RATIO ANALYSIS

It refers to the systematic use of ratios to interpret the financial statements in

terms of the operating performance and financial position of a firm. It involves
comparison for a meaningful interpretation of the financial statements.

In view of the needs of various uses of ratios the ratios, which can be calculated
from the accounting data are classified into the following broad categories

A. Liquidity Ratio
B. Turnover Ratio
C. Solvency or Leverage ratios
D. Profitability ratios

A. LIQUIDITY RATIO

It measures the ability of the firm to meet its short-term obligations, that is
capacity of the firm to pay its current liabilities as and when they fall due. Thus
these ratios reflect the short-term financial solvency of a firm. A firm should
ensure that it does not suffer from lack of liquidity. The failure to meet
obligations on due time may result in bad credit image, loss of creditors
confidence, and even in legal proceedings against the firm on the other hand
very high degree of liquidity is also not desirable since it would imply that funds
are idle and earn nothing. So therefore it is necessary to strike a proper balance
between liquidity and lack of liquidity.

The various ratios that explains about the liquidity of the firm are
1. Current Ratio
2. Acid Test Ratio / quick ratio
3. Absolute liquid ration / cash ratio

1. CURRENT RATIO
The current ratio measures the short-term solvency of the firm. It establishes
the relationship between current assets and current liabilities. It is calculated by
dividing current assets by current liabilities.

Current Ratio = Current Asset

Current Liabilities

Current assets include cash and bank balances, marketable securities, inventory,
and debtors, excluding provisions for bad debts and doubtful debtors, bills
receivables and prepaid expenses. Current liabilities includes sundry creditors,
bills payable, short- term loans, income-tax liability, accrued expenses and
dividends payable.
2. ACID TEST RATIO / QUICK RATIO
It has been an important indicator of the firm’s liquidity position and is used as a
complementary ratio to the current ratio. It establishes the relationship between
quick assets and current liabilities. It is calculated by dividing quick assets by the
current liabilities.

Acid Test Ratio = Quick Assets

Current liabilities

Quick assets are those current assets, which can be converted into cash
immediately or within reasonable short time without a loss of value. These
include cash and bank balances, sundry debtors, bill’s receivables and short-term
marketable securities.

3. ABSOLUTE LIQUID RATION / CASH RATIO

It shows the relationship between absolute liquid or super quick current assets
and liabilities. Absolute liquid assets include cash, bank balances, and
marketable securities.

Absolute liquid ratio = Absolute liquid assets

Current liabilities

B. TURNOVER RATIO

Turnover ratios are also known as activity ratios or efficiency ratios with which a
firm manages its current assets. The following turnover ratios can be calculated
to judge the effectiveness of asset use.

1. Inventory Turnover Ratio

2. Debtor Turnover Ratio
3. Creditor Turnover Ratio
4. Assets Turnover Ratio
1. INVENTORY TURNOVER RATIO
This ratio indicates the number of times the inventory has been converted into
sales during the period. Thus it evaluates the efficiency of the firm in managing
its inventory. It is calculated by dividing the cost of goods sold by average
inventory.

Inventory Turnover Ratio = Cost of goods sold

Average Inventory

The average inventory is simple average of the opening and closing balances of
inventory. (Opening + Closing balances / 2). In certain circumstances opening
balance of the inventory may not be known then closing balance of inventory
may be considered as average inventory

2. DEBTOR TURNOVER RATIO

This indicates the number of times average debtors have been converted into
cash during a year. It is determined by dividing the net credit sales by average
debtors.

Debtor Turnover Ratio = Net Credit Sales

Average Trade Debtors

Net credit sales consist of gross credit sales minus sales return. Trade debtor
includes sundry debtors and bill’s receivables. Average trade debtors (Opening
+ Closing balances / 2)

When the information about credit sales, opening and closing balances of trade
debtors is not available then the ratio can be calculated by dividing total sales by
closing balances of trade debtor

Debtor Turnover Ratio = Total Sales

Trade Debtors

3. CREDITOR TURNOVER RATIO

It indicates the number of times sundry creditors have been paid during a year.
It is calculated to judge the requirements of cash for paying sundry creditors. It
is calculated by dividing the net credit purchases by average creditors.

Creditor Turnover Ratio = Net Credit Purchases

Average Trade Creditor
Net credit purchases consist of gross credit purchases minus purchase return

When the information about credit purchases, opening and closing balances of
trade creditors is not available then the ratio is calculated by dividing total
purchases by the closing balance of trade creditors.

Creditor Turnover Ratio = Total purchases

Total Trade Creditors

4. ASSETS TURNOVER RATIO

The relationship between assets and sales is known as assets turnover ratio.
Several assets turnover ratios can be calculated depending upon the groups of
assets, which are related to sales.

a) Total asset turnover.

b) Net asset turnover
c) Fixed asset turnover
d) Current asset turnover
e) Net working capital turnover ratio

a. TOTAL ASSET TURNOVER

This ratio shows the firms ability to generate sales from all financial resources
committed to total assets. It is calculated by dividing sales by total assets.

Total asset turnover = Total Sales

Total Assets
b. NET ASSET TURNOVER
This is calculated by dividing sales by net assets.

Net asset turnover = Total Sales

Net Assets

Net assets represent total assets minus current liabilities. Intangible and
fictitious assets like goodwill, patents, accumulated losses, deferred expenditure
may be excluded for calculating the net asset turnover.

c. FIXED ASSET TURNOVER

This ratio is calculated by dividing sales by net fixed assets.

Fixed asset turnover = Total Sales

Net Fixed Assets
Net fixed assets represent the cost of fixed assets minus depreciation.
d. CURRENT ASSET TURNOVER
It is divided by calculating sales by current assets

Current asset turnover = Total Sales

Current Assets

e. NET WORKING CAPITAL TURNOVER RATIO

A higher ratio is an indicator of better utilization of current assets and working
capital and vice-versa (a lower ratio is an indicator of poor utilization of current
assets and working capital). It is calculated by dividing sales by working capital.

Net working capital turnover ratio = Total Sales

Working Capital

Working capital is represented by the difference between current assets and

current liabilities.

C. SOLVENCY OR LEVERAGE RATIOS

The solvency or leverage ratios throws light on the long term solvency of a firm
reflecting it’s ability to assure the long term creditors with regard to periodic
payment of interest during the period and loan repayment of principal on
maturity or in predetermined instalments at due dates. There are thus two
aspects of the long-term solvency of a firm.

a. Ability to repay the principal amount when due

b. Regular payment of the interest.

The ratio is based on the relationship between borrowed funds and owner’s
capital it is computed from the balance sheet, the second type are calculated
from the profit and loss a/c. The various solvency ratios are

1. Debt equity ratio

2. Debt to total capital ratio
3. Proprietary (Equity) ratio
4. Fixed assets to net worth ratio
5. Fixed assets to long term funds ratio
6. Debt service (Interest coverage) ratio
1. DEBT EQUITY RATIO
Debt equity ratio shows the relative claims of creditors (Outsiders) and owners
(Interest) against the assets of the firm. Thus this ratio indicates the relative
proportions of debt and equity in financing the firm’s assets. It can be calculated
by dividing outsider funds (Debt) by shareholder funds (Equity)

Debt equity ratio = Outsider Funds (Total Debts)

Shareholder Funds or Equity (net worth)

The outsider fund includes long-term debts as well as current liabilities. The
shareholder funds include equity share capital, preference share capital, reserves
and surplus including accumulated profits. However fictitious assets like
accumulated deferred expenses etc should be deducted from the total of these
items to shareholder funds. The shareholder funds so calculated are known as
net worth of the business.

2. DEBT TO TOTAL CAPITAL RATIO

Debt to total capital ratio = Total Debts
Total Assets

3. PROPRIETARY (EQUITY) RATIO

This ratio indicates the proportion of total assets financed by owners. It is
calculated by dividing proprietor (Shareholder) funds by total assets.

Proprietary (equity) ratio = Shareholder funds

Total assets

4. FIXED ASSETS TO NET WORTH RATIO

This ratio establishes the relationship between fixed assets and shareholder
funds. It is calculated by dividing fixed assets by shareholder funds.

Fixed assets to net worth ratio = Fixed Assets X 100

Net Worth
5. FIXED ASSETS TO LONG TERM FUNDS RATIO
Fixed assets to long term funds ratio establishes the relationship between fixed
assets and long-term funds and is calculated by dividing fixed assets by long
term funds.

Fixed assets to long term funds ratio = Fixed Assets X 100

Long-term Funds

6. DEBT SERVICE (INTEREST COVERAGE) RATIO

This shows the number of times the earnings of the firms are able to cover the
fixed interest liability of the firm. This ratio therefore is also known as Interest
coverage or time interest earned ratio. It is calculated by dividing the earnings
before interest and tax (EBIT) by interest charges on loans.

Debt Service Ratio = Earnings before interest and tax (EBIT)

Interest Charges

PROFITABILITY RATIOS
The profitability ratio of the firm can be measured by calculating various
profitability ratios. General two groups of profitability ratios are calculated.
a. Profitability in relation to sales.
b. Profitability in relation to investments.

Profitability in relation to sales

1. Gross profit margin or ratio
2. Net profit margin or ratio
3. Operating profit margin or ratio
4. Operating Ratio
5. Expenses Ratio

1. GROSS PROFIT MARGIN OR RATIO

It measures the relationship between gross profit and sales. It is calculated by
dividing gross profit by sales.

Gross profit margin or ratio = Gross profit X 100

Net sales

Gross profit is the difference between sales and cost of goods sold.
2. NET PROFIT MARGIN OR RATIO
It measures the relationship between net profit and sales of a firm. It indicates
management’s efficiency in manufacturing, administrating, and selling the
products. It is calculated by dividing net profit after tax by sales.

Net profit margin or ratio = Earning after tax X 100

Net Sales

3. OPERATING PROFIT MARGIN OR RATIO

It establishes the relationship between total operating expenses and net sales.
It is calculated by dividing operating expenses by the net sales.

Operating profit margin or ratio = Operating expenses X 100

Net sales
Operating expenses includes cost of goods produced/sold, general and
administrative expenses, selling and distributive expenses.

4. EXPENSES RATIO
While some of the expenses may be increasing and other may be declining to
know the behavior of specific items of expenses the ratio of each individual
operating expenses to net sales should be calculated. The various variants of
expenses are

Cost of goods sold = Cost of goods sold X 100

Net Sales

Administrative Expenses Ratio = Administrative Expenses X 100

Net sales

Selling and distribution expenses ratio = Selling and distribution expenses X 100
Net sales

5. OPERATING PROFIT MARGIN OR RATIO

Operating profit margin or ratio establishes the relationship between operating
profit and net sales. It is calculated by dividing operating profit by sales.

Operating profit margin or ratio = Operating Profit X 100

Net sales
Operating profit is the difference between net sales and total operating
expenses. (Operating profit = Net sales – cost of goods sold – administrative
expenses – selling and distribution expenses.)
PROFITABILITY IN RELATION TO INVESTMENTS
1. Return on gross investment or gross capital employed
2. Return on net investment or net capital employed
3. Return on shareholder’s investment or shareholder’s capital employed.
4. Return on equity shareholder investment or equity shareholder capital
employed.

1. RETURN ON GROSS CAPITAL EMPLOYED

This ratio establishes the relationship between net profit and the gross capital
employed. The term gross capital employed refers to the total investment made
in business. The conventional approach is to divide Earnings After Tax (EAT) by
gross capital employed.

Return on gross capital employed = Earnings After Tax (EAT) X 100

Gross capital employed

2. RETURN ON NET CAPITAL EMPLOYED

It is calculated by dividing Earnings Before Interest & Tax (EBIT) by the net
capital employed. The term net capital employed in the gross capital in the
business minus current liabilities. Thus it represents the long-term funds
supplied by creditors and owners of the firm.

Return on net capital employed = Earnings Before Interest & Tax (EBIT) X 100
Net capital employed

3. RETURN ON SHARE CAPITAL EMPLOYED

This ratio establishes the relationship between earnings after taxes and the
shareholder investment in the business. This ratio reveals how profitability the
owners’ funds have been utilized by the firm. It is calculated by dividing
Earnings after tax (EAT) by shareholder capital employed.

Return on share capital employed = Earnings after tax (EAT) X 100

Shareholder capital employed

4. RETURN ON EQUITY SHARE CAPITAL EMPLOYED

Equity shareholders are entitled to all the profits remaining after the all outside
claims including dividends on preference share capital are paid in full. The
earnings may be distributed to them or retained in the business. Return on
equity share capital investments or capital employed establishes the relationship
between earnings after tax and preference dividend and equity shareholder
investment or capital employed or net worth. It is calculated by dividing
earnings after tax and preference dividend by equity shareholder’s capital
employed.
Return on equity share capital employed = Earnings after tax (EAT), preference dividends X 100
Equity share capital employed

EARNINGS PER SHARE

IT measure the profit available to the equity shareholders on a per share basis.
It is computed by dividing earnings available to the equity shareholders by the
total number of equity share outstanding
Earnings per share = Earnings after tax – Preferred dividends (if any)
Equity shares outstanding

DIVIDEND PER SHARE

The dividends paid to the shareholders on a per share basis in dividend per
share. Thus dividend per share is the earnings distributed to the ordinary
shareholders divided by the number of ordinary shares outstanding.

Dividend per share = Earnings paid to the ordinary shareholders

Number of ordinary shares outstanding

DIVIDENDS PAY OUT RATIO (PAY OUT RATIO)

It measures the relationship between the earnings belonging to the equity
shareholders and the dividends paid to them. It shows what percentage shares
of the earnings are available for the ordinary shareholders are paid out as
dividend to the ordinary shareholders. It can be calculated by dividing the total
dividend paid to the equity shareholders by the total earnings available to them
or alternatively by dividing dividend per share by earnings per share.

Dividend pay our ratio (Pay our ratio) = Total dividend paid to equity share holders
Total earnings available to equity share holders

Or

Dividend per share

Earnings per share

DIVIDEND AND EARNINGS YIELD

While the earnings per share and dividend per share are based on the book
value per share, the yield is expressed in terms of market value per share. The
dividend yield may be defined as the relation of dividend per share to the market
value per ordinary share and the earning ratio as the ratio of earnings per share
to the market value of ordinary share.

Dividend Yield = Dividend Per share

Market value of ordinary share
 Earnings yield = Earnings per share
Market value of ordinary share

PRICE EARNING RATIO

The reciprocal of the earnings yield is called price earnings ratio. It is calculated
by dividing the market price of the share by the earnings per share.

Price earnings (P/E) ratio = Market price of share

Earnings per share