Ratio analysis

BY S SURYA
RAJENDRA KUMAR
Profitability Ratios
Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to
generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders’ equity during a specific
period of time.

They show how well a company utilizes its assets to produce profit and value
to shareholders.

A higher ratio or value is commonly sought-after by most companies, as this usually means the business is performing well by
generating revenues, profits, and cash flow. 

The profitability of a firm can be measured by its profitability ratios.

 Further the profitability ratios can be determined (i) in relation to sales and (ii) in relation to
investments
 Profitability ratios in relation to sales:
1. gross profit margin
2. Net profit margin
3. Expenses ratio
 Profitability ratios in relation to investments:
1. Return on assets (ROA)
2. Return on capital employed (ROCE)
3. Return on shareholder’s equity (ROE)
4. Earnings per share (EPS)
5. Dividend per share (DPS)
6. Dividend payout ratio (D/P)
7. Price earning ratio (P/E
Gross profit margin
 This ratio is calculated by dividing gross profit by sales. It is expressed as a percentage.
Gross profit is the result of relationship between prices, sales volume and costs. Gross profit margin
= gross profit x 100 Net sales
 Net profit margin
• This ratio is calculated by dividing net profit by sales. It is expressed as a percentage.
Net profit margin = net profit after interest and tax / Net sales x 100
• Another variant of net profit margin is operating profit margin which is calculated as:
Operating profit margin = net profit before interest and tax/ Net sales x 100
• Higher the ratio, greater is the capacity of the firm to withstand adverse economic conditions and
vice versa
 Expenses ratio
 These ratios are calculated by dividing the various expenses by sales. The variants of expenses
ratios are:
Material consumed ratio = Material consumed/ Net sales x 100
Manufacturing expenses ratio = manufacturing expenses/ Net sales x 100 Administration expenses
ratio = administration expenses/ Net sales x 100 Selling expenses ratio = Selling expenses/ Net sales
x 100
Operating ratio = cost of goods sold plus operating expenses/ Net sales x 100 Financial expense ratio
= financial expenses/ Net sales x 100
 return on Assets (ROA)

• This ratio measures the profitability of the total funds of a firm.

• It measures the relationship between net profits and total assets.
• The objective is to find out how efficiently the total assets have been used by the management.
Return on assets = net profit after taxes plus interest / Total assets x 100
 Return on capital employed (ROCE)
• This ratio measures the relationship between net profit and capital employed. It indicates how
efficiently the long-term funds of owners and creditors are being used.
Return on capital employed = net profit after taxes plus interest / Capital employed x 100
 Return on shareholders equity
• This ratio measures the relationship of profits to owner’s funds.
• Shareholders fall into two groups i.e. preference shareholders and equity shareholders.
• So, the variants of return on shareholders equity are
Return on total shareholder’s equity = net profits after taxes/ Total shareholders equity x 100
 Earnings per share (EPS)
• This ratio measures the profit available to the equity shareholders on a per share basis.
• This ratio is calculated by dividing net profit available to equity shareholders by the number of
equity shares.
Earnings per share = net profit after tax – preference dividend Number of equity share
 Dividend per share (DPS)
• This ratio shows the dividend paid to the shareholder on a per share basis.
• This is a better indicator than the EPS as it shows the amount of dividend received by the ordinary
shareholders, while EPS merely shows theoretically how much belongs to the ordinary shareholders
Dividend per share = Dividend paid to ordinary shareholders/ Number of equity shares
 Dividend payout ratio (D/P)
• This ratio measures the relationship between the earnings belonging to the ordinary shareholders
and the dividend paid to them.
Dividend pay out ratio = total dividend paid to ordinary shareholders /Net profit after tax –
preference dividend x 100
OR Dividend pay out ratio = Dividend per share/ Earnings per share x 100
 Price earning ratio (P/E)
• This ratio is computed by dividing the market price of the shares by the earnings per share.
• It measures the expectations of the investors and market appraisal of the performance of the firm.
Price earning ratio = market price per share/ Earnings per share
  Activity ratios
• These ratios are also called efficiency ratios / asset utilization ratios or turnover ratios.
• These ratios show the relationship between sales and various assets of a firm. The various ratios under this group are:
1. Inventory/stock turnover ratio
2. Debtors turnover ratio and average collection period
3. Asset turnover ratio
4. Creditors turnover ratio and average credit period
 Inventory /stock turnover ratio
• This ratio indicates the number of times inventory is replaced during the year.
• It measures the relationship between cost of goods sold and the inventory level.
• There are two approaches for calculating this ratio, namely:
Inventory turnover ratio = cost of goods sold /Average stock
AVERAGE STOCK can be calculated as Opening stock + closing stock /2
• A firm should have neither too high nor too low inventory turnover ratio. Too high a ratio may indicate very low
level of inventory and a danger of being out of stock and incurring high ‘stock out cost’. On the contrary too low a
ratio is indicative of excessive inventory entailing excessive carrying cost.
 Debtors' turnover ratio and average collection period
• This ratio is a test of the liquidity of the debtors of a firm.
• It shows the relationship between credit sales and debtors.
Debtors' turnover ratio = Credit sales/ Average Debtors and bills receivables
Average collection period = Months OR days in a year /Debtor's turnover
• These ratios are indicative of the efficiency of the trade credit management. A high turnover ratio and shorter collection
period indicate prompt payment by the debtor. On the contrary low turnover ratio and longer collection period indicates
delayed payments by the debtor. In general, a high debtor turnover ratio and short collection period is preferable
 Asset turnover ratio
• Depending on the different concepts of assets employed, there are many variants of this ratio.
• These ratios measure the efficiency of a firm in managing and utilising its assets.
Total asset turnover ratio = sales/cost of goods sold Average total assets
Fixed asset turnover ratio = sales/cost of goods sold Average fixed assets
Capital turnover ratio = sales/cost of goods sold Average capital employed
Working capital turnover ratio = sales/cost of goods sold Net working capital
• Higher ratios are indicative of efficient management and utilization of resources while low ratios are indicative of
underutilization of resources and presence of idle capacity.
 Creditors turnover ratio and average credit period
• This ratio shows the speed with which payments are made to the suppliers for purchases made
from them.
 It shows the relationship between credit purchases and average creditors.
Creditors turnover ratio = credit purchases /Average creditors & bills payables
Average credit period = months OR days in a year /Creditor's turnover ratio
 Higher creditors turnover ratio and short credit period signifies that the creditors are being paid
promptly and it enhances the creditworthiness of the firm