ratio between turnover (sales) and
Working capital.
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔
Working capital Turnover Ratio =
𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒄𝒂𝒑𝒊𝒕𝒂𝒍

Working capital = Current assets – current liabilities

(v) Total Assets Turnover Ratio : It is the ratio of sales to total assets.
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔
Total Assets Turnover Ratio =
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

4. Profitability Ratios
(i) Gross profit Ratio : This is the ratio between gross profit and net sales.
𝑮𝒓𝒐𝒔𝒔 𝒑𝒓𝒐𝒇𝒊𝒕
Gross profit Ratio = x 100
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔

Gross profit = Net sales – cost of goods sold

(ii) Net profit ratio = This is the ratio between net profit and net sales.
𝑵𝒆𝒕 𝒑𝒓𝒐𝒇𝒊𝒕
Net profit Ratio = x 100
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔

(iii) Operating Ratio = This is the ratio between cost of goods sold plus operating
Expenses and net sales. It measures the proportion of operating expenses per
Rupee of sales.

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔

Operating Ratio = x 100
𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔

Operating Expenses = Administrative Expenses + Selling and Distribution Expenses

(iv) Return on capital Employed : It is the relationship between Earning Before interest
And Tax (EBIT) and capital Employed.
 𝑬𝑩𝑰𝑻
Return on capital Employed (ROCE) = x 100
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅

Capital Employed = Share capital + Reserve and Surplus – Fictitious Assets +

Long-term Loans

(v) Return on Networth / Equity : It is the ratio of net profit after tax to networth.

𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙

Return on Networth = x 100
𝑵𝒆𝒕𝒘𝒐𝒓𝒕𝒉

Networth = Share capital + Reserve & surplus – Fictitious assets

Or
Fixed Assets + Working Capital

𝑭𝒊𝒙𝒆𝒅 𝒄𝒉𝒂𝒓𝒈𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 (𝒍𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝑳𝒐𝒂𝒏𝒔 𝒑𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒔𝒉𝒂𝒓𝒆𝒔)

(vi) Gearing Ratio = x100
𝑬𝒒𝒖𝒊𝒕𝒚 (𝑬𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝑹𝒆𝒂𝒔𝒆𝒓𝒗𝒆 𝑭𝒊𝒄𝒕𝒊𝒕𝒊𝒐𝒖 𝑨𝒔𝒔𝒆𝒕𝒔)

𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙 𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝑹𝒆𝒒𝒖𝒊𝒓𝒆𝒎𝒆𝒏𝒕

(vii) Earnings per share (EPS) =
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒔

𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

(viii) Price Earnings Ratio (P/E ratio) =
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

𝑬𝑷𝑺
(ix) Earning yield = x 100
𝑴𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆

(x) Dividend yield = x 100
𝑴𝒂𝒓𝒌𝒆𝒕 𝒗𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆