Ratio Analysis

Meaning
Ratio is a:
• mathematical number calculated as a reference to
• relationship of two or more numbers and can be
• expressed as a fraction, proportion, percentage and a
number of times
 Ratio Analysis
• Ratio analysis is the use of relationships among financial
statement accounts to gauge the financial condition and
performance of a company.

Copyright © 2013 CFA Institute 3

 I) LIQUIDITY RATIOS
• Calculated to measure the
– short-term solvency of the business
– firm’s ability to meet its current obligations.
• These are analysed by looking at current assets and
current liabilities in the balance sheet.
What are various current assets?
 What are various Current Liabilities?
• Creditors
• Bills payables
• Bank overdraft
• Short – tem loans
• Outstanding expenses
• Incomes received in Advance
Types of Liquidity Ratios

Copyright © 2013 CFA Institute 7

 1.) Current Ratio
• It is expressed as follows:-
Current assets
Current liabilities

• Ideal ratio = 2:1 (twice the current assets to pay off the current
liabilities)

Interpretation:-
• This ratio measures the margin of safety available to pay off it’s short
term debts or obligations.
• It indicates whether the business can pay debts due within one year
out of the current assets.
Analysis of Current Ratio
 Interpretation of Current Ratio
Very high current ratio = BAD SIGN
• Implies heavy investment in current assets
• Under utilisation or improper utilisation of resources.

Low current ratio = BAD SIGN

• Endangers the business
• Firm will not be able to pay its short-term debt on
time
 2.) Quick Ratio or Liquid Ratio
• Also known as Acid – Test ratio
• It is expressed as follows:-
Quick assets
Current liabilities

• Quick assets = Current Assets – Stock – Prepaid expenses

• Better/Strict measure of liquidity position
• Ideal ratio = 1:1
 3.) Cash Ratio or Absolute Liquid Ratio
• Ability to satisfy current liabilities using only cash and cash
equivalents.

• Ideal Ratio = 0.5:1

= It is expressed as follows:-
Cash and cash equivalents
Current liabilities
Case Analysis
• The following data is given for 2 companies relating to their current assets
and current liabilities.
• Both the companies have same current ratio, analyse which of the 2
companies is at the better position?
 Practical Problem – I
• Following information is given for a company:
Particulars Amount ( in Rs.)
Plant and Machinery 400,000
Marketable securities 150,000
Bills receivable 40,000
Cash in hand 45,000
Cash at bank 30,000
Inventories 75,000
Bank overdraft 70,000
Sundry creditors 60,000
Bills payable 90,000
Outstanding expenses 30,000

You are requires to calculate the liquidity ratios and interpret the same.
 MCQ
Current ratio is often termed as the ‘crude’ ratio because:
a)It measures only the quantity of current assets
b)It measures only the quality of current assets
c)Both a and b
d)it is better measure of liquidity than quick ratio
 MCQ
• The company is having the liquid ratio of 0.4:1.
Which of the following reasons hold true for this ratio?
a)The company is having unsaleable inventories or slow
moving stock
b)The company is collecting from debtors is quickly
c)The company is paying its’ creditors on time
d)All of the above
II) TURNOVER RATIOS OR ACTIVITY RATIOS

• Also known as efficiency ratios

• Measures the efficiency with which a firm manages its
resources or assets
• Indicate the speed with which resources or assets are
being turned ( or converted) into sales.
1.) Stock or inventory turnover ratio
• Meaning
This ratio established relationship b/w cost of goods sold
and average inventory.
• Objective
To determine the efficiency with which inventory is
converted into sales.
• Formula
Stock Turnover Ratio = COGS
Average Stock
Interpretation of Stock Turnover Ratio
 B.) Inventory Conversion Period
Number of days/months/year
Inventory turnover ratio
 Problem Solving – 1
• Donny’s Furniture Company sells industrial furniture for office
buildings.
• During the current year, Donny reported cost of goods sold on its
income statement of $1,000,000. Donny’s beginning inventory
was $3,000,000 and its ending inventory was $4,000,000.
• You are required to:
– Calculate the Inventory Turnover Ratio and
– Make suitable interpretation of the same.
Problem solving – II
• From the following information, calculate the inventory turnover
ratio of Company X which is in retail sector:
Inventory in the beginning 18000
Inventory at the end 22000
Net purchases 46000
Wages 14000
Revenue from operations 80000
Carriage inwards 4000

• Company Y, also in the retail sector is having the inventory

turnover ratio of 7 times.
• Interpret the results with suitable justifications.
2) Debtors Turnover Ratio
• Meaning
Establishes relationship b/w net credit sales and average
debtors.
• Objective
To determine the efficiency with which debtors are
converted into cash
• Formula
Debtors turnover ratio = Net credit sales
Average debtors
Interpretation of Debtors Turnover Ratio
2.1) Debt collection period (or debtors velocity)
• Shows average credit period enjoyed by debtors
• Measures the quality of debtors
• Shows the speed with which money/dues are collected
from debtors

Formula
• Debt collection period = 12 months/52 weeks/365 days
Debtors Turnover Ratio
Problem solving
Following are the details of the Company A (in rupees lakhs) for the year 2017:
•Total gross sales = 100
•Cash sales (included in above) = 20
•Sales Returns = 7
•Total debtors at beginning of the period = 5
•Total debtors at beginning at the end of the period = 13
•Bill receivable at beginning of the period = 5
•Bill receivable at the end of the period = 15
Calculate the a) Debtors Turnover Ratio and b) Average Collection Period
In last year 2017, company was having the debtor turnover ratio of 9 times and average collection period was 45 days.
•Analyse the results for 2 years and make the suitable interpretation.

•
 3.) Creditors turnover ratio
• Meaning
Establishes relationship b/w net credit purchases and
average creditors
• Objective
To determine the efficiency with which creditors are paid
with cash
• Formula
Creditors turnover ratio = Net credit purchases
Average creditors
Interpretation of Creditors Turnover Ratio
 3.1) Debt payment period (or creditors
velocity)
• Shows an average period for which credit purchases
remains outstanding or average credit period availed by
the firm

• Average debt payment period = Average creditors

Average net credit purchases
Problem solving
• From the following particulars, calculate the creditors turnover ratio
and average payment period of Company X for the year 2017:

Particulars Amount (in Rs.)

Total purchases 400,000
Cash purchases (included in above) 50000
Purchases returns 20000
Creditors at the beginning 60000
Creditors at end 20000
Reserve for discount on creditors 5000
• For the year 2016, the creditor turnover ratio was 6.9 times and
average payment period was 94 days.
• Analyse the results for 2 years and make the suitable
interpretation.
 4.) Fixed assets turnover ratio
• Meaning
Establishes the relationship b/w net sales & fixed assets
• Objective
To determine the efficiency with which fixed assets are utilized, number of
times an asset is used to generate sales
• Components
Net sales & Net assets
• Formula
Fixed assets turnover ratio = Net sales
Net fixed assets
Interpretation
 5.) Working capital turnover ratio
• Meaning
Establishes the relationship b/w net sales & working capital
• Objective
To determine the efficiency with which working capital are utilized
• Components
Net sales & Working capital
• Formula
Working capital turnover ration = Net sales
Working capital
Interpretation
 Problem solving
• Find the working capital turnover ratio from the following
information of the company:
• Cash = 10000
• Bills receivable = 5000
• Debtors = 25000
• Stock = 20000
• Creditors = 30000
• Net sales = 150000
 MCQ
• Debt collection period measures the:
a)Quality of current assets
b)Quality of debtors
c)Quality of creditors
d)All of the above
 MCQ - 1
• If stock turnover ratio in the year 2017 was 7 times and in
the year 2018 is 10 times. It reflects:
a)Fast moving stock in year 2018
b)Stock converted into sales faster in year 2017 compared
to year 2018
c)Slow moving stock in year 2018
d)Efficient management of stock in 2017 compared to 2018.
 MCQ - 2
• The debtor turnover ratio of the company has fallen from
11 times to 5 times. In lieu of this, the company:
a)Must make more sales on credit
b)Must seller lesser stock
c)Must reduce its’ expenses to improve its’ liquidity
d)Must speed up collection of its’ debts
PROFITABILITY RATIOS
 PROFITABILITY
• How much profit the firm generates from sales.
• Different measures of profit
– Gross profit
– Net Profit
Overview of Profitability Ratios
 POINTS TO REM
(A) Operating income = Sales / Revenue from operations
(B) Non - Operating income = rent received, commission received,
interest received, royalty received etc.
(C) Operating expenses = cost of goods sold + office expenses +
administrative expenses + selling expenses + distribution expenses +
depreciation on fixed assets
(D) Non operating expenses = interest on loan, taxes
•OPERATING PROFIT = (A) – (C)
•NET PROFIT = [(A)+(B) – (C)+(D)]
 1.) Gross Profit Ratio
• Meaning
Measures the relationship b/w gross profit & net sales
• Objective
It measures the cost of operations on every Rs. 100 sales
• Formula
Gross Profit
Net sales
 Interpretation
• High GP ratio => low cost of production & high sales

• Low GP ratio => high cost of production & low selling

price
 2.) Operating Ratio
• Meaning
Measures the relationship b/w operating cost & net sales
• Objective
It measures the cost of operations on every Rs. 100 sales
• Formula
Operating cost
Net sales
 Interpretation
For example:-
• Operating ratio is 65% = On every sale of Rs. 100, Rs. 65 is
consumed in the operating costs of the company.

• Operating ratio, if high = less favourable for the company as,

small margin (operating profit) left. In the above example, it is only
35%.

• Lower the ratio, better it is for the company.

• Indian railways have the operating ratio of 95-110%. This is highly
unfavourable.
News Analysis
Railways’ operating ratio in FY 19 could be its worst ever
• It signifies:
–It does not have money for capital investments. Therefore,
–laying new railway lines,
–deploying more coaches and
–similar modernisation efforts cannot be carried out.
 3.) Operating Profit Ratio
• Meaning
Measures the relationship b/w operating profit & net sales
• Objective
To determine the operational efficiency of the firm
• Formula
Operating profit
Net sales
 Interpretation
• Shows revenues left after all the operating costs have been paid.

• Shows operating profit earned on sale of Rs. 100.

• For example:- if operating profit ratio of a company is 40%. [On

every sale of Rs. 100, 60% = operating expenses and 40% =
operating profit].

• Higher the ratio, better it is for the firm.

 4.) Net profit Ratio
• Meaning
Measures the relationship b/w net profit & net sales
• Objective
To determine the overall profitability of the firm
• Formula
Net profit
Net sales
 Interpretation
• Ratio indicates the net profit earned on sale of Rs. 100

• It measures the overall profitability of the firm

• It shows:-
• What amount is left to pay dividend to shareholders
• Firm’s capacity to withstand adverse economic condition.
Problem solving
• From the following information, calculate:
– Operating Ratio
– Operating profit Ratio
– Net profit ratio
• Opening stock = 2600
• Purchases = 8000
• Wages = 2400
• Manufacturing expenses = 1600
• Sales = 16000
• Closing stock = 3800
• Selling expenses = 400
• General expenses = 2400
• Loss of furniture due to fire = 80
• Compensation received for land acquisition = 480
 MCQ - I
• Following are the expenses (in Rs. 000’) incurred by the company in the year
2017,
• Advertisement expenses = Rs. 200, Taxes paid = Rs. 100, Administrative
expenses = Rs. 200 and interest on loan = Rs. 50. In lieu of this, the total
operating cost of the company will be:
a) Rs. 500
b) Rs. 400
c) Rs. 450
d) Rs. 550
 MCQ - II
• The net profit earned by any company includes:
a)Operating incomes and all operating expenses
b)Operating incomes, operating expenses and non - operating
expenses
c) Operating incomes, operating expenses and non - operating
incomes
d)Operating incomes, operating expenses and non - operating
incomes, non – operating expenses
PROFITABILITY RATIOS (OWNER’S VIEW POINT)
1) Return on Investment (ROI)
• Formula
Net profit (before interest and tax)
Total funds

• Indicates the return that investors could receive on their investment in a company.

• Indicates the ‘overall efficiency’ of the firm.

• Primary objective of business is to maximise the earnings of its’ investors, this

ratio indicates to what extent this primary objective has been achieved.

• Higher the ratio, better it is

2) Return on Equity capital (ROEC)/Shareholder Funds

• Also known as ‘Return on Net Worth’.

• The profitability & performance of company is judged using this ratio.
• Ratio used by equity shareholders.

• Formula:
Net profit after tax – Preference dividend
Shareholder Funds

• Higher ratio is favourable as it means that the company is efficient in

generating income on investment.
Interpretation
• Measures overall efficiency of the business.

• Owners are interested in knowing the profitability of business in

relation to their money invested in it.

• High ROCE will satisfy the shareholders (or owners).

• Low ROCE indicates low profitability of the company.

 Problem solving
• From the following information (in Rs.), calculate
a) Return on Investment and,
b) Return on Shareholder Funds
• Equity share capital = 400,000
• Preference share capital = 100,000
• 10% debenture = 400,000
• General reserve = 184,000
• Net profit after interest and after tax = 150,000
• Tax amount = 50,000
3) Earning Per Share
• Measures the net income (in rupees) earned by each share
• Formula
Net profit after tax – Preference dividend
Number of equity shares outstanding

Higher the ratio, better it is as it means

• the company is more profitable and
• the company has more profits to distribute to its shareholders.
• the company has strong financial position.
• it is the reliable company to invest money.
4) Dividend per share Ratio
• Shows amount of profit which is distributed to
shareholders per share
• Formula
Dividend paid
Number of shares
5) Price earning ratio (P/E ratio)
• Relationship b/w stock price and earnings of the
company
• Shows how much amount an investor is willing to pay to
buy 1 share based on its’ earnings.

• Formula
Market price per share
Earnings per share
Interpretation
• For example:- if the P/E ratio = 10 times, this means that the
market price of the share of the company is 10 times the earnings
of the company.
• High P/E ratio indicates that the share of the company is sold in
the stock market at a high price and the investors have high
expectations.
• Low P/E ratio indicates low profits of the company as the EPS
(denominator) is less.
 Problem solving
• From the following information calculate
(i) Earning per share
(ii) Price earning ratio
• 70,000 equity shares of Rs 10 each = Rs. 700,000
• Net Profit after tax = Rs. 1,75,000
• Market price of a share = Rs. 13
 MCQ - 1
• The EPS of JKL Ltd. In year 2018 was Rs. 150 per share and in
year 2019 it increased to Rs. 345 per share. It signifies that JKL
Ltd is:
a)Reliable company to invest money
b)Has strong financial position
c) Distributing more dividend to its’ shareholders over a period of
time
d)All of the above
 MCQ – 2
• Comparison of market price of share and earnings of the
company gives the ratio which is known as:
a)Dividend yield ratio
b)Earning per share
c) Price earning ratio
d)Any of the above
 MCQ - 3
• If the market price of the share is Rs. 2.41 and dividend per share
is Rs. 0.9, then the dividend yield is:
a)9%
b)35%
c) 37.3%
d)3.73%
 MCQ - 4
• If EPS is Rs. 0.12 and market price of the share is Rs. 3.60, then
the P/E ratio will be:
a)0.3
b)3 times
c) 30
d)3.33%
 SOLVENCY RATIOS

• The persons who have given money to the business on long-term

basis are interested
– in safety of their periodic payment of interest, as well as the
– repayment of principal amount at the end of the loan period.
• Solvency ratios are calculated to determine the ability of the
business to service its debt in the long run.
1.) Debt – equity ratio
• Meaning
Establishes the relationship b/w long - term debts and
shareholder’s funds used in financing the firm’s assets
• Objective
To measure the proportion of debt and equity in the firm
• Formula
Long – term debts
Shareholder funds

IDEAL RATIO = 1:2

Interpretation
 Interpretation
• Ratio less that 1 i.e. reflects the low – debt equity ratio.
– This shows more security available to creditors.
– This also implies a more financially stable business.
– Companies with low – debt equity ratio are less risky to creditors.
• Ratio greater that 1 i.e. reflects the high – debt equity ratio
– This shows that company has raised more debt compared to equity to
buy its’ assets.
– More debt means that the company is highly leveraged.
– The company is taking advantage of trading on equity.
– Companies with a higher debt to equity ratio are considered more risky
to creditors and investors
2.) Proprietary ratio or equity ratio
• Meaning
Establishes the relationship b/w shareholder funds to total
assets in the company.

• Formula
Shareholder Funds *100
Total assets
 Interpretation
• The proprietary ratio shows the contribution of
shareholders in total capital of the company.
• A high ratio indicates a strong financial position of the
company and greater security for creditors.
• A low ratio proprietary indicates that the company is
already heavily depending on debts for its operations.
• A large portion of debts in the total capital increases
interest expenses and also the risk of bankruptcy.
Problem solving
• From the following information, calculate the:
a)Debt – equity ratio
b)Proprietary ratio
• Equity share capital = 400,000
• Reserves and surplus = 100,000
• Long term borrowings = 150,000
• Current liabilities = 50,000
• Fixed assets = 400,000
• Investments = 100,000
• Current assets = 200,000
 3.) Interest coverage ratio
Meaning
• Measures the debt servicing capacity of the company.

Formula
Net profit before interest and tax
Fixed interest charges
 Interpretation
• This ratio is expressed in times.
• It indicates number of times interest is covered by profits
available to pay interest charges.
• Long term creditors are interested in knowing the
company’ ability to pay interest charges.
• Higher the ratio, more safety available to creditors.
 Problem Solving
• Calculate and interpret the ‘interest coverage ratio’ from
the following information of the company.
• Net profit after tax = 500,000
• 10% long – term loan = 200,000
• 10% debentures = 100,000
• Tax amount = 40000
 Problem Solving
• Following information is given for the company:
Particulars Amount Particulars Amount
Equity share capital (40,000 400,000 Current liabilities 100,000
shares of Rs. 10 each)
12% Preference Share Capital 100,000 Fixed assets 950,000
General reserve 184,000 Current assets 234,000
10% debentures 400,000

• Net profit after tax = 150,000, tax amount = 50,000, market price of share =
Rs. 34
• Calculate:
a) Return on investment
b) Return on equity capital
c) EPS and;
d) P/E ratio
 DuPont Framework
• Developed internally at DuPont around 1920.
• Provides a systematic approach to identifying general
factors causing ROE to deviate from normal.
• Establishes a framework for more in-depth analysis of a
company’s areas of strength and weakness.
 DuPont Framework
DuPont: ROE can be decomposed into three components:

Profitability x Efficiency x Leverage

Return on x Asset x Assets-to-
Sales Turnover Equity Ratio
Net Income x Sales x Assets
Sales Assets Equity
 DuPont Framework
Net Income x Sales x Assets
Sales Assets Equity

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 Colesville Corporation ROE
Net Income x Sales x Assets
Sales Assets Equity
2008 $180,000
x x $5,700,000 $2,278,000
3.16% 2.50 1.55
$5,700,000 $2,278,000 $1,468,000

Return on Equity = 12.3%

2007 $205,000 x 3.01$6,600,000 $2,191,000

3.11% x 2.01
$6,600,000 $2,191,000 $1,090,000
Return on Equity = 18.8%