Meaning of Ratio Analysis

• Ratio analysis is a technique of calculating a number of accounting ratios from the data or
figures found in the financial statements, comparing the computed accounting ratios with
those of the other concerns engaged in similar line of activities on which those of
standard or ideal ratios, and interpreting the comparison.
Classification of accounting ratios on the basis of functions
• Liquidity ratios or short term solvency ratios
• Long term solvency ratios
• Turnover ratios
• Profitability ratios
Liquidity ratios
• Liquidity ratios indicate whether it will be possible for an enterprise to meet its short term
obligations or liabilities out of its short term resources or assets.
• Particularly, bondholders and professional investors have been watching the liquidity
ratios.
Principal liquidity ratios
• Current ratio
• Quick ratio or acid test ratio of liquid ratio
• Absolute liquid ratio or cash ratio or super quick ratio.

Current ratio
Meaning: Current ratio is the ratio expresses the relationship between current assets and current
liabilities.
Computation: Current ratio = Current assets/ Current liabilities.
Interpretation
• A high current ratio might be the result of a high receivables or high inventories. This is
not a good indication, especially if the firm cannot sell their goods.
• Sometimes if the firm is holding a lot of inventory, then the company might be expecting
higher demand for their products.

 A low current ratio would indicate that the firm might not be able to repay its lenders, or
might have to cut back on operations to reduce expenditure. Firms facing liquidity
problem are more likely to have higher financial distress costs. 

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Quick ratio
Meaning: Quick ratio is the ratio that expresses the relationship between quick assets and current
liabilities.
Computation: Quick ratio = Quick Assets/ Current Liabilities.
Quick Assets = Current Assets – Inventory

Interpretation
• It indicates whether the firm is over-stocking or under-stocking the inventory. If the
current ratio is good, but the quick ratio is poor, it indicates that the firm has high
inventories.
• Managers use this to plan for worst-case scenarios when it might not be able to sell its
inventory.

Absolute Liquid ratio

Meaning: Absolute liquid ratio is the ratio expresses the relationship between absolute liquid
assets and current liabilities.
Computation: Absolute liquid ratio = Absolute liquid assets / Current Liabilities.
Absolute liquid assets = Cash in hand + Cash at Bank + Short term investments
Interpretation
• Cash is the most liquid asset among all assets. It is of vital importance to the daily
operations of business firms.
• Crucial for the solvency of the business, it is referred to as the “life blood of the
business”.
• Firms with both high current ratio and quick ratio, and with low absolute liquid ratio can
be interpreted as the firm has low levels of cash and cash equivalents. With this, they may
find it difficulty in meeting their short term obligations.
• This ratio is the most rigorous and conservative test of a firm’s liquidity position. Further,
it is suggested that it would be useful for the management, if the liquidity measure also
takes into account of “reserve borrowing power”. Firm’s real debt paying ability depends
not only on cash resources available with it but also on its capacity to borrow from the
market at short notice.

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Long term solvency ratios
• Debt equity ratio
• Interest coverage ratio

Debt- equity ratio

Meaning: Debt- equity ratio is the ratio that expresses the relationship between the debt and
equity.
Computation: Debt Equity ratio = Long term debt / Net worth
• Net worth = Equity shareholders’ funds = Owners’ funds = Equity share capital +
Reserves and Surplus
• This ratio measures the proportion of debt and equity in the capital structure of a
company.
Interpretation
• The tax benefits associated with leverage provides an additional incentive for firms to
have higher debt in their capital structure. However, firms with higher leverage are more
likely to have higher probability of financial distress costs.
Alternative definitions of leverage ratio
• Leverage ratio = Long term debt / (Long term debt + Net worth)
• Leverage ratio = Total Assets / Net worth

Interest Coverage Ratio

Meaning: This ratio measures the relationship between firm’s operating profit and its interest
requirements.
Computation: Interest coverage ratio = [EBIT /Interest]
Interpretation:

 This ratio measures whether the firms have enough income to meet its interest
obligations.
 A high interest coverage ratio implies adequate safety for payment of interest even if
there is drop in sales.
Firms with higher debt-equity ratio and lower interest coverage ratio are more likely to have
financial distress costs.

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Turnover ratios or Activity ratios or Efficiency ratios
• Activity ratios refer to those ratios that measure the level of activities, the performance or
the operating efficiency of an enterprise. The activity ratios are calculated on the basis of
turnover. The key turnover ratios are mentioned below:
- Trade receivables turnover ratio
- Trade payables turnover ratio
- Inventory turnover ratio
- Fixed Assets turnover ratio
- Total Assets turnover ratio

Trade Receivables turnover ratio.

Meaning: It measures the efficiency of trade receivables.
Computation:
Trade Receivable turnover ratio = Credit Sales / Average Accounts Receivable
Credit Sales = Net Sales – Cash Sales
Average Trade Receivable = (Opening trade receivables + Closing trade receivables)/2
Note: 1. In case of absence of information on cash sales, we can consider net sales instead of
credit sales.
2. In case of newly started businesses, there won’t be any opening balance of trade
receivable. Hence, we consider the closing balance of trade receivable instead of average balance
of trade receivable.
Interpretation:

 A high trade receivable turnover ratio would mean that the firm is very efficient in
converting its trade receivable into cash. It also means that the quality of portfolio of
trade receivables is good.

Average Collection period:

Meaning: This ratio measures the average time the firm takes to collect the cash from its credit
sales.
Computation:
Average collection period (in days) = (Average Trade Receivable/Credit Sales) * 365
Average collection period (in months) = (Average Trade Receivable/Credit Sales) * 12
Interpretation:

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  If average collection period is high, it may be an indication that customers might in
trouble.
- Industries with excess capacity and looser credit policies are sometimes used as a
competitive marketing tool, thus increases the average collection period of firms in
those industries.
 If collection period of firms is significantly longer than its competitors would mean that
inadequate collection procedures.
 In order to know more about average collection period, firms have to look at the ageing
schedule of accounts receivable.

Trade Payables turnover ratio

Meaning: It measures the efficiency of trade payables.
Computation:
Accounts Payable turnover ratio = Credit Purchases / Average Trade payables.
Credit purchases = Net Purchases – Cash Purchases
Average Trade Payable = (Opening Trade Payables + Closing Trade payables)/2
Note: 1. In case of absence of information on cash purchases, we can consider net purchases
instead of credit purchases.
2. In case of newly started businesses, there won’t be any opening balance of trade
payables. Hence, we consider the closing balance of trade payables instead of average balance of
trade payables.

Average Payment period:

Meaning: This ratio measures the average time the firm takes to pay to suppliers for credit
purchases.
Computation:
Average payment period (in days) or credit payment period = (Average Trade Payables/Credit
Purchases) * 365
Average payment period (in months) or credit payment period = (Average Trade Payables/Credit
Purchases) * 12
Interpretation:
- If the average payment period is high, this indicates that the cash position would be
better. However, it is more likely that the vendors of the firm would be unhappy. As a
result, suppliers might charge higher prices for future transactions.

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Inventory turnover ratio
Meaning: This ratio shows the number of times a company’s inventory is turned into sales.
Computation:
Inventory turnover ratio = Cost of Goods Sold/Average Inventory
Cost of Goods Sold = Net Sales – Gross Profit
Cost of Goods Sold = Opening Inventory + Net Purchases + direct expenses – Closing Inventory.
Average Inventory = (Opening Inventory + Closing Inventory)/2
Note: 1. In case of absence of information on cost of goods sold, we consider net sales instead of
cost of goods sold.
2. In case of newly started businesses, there won’t be any opening balance of inventory.
Hence, we consider the closing balance of inventories instead of average balance of inventories.
Interpretation:
- High inventory turnover ratio is an indication of efficient inventory management.
Some firms tend to have lesser inventory if they are following just-in-time inventory
practices.
- If the inventory turnover falls, this indicates that the firm is stocking more goods.
- Inventory turnover ratio may fall either because of inventory buildup in anticipation
of increased sales or because sales volume has declined, leaving excess merchandise
on hand. The first event is favourable and the second is unfavourable.
Inventory turnover ratio is one of the key ratios for retailers. Hence, retailers keep watch
on this ratio. Higher this ratio, better for the company in managing not only its inventory
but also other assets

Inventory holding period

Meaning: It measures how long the inventory stays in the system.
Computation:
Inventory holding period (in days) = (Average Inventory / Cost of Goods Sold) * 365
Inventory holding period (in months) = (Average Inventory / Cost of Goods Sold) * 12
Interpretation:
- The increase in the holding period implies greater risk of obsolescence. If a company
is holding excessive inventory, it will result in high carrying costs to store the
inventory.

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Total Assets turnover ratio
Meaning: It is a measure of how efficient the firm is in generating revenue from total assets.
Computation:
Total assets turnover ratio = Net Sales / Average Total Assets
Average Total Assets = (Opening balance of total assets + Closing balance of total assets)/2
Interpretation:
- If the firm can increase sales while keeping total assets constant, then it results in
increase in total assets turnover ratio.

Fixed Assets turnover ratio

Meaning: It is a measure of how efficient the firm is in generating revenue from fixed assets.
Computation:
Fixed assets turnover ratio = Net Sales / Average Fixed Assets
Average Fixed Assets = (Opening balance of fixed assets + Closing balance of fixed assets)/2
Interpretation:
• A firm with higher fixed assets turnover ratio may be utilizing its fixed assets efficiently
as compared to the firm with lower one.

Profitability ratios: These ratios evaluate the firm’s ability to generate profits. Some of the
key profitability ratios are mentioned below:
- Gross profit ratio
- Operating profit ratio
- Net profit ratio
- Return on total assets
- Return on net worth

Gross profit ratio

Meaning: This ratio measures the firm’s gross profit as compared to its net sales.
Computation:
Gross profit ratio = [Gross profit / Net Sales] * 100
Gross profit = Net Sales – Cost of goods sold or cost of services

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Interpretation:

 If a firm’s gross profit is not increasing over a period, it is because of two reasons. First,
the business might be under severe price pressure. Second, the direct materials, direct
labour or other direct expenses might have increased. The former results in decrease in
sales, and the latter results in increase in cost of goods sold.

• Operating Profit ratio

Meaning: It measures how well the firm is able to generate profits from the operational point
of view.
Computation:
Operating Profit ratio = [Operating Profit / Net Sales] * 100
Operating profit = Gross profit – Operating expenses.
Interpretation:

 If the operating profit is decreasing over period which may be because of following
reason:
- Costs and expenses might have increased more than net sales.
 Higher gross profit ratio and lower operating profit indicate that the proportion of
operating expenses to net sales might be higher.

Net Profit ratio

Meaning: It is a ratio that measures that relationship between firm’s net profit and its net sales. It
is also termed as return on sales.
Computation:
Net Profit ratio = [Net Profit / Net Sales] * 100
Net profit = Net Sales – Cost of goods sold – Operating expenses – Depreciation – Interest –
Taxes
Interpretation:

 Higher the net profit ratio, it is better for the company.

 Firms with higher operating profit with lower net profit ratio would imply that the
company might not have borrowed debt in favourable terms or the cost of debt might
high.

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Return on Total Assets
Meaning: It measures how much firm has earned on its total assets. In other words, it measures
how efficiently firms have used their total assets to generate profits.

Computation:
Return on Total Assets= [Profit Before Interest and Taxes / Average Total Assets] * 100
Alternatively, an analyst might be interested in measuring return on total assets after taxes but
independently of financing. In this case, The ROA can be measured as below:
Return on Total Assets = (Net Income + Interest (1-tax rate) / Average Total Assets)
The denominator of both Return on Total Assets is average total assets, those claimed by all
providers of capital i.e., shareholders and debt holders. The numerators include income available
to both debt and equity holders.
Interpretation:
- Lenders are more concerned with how efficiently the firm uses its total assets to
generate returns for all suppliers of capital.
- Firms that are willing to increase return on total assets would focus on increasing the
efficiency of assets. For example, firms can increase their efficiency of assets by
reducing inventory holding period or by reducing the average collection period of
customers. Further, they can improvise their efficiency of assets by increasing fixed
assets turnover ratio, or by increasing cash turnover ratio, etc.
In order to explore return on total Assets further, it can be decomposed into two parts:
Return on Total Assets = (PBIT/Net Sales) * (Net Sales/Average Total assets)
- From the aforementioned equation, it can interpreted as firms can increase its return
on total assets in two ways. First, by increasing operating profit ratio, and second, by
increasing the total assets turnover ratio.
- Firms can achieve the same ROA with different combinations of operating profit and
total assets turnover ratios.

Return on Net worth

Meaning: It measures how much equity shareholders of the firm get on their investment.
Computation:
Return on Net worth = [Earnings available to equity shareholders/Average Net worth] * 100

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Why should earnings available to equity shareholders be considered in the numerator while
computing return on net worth?
The numerator should represent the income that is available to equity shareholders. The
company must have been paid both interest and taxes and the left over profit should be provided
to equity shareholders. Hence, it is appropriate to consider earnings available to equity
shareholders in the numerator while computing return on net worth.
Average net worth = (Opening Net worth + Closing Net worth)/2
Net sales – Cost of Goods Sold (COGS) – Operating expenses – Depreciation – Interest – Tax =
Earnings available to equity shareholders.
Interpretation:
• Higher the return on net worth, it is better for company’s equity shareholders. Equity
shareholders would expect higher returns on their investment since they are taking higher
risk as compared to other suppliers of capital, such as debt holders or preference
shareholders.

Du Pont Analysis (Return on Net worth)

• Return on Net worth = (Net Profit /Net Sales) * (Net Sales/Average Total Assets) *
(Average Total Assets/Average Net worth).
• Return on Net worth = Profitability ratio * Total Assets turnover ratio * Leverage ratio.
• Return on Net worth = Net Profit ratio * Total Assets turnover ratio * Leverage ratio.
Du Pont Analysis on Return on net worth can also be computed based on closing total assets
rather than average total assets as below:
Return on Net worth = (Net Profit /Net Sales) * (Net Sales/Total Assets) * (Total Assets/Average
Net worth).
The above equation highlights that the net profit ratio, total assets turnover ratio, and leverage
ratio each contribute to the rate of return on net worth. Firms can achieve same return on net
worth with different combinations of net profit ratio, total assets turnover ratio, and leverage
ratio.
Other ratios

Earnings per share (EPS)

Meaning: This ratio provides the information regarding the earnings that is available to each
equity share.
Computation:
• EPS = (Earnings available to equity shareholders / No of equity shares)

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Types of EPS
There are two types of earnings per share (EPS), which are to be reported by the enterprise on
the face of the statement of profit and loss account.
- Basic EPS
- Diluted EPS
Basic EPS: Basic EPS is calculated as follows:
Basic EPS = Net Profit or loss for the period attributable to equity shareholder / Weighted
average number of equity shares outstanding during the period.
Diluted earnings per share
Diluted earnings per share is calculated when there are potential equity shares in capital
structure of the enterprise. Potential equity shares are those financial instruments which entitle to
its holder the right to acquire equity shares like convertible debentures, convertible preference
shares, options, warrants, etc.

 The formula to calculate diluted earnings per share is as follows:

= Net profit attributable to equity shareholders (after adjustment for diluted
earnings) / Average number of weighted equity shares outstanding during the period
(assuming the conversion of diluted potential equity shares).

Diluted potential equity shares: Potential equity shares are diluted if their conversion into equity
shares reduces the earning per share and if their conversion does not decrease the EPS, then the
potential equity shares are not to be considered dilutive.
- Compute net profit and loss for the period attributable to existing equity
shareholder.
- Add back dividend along with distribution tax on convertible preference shares
previously deducted.
- Add back interest net of tax effect charged on convertible debenture or loans.
• Dividend per share = (Dividends payable to equity shareholders / No of equity shares)
• Dividend payout ratio = (Dividend per share / Earnings per share)
How much dividends should firms pay to its shareholders?
The above question cannot be answered so easily since it depends on how the firm will
finance its future growth opportunities. According to pecking order hypothesis, firms would
prefer retained earnings most followed by debt and equity. If we assume that firms are following
pecking order to finance for their growth, then they are more likely to pay lesser dividends and
retain more. As a result of this, the dividend payout ratio of above mentioned firms would be
less.

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Sustainable Growth Rate
Meaning: It is the growth that the firm is able to achieve with its internal funds and without
depending on external funds.
Computation:
Sustainable Growth Rate (SGR) = Return on Net worth * Retention ratio.
• Can SGR and Return on Net worth be same? If so, when?
• How do we interpret the above statement?

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