1

UNIT-V
Financial Analysis and Interpretation
Ratio Analysis
Managerial Economics and Financial Analysis
 2
Financial Analysis and Interpretation

 The following are the techniques of Financial Analysis

1. Ratio Analysis
2. Funds flow  and Cash flow analysis
3. Common size statement analysis
4. Comparative statement analysis
5. Trend analysis
 3
Ratio Analysis

It is the process of analysing and interpreting the financial statements to explain the issue of
Liquidity, Solvency and Profitability based on certain parameters with the help of ratios,
proportions, percentages etc., It is a valuable tool for decision making and forward planning. By
using the ratios,the financial performance of given firm can be analysed and compared from year to
year, with that of other firms and even with that of industry.
 Ratio analysis is the process of determining and interpreting numerical relationship
based on financial statements.
 It is the technique of interpretation of financial statements with the help of
accounting ratios derived from the balance sheet and profit and loss account.
 4
Objectives of Ratio Analysis

• Standardize financial information for comparisons

• Evaluate current operations
• Compare performance with past performance
• Compare performance against other firms or industry standards
• Study the efficiency of operations
• Study the risk of operations
 5
Advantages of Ratio Analysis

 Simplification of Mass accounting data.

 An individual aid to management.
 Facilitates better co-ordination and control.
 A tool to assess important characteristics of business.
 An effective tool of analysis of intra-firm and inter-firm
comparisons.
 6
Limitations of Ratio Analysis

 Limitations of Financial Statements

 Accounting ratios are retrospective
 Accounting methods, policies and procedures are not common
 Qualitative factors are ignored
 Lack of standard formulae
 Problems of price level changes
 Ratios alone are not adequate
 It is no substitute for personal judgement
 7
Types of Ratios

1. Liquidity ratios
2. Solvency ratios/Capital Structure ratios
3. Activity ratios/ Turnover ratios
4. Profitability ratios
 8
Liquidity ratios
1. Current Ratio

It is calculated by dividing current assets by current liabilities.

Current ratio =     Current assets                            where
                              Current liabilities
Conventionally a current ratio of 2:1(ideal ratio)  is considered satisfactory.
Current Assets include
      Cash in hand, Cash at bank, Short-term investments, Stock, Debtors, Bills receivable,
Prepaid expenses, Accrued Income(income yet to be received) etc.,
Current Liabilities include
      Creditors. Bills Payable, Bank overdraft, Outstanding expenses, Pre-received incomes, all
provisions, dividends payable etc.,
 9
Liquidity ratios
2. Quick Ratio/Acid test Ratio/Liquid Ratio

 Quick Ratio =       Quick assets                         

                                Current liabilities
 Quick Assets=Current assets-(Stock + Prepaid expenses)
 Ideal Rato is 1:1
 Quick assets include
Cash, Bank, Marketable securities, Debtors and Bills receivables
 10
Liquidity ratios
3. Absolute Quick Ratio

 Absolute Quick Ratio = Absolute Quick assets

                                                 Current Liabilities
 Ideal Ratio is 0.5:1 or 1:2
 Absolute Quick Assets include
 Cash, Bank balance and Marketable securities.
 11
Solvency Ratios or Capital Structure Ratios or
Leverage Ratios

1. Debt-equity Ratio =    Long term debts   

                                       Share holders' funds
                  
                                   =     Outsiders funds
                                         Share holders' funds
Long-term debts = Debentures, Bonds, Longterm loans etc.,
Share holders' funds= Equity share capital, Preference share capital, reserves, retained earnings and such other(or)
Shareholder's funds=Equity share capital +Preference share capital+ Reserves & 
Surplus(-) Accumulated losses(-) Defered revenue expenses(Or) Fictitious assets
Ideal Ratio is 1:1
 12
Solvency Ratios or Capital Structure
Ratios or Leverage Ratios

2. Interest coverage ratio = Net profit before interest and taxes

                                                           Fixed Interest charges
3. Proprietary ratio/Ratio of proprietors' funds to Total assets
                                           = Shareholders Funds/Proprietors’ funds
                           Total Assets
Shareholders funds-Equity share capital+ Preference share capital+ Reserves+ Retained
earnings & Surplus(-) Accumulated losses(-) Deferred revenue expenses(or)Fictitious assets
Total Assets=  Fixed assets+ Current assets
 13
Solvency Ratios or Capital
Structure Ratios or Leverage Ratios

4. Fixed Assets to Net worth Ratio (or)  Fixed Assets to Shareholder's funds
                         =           Fixed assets       
                                  Shareholders' funds
Net worth= Total assets-Outside liabilities(Long term liabilities and Current liabilities)
5. Ratio of Current Assets to Proprietors' funds
                        =      Current assets   
                              Proprietors' funds   
 14
Activity Ratios or Turnover Ratios

1. Inventory Turnover Ratio/ Stock turnover ratio

                        =            Cost of goods sold            
                                   Average Stock/Inventory
Cost of goods sold = Sales-Gross Profit (or)
            = Opening Stock+ Purchases+ Direct Expenses(-                                         
              Closing stock
Average stock =Opening stock+ Closing Stock 
                                                     2
•Inventory holding period = 365 days/Inventory turnover ratio
 15
Activity Ratios or Turnover Ratios

2. Debtors Turnover Ratio =     Net Credit Sales 

                                                  Average Debtors
Average Debtors =Opening Debtors+ Closing Debtors
                                                                2
Debtors include Trade debtors and  also Bills Receivable
*Debt Collection period = 365 days/Debtors turnover ratio
 16
Activity Ratios or Turnover Ratios

3. Creditors Turnover Ratio =     Net Credit Purchases

                                                         Average Creditors
Average Creditors =Opening Creditors+ Closing Creditors
                                                                2
Creditors include Trade creditors and  also Bills Payable
*Credit Collection period = 365 days/Creditors turnover ratio
 17
Activity Ratios or Turnover Ratios

4. A) Assets turnover ratio                = Sales/Total assets (or) Cost of sales/Total assets

    B) Fixed assets turnover ratio       =    Sales/ Fixed assets
     C) Current assets turnover ratio =    Sales/ Current  assets (or) 
                                                                Cost of sales/Current assets
5. Capital turnover ratio
A) Total Capital turnover  ratio              = Sales/ Total capital employed
*Capital employed= Shareholders’ Net worth+ Long term liabilities(or)
Net Fixed assets + Current assets-Current liabilities
B) Shareholders Capital turnover ratio=  Sales/ Shareholders funds
C) Working Capital turnover  ratio       = Sales/ Net working capital
Net working Capital= Total of Current Assets – Total of Current Liabilities
 Profitability Ratios or Efficiency Ratios 18
A)General Profitability Ratios

1.  Gross Profit ratio                         =     Gross Profit                                                       X    100

                                                                  Net  Sales       
2.  Operating ratio                        =    Cost of goods sold + Operating expenses      X   100
                                                                                         Net Sales
3.  Expenses Ratio     
      I) Administrative expenses Ratio = Administrative Expenses                   X   100
                                                                    Net Sales               
     II) Selling expenses Ratio              =  Selling Expenses                                X   100
                                Net Sales
4.  I) Net Operating Profit Ratio     =   Net Operating Profit                           X   100
                                                                    Net Sales
    II) Net Profit ratio                        =      Net Profit                                            X    100
 19
Profitability Ratios or Efficiency Ratios
B) Overall Profitability Ratios

A) Return on Capital Ratios

1) Return on Capital employed= Net profit before interest and taxes
Capital employed
*Capital employed  = Total assets- Current Liabilities   (Or) Fixed assets +Current assets-Current liabilities    (Or) Fixed assets- Net
Working capital​
2)Return on Shareholders Investment Ratio(ROI)
                             =           Net Profit after taxes                                      X     100
                                    Shareholders Funds
3) Return on Equity Capital Ratio(R.E.C)
                     =   Net Profit  after taxes- Preference dividend                   X     100
                 Equity Share capital
 20
Profitability Ratios or Efficiency Ratios
B) General Profitability Ratios

B) Investment Ratios
1) Earning Per Share(E.P.S.)            =     Net Profits to equity shareholders 
                                                                           No. of Equity Shares
2) Dividend Per Share(D.P.S.)         =     Dividends to Equity Share holders
                                                                           No. Of Equity Shares  
3) Price Earning Ratio (P.E.R.) or P/E Ratio=      Market Price of the Equity Share
                                                                                       E.P.S(Earning per share)
 Profitability Ratios or Efficiency Ratios 21
B) Overall Profitability Ratios

4) Pay out Ratio                                =       Dividend per equity share 

                                                                      Earning per equity share
5) Dividend Yield Ratio (D.Y.R.)      =        Dividend Per Share                            X   100 
                                                                    Market Price per share 
6) Earning Yield Ratio (E.Y.R.)         =         Earning per share                              X  100
                                                                     Market Price per share