Ratio Analysis

One of the most important financial tools which have come to be used very frequently for analyzing the financial strengths and weaknesses

of the enterprise is ratio analysis. Ratio Analysis is a technique of analysis and interpretation of financial statements. It is process of

establishing and interpreting various ratios for helping in making certain decisions.
 Interpretation of the Ratios
Interpretation of the ratios are described as follow:
1. Trend Ratio
2. Inter-firm Ratio
3. Comparison with Standards.
4. Comparison within single year’s financial statement.
 Classification/Miscellaneous Group of Ratios

Classification of Ratios

Traditional Classification Functional Classification Significance Ratios

1)Balance sheet Ratios 1)Liquidity Ratios 1)Primary Ratios

2)Income statement Ratios 2)Solvency/leverage 2)Secondary Ratios
Ratios
3)Mixed Ratios
3)Turnover /Activity
Ratios
4)Profitability Ratios
 Traditional Classification/Statement Ratio/Nature

Traditional Classification

Balance sheet Ratios Income statement Ratios Composite/Mixed Ratios

1)Current Ratio 1)Stock Turnover Ratio
1)Gross Profit Ratio
2) Liquid Ratio 2)Debtors Turnover
2) Operating Ratio
3)Absolute liquidity Ratio 3)Fixed Assets Turnover Ratio
3) Operating Profit Ratio
4)Debt Equity Ratio 4)Return on Equity
5) Capital Gearing Ratio 4)Net Profit Ratio
5)Expense Ratio 5)Return on Shareholders’
6) Asset-Proprietorship Funds
Ratio 6)Interest Coverage Ratio
7) Capital Inventory to 6)Return on Capital Employed
Working capital Ratio 7)Capital Turnover Ratio
8) Capital Gearing Ratio 8)Working Capital
9)Ratio of current assets Turnover Ratio
to fixed assets 9)Return on Total Resources
10)Total Assets Turnover
 Traditional Classification/Statement Ratio/Nature
I. Balance Sheet Ratios: Balance Sheet ratios deal with the relationship between two balance sheet
items, e.g. The ratio of current assets to current liabilities, or the ratio of proprietor’s funds to fixed-
assets .Both the items must, however, pertain to the same balance sheet .The various balance sheet
ratios have been named in the classifying statement ratios.
II. Profit and loss Account or income statement Ratios: These ratios deals with the relationship between
two profit and loss account items, e.g. The ratio of gross profit to sales , or the ratio of net profit to
sales .Both the items must, however, belong to the same profit and loss account. The various profit and
loss account ratios, commonly used , are named in the chart classifying statement ratios.
III. Composite /Mixed Ratios: These ratios exhibit the relation between a profit and loss account or
income statement item and a balance sheet item ,e.g.,stock turnover ratio, or the ratio of total assets
to sales .The most commonly used inter-statement ratios are given in the chart exhibiting traditional
classification or statement ratios.
 Functional Classification
Liquidity Ratio Turnover Ratios Solvency/ Leverage Profitability Ratios
Ratios A)In Relation to Sales
1) Current Ratio 1)Capital Turnover Ratio 1)Debt Equity Ratio 1)Gross Profit Ratio
2) Liquid Ratio 2)Fixed Assets Turnover Ratio 2)Debt to total 2) Operating Ratio
3)Absolute liquidity Ratio 3)Working Capital capitalization ratio
3) Operating Profit Ratio
Turnover Ratio 3)Proprietary/Equity Ratio 4)Net Profit Ratio
4)Stock Turnover Ratio
5)Debtors Turnover 4)Interest Coverage Ratio 5)Expense Ratio
Ratio 5) Cash flow/Debt service
Ratio B)In relation to
6)Creditors Turnover investment
Ratio 6) Dividend Coverage
Ratios 1)Return on
7)Total Assets Turnover Investments
Ratio 7) Capital Gearing Ratio
2)Return on Capital
3)Return on Equity
4)Return on Total
Resources
5)Earning per share
6)Price-Earning Ratio
 Functional classification
i. Liquidity Ratio: These are the ratios , which measures the short term solvency or financial position of a
firm.
ii. Leverage Ratio: Leverage ratios are the financial statement ratios which show the degree to which the
business is leveraging itself through its use of borrowed money. Leverage ratios are used to understand a
company’s ability to meet its long term financial obligations.
iii. Turnover Ratio: Leverage ratios are calculated to measure the efficiency with which the resources of a
firm have been employed .These ratios are also called activity ratios because they indicate the speed
with which assets are being turned over into sales.
iv. Profitability Ratios : These ratios measure the result of business operations or overall performance and
effectiveness of the firm. Generally two types of profitability ratios are calculated are:
a) In relation to sales
b) In relation to investment
 Significance Ratios
Significance Ratio or Ratio According to Importance: The ratios have also been classified according to their
significance or importance . The British Institute of Management has recommended the classification of ratio
according to importance for inter-firm comparisons. For inter-firm comparisons, the ratios may be classified
as:
1) Primary Ratios: The primary ratio is one which is of the prime importance to concern; thus return on
capital employed is named as primary ratio.
2) Secondary Ratios: The other ratios which support and exhibit the primary ratio is called secondary
ratio,e.g.,the relationship of operating profit to sales or the relationship of sales to total assets of the
firm.
 Liquidity Ratios
Liquidity refer to the ability of a concern to meet its current obligations as and when these become due.
Liquidity ratios are calculated to measure short-term financial soundness of the business .The short-term
obligations are met by realizing amounts from current , floating or circulating assets. The current assets
should either be liquid or near to liquidity. These should be convertible into cash for paying obligations of
short-term nature.
To measure the liquidity of a firm , the following ratios can be used:
1) Current Ratio or Working Capital Ratio.
2) Quick Ratio or Acid Test or Liquid Ratio.

Note: The ideal current ratio is 2:1

The ideal quick ratio is 1:1