Ratio Analysis: 06/02/2020 1 Imlak Shaikh, PH.D, MDI Gurgoan

Ratio Analysis
1 Imlak Shaikh,Ph.D, MDI Gurgoan 06/02/2020

Outline
 What is Ratio Analysis
 Ratio Analysis and Financial statement
 Window Dressing
 Uses of ratio analysis
 Classification of Ratios
 (A) According to Financial Statements
 (B) According to Purpose or Functional Classification

Ratio Analysis and Financial
statement
 Ratio analysis is an important and useful tool to check
upon the efficiency with which working capital is being
used in the enterprise.
The use of ratio analysis is not confined to
the financial manager only.
It functions as a sort of HEALTH
The credit supplier, bank, lending TEST. With the help of ratio
institutions and experienced analysis financial executive can
investor all use ratio analysis as measure whether the company is
their initial tool in evaluating the at present financially healthy or
company as a desirable borrower not. The following are the
or as potential investment outlet. important material uses of ratio
analysis.

 Ratio analysis is the process of determining and
interpreting numerical relationships based on financial
statements.
A ratio is a statistical yard stick that
provides a measure of the
relationship between variables or
figures.
This relationship can be expressed as percent
(cost of goods sold as a percent of sales) or
as a quotient (current assets as a certain
number of times the current liabilities).
 THE PARTIES INTERESTED : The persons interested
in the analysis of financial statements can be grouped
under three heads:

(i) Owners or investors;
(ii) Creditors; and
(iii) Financial executives.

Uses of ratio analysis
Aid in Financial Aid in

FORECASTING COMPARISON
Aid in COST COMMUNICATI

CONTROL ON value

Window Dressing
 The term window dressing means manipulation of
accounts in a way so as to conceal vital facts and present
the financial statements in a way to show a better
position than what it actually is.
On account of such a situation, presence of a particular ratio
may not be a definite indicator of good or bad management.
For example, a high stock turnover ratio is generally

considered to be an indication of operational efficiency of
the business. But this might have been achieved by
unwarranted price reductions or failure to maintain proper
stock of goods.

Advantages of Ratio Analysis
• To measure the liquidity position
Liquidity and
solvency
• To know the solvency position
• Operating efficiency or turnover of the firm

Operating
efficiency and
• To assess the profitability position of the firm
profitability
• Inter - firm and intra – firm comparison

Comparison and • Trend Analysis
Trend analysis

Classification of Ratios
 (A) According to Financial Statements:
 Balance Sheet Ratios: These ratios are calculated to know the
financial position of a company on a particular date. Both items
for which ratio is to be calculated appear on the balance sheet.
Such a ratio may be called a financial ratio.
 Example of balance sheet ratios are: -
 current ratio,
 quick ratio,
 liquidity ratio,
 ratio of inventory to working capital,
 ratio of current assets to fixed assets,
 debt to equity ratio,
 proprietary ratio and
 capital gearing ratio.

(A) According to Financial Statements:
 Profit and Loss Ratios: Ratios which are drawn from
trading and profit and loss account are known as profit
and loss ratios. These ratios deal with the relationship
between two items both of which belong to the profit and
loss account. Such a ratio may be called an operating
ratio.
 Examples of these ratios are:-
 Gross profit ratio,
 Operating ratio,
 Operating profit ratio and
 Net profit ratio.

(A) According to Financial Statements:
 Combined Ratios: These ratios shows the relationship
between items, one of which is a part of the balance sheet
and the other of the profit and loss account. Such a ratio
may be called a mixed ratio.
 Examples of these ratios are:-
 Stock turnover ratio,
 Receivable turnover ratio,
 Working capital turnover ratio,
 Fixed assets turnover ratio,
 Capital turnover ratio,
 Total assets turnover ratio,
 Return on shareholders Investment and
 Return on capital employed.

(B) According to
Purpose or Functional
Classification: RATIOS
Profitability Activity Solvency

Ratios Ratios Ratio s
Short Term
Long Term
1. Inventory Turnover Solvency
Solvency
A) In Relation to Sales: Ratio Ratio
Ratio s
1. Gross profit Ratio 2. Debtors Turnover
2. Operating Ratio
Ratio 1. Debt
3. Operating Profit Ratio 1. Current
4. Net Profit Ratio
3. Creditors Turnover Equity
Ratio Ratio
5. Expense Ratio Ratio
4. Fixed Assets 2. Liquidity
B) In Relation to Investment : 2. Proprieta
6. Return on Investment Turnover Ratio Ratio
ry Ratio
7. Return on Equity 5. Working Capital 3. Interest
3. Fixed
Shareholders Fund Turnover Ratio Coverage
Assets
8. Return on Total Resources 6. Capital Turnover Ratio
Ratio
Ratio 4. Capital
Gearing
Financial/Solvency Ratios:

They are also termed as ‘Solvency Ratios’. These ratios
indicate about the financial position of the company.
A company is considered to be financially sound if it is in a
position to carry on its business smoothly and meet all its
obligations both short-term and long-term without strain.
The Financial or Solvency Ratios can

therefore be classified into following
categories:
(i) Short-term Solvency Ratios,
(ii) Long-term Solvency
which include current ratio,
Ratios, which include fixed
liquidity ratio, super-quick ratio
assets ratio, debt equity ratio and
and defensive interval ratio &
proprietary ratio
debt service coverage ratio.
Short-term Solvency Ratios

1. Current Ratio
 The ratio is an indicator of the firm’s commitment to meet its

short-term liabilities. It is expressed as follows:
Current Assets
Current Ratio 
Current Liabilitie s
An ideal current ratio is ‘2’. However, a ratio of 1.5 is also acceptable if the firm has
adequate arrangements with its bankers to meet its short-term requirements of funds.
Significance: The ratio is an index of the concern’s financial stability,

since, it shows the extent to which the current assets exceed its current
liabilities. A higher current ratio would indicate inadequate
employment of funds, while a poor current ratio is a danger signal to
the management.
2. Liquidity Ratio:
 The ratio is also termed as Acid Test Ratio or Quick Ratio. The ratio is ascertained by comparing the
liquid assets i.e., current assets (excluding stock and prepaid expenses) to current liabilities. The ratio
may be expressed as follows:
Liquid Assets
Liquidity Ratio 
Some accountants prefer the term liquid liabilities for current liabilities. The term ‘liquid
liabilities’ means liabilities payable within a short period. Bank overdraft and cash credit
facilities (if they become permanent modes of financing) are excluded from current
liabilities for this purpose. The ratio may be expressed as follows:
Liquid Assets
Liquidity Ratio  The ideal ratio is ‘1’.
Liquid Liabilitie s
Significance: The ratio is an indicator of short-term solvency of the company. A comparison of
the current ratio to quick ratio should also indicate the inventory hold-ups. For instance, if two
units have the same current ratio but different liquidity ratios, it indicates over-stocking by the
concern having low liquidity ratio as compared to the firm which has a higher liquidity ratio.
3. Super-quick Ratio:
 It is a slight variation of quick ratio. It is calculated by comparing the super quick assets with
the current liabilities (or liquid liabilities) of a firm. The ratio may be expressed as follows:
Super Quick Assets

Super - quick Ratio 
The term ‘Super-Quick Assets’ means current assets excluding stock, prepaid
expenses and debtors Thus, super-quick assets comprise mainly CASH,
BANK BALANCE and MARKETABLE SECURITIES.
Significance: This ratio is the most rigorous test of a firm’s liquidity

position. In case the ratio is ‘1’, it means the firm can meet its current
liabilities any time.
The ratio is a conservation test and not widely used in practice.

4. Defensive-Interval Ratio (DIR)
 This ratio denotes the liquidity of a firm in relation to its ability to meet projected
daily expenditure from operations. It can be expressed as follows:
Liquid Assets (quick assets)

Defensive Interval Ratio 
Daily cash requiremen ts (projected )
Daily cash requirements (projected) = Projected cash operating expenditure/Number

of days in a year.
Significance: The DIR is thought by many people to be a better liquidity

measure than the quick and current ratios. Because these ratios compare
assets to liabilities rather than comparing assets to expenses, the DIR and
current/quick ratios would give quite different results if the company hand
a lot of expenses, but no debt.

5. Debt Service Coverage Ratio (DSCR)
 This ratio indicates whether the business is earning sufficient profits to pay not only the interest
charged, but also whether due of the principal amount. The ratio is calculated as follows:
Profit after Taxes + Depreciati on + Interest on Loan

Debt Service Coverage Ratio 
Interest on Loan + Loan repayment in a year
Significance: The ratio is the key indicator to the lender to assess the
extent of ability of the borrower to service the loan in regard to timely
payment of interest and repayment of loan installment. A ratio of 2 is
considered satisfactory by the financial institutions the greater debt
service coverage ratio indicates the better debt servicing capacity of
the organization.

Long-term Solvency Ratios

1. Fixed Assets Ratio:
 The ratio indicates the extent to which fixed assets have been acquired by use of long-term funds. The
ratio is expressed as follows:
Net Fixed Assets

Fixed Assets Ratio 
Long - term Funds
The term ‘Net Fixed Assets’ means original cost of fixed assets less depreciation
to date. The ratio should not be more than ‘1’ . The ideal ratio is 0.67.
Significance: It is sound principle that fixed assets should be financed out of

long-term funds. As a matter of fact a part of working capital termed as core-
working capital, should also be financed by long-term funds. The ratio is
therefore an indication of the fact whether the company has followed sound
financial policy or not. In case the ratio is more than ‘1’, it shows that a part
of working capital has also been used to acquire fixed assets, which may
prove quite troublesome for the company.
2. Debt-Equity Ratio:
 The ratio is determined to ascertain the proportion between the ‘outsiders’ ‘funds and
share-holders funds’ in the capital structure of an enterprise. The term outsiders’, funds
is generally used to represent total long-term debt. The ratio can be computed as follows:
Total Long - term Debt
Debt - Equity Ratio 
Shareholder’s Funds
The ratio may also be calculated for ascertaining proportion of long-term debt in the
total long-term funds. In such a case the ratio will be computed as follows:
Total Long - term Debt
Debt - Equity Ratio 
Total Long - term Funds
The ratio is considered to be ideal if the shareholders’ funds are equal to total long-
term debt. However, these days the ratio is also acceptable if the total long-term debt
does not exceed twice of shareholders’ funds.
Significance: The ratio is an indication of the soundness of the long-term financial
policies pursued by the business enterprise. The excessive dependence on outsiders’
funds may cause insolvency of the business. The ratio provides the margin of safety
to the creditors It tells the owners the extent to which they can gain by maintaining
control with a limited investment.
Profitability Ratios

1. Overall Profitability Ratio
 This is also called as Return on Investment (ROI) or Return on Capital

Employed (ROCE) ratio. It indicates the percentage of return on the
total capital employed in the business. It is calculated as follows:
 ROI = Operating Profit/Capital Employed
 The term ‘Operating Profit’ means “profit before interest and tax while
the term ‘capital employed’ refer to the sum-total of long-term funds
employed in the business.
 Significance: ROI measures the profit which a firm earns by investing a
unit of capital. It is desirable to ascertain this periodically. The profit
being the net result of all operations, ROI, expresses all efficiencies or
inefficiencies of a business collectively. Thus, it is a dependable
measure for judging the overall efficiency or inefficiency of the business.

2. Price Earning Ratio (P/E Ratio)
 This ratio indicates the number of times the earning per

share is covered by its market price. It is calculated as
follows:
Market Price Per Equity Share

P / E Ratio 
Earning Per Share

 For example, if the market price of an equity share is Rs.
20 and earning per share is Rs. 5, the price earning ratio
will be 4 (i.e., 20 ÷ 5).
 This means for every one rupee of earning people are prepared
to pay 4. In other words, the ROR-rate of return expected by
the investors is 25%
 Significance. P/E Ratio helps the investors in deciding whether to
buy or not to buy the shares of a company at a particular price. For
Instance, in the example given, if the EPS falls to Rs. 3, the market
price of the share should be Rs. 12 (i.e. 3 x 4).
 In case the market price of the share is Rs.15, it will not be advisable
to purchase the company’s shares at that price.

3. Proprietary Ratio
 It is a variant of Debt-Equity Ratio. It establishes relationship between the proprietors’
or shareholders’ funds and the total tangible assets. It may be expressed as follows:
Shareholder’s Funds
Proprietar y Ratio 
Total Tangible Assets
Significance: The ratio focuses attention on the general financial
strength of the business enterprise. The ratio is of particular importance
to the creditors who can find out the proportion of shareholders funds in
the total assets employed in the business. A high proprietary ratio will
indicate a relatively little danger to the creditors or vise-versa in the
event of forced reorganization or winding up of the company.
3. Gross Profit Ratio (GPR):
 This ratio expresses the relationship between Gross Profit

and Net Sales. It can be computed as follows:
Gross Profit
Gross Profit Ratio (GPR)  X 100
Net Sales (i.e. Sales less returns)
Significance. The ratio indicates the overall limit within which a business
must manage its operating expenses. It also helps in ascertaining
whether the average percentage of mark-up on the goods is maintained.

4. Net Profit Ratio(NPR):
 The ratio indicates net margin earned on a sale of Rs. 100. It is calculated as follows:
Net Pr ofit
NPR  X 100
Net Sales
Significance. The ratio helps in determining the efficiency with which
the affairs of a business are being managed. Constant increase in the
above ratio year after year is a definite indication of improving
conditions of the business.

5. Operating Ratio:
 This ratio is a complementary of net profit ratio. In case the net profit ratio is 20%, the
operating ratio will be 80%. It is calculated as follows:
Operating Cost
Operating Ratio  X 100
Net Sales
Operating cost includes cost of direct materials, direct labour, direct

expenses and all overheads. Financial charges: such as interest,
provision for taxation, etc. are not to be included in operating cost.
Significance. The ratio is the test of the operational efficiency with which
the business has carried on. The operating ratio should be low enough to
leave a portion of sales for giving a fair return to the investor

6. Fixed Charges Cover Ratio (FCCR):
 The ratio indicates the number of times the fixed financial charges are covered by income before interest
and tax. This ratio is calculated as follows:
Income before Interest and Tax

FCCR 
Interest
Significance: The ratio is significant from the lender’s point of view.

It indicates whether the business would earn sufficient profits to pay
periodically the interest charges.
Higher the ratio, better it is.

7. Pay-out Ratio:
 The ratio indicates what proportion of earning per share has been used for paying dividend. It can be
calculated as follows:
Dividend per equity share

Pay - Out Ratio 
Earning per equity share
Significance: The ratio is an indicator of the amount of earnings that
have ploughed back in the business.
The lower the pay-out ratio, the higher will be the amount of earnings
ploughed back in the business.
.
A lower pay-out ratio means a STRONGER
FINANCIAL POSITION of the company

8. Dividend Yield Ratio (DYR):
 The ratio is calculated by comparing the rate of dividend per share with its market value.
It is calculated as follows:
Dividend Per Share

DYR  X 100
Market Price Per Share
Significance: The ratio helps an intending investor in knowing the
effective return he is going to get on his investment.
For example, if the market price of a share is Rs. 25, paid-up value is Rs.
10 and dividend rate is 20%. The dividend yield ratio is 8% (i.e. 100 x
(20%*10)/25).
The intending investor can now decide whether it will be advisable
for him to go for purchasing the shares of the company or not at the price
prevailing in the market.

9. Return on Shareholders funds or
Return or Net Worth:
 This ratio expresses the net profit in terms of the equity shareholders funds. This ratio calculated as
follows:
Net Profit after Interest & Tax

Ret. on Shar(s) Funds  X 100
Net Worth
[Net Worth = Equity Capital + Reserves & Surplus]
Significance: This ratio is an important yardstick of performance for

equity shareholders since it indicates the return or the funds employed
by them.

Turnover Ratios / Activity Ratio
These ratios indicate the efficiency with which capital
employed is rotated in the business.

1. Over-all Turnover Ratio:
 The ratio indicates the number of times the capital employed has been rotated
in the process of doing a business. The ratio is computed as follows:
Net Sales
Overall Turnover Ratio 
Capital Employed
Significance. The overall profitability of a business depends on two factors,
viz, (a) the profit margin, and (b)turnover. The profit margin is disclosed by
the net profit ratio while the turnover is indicated by the overall turnover ratio.
A business with a lower profit margin can achieve a higher ROI if its turnover
is high. This is the reason for wholesalers earning a larger return on their
investment even when they have a lower profit margin. A business should not,
therefore, increase its profit margin to an extent that it results in reduced turn-
over resulting in reduction of overall profit.
2. Fixed Assets Turnover Ratio:
 The ratio indicates the extent to which the investment in fixed assets has contributed
towards sales. The ratio can be calculated as follows:
Net Sales
Fixed Assets Turnover Ratio 
Net fixed Assets
Significance. The comparison of fixed assets turnover ratio over a

period of time indicates whether the investment in fixed assets has been
judicious or not. Of course, investment in fixed assets does not push-up
sales immediately but the trend of increasing sales should be visible. If
such trend is not visible or increase in sales has not been achieved after
the expiry of a reasonable time it can be very well said that increased
investments in fixed assets has not been judicious.

3. Debtors’ Turnover Ratio:
 The ratio indicates the speed with which money is collected from the debtors` It is computed as follows:
Credit Sales
Debtors Turnover Ratio 
Average Accounts Receivable
Significance: Debtors Turnover Ratio or Debt Collection Period Ratio

measures the quality of debtors since it indicates the speed with which
money is collected from the debtors ` A shorter collection period implies
prompt payment by debtors ` A longer collection period implies too liberal
and inefficient credit collection performance. The credit policy should
neither be too liberal nor too restrictive. The former will result in more
blockage of funds and bad debts while the latter will cause lower sales
which will reduce profits.
Remarks
 The term average account receivable includes trade debtors and bills receivable.
Average accounts receivable are computed by taking the average receivables in
the beginning and at the end of the accounting year. The higher the ratio, better
it is.
Debtors turnover ratio is used for computing the debt collection period.
The formula for its computation is as follows:
For example, if the credit sales are Rs 80,000, average accounts receivable
Rs. 20,000, the debtors’ turn-over ratio and debt collection period will be
computed as follows:
Debtors Turnover Ratio = 80,000/ 20,000 = 4 times
Debts Collection Period = 12 months / 4 = 3 months
This means on an average three months credit is allowed to the debtors An increase in the
credit period would result in unnecessary blockage of funds and with increased possibility
of losing money due to debts becoming bad.
4. Creditors Turnover Ratio:
 This is similar to Debtors Turnover Ratio. It indicates the speed with which
payments for credit purchases are made to creditors. It can be computed as follows:
Credit Purchases
Creditors Turnover Period 
Average Accounts Payable
The term ‘accounts payable’ include trade creditors and bills payable.
From the creditors turnover, ratio, creditors payment period can be computed as
follows:
Months or days in a year
Credit Period Enjoyed 
Creditors Turnover
For example, if the credit purchases during a year are Rs 1,00,000, Average
accounts payable Rs. 25,000, the Creditors Turnover Ratio will be ‘4’ (i.e.,
1,00,000 / 25,000) while the creditors payment period would be 3 months (i.e., 12
months/4).
 Significance: The creditors turnover ratio and the
creditors payment period indicate about the promptness or
otherwise in making payment for credit purchases.
 A higher creditors turnover ratio or a lower creditors
payment period signifies that the creditors are being paid
promptly thus enhancing the credit-worthiness of the
company. However, a very favourable ratio to this effect
also shows that the business is not taking full advantage of
credit facilities which can be allowed by the creditors.

5. Stock Turnover Ratio
 The ratio indicates whether the investment in inventory is efficiently used and whether it
is within proper limits. It is calculated as follows:
Cost of Goods Sold during the year

Stock Turnover Ratio 
Average Inventory
Average inventory is calculated by taking the average of inventory at the
beginning and at the end of the accounting year.
Significance: The ratio signifies the liquidity of inventory.

A high inventory turnover ratio indicates brisk sales and vice-versa.
The ratio is therefore a measure to discover possible trouble in the
form of over-stocking or over-valuation of inventory.

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Ratio Analysis

1 Imlak Shaikh,Ph.D, MDI Gurgoan 06/02/2020

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(ii) Creditors; and

(iii) Financial executives.

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Aid in Financial Aid in

Aid in COST COMMUNICATI

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For example, a high stock turnover ratio is generally

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• Operating efficiency or turnover of the firm

• Inter - firm and intra – firm comparison

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Profitability Activity Solvency

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The Financial or Solvency Ratios can

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 The ratio is an indicator of the firm’s commitment to meet its

Significance: The ratio is an index of the concern’s financial stability,

Super Quick Assets

Significance: This ratio is the most rigorous test of a firm’s liquidity

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Liquid Assets (quick assets)

Daily cash requirements (projected) = Projected cash operating expenditure/Number

Significance: The DIR is thought by many people to be a better liquidity

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Profit after Taxes + Depreciati on + Interest on Loan

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Net Fixed Assets

Significance: It is sound principle that fixed assets should be financed out of

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 This is also called as Return on Investment (ROI) or Return on Capital

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 This ratio indicates the number of times the earning per

Market Price Per Equity Share

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 This ratio expresses the relationship between Gross Profit

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Operating cost includes cost of direct materials, direct labour, direct

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Income before Interest and Tax

Significance: The ratio is significant from the lender’s point of view.

Higher the ratio, better it is.

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Dividend per equity share

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Dividend Per Share

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Net Profit after Interest & Tax

Significance: This ratio is an important yardstick of performance for

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