MBA PROJECT REPORT ON RATIO ANALYSIS

Meaning of Ratio:- A ratio is simple arithmetical expression of the

relationship of one number to another. It may be defined as the indicated
quotient of two mathematical expressions.

According to Accountant’s Handbook by Wixon, Kell and Bedford, “a ratio

is an expression of the quantitative relationship between two numbers”.

  Ratio Analysis:- Ratio analysis is the process of determining and presenting

the relationship of items and group of items in the statements. According to
Batty J. Management Accounting “Ratio can assist management in its basic
functions of forecasting, planning coordination, control and
communication”.

 It is helpful to know about the liquidity, solvency, capital structure and
profitability of an organization. It is helpful tool to aid in applying
judgement, otherwise complex situations.

Ratio analysis can represent following three methods.

Ratio may be expressed in the following three ways :

1.     Pure Ratio or Simple Ratio :- It is expressed by the simple division

of one number by another. For example , if the current assets of a
business are Rs. 200000 and its current liabilities are Rs. 100000, the
ratio of ‘Current assets to current liabilities’ will be 2:1.

2.     ‘Rate’ or ‘So Many Times :- In this type , it is calculated how many
times a figure is, in comparison to another figure. For example , if a
firm’s credit sales during the year are Rs. 200000 and its debtors at the
end of the year are Rs. 40000 , its Debtors Turnover Ratio is
200000/40000 = 5 times. It shows that the credit sales are 5 times in
comparison to debtors.

3.     Percentage :- In this type, the relation between two figures is

expressed in hundredth. For example, if a firm’s capital is Rs.1000000
and its profit is Rs.200000 the ratio of profit capital, in term of
percentage, is 200000/1000000*100 = 20%

ADVANTAGE OF RATIO ANALYSIS 

1. Helpful in analysis of Financial Statements.

2. Helpful in comparative Study.

3. Helpful in locating the weak spots of the business.

4. Helpful in Forecasting.

5. Estimate about the trend of the business.

6. Fixation of ideal Standards.

7. Effective Control.

8. Study of Financial Soundness.

LIMITATIONS OF RATIO ANALYSIS

1.     Comparison not possible if different firms adopt different accounting

policies.

2.     Ratio analysis becomes less effective due to price level changes.

3.     Ratio may be misleading in the absence of absolute data.

4.     Limited use of a single data.

5.     Lack of proper standards.

6.     False accounting data gives false ratio.

7.     Ratios alone are not adequate for proper conclusions.

8.     Effect of personal ability and bias of the analyst. 

CLASSIFICATION OF RATIO 

Ratio may be classified into the four categories as follows:

A.    Liquidity Ratio

a.      Current Ratio

 b.     Quick Ratio or Acid Test Ratio

B.    Leverage or Capital Structure Ratio

a.      Debt Equity Ratio

b.     Debt to Total Fund Ratio

c.     Proprietary Ratio

d.     Fixed Assets to Proprietor’s Fund Ratio

e.      Capital Gearing Ratio

f.       Interest Coverage Ratio

C.    Activity Ratio or Turnover Ratio

a.      Stock Turnover Ratio

b.     Debtors or Receivables Turnover Ratio

c.     Average Collection Period

d.     Creditors or Payables Turnover Ratio

e.      Average Payment Period

f.       Fixed Assets Turnover Ratio

g.     Working Capital Turnover Ratio

D.    Profitability Ratio or Income Ratio

 (A) Profitability Ratio based on Sales :

 a. Gross Profit Ratio

 b. Net Profit Ratio

 c. Operating Ratio

 d. Expenses Ratio

 (B) Profitability Ratio Based on Investment :

          I.       Return on Capital Employed

      II.      Return on Shareholder’s Funds :

a.      Return on Total Shareholder’s Funds

b.     Return on Equity Shareholder’s Funds

c.     Earning Per Share

d.     Dividend Per Share

e.      Dividend Payout Ratio

f.       Earning and Dividend Yield

g.     Price Earning Ratio

LIQUIDITY RATIO

 (A) Liquidity Ratio:- It refers to the ability of the firm to meet  its current
liabilities. The liquidity ratio, therefore, are also called ‘Short-term Solvency
Ratio’. These ratio are used to assess the short-term financial position of the
concern. They indicate the firm’s ability to meet its current obligation out of
current resources.

 In the words of Saloman J. Flink, “Liquidity is the ability of the firms to
meet its current obligations as they fall due”.

 Liquidity ratio include two ratio :-

a.      Current Ratio

b.     Quick Ratio or Acid Test Ratio

 a. Current Ratio:- This ratio explains the relationship between current
assets and current liabilities of a business.

Current Assets:-‘Current assets’ includes those assets which can be

converted into cash with in a year’s time.

Current Assets = Cash in Hand + Cash at Bank + B/R + Short Term

Investment + Debtors(Debtors – Provision) + Stock(Stock of Finished
Goods + Stock of Raw Material + Work in Progress) + Prepaid Expenses.

Current Liabilities :- ‘Current liabilities’ include those liabilities which are

repayable in a year’s time.

Current Liabilities = Bank Overdraft + B/P + Creditors + Provision for

Taxation + Proposed Dividend + Unclaimed Dividends + Outstanding
Expenses + Loans Payable with in a Year.

Significance :- According to accounting principles, a current ratio of 2:1 is

supposed to be an ideal ratio.

It means that current assets of a business should, at least , be twice of its

current liabilities. The higher ratio indicates the better liquidity position, the
firm will be able to pay its current liabilities more easily. If the ratio is less
than 2:1, it indicate lack of liquidity and shortage of working capital.

The biggest drawback of the current ratio is that it is susceptible to “window

dressing”. This ratio can be improved by an equal decrease in both current
assets and current liabilities.

b. Quick Ratio:- Quick ratio indicates whether the firm is in a position to

pay its current liabilities with in a month or immediately.

‘Liquid Assets’ means those assets, which will yield cash very shortly.

 Liquid Assets = Current Assets – Stock – Prepaid Expenses

Significance :- An ideal quick ratio is said to be 1:1. If it is more, it is

considered to be better. This ratio is a better test of short-term financial
position of the company.

LEVERAGE OR CAPITAL STRUCTURE RATIO

(B) Leverage or Capital Structure Ratio :- This ratio disclose the firm’s
ability to meet the interest costs regularly and Long term indebtedness at
maturity.

These ratio include the following ratios :

a.      Debt Equity Ratio:- This ratio can be expressed in two ways:

First Approach : According to this approach, this ratio expresses the

relationship between long term debts and shareholder’s fund.

 Formula:

Debt Equity Ratio=Long term Loans/Shareholder’s Funds or Net Worth

Long Term Loans:- These refer to long term liabilities which mature after
one year. These include Debentures, Mortgage Loan, Bank Loan, Loan from
Financial institutions and Public Deposits etc.

Shareholder’s Funds :- These include Equity Share Capital, Preference

Share Capital, Share Premium, General Reserve, Capital Reserve, Other
Reserve and Credit Balance of Profit & Loss Account.

Second Approach : According to this approach the ratio is calculated as

follows:-

 Formula:

Debt Equity Ratio=External Equities/internal Equities

 Debt equity ratio is calculated for using second approach.

Significance :- This Ratio is calculated to assess the ability of the firm to

meet its long term liabilities. Generally, debt equity ratio of is considered
safe.

If the debt equity ratio is more than that, it shows a rather risky financial
position from the long-term point of view, as it indicates that more and more
funds invested in the business are provided by long-term lenders.
The lower this ratio, the better it is for long-term lenders because they are
more secure in that case. Lower than 2:1 debt equity ratio provides sufficient
protection to long-term lenders.

b. Debt to Total Funds Ratio : This Ratio is a variation of the debt equity
ratio and gives the same indication as the debt equity ratio. In the ratio, debt
is expressed in relation to total funds, i.e., both equity and debt.

Formula:

Debt to Total Funds Ratio = Long-term Loans/Shareholder’s funds + Long-term Loans

Significance :- Generally, debt to total funds ratio of 0.67:1 (or

67%) is considered satisfactory. In other words, the proportion of long term

loans should not be more than 67% of total funds.

A higher ratio indicates a burden of payment of large amount of interest

charges periodically and the repayment of large amount of loans at maturity.
Payment of interest may become difficult if profit is reduced. Hence, good
concerns keep the debt to total funds ratio below 67%. The lower ratio is
better from the long-term solvency point of view.

c. Proprietary Ratio:- This ratio indicates the proportion of total funds

provide by owners or shareholders.

Formula:

Proprietary Ratio = Shareholder’s Funds/Shareholder’s Funds + Long term loans

Significance :- This ratio should be 33% or more than that. In other

words, the proportion of shareholders funds to total funds should be 33%
or more.

A higher proprietary ratio is generally treated an indicator of sound

financial position from long-term point of view, because it means that the
firm is less dependent on external sources of finance.
 If the ratio is low it indicates that long-term loans are less secured and
they face the risk of losing their money.

d. Fixed Assets to Proprietor’s Fund Ratio :- This ratio is also know as

fixed assets to net worth ratio.

 Formula:

Fixed Asset to Proprietor’s Fund Ratio = Fixed Assets/Proprietor’s Funds (i.e., Net
Worth)

Significance :- The ratio indicates the extent to which proprietor’s

(Shareholder’s) funds are sunk into fixed assets. Normally , the purchase of
fixed assets should be financed by proprietor’s funds. If this ratio is less than
100%, it would mean that proprietor’s fund are more than fixed assets and a
part of working capital is provided by the proprietors. This will indicate the
long-term financial soundness of business.

e. Capital Gearing Ratio:- This ratio establishes a relationship between

equity capital (including all reserves and undistributed profits) and fixed cost
bearing capital.

 Formula:

Capital Gearing Ratio = Equity Share Capital+ Reserves + P&L Balance/ Fixed cost
Bearing Capital

Whereas, Fixed Cost Bearing Capital = Preference Share Capital  +

Debentures + Long Term Loan

Significance:- If the amount of fixed cost bearing capital is more than the
equity share capital including reserves an undistributed profits), it will be
called high capital gearing and if it is less, it will be called low capital
gearing.

The high gearing will be beneficial to equity shareholders when the rate
of interest/dividend payable on fixed cost bearing capital is lower than
the rate of return on investment in business.

Thus, the main objective of using fixed cost bearing capital is to

maximize the profits available to equity shareholders.
 f. Interest Coverage Ratio:- This ratio is also termed as ‘Debt Service
Ratio’. This ratio is calculated as follows:

 Formula:

Interest Coverage Ratio = Net Profit before charging interest and tax / Fixed
Interest Charges

Significance :- This ratio indicates how many times the interest charges are
covered by the profits available to pay interest charges.

This ratio measures the margin of safety for long-term lenders.

 This higher the ratio, more secure the lenders is in respect of payment of
interest regularly. If profit just equals interest, it is an unsafe position for the
lender as well as for the company also , as nothing will be left for
shareholders.

 An interest coverage ratio of 6 or 7 times is considered appropriate.

ACTIVITY RATIO OR TURNOVER RATIO

 (C) Activity Ratio or Turnover Ratio :- These ratio are calculated on the bases
of ‘cost of sales’ or sales, therefore, these ratio are also called as ‘Turnover
Ratio’.  Turnover indicates the speed or number of times the  capital employed
has been rotated in the process of doing business. Higher turnover ratio indicates
the better use of capital or resources and in turn lead to higher profitability.

 It includes the following :

a.     Stock Turnover Ratio:- This ratio indicates the relationship between
the cost of goods during the year and average stock kept during that
year.

Formula:

Stock Turnover Ratio = Cost of Goods Sold / Average Stock

 Here, Cost of goods sold = Net Sales – Gross Profit

 Average Stock = Opening Stock + Closing Stock/2

 Significance:- This ratio indicates whether stock has been used or not. It
shows the speed with which the stock is rotated into sales or the number of
times the stock is turned into sales during the year.

The higher the ratio, the better it is, since it indicates that stock is selling
quickly. In a business where stock turnover ratio is high, goods can be sold
at a low margin of profit and even than the profitability may be quit high.

b.     Debtors Turnover Ratio :- This ratio indicates the relationship between
credit sales and average debtors during the year :

Formula:

Debtor Turnover Ratio = Net Credit Sales / Average Debtors + Average B/R

While calculating this ratio, provision for bad and doubtful debts is not
deducted from the debtors, so that it may not give a false impression that
debtors are collected quickly.

Significance :- This ratio indicates the speed with which the amount is
collected from debtors. The higher the ratio, the better it is, since it indicates
that amount from debtors is being collected more quickly. The more quickly
the debtors pay, the less the risk from bad- debts, and so the lower the
expenses of collection and increase in the liquidity of the firm.

By comparing the debtors turnover ratio of the current year with the
previous year, it may be assessed whether the sales policy of the
management is efficient or not.

c.      Average Collection Period :- This ratio indicates the time with in
which the amount is collected from debtors and bills receivables.

 Formula:

Average Collection Period = Debtors + Bills Receivable / Credit Sales per day

Here, Credit Sales per day = Net Credit Sales of the year / 365

Second Formula :-

Average Collection Period = Average Debtors *365 / Net Credit Sales

Average collection period can also be calculated on the bases of ‘Debtors
Turnover Ratio’. The formula will be:

Average Collection Period = 12 months or 365 days / Debtors Turnover Ratio

Significance :- This ratio shows the time in which the customers are paying
for credit sales. A higher debt collection period is thus, an indicates of the
inefficiency and negligency on the part of management. On the other hand,
if there is decrease in debt collection period, it indicates prompt payment by
debtors which reduces the chance of bad debts.

d. Creditors Turnover Ratio :- This ratio indicates the relationship between

credit purchases and average creditors during the year .

Formula:-

Creditors Turnover Ratio = Net credit Purchases / Average Creditors + Average B/P

Note :- If the amount of credit purchase is not given in the question, the ratio
may be calculated on the bases of total purchase.

Significance :- This ratio indicates the speed with which the amount is being
paid to creditors. The higher the ratio, the better it is, since it will indicate
that the creditors are being paid more quickly which increases the credit
worthiness of the firm.

d. Average Payment Period :- This ratio indicates the period which is

normally taken by the firm to make payment to its creditors.

 Formula:-

Average Payment Period = Creditors + B/P/ Credit Purchase per day

This ratio may also be calculated as follows :

Average Payment Period = 12 months or 365 days / Creditors Turnover Ratio

Significance :- The lower the ratio, the better it is, because a shorter
payment period implies that the creditors are being paid rapidly.

d.     Fixed Assets Turnover Ratio :- This ratio reveals how efficiently the
fixed assets are being utilized.
 Formula:-

Fixed Assets Turnover Ratio = Cost of Goods Sold/ Net Fixed Assets

Here, Net Fixed Assets = Fixed Assets – Depreciation

Significance:- This ratio is particular importance in manufacturing concerns

where the investment in fixed asset is quit high. Compared with the previous
year, if there is increase in this ratio, it will indicate that there is better
utilization of fixed assets. If there is a fall in this ratio, it will show that fixed
assets have not been used as efficiently, as they had been used in the
previous year.

e.      Working Capital Turnover Ratio :- This ratio reveals how efficiently
working capital has been utilized in making sales.

Formula :-

Working Capital Turnover Ratio = Cost of Goods Sold / Working Capital

Here, Cost of Goods Sold = Opening Stock + Purchases +  Carriage +

Wages + Other Direct Expenses - Closing Stock

Working Capital = Current Assets – Current Liabilities

Significance :- This ratio is of particular importance in non-manufacturing

concerns where current assets play a major role in generating sales. It shows
the number of times working capital has been rotated in producing sales.

A high working capital turnover ratio shows efficient use of working capital
and quick turnover of current assets like stock and debtors.

A low working capital turnover ratio indicates under-utilisation of working

capital.

Profitability Ratios or Income Ratios

(D) Profitability Ratios or Income Ratios:- The main object of every

business concern is to earn profits. A business must be able to earn adequate
profits in relation to the risk and capital invested in it. The efficiency and the
success of a business can be measured with the help of profitability ratio.
 Profitability ratios are calculated to provide answers to the following
questions:

          i.            Is the firm earning adequate profits?

        ii.            What is the rate of gross profit and net profit on sales?

      iii.            What is the rate of return on capital employed in the firm?

      iv.            What is the rate of return on proprietor’s (shareholder’s) funds?

        v.            What is the earning per share?

 Profitability ratio can be determined on the basis of either sales or

investment into business.

(A)      Profitability Ratio Based on Sales :

 a) Gross Profit Ratio : This ratio shows the relationship between gross
profit and sales.

 Formula :

Gross Profit Ratio = Gross Profit / Net Sales *100

 Here, Net Sales = Sales – Sales Return

Significance:- This ratio measures the margin of profit available on sales.

The higher the gross profit ratio, the better it is. No ideal standard is fixed
for this ratio, but the gross profit ratio should be adequate enough not only to
cover the operating expenses but also to provide for deprecation, interest on
loans, dividends and creation of reserves.

b) Net Profit Ratio:- This ratio shows the relationship between net profit and
sales. It may be calculated by two methods:

 Formula:

Net Profit Ratio = Net Profit / Net sales *100

Operating Net Profit = Operating Net Profit / Net Sales *100

Here, Operating Net Profit = Gross Profit – Operating Expenses such as
Office and Administrative Expenses, Selling and Distribution Expenses,
Discount, Bad Debts, Interest on short-term debts etc.

Significance :- This ratio measures the rate of net profit earned on sales. It
helps in determining the overall efficiency of the business operations. An
increase in the ratio over the previous year shows improvement in the
overall efficiency and profitability of the business.

(c) Operating Ratio:- This ratio measures the proportion of an enterprise

cost of sales and operating expenses in comparison to its sales.

 Formula:

Operating Ratio = Cost of Goods Sold + Operating Expenses/ Net Sales *100

Where, Cost of Goods Sold = Opening Stock + Purchases + Carriage +

Wages + Other Direct Expenses - Closing Stock

Operating Expenses = Office and Administration Exp. + Selling and

Distribution Exp. + Discount + Bad Debts + Interest on Short- term loans.

‘Operating Ratio’ and ‘Operating Net Profit Ratio’ are inter-related. Total of
both these ratios will be 100.

Significance:- Operating Ratio is a measurement of the efficiency and

profitability of the business enterprise. The ratio indicates the extent of sales
that is absorbed by the cost of goods sold and operating expenses. Lower the
operating ratio is better, because it will leave higher margin of profit on
sales.

(d) Expenses Ratio:- These ratio indicate the relationship between expenses
and sales. Although the operating ratio reveals the ratio of total operating
expenses in relation to sales but some of the expenses include in operating
ratio may be increasing while some may be decreasing. Hence, specific
expenses ratio are computed by dividing each type of expense with the net
sales to analyse the causes of variation in each type of expense.

The ratio may be calculated as :

(a) Material Consumed Ratio = Material Consumed/Net Sales*100

(b) Direct Labour cost Ratio = Direct labour cost / Net sales*100

(c) Factory Expenses Ratio = Factory Expenses / Net Sales *100

 (a), (b) and (c) mentioned above will be jointly called cost of goods sold
ratio.

 It may be calculated as:

 Cost of Goods Sold Ratio = Cost of Goods Sold / Net Sales*100

(d) Office and Administrative Expenses Ratio = Office and Administrative

Exp./

                                                                            Net Sales*100

(e) Selling Expenses Ratio = Selling Expenses / Net Sales *100

(f) Non- Operating Expenses Ratio = Non-Operating Exp./Net sales*100

Significance:- Various expenses ratio when compared with the same ratios
of the previous year give a very important indication whether these expenses
in relation to sales are increasing, decreasing or remain stationary. If the
expenses ratio is lower, the profitability will be greater and if the expenses
ratio is higher, the profitability will be lower.

(B) Profitability Ratio Based on Investment in the Business:-

These ratio reflect the true capacity of the resources employed in the
enterprise. Sometimes the profitability ratio based on sales are high whereas
profitability ratio based on investment are low. Since the capital is employed
to earn profit, these ratios are the real measure of the success of the business
and managerial efficiency.

These ratio may be calculated into two categories:

I. Return on Capital Employed

II. Return on Shareholder’s funds

 I.      Return on Capital Employed :- This ratio reflects the overall
profitability of the business. It is calculated by comparing the profit earned
and the capital employed to earn it. This ratio is usually in percentage and is
also known as ‘Rate of Return’ or ‘Yield on Capital’. 

Formula:

Return on Capital Employed = Profit before interest, tax and dividends/

Capital Employed *100

Where, Capital Employed = Equity Share Capital + Preference Share Capital

+ All Reserves + P&L Balance +Long-Term Loans- Fictitious Assets (Such
as Preliminary Expenses OR etc.) – Non-Operating Assets like Investment
made outside the business.

Capital Employed = Fixed Assets + Working Capital  

Advantages of ‘Return on Capital Employed’:-

     Since profit is the overall objective of a business enterprise, this ratio is a
barometer of the overall performance of the enterprise. It measures how
efficiently the capital employed in the business is being used.

     Even the performance of two dissimilar firms may be compared with the
help of this ratio.

     The ratio can be used to judge the borrowing policy of the enterprise.

     This ratio helps in taking decisions regarding capital investment in new
projects. The new projects will be commenced only if the rate of return on
capital employed in such projects is expected to be more than the rate of
borrowing.

     This ratio helps in affecting the necessary changes in the financial policies
of the firm.

     Lenders like bankers and financial institution will be determine whether
the enterprise is viable for giving credit or extending loans or not.

     With the help of this ratio, shareholders can also find out whether they will
receive regular and higher dividend or not.
II. Return on Shareholder’s Funds :-

Return on Capital Employed Shows the overall profitability of the funds

supplied by long term lenders and shareholders taken together. Whereas,
Return on shareholders funds measures only the profitability of the funds
invested by shareholders.

These are several measures to calculate the return on shareholder’s funds:

(a) Return on total Shareholder’s Funds :-

For calculating this ratio ‘Net Profit after Interest and Tax’ is divided by
total shareholder’s funds.

 Formula:

Return on Total Shareholder’s Funds = Net Profit after Interest and Tax / Total
Shareholder’s Funds

Where, Total Shareholder’s Funds = Equity Share Capital + Preference

Share Capital + All Reserves + P&L A/c Balance –Fictitious Assets

Significance:- This ratio reveals how profitably the proprietor’s funds have
been utilized by the firm. A comparison of this ratio with that of similar
firms will throw light on the relative profitability and strength of the firm.

(b) Return on Equity Shareholder’s Funds:-

 Equity Shareholders of a company are more interested in knowing the

earning capacity of their funds in the business. As such, this ratio measures
the profitability of the funds belonging to the equity shareholder’s.

Formula:

Return on Equity Shareholder’s Funds = Net Profit (after int., tax & preference dividend)
/ Equity Shareholder’s Funds *100

RATIO ANALYSIS

 Where, Equity Shareholder’s Funds = Equity Share Capital + All Reserves

+ P&L A/c
 Balance – Fictitious Assets

 Significance:- This ratio measures how efficiently the equity shareholder’s

funds are being used in the business. It is a true measure of the efficiency of
the management since it shows what the earning capacity of the equity
shareholders funds. If the ratio is high, it is better, because in such a case
equity shareholders may be given a higher dividend.

(c) Earning Per Share (E.P.S.) :- This ratio measure the profit available to
the equity shareholders on a per share basis. All profit left after payment of
tax and preference dividend are available to equity shareholders.

 Formula:

Earning Per Share = Net Profit – Dividend on Preference Shares / No. of Equity
Shares

Significance:- This ratio helpful in the determining of the market price of

the equity share of the company. The ratio is also helpful in estimating the
capacity of the company to declare dividends on equity shares.

(d) Dividend Per Share (D.P.S.):- Profits remaining after payment of tax
and preference dividend are available to equity shareholders.

But of these are not distributed among them as dividend . Out of these
profits is retained in the business and the remaining is distributed among
equity shareholders as dividend. D.P.S. is the dividend distributed to equity
shareholders divided by the number of equity shares.

 Formula:

D.P.S. = Dividend paid to Equity Shareholder’s / No. of Equity Shares *100

(e) Dividend Payout Ratio or D.P. :- It measures the relationship between

the earning available to equity shareholders and the dividend distributed
among them.

 Formula:

D.P. = Dividend paid to Equity Shareholders/ Total

 Net Profit belonging to Equity Shareholders*100

OR

D.P. = D.P.S. / E.P.S. *100

(f) Earning and Dividend Yield :- This ratio is closely related to E.P.S. and
D.P.S. While the E.P.S. and D.P.S. are calculated on the basis of the book
value of shares, this ratio is calculated on the basis of the market value of
share

 (g) Price Earning (P.E.) Ratio:- Price earning ratio is the ratio between
market price per equity share & earnings per share. The ratio is calculated to
make an estimate of appreciation in the value of a share of a company & is
widely used by investors to decide whether or not to buy shares in a
particular company.