Kalinga Institute of Industrial Technology (KIIT)

Deemed to be university, Bhubaneswar

Ratio Analysis
4th Semester
Unit-2

Dr. Anjali Prava Mishra

Assistant Professor (Commerce)
School of Economics & Commerce
Email Id: [email protected]
Contact No.- 9437622604, 700885204
 Ratio Analysis
Ratio is an arithmetical expression of relationship
between two related or interdependent items. It is the
numerical or quantitative relationship between two items and
variables.
OBJECTIVE:
• Estimation of business earnings
• Judging managerial efficiency
• Solvency determination
• Making comparison
• Formulation of Policies
• Enables SWOT analysis
 Classifications or Types of Ratio
(A) Liquidity Ratios
1. Current Ratios/Working Capital Ratio
2. Liquid Ratios/Quick/Acid Test Ratio
3. Absolute Liquid Ratio
(B) Activity/Efficiency/Turnover/Performance Ratios
1.Stock (Inventory) Turnover Ratio
2. Debtors’ (Trade Receivables) Turnover Ratio
3. Creditors’ (Trade payables)Turnover Ratio
4. Working Capital Turnover Ratio
(C) Solvency Ratios
1. Debt Equity Ratio or Leverage Ratio
2. Total Assets to Debt Ratio
3. Proprietary Ratio
4. Interest Coverage Ratio
(D) Profitability Ratios
1. Gross Profit Ratio
2. Operating Ratio (Operating Cost Ratio)
3. Operation profit Ratio
4. Net Profit Ratio
5. Return on Investment or Return on Capital Employed
 Overall Profitability Ratio
• Earning Per Share = Net Profit after Tax and preference dividend
No. of Equity Share
• Return on Assets = Net Profit after Tax * 100
Average total Assets
• Return on Shareholder’s Net Worth = Net Profit after Tax * 100
Shareholder’s Fund
• Dividend Yield Ratio = Dividend per Share * 100
Market Value per Share
• Dividend Pay-out Ratio = Dividend per Equity Share * 100
Earning per Share
• Capital Gearing Ratio = Equity Share Capital + Reserve and Surplus * 100
Pref. Capital + Long term debt
 Liquidity Ratios
Liquidity shows the ability of the enterprise to meet its short-term financial obligation.
1. Current Ratios/Working Capital Ratio
• Working Capital= Current assets - Current Liabilities
Current Ratio = Current Assets
Current Liabilities
• Normally, 2:1 is considered as ideal current ratio (Rule of Thumb).
2. Liquid Ratios/Quick/Acid Test Ratio
Liquid ratio = Liquid or Quick Assets
Liquid Liabilities
• Liquid Assets = Current Assets – (Inventories+ Prepaid Expenses)
• Liquid Assets = Current Liabilities – (Bank Overdraft)
• Normally, 1:1 is considered as ideal Liquid ratio (Rule of Thumb).
3. Absolute Liquid Ratio
Absolute Liquid ratio = Cash + Bank + Short-term Securities or Investment
Current Liabilities

• Normally, 1:2 is considered as ideal Absolute Liquid ratio (Rule of Thumb).

 Activity/Efficiency/Turnover/Performance Ratios
Activity ratios show how efficiently a company is using its assets to generate
sales. Higher turnover ratios means better utilisation of assets and signifies
improved efficiency and profitability.
1.Stock (Inventory) Turnover Ratio
• It determines the number of times stock is turned into sales during the
accounting period under consideration.
Stock (Inventory) Turnover Ratio = Cost of Goods Sold
Average inventory
• Cost of Goods Sold = Opening Stock + Net Purchase (Purchase - Return outward)
+ Direct Expenses – Closing Stock
• CGS = Sales – Gross Profit
• Average inventory = Opening Stock + Closing Stock
2
Stock (Inventory) Conversion Period
365 days or 12 month
Stock (Inventory) Turnover Ratio
2. Debtors’ (Trade Receivables) Turnover Ratio
• It indicates economy efficiency in collection of amount due from debtors. Higher
the ratio better it is, since it indicates that debts are being collected more
quickly. Debtors’ (Trade Receivables) Turnover Ratio = Net Credit Sales
Average Trade Receivables

• In absence of credit sales total sales will be considered.

• Credit Sales = Total Sales – Cash Sales – Sales Return
• Trade receivable = Debtors + Bills Receivable
• Average trade receivable = Opening Trade Receivable + Closing Trade Receivable
2
Debt Collection Period or Average Collection Period
• Average Collection Period = 12 or 365 = (Answer in
Debtors Turnover Ratio No. of Months or Days)

• Average Collection Period = Debtor = (Answer in

Sales per Day No. of Months or Days)
3. Creditors’ (Trade payables)Turnover Ratio
• It indicates the number of times , the creditors are turned over in relation to
purchases. Higher the ratio and shorter payment period indicates that the
availability of less credit or yearly payments.
• In absence of credit purchase total purchase will be considered.
• Credit purchase = Total purchase – Cash purchase – purchase Return

• Trade Payable = Creditors + Bills Payable

• Average trade Payable = Opening Trade Payable + Closing Trade Payable
2
Creditors’ (Trade Payables) Turnover Ratio = Net Credit Purchase
Average Trade Payables

Debt Payment Period or Average Payment Period

• Average Payment Period = 12 or 365 = (Answer in
Creditors Turnover Ratio No. of Months or Days)
• Average Payment Period = Creditor = (Answer in
Purchase per Day No. of Months or
Days)
4. Working Capital Turnover Ratio
• It indicates the number of times, the working capital has been employed
in the process of carrying of business.
Working Capital Turnover Ratio = Net Sales or Cost of Goods Sold
Working Capital

• Higher he ratio, better the efficiency in utilisation of working capital.

• Working Capital = Current Assets – Current Liabilities
5. Capital Turnover Ratio = Sales or Cost of Sales * 100
Capital Employed

6. Working Capital Turnover Ratio = Sales or Cost of goods Sold * 100

(Net) Working Capital
 Solvency Ratios
Solvency shows the ability of the enterprise to meet its long-term financial obligation.
1. Debt Equity Ratio or Leverage Ratio
• It express the relationship between long term debt (external equity) and the
equity (internal equity) i.e. shareholders’ fund.
• Soundness of financial position of the firm.
Debt Equity Ratio = Debt(Long-term external Equities)
Equity(Shareholders’ fund).

• Debt = All non-current liabilities like; long-term loans or borrowings and long-term
provisions.
• Equity = Total Assets-Total Debts
• A debt Equity Ratio of 2:1 may be satisfactory.
2. Total Assets to Debt Ratio
Total Assets to Debt Ratio = Total Assets
Total long-term Debts
• Total Assets = Non-current Assets + Current Assets
• A higher ratio indicates that assets have been mainly financed by owner’s funds
and the long-term debt is adequately covered by assets.
3. Proprietary Ratio
• This ratio shows the portion of shareholders’ funds in the total
assets of the business.
Proprietary Ratio = Shareholders’ funds
Total assets

• Higher the ratio greater the satisfaction for lenders and creditors.
• Proprietary Ratio is satisfactory at 2:1.
4. Interest Coverage Ratio
• The Interest coverage ratio shows how many times the interest
charges are covered by the profit available to pay interest.
Interest Coverage Ratio = Net Profit before Interest and Tax (EBIT)
Interest on Long Term Debts
• The higher ratio, more secured the lender In respect of payment of
interest regularly.
• The ideal interest coverage ratio is 6 to 7 times.
 Profitability Ratios
Profitability ratios helps in assessing the overall efficiency of the business.
1. Gross Profit Ratio
• This ratio shows the margins available to provide for operating expenses and
appropriations. Higher the ratio, better it is.
Gross Profit Ratio = Gross Profit * 100
Revenue from operation (Net Sales)
2. Operating Ratio (Operating Cost Ratio)
• It shows the proportion of cost of revenue from operations and operating
expenses to revenue from operations.
Operating Ratio = Operating Cost
Revenue from Operation (Net Sales)
• Operating Cost = Cost of Revenue from Operation + Operating Expenses
• Operating Expenses = Employees Benefit Expenses + Other Expenses (Office
Expenses, Administrative Expenses, Selling and Distribution Expenses,
Depreciation and Amortization etc.) Loss on sale of fixed is not a operating
expenses.
• It is a cost ratio, so lower the ratio will be better. A rise in this ratio will indicate a
decline in efficiency.
3. Operating Profit Ratio
• This ratio indicates the part of sales available after absorbing cost of revenues
from operations and operating expenses.
Operating Profit Ratio = Operating Profit
Net Sales
• It is a profit ratio, so higher the ratio better it is.
• Operating Profit = Gross Profit + Other Operating Income – Other Operating
Expenses.
• Operating Profit = Net Profit (Before tax) + Non-Operating Expenses – Non-
Operating Income.
• Non-Operating Expenses : Those expenses which are not incurred to earn profit
e.g. interest on long term borrowings, loss on sale of fixed assets.
• Non-Operating Income : Those income which are not earn from the operating
activities
4. Net Profit Ratio
Net Profit Ratio = Net Profit After Tax * 100
Revenue from operations (Net Sales)
• Net Profit = Revenue from Operations - Cost of Revenue from operations –
Operating Expenses – Non-operating Expenses + Non-operating Income – Tax.
• This ratio is an indicator of the overall efficiency of the business.
• It is the profit ratio, so higher the ratio better is will be.
5. Return on Investment or Return on Capital Employed
Return on Investment = Net Profit before Interest, Tax and Preference Dividend * 100
Capital Employed
• Higher the ratio better it is.
Calculation of Capital Employed
(a) When Liabilities approach is followed
Capital Employed = share Capital + Reserve and Surplus + Long- Term Debt/
Borrowings/Loans
(b) When Assets approach is followed
Capital Employed = Non-Current Assets (Which includes Fixed Assets and Long-term
investment) + Working Capital (Current Assets – Current Liabilities)