Unit 9-Ratio Analysis

9.01 Introduction:

Ratio analysis is used to evaluate relationships among financial statement items. The
ratios are used to identify trends over time for one company or to compare two or more
companies at one point in time. Financial statement ratio analysis focuses on three key
aspects of a business: liquidity, profitability, and solvency. Ratios are presentation
technique, which helps the reader to get idea about the performances & Position of a firm
with least efforts. He can get overall view of the firm from the ratios presented to him. He
can compare such ratios with the ratios of the past & also with ratios other firm in
industry. For getting insight we must know how such ratios are calculated.

9.02 Objectives:
After studying this
Meaning of Ratio
Types of Ratios

Types of Ratios

Liquidity Profitability Solvency Activity

Ratios Ratios Ratios Ratios

 Liquidity Ratios: Short term solvency ratios. (Pure Ratio shown in 1 : 1 form)

 Current Ratio
 Liquid Ratio
 Quick Ratio

Current Assets
1. 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.

 Components:
Current Assets refer to those assets which are held for their conversion into cash normally within a
year and include the following:

Cash Balance Stock of Finished Goods

Bank Balance Prepaid Expenses
Debtors (after deducting Provision) O/S income
Bills Receivable (after deducting Advance Payment of tax
Provision) Tax deducted at source (TDS) (debit
Listed Marketable Securities (non – trade) Balance)
Stock of Raw – materials
Stock of Work – in – Progress
 Current Liabilities:-
Current Liabilities refer to those liabilities which are expected to be matured normally within a year
and include the following:

Creditors for goods Provision for Tax

Bills Payable Unclaimed dividend
Creditors for Expenses (or O/S Exp.) Incomes received – in – advance
Bank Overdraft
Proposed dividend

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 or the absence of investment opportunities with the firm and too low ratio may indicate problem
of short-term insolvency. Traditionally, a current ratio of 2:1 is considered to be a satisfactory ratio.

Liquid Assets
2. Liquid Ratio or Acid Test Ratio =
Liquid Liabilities

Liquid Assets = Current Assets – Stock

Liquid Liability = Current liabilities – Bank O/D – cash credit

 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.
Traditionally, a quick ratio of 1:1 is considered to be a satisfactory ratio. However, this traditional rule
should not be used blindly since a firm having a quick ratio of more than 1, may not be meeting its
short–term obligations in time if its current assets consist of doubtful and slow paying debtors while a
firm having a quick ratio of less than 1, may be meeting its short–term obligations in time because of
its very efficient debtors management.

Quick Assets
3. Quick Ratio 
Liquid Liabilities

 Quick Assets = Current ratio less stock and debtor. This ratio suggests whether available cash &
cash equivalent (which can quickly convertible in cash) are sufficient to meet its short term
liabilities.
 Profitability Ratios (Always is percentage except EPS)

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
Income statement
Net Sales
Less: Cost Of Goods Sold
= Gross Profit
Less: Operating Exp (Administrative & Selling Expense)
Add : Operating income (commission, discount received.)
= Operating Profit (PBIT)
Less: Non operating Expenses:
Int. on Debentures
Loss on Sale of assets or loss due to fire
Add: Non-operating Income:
Interest & Dividend on Investment
Profit on sale of Assets & Investment
= Net Profit before tax
Less: Tax
= Net Profit after tax
Less: Preference dividend
= Equity Profit

Gross Profit
1. Gross Profit Ratio  100
Net Sales

 Gross Profit = Sales – Cost of goods sold.

 Cost of goods sold = Opening stock + Net purchase + Purchase Exp +wages – closing stock

 Objective :
The objective is 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. And (c) what portion of sales is left to cover
operating expenses and non – operating expenses like to pay dividend and to create reserves. 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.

Net Profit After Tax

2. Net Profit Ratio  100
Net Sales

 Objective:-
The objective is to determine the overall profitability due to various factors such as operational
efficiency.

 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.

3. Operating Ratio =

Cost of Goods sold + Administrative / Selling/ Distribution / Financial Expenses

 100
Net Sales

 Objective:
The objective is to determine the operational efficiency with which production and /or purchases and
selling operations are carried on.

 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.

In relation to Investment
Profit before Int & tax [profit available to equity shareholder,
Pref. shareholder, debenture holder
Less: Interest
Profit before tax
Less: Tax
Profit after tax [Profit available to equity shareholder
& Pref. shareholder]
Less: Pref. Dividend
= Equity Profit [Profit available to equity share holder]
Format of Capital Employed:

Equity share capital

Add: Reserve & Surplus
Less: Miscellaneous Expenditure
= Equity share holder’s fund
Add: Preference share capital
= Share holder’s fund (Equity)
Add: Debt (debenture and term loan)
= Capital Employed

P.B.I.T
1. Return on Capital Employed =  100
Capital Employed

Capital employed = total investment=long term fund

 Objective:
The objective is to find out how efficiently the long – term funds supplied by the Debenture holder and
shareholders have been used.

 Interpretation:-
Higher the ratio, the more is the efficient the management and utilization of Capital Employed.

P. A . T
×100
2. Return on Equity = Equity
Equity = shareholder Fund = Owners fund = Proprietors Fund

 Objective:-
The objective is to find out how efficiently the funds belonging to the shareholders (equity and
preference) have been used.

 Interpretation:
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.

Equity Profit
 100
3. Return on Equity shareholder fund = Equity shareholder fund

 Objective:
The objective is to find out how efficiently the funds supplied by the equity shareholders have been
used.
 Interpretation:
This ratio indicates the firm’s ability of generating profit per 100 rupees of equity
shareholders’ funds. Higher the ratio, the more efficient the management and more is the
utilisation of equity shareholders’ funds.

Equity Profit
×100
4. Return on equity share capital = Equity Share Capital
 Objective:
The objective is to find out how efficiently the funds supplied by the equity shareholders have been
used.

 Interpretation:
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.

Equity Profit
5. Earning Per Share = No. of Equity Shares

 Objective:-
The objective is to measure the profitability of the firm on per equity share basis.

 Interpretation:
In, general, higher the EPS, better it is and vice versa. EPS helps in determining the market price of
the equity shares of the company. It also helps in estimating the company’s capacity to pay dividend.

 Solvency Ratios (Long term Solvency)

 Debt – Equity Ratio  Interest Coverage Ratio

 Capital Gearing Ratio  Debt Service Coverage Ratio
 Proprietary Ratio  Long term fund to fixed Asset

Debt
×100
1. Debt – Equity Ratio (Leverage Ratio) = Equity

 Objective :-
The objective is to measure the relative proportion of debt and equity in financing the assets of a firm.

 Interpretation:-
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 providers since owner’s equity is treated
as a margin of safety by debenture holder and vice versa. The implications from the point of view of
long term providers of loan and the firm may be seen as under.
 Debt +Pref . Shares
×100
2. Capital Gearing Ratio = Equity Share Capital

 Objective:-
The objective is to find proportion of fix return bearing security to not fix return bearing securities in
total capital of firm.

 Interpretation:-
It indicate that for every 100 Rs. of equity capital what proportion of fix return bearing capital existing.
More this ratio higher is the risk of fix commitment & more burden for generating equity profit.
However it may result in to benefit by effect on trading on equity.

Prop . fund (equity )

×100
3. Proprietary ratio = Total Asset

 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.
 Total Assets = All Assets (Excluding Fictitious Assets like preliminary exp. underwriting exp,
debenture discount.)

P . B. I . T
4. Interest Coverage Ratio = Interest On Loan

 Objective:-
The objective is to measure the debt servicing capacity of a firm so far fixed interest on long – term
debt and debenture is concerned.

 Interpretation:
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.

5. Debt Service Coverage Ratio =

Cash Available for Debt Service
Int . On . Debt +Install Due On Loan during finance year
Cash available for debt payment means P.A.T. +Depreciation & other non cash expenditure dr. to P
& L account + Interest on debt
 Long Term Fund
×100
6. Long term Fund to Fixed Assets = Fixed Assets

 Interpretation:
Sound business technique it to Acquire major permanent assets from permanent capital & temporary
capital should be invested in current assets. If temporary capital is invested in permanent assets than
financial position may get disturb? This ratio suggests how much proportion of permanent assets is
purchased from permanent capital. Higher the ratio more is the finance from long term sources.

 Activity Ratios:-
 Capital Turnover Ratio  Debtors Turnover Ratio (Debtors Ratio)
 Fixed Assets Turnover Ratio  Creditors Turnover Ratio (Creditors Ratio)
 Stock Turnover Ratio

Net Sales
1. Capital Turnover Ratio (In times) = (Avg .) Capital Employed [ Debt+Equity ]

 Objective:
The objective is to determine the efficiency with which the capital employed is utilized.

 Interpretation:
It indicates the firm’s ability to generate sales per rupee of capital employed. In general, higher the
ratio, the more efficient the management and utilization of capital employed is.

Net Sales
2. Fixed Assets Turnover Ratio (in times) = (Avg.)Fixed Assets

 Objective:
The objective is to determine the efficiency with which the fixed assets are utilized.

 Interpretation:
It indicates the firm’s ability to generate sales per rupee of investment in fixed assets. In general,
higher the ratio, the more efficient the management and utilization of fixed assets is and vice versa.

Cost Of Goods Sold

3. Stock Turnover Ratio (in times) = Avg . Stock

 Objective:-
The objective is to determine the efficiency with which the inventory is utilised.

 Interpretation:-
It indicates the speed with which the inventory is converted into sales. In general, a high ratio indicates
efficient performance. However, too high ratio and too low ratio should be called for further
investigation. 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.)

Cr . Sales
4. Debtors Turnover Ratio (in times) = (Avg .) Debtors+B/R

Debtors Ratio OR
(Avg ) Debtors + B/R
×365/360/12/52( week )
Debt Velocity Ratio (in days) = Credit Sales
 Objective:-
The objective is to determine the efficiency with which the trade debtors are managed.

 Interpretations:
High Debtors T/O ratio =shorter debtors ratio = quick recovery of money.
Low debtors T/O ratio = higher debtor ratio = delay in recovery of money.

It shows the efficiency of collection policy of the firm. It is always a goods idea to collect quickly,
money from debtors as uncertainty of collection increases with credit policy being liberal. However a
firm should under take cost benefit study of liberal credit policy, if benefit is more than cost than it
should increase credit period.

Benefit Cost
 In profit due to  In sales  In bad – debt
 In collection expenses
 In Interest cost on money blocked with debtor

 Tutorial Notes:
(i) The ‘Provision for doubtful debts’ is not deducted from the total amount of trade debtors
since here, the purpose is to calculate the number of days for which sales are tied up in
debtors and not to ascertain the realizable value of debtors.
(ii) If the figure of Average Debtors cannot be ascertained due to the absence of the figure of
opening Debtors, the figure of closing Debtors may be applied by giving a suitable note to
that effect.
(iii) If the figure of Net Credit Sales is not ascertainable, the figure of total sales given may be
used assuming that all sales are credit sales.

Net Credit Purchase

5. Creditors Turnover Ratio (in times) = (Avg ) Creditors+B . P .
Creditors Velocity Ratio (in days) OR
(Avg ) Creditors + B . P .
×365/360/12/52(week )
Creditors Ratio = Net Credit Purchase
 Objective: -
The objective is to determine the efficiency with which the creditors are managed.

 Interpretation:
High creditor T/O ratio = low creditor ratio = quick payment to creditor
Low creditor T/O ratio = high creditor ratio = delayed payment to creditor

It shows the market standing of the firm. A new firm may have less creditor’s ratio, as their market
standing will be less. An established firm will have greater market standing hence it is in position to
pay their creditor later. However a firm should study advantage of paying early and availing of cash
discount.

Net Sales
6. Total Assets Turnover Ratio (in times) = Total Assets
 Objective:
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.

 ADVANTAGES:

1. Simplifies financial statements:

Ratio Analysis simplifies the comprehension of financial statements. Ratios tell the whole
story of changes in the financial condition of the business. It gives reader full idea about overall
situations of the firm without going deep in to the financial statement.
2. Facilitates inter – firm comparison:
Ratio Analysis provides data for inter – firm comparison. Ratios highlight the factors associated
with successful and unsuccessful firms. They also reveal strong firms and weak firms, over
valued and undervalued firms.
3. Makes intra – firm comparison possible:
Ratio Analysis also makes possible comparison of the performance of the different divisions of
the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and
likely performance in the future.
4. Helps in planning:
Ratio analysis helps in planning and forecasting. Over a period of time a firm or industry
develops certain norms that may indicate future success or failure. If relationship changes in
firm’s data over different time periods, the ratios may provide clues on trends and future
problems.
6. Helps in decision making :
Some times ratio may indicate better guideline for decision making.
Example: good trend of profitability and dividend payout ratio helps investor to buy shares.
Lower debt service coverage ratio & int coverage ratio prevent bank from financing to
company.

 LIMITATIONS:

1. 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. However, such a
comparison only provides a glimpse of the past performance, and 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.

2. 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.

3. 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.

5. 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. Financial analysis is an individual
matter and value for a ratio which is perfectly acceptable for one company or one industry may
not be at all acceptable in case of another.

6. 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.

7. 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.

8. 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.