RATIO ANALYSIS

A tool for Analysis and interpretation of Financial statements

 RATIO
 A ratio is a simple arithmetical expression of the
relationship of one number to another.

 Quantitative relationship between two numbers.

 In simple terms, ratio is one number expressed in

terms of another and can be worked out by
dividing one number with other.

 For e.g. If current assets of a firm on a given date

are Rs.4,00,000 and current liabilities are
Rs.2,00,000 then the ratio of CA to CL is 2:1
 How a Ratio is expressed?

 As Percentage - such as 25% or 50% . For example if

net profit is Rs.25,000/- and the sales is Rs.1,00,000/-
then the net profit can be said to be 25% of the sales.

 As Proportion - The above figures may be

expressed in terms of the relationship between net
profit to sales as 1 : 4.

 As Pure Number /Times - The same can also be

expressed in an alternatively way such as the sale is
4 times of the net profit or profit is 1/4th of the sales.
 ACCOUNTING RATIO

 Ratios calculated on the basis of

accounting information are called as
ratio analysis.
 Advantages of Ratios Analysis

 Simplifies financial statements

 Facilitates inter-firm comparison
 Helps in planning & forecasting
 Makes inter-firm comparison possible
 Help in investment decisions
 Limitations of Ratios Analysis

 Limitations of financial statements

 Comparative study required
 Problems of price level changes
 Lack of adequate standard
 Limited use of single ratios
 Personal bias
 Incomparable
 Qualitative aspect is ignored
 Subjectivity
Functional classification of Ratios
Liquidity Turnove Solvency Profitabil
ratios r ratio ratios ity ratios
Debtor
Debtor
Current
Current Debt/equit
Debt/equit Net
Net profit
profit
turnover
turnover
ratio
ratio y
y ratio
ratio ratio
ratio
ratio
ratio

Liquid
Liquid Fixed
Fixed asset
asset Interest
Interest Gross
Gross
ratio/acid
ratio/acid turnover
turnover coverage
coverage profit
profit ratio
ratio
test
test ratio
ratio ratio
ratio ratio
ratio
Debt
Debt to
to
Absolute
Absolute Capital
Capital total
total Operating
Operating
liquidity
liquidity employed
employed capital
capital profit
profit ratio
ratio
ratio
ratio turnover
turnover ratio
ratio
Working
Working Expense
Expense
capital
capital ratio
ratio
turnover
turnover

EPS/
EPS/ ROI/
ROI/
P/E ratio
P/E ratio
Ratios which give us details regarding firm’s
ability to repay its short term liability on time

LIQUIDITY RATIOS

Absolute
Current
Quick ratio liquidity
ratio
ratio
 Current ratio

 Shows the
relationship Current assets
between current Current liabilities
assets and current
liabilities.

Standard ratio is
*Higher the ratio, better it is.
2:1it should neither be too high nor too low.
*But
 Current Assets: are those assets which can be converted
into cash within an accounting period of one year.
 Cash in hand
 Cash at bank
 Marketable securities
 Short term investments
 Sundry debtors
 B/R
 Stock including work in progress
 Prepaid expenses/unexpired payments
 Current Liabilities: are those liabilities which are to be
discharged within an accounting period of one year.
 B/P
 sundry creditors
 Outstanding expenses
 Bank overdraft*
 Any other liability payable within one year
 Quick / acid test ratio

 Shows the
relationship Quick assets
between quick Current liabilities
assets and current
liabilities.

Standard ratio is
*Quick assets = current assets – stock – prepaid expenses
1:1 ratio indicates towards good liquidity position of
*Higher
company.
 Absolute liquidity ratio

 Depicts the
relationship Super liquid assets
between super Current liabilities
liquid assets and
current liabilities.

Standard ratio is
* Super liquid assets = Cash + bank + marketable
0.5:1
securities
*Higher ratio indicates towards good liquidity position of
company.
 Practice question

Q. No. Q.No.
1 liabilities of
 Current Z
2
ltd’s stock is
a company are Rs.1,32,000.
Rs.30,000.  Liquid assets are
 Its current ratio is Rs.1,28,000 and
3:1.  Quick ratio is 1:6.
 Quick ratio is 1.8:1.
 Find out current
 Calculate the value ratio
of current assets,
liquid assets and
stock.
 Calculate the current ratio and quick ratio and also
give your comments on the position of company
Particulars Rs.
Cash 6,000
Sundry debtors 74,000
B/R 10,000
Stock 1,70,000
Prepaid expenses 10,000
Land and building 2,00,000
Patents 20,000
Marketable securities 10,000
Goodwill 50,000
B/P 20,000
Bank overdraft 40,000
Sundry creditors 30,000
10% debentures 1,00,000
Ratios which tells the efficiency, earning power and
profitability of the company to its various users
 Based on sales
Gross profit
ratio Net profit ratio

Gross profit Net profit

Net sales 10 Net sales 100
0

•Gross profit ratio indicates margins on sales.

•No standard ratios are given for both.
•Higher the ratios, higher the profitability and efficiency of
company.
 Based on sales
Operating profit
ratio Operating ratio

Operating profit Operating costs

Net sales 10 Net sales 100
0

 Operating cost = COGS + selling & distribution

expenses + office and administration expenses
 Lower the operating ratio, more efficient the firm will
be considered.
 Operating profit ratio should be high.
 EXPENSE RATIO

Particular expense
100
Net sales

It should be on the lower side

 Calculate the operating ratio and operating profit
ratio
Particulars Rs.
Sales 4,10,000
Sales return 10,000
Purchases 2,25,000
Opening stock 25,000
Closing stock 40,000
Carriage 7,500
Wages 17,500
Manufacturing expenses 20,000
Office expenses 30,000
Selling expenses 10,000
Discount 2,500
Bad debts 1,000
Interest on short term loan 1,500
Interest on long term loan 12,500
Loss by fire 10,000
 BASED ON INVESTMENT
Return on
investment Return on equity capital

Net profit after

Net Profit after tax int., tax and pref. div.
10 100
Shareholders’ funds Equity
0

Shareholder’s fund= paid up share capital + paid up

equity share capital + reserves & surpluses – accumulated
losses
Equity = paid up equity share capital + reserves &
surpluses –accumulated losses
 BASED ON INVESTMENT
Earnings per
share Price earning ratio

Earnings available for

equity shareholders Market price of shares
Number of equity EPS
shares
 BASED ON INVESTMENT
Dividend payout
ratio Dividend per share

Earnings available for

Dividend per share equity shareholders
Earning per share Number of equity shares
 BASED ON INVESTMENT
Return on capital
employed Return on total assets

EBIT EBIT / EAT

100
Capital employed100 Total assets

Calculation of Capital employed : see next slide

 Calculation of capital employed
From assets side From liability side
Particulars Rs.
Particulars Rs.
Paid up equity share
capital
Fixed assets (after
depreciation) (+) paid up preference
share capital
(+) reserves & surpluses
(+) current assets
(+) long term debt
(=) Gross cap. (+) short tern debt
employed (-) debit balance of P&L
(-) current liabilities a/c (losses)
(=) Gross capital
(=) Net capital employed
employed
(-) current liabilities
(=) Net capital
employed
 Income statement
Particulars Rs.

Earnings before interest and tax (EBIT)

Less: Interest

(=) Earnings before Tax (EBT)

Less: Tax

(=) Earnings after tax (EAT)

Less: Preference dividend (if any)

(=) Earnings available for equity shareholders

 Practice question
Calculate earning per share, P/E ratio, ROI, ROEC:

Particulars Rs.

Net profit before interest and tax 6,00,000

Tax rate 50%

10% debentures 10,00,000

10% preference share capital 5,00,000

(Rs.10 each)
Equity share capital (Rs.100 each) 5,00,000
 Ratios which give us details regarding firm’s
ability to meet its long term liabilities on time
 Solvency ratios

Debt-equity ratio Rule of thumb is 1:1

Debt
Equity

Debt includes: Equity includes:

Debentures Paid up equity
share capital
Unsecured loans
Paid up preference
Secured loans share capital
having maturity
period of more Reserves &
than one year surpluses
 Solvency ratios
Total Debt-equity
ratio Rule of thumb is 1:1

Total Debt
Equity

Total Debt includes: Equity includes:

Long term debt Paid up equity
share capital
Short term debt
Paid up preference
Total share capital
Reserves &
surpluses
 Solvency ratios
Funded debt to total
capitalization This ratio divulges the extent
of dependence on outside
Funded debt sources for providing long
term finance. On an average,
Total capitalization in case of industrial and
trading concerns 67% is
considered to be a reasonable
ratio, beyond which it is
Total capitalization considered to be risky. A very
includes: high percentage may reduce
Paid up equity the security for lenders.
share capital
Paid up preference
share capital Funded debt includes:
Reserves & Long term debts
surpluses
Long term debts
 Solvency ratios
If the ratio is less than 1, it is a
Capital gearing ratio case of highly geared capital
structure and vice versa. There is
Equity capital no hard and fast rule for this
ratio, because a company having
Fixed income bearing regular and adequate earnings
securities can have more of fixed income
bearing securities as it will have
no problem in servicing the same
Equity capital includes: Fixed
and vice income bearing
versa.
securities includes:
Equity share
capital Preference share
capital
Reserves &
surpluses Long term debts
Total Total
 Solvency ratios
Interest coverage
ratio

EBIT
Total interest

Debt service simply means regular &

timely payment of interest charges,
higher it will be, more the satisfaction
level of creditors will be.
 Solvency ratios
Dividend coverage
ratio

EAT
Preference dividend

Dividend coverage simply means

regular & timely payment of dividend
charges, higher it will be, more the
satisfaction level of preference
shareholders will be.
 Solvency ratios
Fixed charges
coverage ratio

EBIT
Interest +Preference
dividend

Fixed charges coverage simply means regular &

timely payment of fixed charges(interest and
preference dividend), higher the ratio is, more the
level of satisfaction of creditors is.
 Solvency ratios
Proprietary/ Equity
ratio

Proprietor’s funds
Total assets Proprietor’s funds
includes:
Paid up equity
share capital
Paid up preference
share capital
This ratio tells us about the Reserves &
contribution made by the surpluses
shareholders in the total
assets of the company. More is (=) equity
the contribution, better it is for (-) Debit balance of
long term creditors/lenders. P&L a/c
(=) Proprietor’s
fund
 Solvency ratios
Fixed assets to net
worth

Net worth includes:

Fixed assets Paid up equity
Net worth share capital
Paid up preference
share capital
Reserves &
surpluses
(=) equity
(-) Debit balance of
P&L a/c
Net worth, shareholder's
funds, proprietor’s fund are (=) net worth
one and same
 Solvency ratios
Long term debt- net
worth

Net worth includes:

Long term debt Paid up equity
Net worth share capital
Paid up preference
share capital
Reserves &
surpluses
(=) equity
(-) Debit balance of
P&L a/c
Net worth, shareholder's
funds, proprietor’s fund are (=) net worth
one and same
Compute capital gearing
ratio

Particulars Rs.
Equity share capital 2,50,000
Preference share 1,00,000
capital
Long tern loans 50,000
Calculate debt equity ratio, proprietary ratio,
fixed assets to net worth ratio and total
capitalization ratio
Liabilities Rs. Assets Rs.
Equity share capital 1,50,000 Goodwill 50,000
Preference share 75,000 L&B 1,50,000
capital
Reserve fund 75,000 P&M 1,75,000
Dividend 25,000 Stock 1,00,000
equalization fund
5% debentures 2,00,000 Debtors 75,000
Current liabilities 50,000 Cash at bank 17,500
Accrued incomes 7,500
5,75,000 5,75,000
 Turnover refers to rotation or utilization of a
resource or an asset in the process of business
activity-the number of times a unit of ---- is turned
over.

Efficiency ratios can also be called as activity ratios or

turnover ratios.
 Efficiency ratios
Inventory turnover
ratio

It indicates whether stock has

efficiently been used or not. Higher
ratio indicates that more sales are
done with less investments in stock.
COGS
Average stock

Average stock = (opening stock +closing stock )/ 2

When opening stock is not given, then closing stock is used in
place of average stock
 Efficiency ratios
Inventory Conversion
Period

To calculate the period it takes, on

an average, to clear a lot of stock.

365/12 No. of days

Inventory turnover ratio / months

COGS = opening stock + purchases + direct expenses – closing

stock
or Net sales – gross profit
 Efficiency ratios
Debtors turnover
ratio

Net credit sales

No. of
Average accounts times
receivables
Accounts receivables = bills receivables + debtors
Average accounts receivables = (opening acc. Rec + closing
acc. Rec.) /2
If credit sales are neither given nor can be found out, we can
take net sales and a note be given accordingly.
 Efficiency ratios
Average collection
Period

360/365/12 No. of days

Debtor turnover ratio / months

The higher the ratio, the faster the

cash collection. But too high a ratio
may not be desirable as it indicates
that the credit is too tight which
may cause the loss of sales to good
customers.
 Efficiency ratios
Creditors turnover
ratio

Lesser is the number of times, the

more credit period business enjoys
and better it is, as it indicates that
the company enjoys goodwill in the
Net credit purchases
market. One should not jump at the
conclusion, without going into other
Average accounts factors for favorable ratio.
payables
Accounts Payable = bills payables+ creditors
Average accounts payables = (opening acc. pay + closing acc.
pay) /2
If credit purchases are neither given nor can be found out, we
can take net purchases and a note be given accordingly.
 Efficiency ratios
Average payment
Period

360/365/12 No. of days

Creditors turnover ratio / months

Average credit period/Average age of

creditors/Creditors’ velocity: This ratio tells
us how promptly and timely we are making
payments.
 Efficiency ratios
Cash turnover
A high cash turnover
ratio indicates, low cash balance,
which means cash is being
utilized efficiently and
effectively. A low ratio means
idle/ redundant cash which is
Total cash payments not a healthy sign of financial
management.
(incl. cheques
No. of
Average cash in
times
hand and at bank

Average cash and bank bal.= (opening balance+ closing

balance) /2
 Efficiency ratios
Working capital
turnover ratio

Higher is the ratio, more is

the utilization of working
capital and better it is.

Cost of sales
No. of
Average working times
capital
Average working capital = (opening WC+ closing WC) /2
If cost of sales is neither given nor can be worked out, net sales be
taken.
If opening working capital is not given, closing working capital may be
taken as the denominator.
 Efficiency ratios

Assets turnover ratio

This ratio can be
calculated separately for
different kind of assets,
for e.g. for
Fixed assets ratio
Net sales Current assets ratio
Tangible assets ratio
Total assets Intangible assets ratio
For calculation of any of
the above ratio, replace
the denominator in the
formula with the ratio
Ratio for fictitious assets is not calculated.
required.
 Practice question

 Opening stock is Rs. 29,000

 Closing stock is Rs. 31,000
 Sales Rs.3,20,000
 Gross profit ratio is 25% on sales

You are required to calculate stock

turnover ratio.
 Stock turnover ratio is 5 times
 Closing stock is 10,000 more than opening
stock
 Sales Rs.6,00,000
 Gross profit ratio is 25%
 Current liabilities are Rs.40,000
 Quick ratio is .75
Calculate COGS, opening and closing stock,
current and quick assets
 Questions for Practice
 The net profit (after taxes) of a firm is Rs. 75,000
and its fixed interest charges on long term
borrowing are Rs. 10,000. The rate of income tax
is 50%. Calculate interest coverage ratio.
 A company is currently earning an EBIT of Rs.
12,00,000. its present borrowings are:
Rs.
11% term loans 40,00,000
Working Capital:
Borrowing form Bank at 16% 33,00,000
Public Deposits at 12% 15,00,000

Calculate DSCR.
 (Continue the previous question)
The sales of the company are growing and to
support this the company proposes to obtain an
additional bank borrowing of Rs. 25 Lakhs. The
increase in EBIT is expected to be 20%. Calculate
the change in interest coverage ratio after
additional borrowing and comment.