Unit V

Ratio Analysis: Ratio analysis is the process of determining and interpreting

numerical relationships based on financial statements. By computing ratios, it is easy
to understand the financial position of the firm. Ratio analysis is used to focus on
financial issues such as liquidity, profitability and solvency of a given firm.
The relationship between two accounting figures expressed
mathematically, is known as a financial ratio (or simply as a ratio). Ratios help to
summarize large quantities of financial data and to make qualitative judgment about
the firm’s financial performance.

 Advantages and Uses of Ratio Analysis

Ratio analysis helps the various groups in the following manner: -
1. Helps in decision making: - Financial statements are prepared primarily for
decision-making. Ratio analysis helps in making decision from the information
provided in these financial Statements.
2. Helps in financial forecasting and planning: - Ratio analysis is of much help in
financial forecasting and planning. Planning is looking ahead and the ratios
calculated for a number of years a work as a guide for the future. Thus, ratio analysis
helps in forecasting and planning.
3. Helps in communicating: - The financial strength and weakness of a firm are
communicated in a easier and understandable manner by the use of ratios. Thus,
ratios help in communication and enhance the value of the financial statements.
4. Helps in co-ordination: - Ratios even help in co-ordination, which is of at most
importance in effective business management. Better communication of efficiency
and weakness of an enterprise result in better co-ordination in the enterprise
5. Helps in control: - Ratio analysis even helps in making effective control of
business. The weaknesses are otherwise, if any, come to the knowledge of the
managerial, which helps, in effective control of the business.
 Limitations of Ratio Analysis
1. False results: - Ratios are based upon the financial statement. In case financial
statement are in correct or the data of on which ratios are based is in correct, ratios
calculated will all so false and defective. The accounting system itself suffers from
many inherent weaknesses the ratios based upon it cannot be said to be always
reliable.
2. Limited comparability: - The ratio of the one firm cannot always be compare
with the performance of other firm, if uniform accounting policies are not adopted
by them. The difference in the methods of calculation of stock or the methods used

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to record the deprecation on assets will not provide identical data, so they cannot be
compared.
3. Absence of standard universally accepted terminology: - Different meanings
are given to a particular term, egg. Some firms take profit before interest and tax;
others may take profit after interest and tax. A bank overdraft is taken as current
liability but some firms may take it as noncurrent liability. The ratios can be
comparable only when all the firms adapt uniform terminology.

 Classifications of Ratios
1. Liquidity Ratio: These ratios refer to the ability of the firm to meet the short term
obligations out of its short term resources. Those ratios help to determine the
solvency of the firm. Again it classified into two types

A. Current Ratio: Current ratio is the ratio of current assets and current
liabilities. Current ratio is also called as working capital ratio. Current ratio measures
a company’s ability to meet the claims of short-term creditors by using only current
assets. The firm is said to be comfortable in its liquidity position when current ratio
is 2:1.

Current ratio = current assets/ current liabilities

Example: From the following information calculate the Current Ratio.

Liabilities Amount Assets Amount

Share Capital 50,000 Fixed Asset 1,24,000
Preference Share
Capital 30,000 Short Term Capital 10,000
General Reserve 40,000 Debtors 95,000
Debentures 60,000 Stock 50,000
Trade Payable 10,000 Cash and Bank 15,000
Bank Overdraft 20,000 Discount on Share Issue 6,000
Provision for Tax 40,000
Provision for
Depreciation 20,000
3,00,000 3,00,000

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Solution:

Current Ratio = Current Assets/Current Liabilities

Current Assets = Debtors + Stock + Cash + Short term Capital = 1, 70,000

Current Liabilities = Trade Payables + Bank Overdraft + Provision for Taxes +

Provision for Depreciation = 90,000

Current Ratio = 170000/90000 = 1.889: 1

B. Quick Ratio: Quick ratio measures the firm’s ability to convert its current
assets quickly into cash to meet its current liabilities. It is also called as acid-test
ratio

quick ratio = quick assets/ current liabilities

Quick assets = Current asset – (Stock + Prepaid expenses)

Quick ratio indicates the ability of a firm to meet its short term obligations with
short-term assets. The standard for this ratio is 1:1

 Calculate Quick Ratio from the given details.

Current Liabilities 65,000

Current Assets 85,000
Stock 20,000
Advance Tax 5,000
Prepaid Expense 10,000

Solution:

Quick Ratio = Quick Assets / Current Liabilities

Quick Assets = All Current Assets – Stock – Advanced tax – Prepaid Expenses =
85000 – (20000+5000+10000) = 50,000

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Quick Ratio = 50,000 / 65000 = 0.77:1
2. Solvency Ratios

Solvency ratios also known as leverage ratios determine an entity’s ability to service its
debt. So these ratios calculate if the company can meet its long-term debt. It is
important since the investors would like to know about the solvency of the firm to
meet their interest payments and to ensure that their investments are safe. Hence
solvency ratios compare the levels of debt with equity, fixed assets, earnings of the
company etc.

The difference between solvency ratios and liquidity ratios. Liquidity ratios

compare current assets with current liabilities, i.e. short-term debt. Whereas solvency
ratios analyze the ability to pay long-term debt.

A. Debt to Equity Ratio

The debt to equity ratio measures the relationship between long-term debt of a firm
and its total equity. Since both these figures are obtained from the balance sheet itself,
this is a balance sheet ratio.

Debt to Equity Ratio = Long-Term Debt / Shareholders Funds

Long Term Debt = Debentures + Long Term Loans

Shareholders’ Funds = Equity Share Capital + Preference Share Capital + Reserves  

B. Proprietary Ratio 

Proprietary ratio or equity ratio. It expresses the relationship between the proprietor’s
funds, i.e. the funds of all the shareholders and the capital employed or the net assets.
Like the debt ratio shows us the comparison between debt and capital, this ratio shows
the comparison between owners’ funds and total capital or net assets.

Proprietary Ratio = Shareholders Funds / Net Assets

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 Example: The Balance Sheet of Punjab Auto Limited as on 31/12/2002 was as
follows:

Liabilities Rs. Assets Rs.

Equity Share Capital 40,000 Plant and Machinery 24,000
Capital Reserve 8,000 Land and Buildings 40,000
8% Loan on Mortgage 32,000 Furniture & Fixtures 16,000
Creditors 16,000 Stock 12,000
Bank overdraft 4,000 Debtors 12,000
Taxation: Investments (Short term) 4,000
Current 4,000 Cash in hand 12,000
Future 4,000
Profit and Loss A/c 12,000
1,20,00
0 1,20,000

Calculate Debt-equity ratio; Proprietors ratio;

1.  Debt – Equity Ratio   = Long Term Debt (Liabilities) / Shareholders Fund

Long Term Liabilities = Debentures + long term loans

= 0+32000
Shareholders Fund = Equity Share Capital + Reserves & Surplus + Preference Sh.
Cap. – Fictitious Assets
= 40,000 + 8,000 + 12,000 = 60,000
= 32,000 / 60,000 = 0.53: 1
2. Proprietary Ratio     = Shareholders’ Funds / Total Assets
=     60,000 / 1, 20,000
= 0.5: 1

C. Interest Coverage e Ratio

All debt has a cost, which we normally term as an interest. Debentures, loans, deposits
etc all have an interest cost. This ratio will measure the security of this interest payable
on long-term debt. It is the ratio between the profits of a firm available and the interest
payable on debt instruments. The formula is,

Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-Term
Debt

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Example: Calculate interest coverage ratio from the following information
Net profit after deducting interest and taxes Rs. 6, 00,000; 12% of the debentures of
Rs. 15,00,000 and amount provided towards taxation is Rs.1,20,000

Solution
Interest coverage ratio = Net profit brfore interest and tax/ Interest on Long-Term
Debt
9, 00,000/1, 80,000 = 5 times

Net profit after interest and tax = 6, 00,000

Add: interest (15, 00,000*0.12= 1, 80,000) = 1, 80,000
Add: Tax = 1, 20,000
9,00,000

3. Profitability Ratios: The main object of a business concern is to earn profit. In

general terms, efficiency in business is measured by profitability. A low profitability
may arise due to lack of control over the expenses. Bankers and other creditors look
at the profitability ratios as an indicator whether or not the firm earns substantially
more than it pays interest for the use of borrowed funds and whether the ultimate
repayment of their debt appears reasonably certain. Owners are also interested to
know the profitability as it indicates the return which they can get on their
investments. Some of the most important profitability ratios:

A. Gross Profit ratio: Gross profit ratio is the ratio of gross profit to net sales i.e.
sales less sales returns. The ratio thus reflects the margin of profit that a concern
is able to earn on its trading and manufacturing activity. It is employed for inter-
firm and inter-firm comparison of trading results.

Formula:

Gross Profit Ratio = Gross profit / (Net sales × 100)

Where Gross profit = Net sales - Cost of goods sold

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 Cost of goods sold = Opening stock + Net purchases + Direct expenses - Closing
stock

Net sales = Sales - Returns inwards

Example:

Trading Account for the year ending 31/03/2016

Dr. Cr
Particulars Amount Particulars Amount
To Opening stock 40000 By Sales 155000
To Purchases 80000 (-) Sales returns 5000 100000
(-) Purchase returns 10000 70000 By Closing stock 10000

Solution:

Cost of goods sold = Opening stock + Net purchases - Closing stock

= 40,000 + 70,000 - 10,000= 1, 00,000

Net sales = 1, 55,000 - 5,000= 150,000

Gross profit = 1, 50,000 - 1, 00,000= 50,000

Gross profit ratio = (50,000 / 1, 50,000) x 100

= 33.33 %

B. Net Profit Ratio: It expresses the relationship between net profit after taxes and
sales. This ratio is measures of the overall profitability. Net profit is arrived at after
taking into account both the operating and non-operating items of incomes and
expenses. The ratio indicates what portion of the net sales is left for the owners after
all expenses have been met.

Formula:
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 Net profit ratio = (Net profit after tax / Net sales) × 100

It is expressed in percentage. Higher the net profit ratio, higher is the profitability of
the business.

Example:

From the following information calculate net profit ratio (NP ratio)

Total sales = 520,000; Sales returns = 20,000; Net profit =40,000

Net sales = (520,000 – 20,000) = 500,000

Net Profit Ratio = [(40,000 / 500,000) × 100]

= 8%

C. Operating Ratio: The operating ratio is determined by comparing the cost of the
goods sold and other operating expenses with net sales.
Formula:

Operating ratio = (Cost of goods sold + Operating expenses / Net sates)] × 100

Here cost of goods sold = Operating stock + Net purchases + Manufacturing

expenses - Closing stock

OR

= Net sales - Gross profit

Operating expenses = Office and administrative expenses + Selling and distribution

expenses

Interpretation:

This ratio is a test of the efficiency of the management in their business operation. It
is a means of operating efficiency.

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Example:

From the following details, calculate the operating ratio:

Cost of goods sold 6,00,000

Operating Expenses 40,000
Sales 8,20,000
Sales returns 20,000

Solution:

Operating ratio = (Cost of goods sold + Operating expenses) / Net Sales× 100

= [(6, 00,000 + 40,000) / 800,000*] × 100

= 640,000 / 800,000

= 80 %

D. Earnings per Share (EPS): Earning per share is a financial ratio that gives the
information regarding earning available to each equity shareholder. EPS is a
carefully scrutinized metric that is often used as a barometer to gauge a company's
profitability per unit of shareholder ownership. It is a portion of a company's profit
allocated to each outstanding share of common stock.

Formula

EPS = Earnings available to equity share holders / no. Of equity shares

E. Return on investment: It is a measurement designed to evaluation the ability

of an investment to generate income. The ratio is used to compare alternative
investment choices, as well as to determine if an existing investment represents
an efficient use of resources. 

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Formula

Return on investment = (Current value of investment - Cost of

investment) ÷ Cost of investment

For example, let us consider Investment A and Investment B, each with a cost of
Rs.100. These two investments are risk-free (cash flows are guaranteed) and the cash
flows are Rs.500 for Investment A and Rs.400 for Investment B next year.
Calculating the Return on Investment for both Investments A and B would give
us an indication of which investment is better. In this case, the ROI for Investment A
is (500-100)/ (100) = 400%, and the ROI for Investment B is (400-100)/(100) =
300%. In this situation, Investment A would be a more favorable investment.

F. Price/Earnings Ratio: The price-earnings ratio, often called as P/E ratio is the
ratio of company’s stock price to the company’s earnings per share. It is a market
prospect ratio which is useful in valuing companies. The relationship between the
two essential parts of this ratio i.e. Market value of the stock and its relative earnings
shows what the market is willing to pay for a stock based on its current earnings.
Thus, it is also known as the price multiple or the earnings multiple.

Price / Earnings Ratio = Market Value per Share/ EPS

P/E ratio reflects the current price in the market for each rupee of EPS.

Suppose, the market price per share of QPR Ltd. is Rs.100 and the earnings per
share are Rs.25, then the price-earnings ratio shall be as follows:

P/E Ratio = Rs.100 (Market Price) / Rs.25 (Earnings) = 4

This means that the Market price is 4 times the earnings of the company.

4. Activity Ratio: Activity ratios express how active the firm is in terms of selling
its stocks, collecting its receivables and paying its creditors. These are,

A. Inventory or Stock Turnover Ratio: Inventory turnover ratio indicates the

number of times the average inventory is sold during any given accounting period.
This ratio is used to test the effectiveness of inventory management

Inventory Turnover Ratio = Cost of goods sold/ Average inventory

Cost of goods sold = Sale – Gross Profit or (Or)

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 Opening Stock + Selling expenses + Administration expense – Closing Stock

Average Stock= Opening Stock + Closing Stock/2

A high inventory turnover ratio implies the efficiency of the firm whereas
a low inventory turnover ratio indicates the firm is not in a position to clear its
stocks.
Example:
Ram & Company supplies the following information regarding the year ended 31st
December:

Solution

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B. Debtors Turnover Ratio: This ratio is also called as receivable turnover ratio.
The debtor’s turnover ratio measures how quickly receivable or debtors are
converted into cash i.e. liquidity of receivables.

Debtor Turnover Ratio = Credit Sales/ Average Debtors

Average Debtors = Debtors at the beginning of year + Debtors at the end of year/2

When debtor’s turnover ratio is low, it means that the trade credit
management is poor. It indicates long collection period or the debtor’s are not
prompt. Hence, moderate ratio is desirable.

Debt collection period: Debt collection period refers to the time taken to collect the
debts.

Debt collection period = 365 days/ Debtors Turnover Ratio

Example:
From the following particular calculate Receivables turnover ratio and average
collection period
Rs.
Annual total sales 49,50,000
Cash sales (included in above) 6,25,000
Sales returns 75,000
Opening balance of receivables (net) 3,60,000
Closing balance of receivables (net) 4,00,000
Provision for bad and doubtful debts
40,000
(opening)
Provision for bad and doubtful debts
50,000
(closing)
Solution:
Working:
Annual credit sales (net) Rs.
Total sales 49,50,000
Less: Cash sales 6,25,000
Less: Sales returns 75,000 7,00,000

42,50,000

Average receivables:

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 Opening receivables (net) 3,60,000
 Add: Provision opening 40,000
Add: Closing receivables (net) 4,00,000
Provision closing 50,000

8,50,000

 Average (i.e. 8,50,000 / 2) Rs. 4,25,000

Receivables turnover ratio = Annual credit sales (net)

/Average accounts receivables
= 42,50,000 / 4,25,000
= 10 times
Receivables collection period = No. of days in the year / Receivable turnover ratio
= 365 / 10
= 36.5 approx. or 37 days.

C. Creditors Turnover Ratio: Creditors turnover ratio reveals the number of times
the average creditors are paid during a given accounting period. In other words, it
shows how promptly the firm is in a position to pay its creditors.

Creditors Turnover Ratio = Credit Purchases/ Average Creditors

Creditor’s payment period: Creditors collection period refers to the time taken to pay
the debts to creditors.
Creditors collection period =365 days/ Creditors Turnover Ratio
Example.

From the following figures calculate average age of creditors and creditor turnover
ratio:

$
Creditor (opening) 54200
Bills payable (closing) 5800
Total purchases 338000
Cash purchases 28500
Purchases returns 9500
Days of year 365

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SOLUTION:

Creditors turnover ratio = Net credit purchase / Average accounts payable

= 300,000 / 60,000

= 5 times

Average age of creditors = Days of year /

= 365 /5

= 73 days

Working:

As opening creditors are not given so average creditors will be considered as ending
creditors + Ending bills payable

i.e., = 54200 + 5800 = $60,000

No. of days in a year = 365

Net Credit Purchases:

Total purchases $3,38,000

Less: Cash purchases 28500
Less: Return outwards 9500 38,000

3,00,000

D. Fixed Asset Turnover Ratio: It is a ratio which determines the connection

between the sales and the total asset of a company. It checks for the efficiency with
which the company’s all assets are utilized to earn revenue. The formula for

Total Asset Turnover Ratio = Sales (Net Sales) / Total Assets of the Company 

For example, ABC Company has gross fixed assets of $5,000,000 and
accumulated depreciation of $2,000,000. Sales over the last 12 months totaled
$9,000,000. The calculation of ABC's fixed asset turnover ratio is:

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 Net sales ÷ total assets of the company

= $9,000,000 / 30, 00,000

= 3.0 Turnover per year

F. Working Capital Turnover Ratio: It measures how efficiently the working

capital is utilized. Net working capital is the excess of current assets over current
liabilities. This ratio indicates number of times the net working capital is converted
into sales. The higher ratio reflects the efficiency in the management of working
capital.

Working Turnover Ratio = Sales/ Net Working Capital

Example:

From the summarized balance sheet given below of a company calculate working

capital turnover ratio.

2000 2001
$ $
Equity 1,24,000 1,22,000
Long term loans 1,10,000 80,000
Current liabilities 74,000 38,000

3,08,000 3,40,000

Fixed assets 2,08,000 1,98,000

Current assets 1,00,000 1,42,000

3,08,000 3,40,000

Sales (net) during 2000 and 2001 amounted to $6, 00,000 and $5,00,000
respectively

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Working Notes:

Current assets 1,00,000 1,42,000

Less: current liabilities 74,000 38,000

Net working capital 26,000 1, 0 4,000

Working capital turnover ratio (2000)

= sales / net working capital

= 6, 00,000 / 26,000

23 times

Working capital turnover ratio (2001)

= sales / networking capital

= 5, 00,000 / 1,04,000

= 4.8times (approx. 5 times)

Problem 1:
The following is the Balance Sheet of a company as on 31st March:

Calculate
1. Current ratio
2. Quick ratio

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 3. Debt to equity ratio
4. Proprietary ratio

Solution

1. Current ratio = current assets/ current liabilities

= 3,50,00/1,50,000 = 2.33:1

Current assets = stock+ sundry debtors+ bolls receivables+ cash at bank

= (2, 00,000+1, 00,000+10,000+40,000)
= 3, 50,000
Current liabilities = sundry creditors+ bills payables
= (1,00,000+50,000)
= 1, 50,000
2. Quick Ratio = Quick assets / current liabilities
=1, 50,000 / 1, 500, 00 = 1:1
Quick assets = Current assets – (stock+ prepaid expenses)
= 3, 50,000 – (2, 00,000 + 0) = 1,50,000

3. Debt – equity ratio = long term debt / share holders fund (or) debt / equity

= 4, 20,000 / 2, 70,000 = 1.56:1

4. Proprietary ratio = shareholders fund / total assets

= 2, 70,000 / 8, 40,000 = 0.32:1

Problem 2:
The Capital of a Company is as follows:

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You are required to calculate:
1. Dividend yield on equity shares
2. EPS Ratio
3. P/E Ratio
Solution
1. Dividend yield on equity shares
= dividend per share / Market per share *100
= Rs. 2 (i.e 20% of Rs. 10) / Rs. 40 *100 = 5%

2. EPS Ratio = Earnings available to equity shareholders / No.of equity shares

= 2, 43,000 / 80,000 = 3.03 per share

3. P/E Ratio = Market price per share / EPS

= 40/ 3.03 = 13 times

Problem 3
Following is the summarized Balance Sheet of a concern as at 31st December:

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Solutions

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1

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Comments:
1. Liquidity and Solvency Position:
Current Ratio is 2.9. It means current assets of Rs.2.90 are available against each
rupee of current liability. The position is satisfactory on the basis of current ratio.
However, the Liquid Ratio is 0.65: 1. It means greater part of current assets
constitute stock; the stock is slow-moving. Therefore, the liquidity position is not
satisfactory.

2. Credit Terms:
The collection system is faulty because debtors enjoy a credit facility for 96 days,
which is beyond normal period. The performance of Debt Collection Department is
poor.

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3. Profitability:
Gross Profit Ratio is 20% which is a healthy sign. But the Net Profit Ratio is only
5%. It means operating expenses are higher.

4. Investment Structure:
Debt-Equity Ratio is 0.34: 1. It means the firm is not dependent on outside
liabilities. The position is satisfactory. Capital Gearing Ratio is also satisfactory.
However, the fixed assets to proprietorship ratio reveals that the entire fixed assets
were not purchased by the proprietors’ equity. It means the firm depends on outside
liabilities. It is not desired.

5. Return on Proprietors’ Fund:

5% of the sales is net profit and are available for the proprietors. The state of low
return is not desirable.

Stock Turnover Ratio and Turnover to fixed assets indicate an unhealthy sign. Fixed
assets are not used properly. It is a sign of under trading. The economic condition of
the firm is not sound. The firm can increase the rate of return on investment by
increasing production.

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