RATIO ANALYSIS

What is RATIO..??
An Arithmetical Expression of relationship between two
related or Inter-Dependent items.

What is ACCOUNTING RATIO..??

The term Accounting Ratio is used to describe the significant
relationships which exists between figures shown in a Balance
Sheet, in a Profit/Loss Account, in a Budgetary Control system
or in any part of the accounting organization.
 EXPRESSION OF

RATIO
PURE – Expressed as a Quotient.
e.g. Current Ratio = Current Assets/Current Liabilities
= Rs. 2,00,000/ Rs. 1,00,000
= 2:1

 PERCENTAGE - Expressed in Percentage

e.g. Gross Profit Ratio = Gross Profit/Net Sales X 100
= 25%

 TIME – Expressed in number a particular figure is compared to another figure.

e.g. Stock turnover ratio which studies relationship between cost of goods sold
and average stock is (say) 4times.

 Fraction – Expressed as Fraction.

e.g. Ratio of fixed assets to share Capital is (say) 3/4 (0.75)

 Days - Expressed in number of Days.

e.g. The average collection period is 73 Days.

 MEANING OF RATIO
ANALYSIS
It’s a technique or process of determining and
interpreting relationship between the items of
financial statements to provide a meaningful
understanding of the performance and
financial position of an enterprise.
It’s a study of relationship among various
Financial factors in a Business.
 OBJECTIVE OF RATIO
ANALYSIS
Its main Objective is to Test and make Qualitative Judgment
about the Firm’s Profitability, Financial Position (Liquidity &
Solvency), and Operating Efficiency. E.g. a Current Ratio is
calculated by dividing current assets by current liabilities; the
ratio indicates a relationship-a qualified relationship between
current assets and current liabilities.
It measures the Firm’s Liquidity: The Greater the Ratio, the
greater the firm’s liquidity and vice-versa.
In Financial Analysis, a ratio is used as a benchmark for
evaluating the financial position and performance of a firm.
An Accounting figure conveys meaning when it is related to
some other relevant information. E.g. a Rs. 5Crore Net Profit
may look impressive, but the firm’s performance can be said to
be good or bad only when the net profit is related to the firm’s
investment.
 TYPES OF RATIOS
 Liquidity Ratios: They Measure the Firm’s ability to meet
current Obligations.

 Solvency Ratios: They Show the Proportions of Debt & Equity

in financing the Firm’s assets.

 Activity Ratios: They reflect the Firm’s efficiency of utilizing

assets.

 Profitability Ratios: They measure overall performance and

effectiveness of the Firm.

 Coverage Ratios: They measure the profit to measure the

interest charges.
Liquidity ratios measure the ability of firm to meet its
current obligations. In fact, analysis of liquidity needs the
preparation of cash budgets and cash and fund flow
statement; but liquidity ratios, by establishing a
relationship between cash and other current assets to
current obligations, provide a quick measure of liquidity.
A firm should ensure that it does not suffer from lack of
liquidity , and also that it does not have excess liquidity.
 Current ratio
 Quick or acid test or liquid ratio
 Cash ratio
 Net working capital ratio
The current ratio is calculated by dividing current assets by current liabilities:

Current ratio = Current assets / Current

liabilities
The current ratio is a measure of the firm’s short-term solvency. It indicates the
availability of current assets in rupees for every one rupee of current liability. A
ratio of greater than one means that the firm has more current assets than
current claims against them.
As a conventional rule , a current ratio of 2:1 or more is considered satisfactory.
It is found out by dividing :
Quick ratio = Quick assets / Current liabilities
Quick assets = current assets – inventories –
prepaid expenses
Generally ,a quick ratio of 1:1 is considered to represent
a satisfactory current financial conditions.
The computation of cash ratio :
Cash ratio = Cash + marketable securities/
Current liabilities
Since cash is the most liquid asset, a financial analyst may
examine cash ratio and its equivalent to current
liabilities. Trade investment or marketable securities are
equivalent of cash, therefore, they may be included in the
computation of cash ratio.
It can be computed by :
NWC Ratio = Net working capital / Net
assets
The difference between current assets and current liabilities
excluding short - term bank borrowings is called net
working capital or net current assets. NWC is sometimes
used as the measure of a firm’s liquidity. It however ,
measure the firm’s potential reservoir of funds.
 The term ‘solvency’ implies ability of an enterprise
to meet its long-term indebtedness and thus,
solvency ratios convey an enterprises ability to meet
its long-term obligations. Some important solvency
ratios are :

 Debt-Equity Ratio,
 Interest Coverage Ratio,
 Debt to Total Funds Ratio,
 Fixed Asset Ratio,
Debt Equity Ratio.
The debt-equity ratio is worked out to ascertain soundness of the long-
term financial policies of the firm.

The ratio ascertained as follows;

Debt-Equity Ratio = Debt (Long-Term Loans)

Equity (Shareholders’ Funds)

Dept – equity ratio indicates the proportion between shareholders’ funds

and the long-term borrowed funds. A higher ratio indicates a risky
financial position while a lower ratio indicates safer financial position.
Objective and Significance

This ratio is sufficient to assess the soundness of

long-term financial position. It also indicates the
extent to which the firm depends upon outsiders
for its existence
Ascertain Dept-Equity ratio;

Equity share capital 2,00,000

General reserve 1,60,000
10% debenture 1,50,000
Current liabilities 1,00,000
Preliminary expenses 10,000

Solution ;
Dept-equity Ratio = Dept
Equity

Dept = debentures = Rs. 1,50,000

Equity= Equity Share Capital + General Reserve- preliminary Expenses
= 2,00,000+1,60,000-10,000
= 3,50,000
Dept-Equity ratio= 1,50,000
3,50,000
= 15:35= 3:7
Interest Coverage ratio:
when a business borrows money, the lender is interested in
finding out whether the business would earn sufficient
profit to pay periodically the interest charge. A ratio
which expresses this is called Interest Coverage Ratio or
Dept service Ratio or fixed charges cover.
This ratio is determined by dividing profit before interest
by the interest charges

Interest Coverage Ratio =Net profit before interest and tax

Interest on fixed (long-term) loans or Debentures
Objective and Significance :
This ratio indicates how many times the profit
covers fixed interest. It measures the margin of
safety for the lenders. The higher the number,
more secure the lender is in respect of his
periodical interest income.
Example:
The operating profit of Exe. Ltd. After charging interesr on debentures and
tax is Rs 1,00,000. The amount of interest is Rs 20,000 and the provision
for tax has been made at Rs 40,000. Calculate the interest coverage ratio.

Solution:
Interest Coverage Ratio = net profit before interest and tax
Interest charges

= 1,60,000
20,000
 The Debt to Total Funds Ratio is a measure for long term financial
soundness.

 Debt Total Funds Ratio = Debt

Equity + Debt

 Objective and Significance:

The main purpose of the ratio is to determine the
relative stock of outsiders and shareholders.
9% Pref. Share Capital 10,00,000
Equity Share Capital 20,00,000
Reserves 10,00,000
10% Debentures 30,00,000
Loans From Industrial Finance corporation 20,00,000
Current liabilities 8,00,000

Debt to Total Funds Ratio = Long-term loans

Shareholders funds + Long-term loans
= 30,00,000 + 20,00,000
10,00,000 + 20,00,000 + 10,00,000 + 30,00,000
+ 20,00,000
= Rs. 50,00,000 = 5 : 9 or 0.56.
Rs. 90,00,000
Fixed Assets Ratio
= Shareholders’ funds + Long-term loans
Net Fixed Assets

Objective and Significance.

This ratio indicates as to what extent fixed
assets are financed out of long-term solvency.
Share capital 2,00,000
Reserves 50,000
9% Debentures 2,00,000
Trade Creditors 75,000
Plant and Machinery 2,00,000
Land and Building 2,00,000
Furniture 50,000
Trade Debtors 60,000
Cash Balance 40,000
Bills Payable 24,000
Stock 80,000

Fixed Assets Ratio = Long-term Funds

Fixed Assets
= 2,00,000 + 50,000 + 2,00,000 = 4,50,000 = 1
2,00,000 + 2,00,000 + 50,000 4,50,000
 Activity ratios are also known as turnover or
efficiency ratios.
 Activity ratios indicate the efficiency with which
the resources available to the firm are utilized.
 Higher turnover ratio means better use of
resources available to the firm.
 This ratio expresses the relationship between
net sales and capital employed.

Formula : NET SALES

CAPITAL EMPLOYED
NET SALES= Sales – Sales returns
CAPITAL EMPLOYED=
Two methods:
i. Shareholder funds + Long term debts
 Shareholder funds:
Equity share capital + Preference share
capital+ Reserves & surplus + P&L a/c
Less:
Preliminary expenses, underwriting commission,
discount on issue of shares & debentures, p & l
a/c(Dr.)
 Long term debts:

Debentures + loans + public deposits

ii. Fixed assets + current assets – current

liabilities
Objective:
 The objective of working out this ratio is to
determine how efficiently the capital employed is
being used.

Interpretation:
 A higher ratio means efficient utilization of capital
employed & vice versa.
 A very high capital turnover ratio would indicate
overtrading or under capitalization.
From the following Balance sheet of S Ltd. For the year ended 31st
December, 2007, calculate Capital Turnover Ratio:

LIABILITIES AMOUNT ASSETS AMOUNT

Equity share 75,000 Fixed Assets 40,000

capital Stock 90,000
Profit for the year 47,000 Debtors 86,000
Reserves 25,000 Cash 7,000
Trade Creditors 76,000
2,23,000 2,23,000

Sales for the year amounted to Rs. 3,50,000.

Capital employed = Fixed Assets + Working
capital.

=40,000+90,000+86,000+7,000-76,000
=Rs. 1,47,000
Capital Turnover Ratio = Net sales
Capital employed
= 3,50,000
1,47,000
= 2.38 Times
 This ratio indicates the extent to which
investment in fixed assets contribute towards
sales.
 Formula: NET SALES
NET FIXED ASSETS
NET FIXED ASSETS = Fixed Assets –
Depreciation
Objective:
 Fixed Asset Turnover Ratio indicates how
efficiently fixed assets are used.

Interpretation:
 If there is increase in the ratio it will indicate that
there is improvement in the utilization of fixed
asset & a decline in ratio will indicate that fixed
assets have not been used efficiently by the firm.
From the following data, calculate the Fixed
Assets Turnover Ratio:
Gross Fixed Assets = Rs. 3,00,000
Accumulated Depreciation = Rs. 1,00,000
Total Sales = Rs. 8,50,000
Sales Returns = Rs. 50,000.
 This ratio indicates whether the working
capital has been efficiently utilized or not in
making sales.

Formula: NET SALES

NET WORKING CAPITAL
Objective:
This ratio indicates whether or not working
capital has been effectively utilized in making
sales. In other words, it measures the rate of
working capital utilization.

Interpretation:
A high working capital turnover ratio shows the
efficient utilization of working capital & vice
versa.
Solution:
Calculation of Working Capital Turnover Ratio:
Net Sales = Rs. 30,50,000 – Rs. 50,000
= Rs. 30,00,000
Working Capital = Current Assets – Current Liabilities
= Rs. 9,00,000 – Rs. 3,00,000
= Rs. 6,00,000
Working Capital
Turnover Ratio = Rs. 30,00,000
Rs. 6,00,000
= 5 Times
INDICATES THE VELOCITY WITH WHICH THE PAYMENTS
FOR CREDIT PURCHASE ARE MADE TO CREDITORS.

THE TERM ACCOUNTS PAYABLE INCLUDES CREDITORS

AND BILLS PAYABLE.

THE RATIO IS CALCULATED AS FOLLOWS:

CREDITORS TURNOVER RATIO = TOTAL CREDIT

PURCHASES
AVERAGE ACCOUNTS
PAYABLE

AVERAGE ACCOUNTS PAYABLE = OPENING CREDITORS +

OPENING BILLS PAYABLE + CLOSING CREDITORS +
CLOSING BILLS PAYABLE
OBJECTIVES AND SIGNIFICANCE:

1. CREDITORS TURNOVER RATIO AND THE DEBT

PAYMENT ENJOYED BOTH INDICATES
WHETHER THE FIRM IS ENJOYING ACTUALLY
THE CREDIT PROMISED BY SUPPLIERS.

2. IF THE FIRM ENJOYS LOWER CREDIT PERIOD,

IT MEANS THE CREDITORS ARE BEING PAID
PROMPTLY AND THE FIRM IS NOT TAKING THE
FULL ADVANTAGE OF CREDIT FACILITIES.
INDICATES THE TIME WITHIN WHICH THE PAYMENTS FOR CREDIT
PURCHASES ARE MADE TO CREDITORS.

THE RATIO IS CALCULATED AS FOLLOWS:

AVERAGE PAYMENT PERIOD = MONTHS (OR DAYS) IN A YEAR

CREDITORS TURNOVER

OR

AVERAGE PAYMENT PERIOD = ACCOUNTS PAYABLE

MONTHLY CREDIT PURCHASES

OR

AVERAGE PAYMENT PERIOD = ACCOUNTS PAYABLE x MONTHS IN A

YEAR
CREDIT PURCHASES IN A YEAR
OBJECTIVES AND SIGNIFICANCE:

1. PROPER EMPLOYEMENT OF CAPITAL BEING ONE

PART OF GOOD MANAGEMENT WORKING
CAPITAL ONE SHOULD ASCERTAIN WHETHER THE
FIRM IS ACTUALLY ENJOYING THE CREDIT
PROMISED BY SUPPLIERS.

2. IF SUPPLIERS ALLOW CREDIT PERIOD OF ONE

MONTH BUT
IF, AS PER CALCULATIONS, A FIRM IS TAKING 2
MONTHS CREDIT PERIOD, IT MAY MEAN EITHER
THAT THE FACILITIES GIVEN BY THE CREDITORS
ARE NOT BEING PROPERLY UTILISED AR THAT
THE FIRM IS UNNECESSARILY DAMAGING ITS
CREDITS IN THE MARKETS.
 Profitability Ratios
 Main object – earn profit
 Profit as compared to the capital employed
 Measures overall efficiency of business
 Shows r’ship of sales with D.C. (purchases, mfrg cost)

 G.P.R. = Gross Profit * 100

Trading
Net Sales A/C
G.P.→ net sales – cost of goods sold
(no a/c of exp charged to P/L)
 Net Sales = Gross sales - (sales tax + excise duty)

 Shows avg margin on goods sold

 In Case of Trading Concern: In Case of Manufacturing Concern:
A. Net Sales XXX A. Net Sales XXX

B. Less: Cost of Goods Sold B. Less: Cost of Goods Sold

Opening Stock XX Raw Material Consumed
(O.S + Purchases-C.S. of
Raw Material) XX
Purchases XX Wages XX
Wages XX Direct Expenses XX
Direct Expenses XX Other mfrg exp XX
Less: Closing Stock XXX Add: O.S. of finished goods XXX
XXX Less: Closing Stock XXX
C. Gross Profit (A-B) C. Gross Profit (A-B) XXX
 P/L A/C OF HEMANT GOEL FOR YR ENDING 31ST MARCH 2007
PARTICULARS AMOUNT PARTICULARS AMOUNT
To O.S. 76,250 By Sales 5,00,000
To Purchases 3,15,250 By C.S. 98,500
To Wages 5,000 By Int on Securities 1,500
To Carriage & Freight 2,000 By Dividend on Shares 3,750
To Office & Adm Exp 1,01,000 By Profit on Sale of 750
To S&D Exp 12,000 Shares
To Finance Exp
Int on B/P 1,200
Discount 2,400
Bad Debts 3,400 7,000
To Int on Debentures 8,000
To Loss on Sale of 350
Securities
To Loss on Sale of 6,000
Furniture
To Provision for Legal 1,650
Suit 70,000
To Net Profit 6,04,500 6,04,500
 N.P.R. = Net Profit * 100
Net Sales
 Net Profit = Gross Profit - [op. exp (S&D…) +
Non-op exp (int on debentures…)]
+ Non-op income (int on shares..)
 Can be PBT/PAT
 Reveals overall efficiency of business.
 Higher the N.P.R. the better it is.
 EXPENSE RATIOS
 Ascertains relationship b/w operating exp & volume of
sales

 Indicates portion of sales consumed by various operating

expenses

 Throws light on the level of efficiency in different

aspects of work

 It includes the following ratios:

Ratio of materials used to sales:

 Direct material cost to sales = D.M.C. * 100

Net Sales
Ratio of labour to sales:
 Direct labour cost to sales = D.L.C. * 100
Net Sales
 Factory exp
 Office & administration exp
 S&D EXP
Operating profit ratio establishes relationship between
operating profit & net sales.
Operating profit is the net profit arising from the
normal operation of an enterprise.

Operating profit ration: operating profit x 100

Net sale

Operating profit = NP + Non- operating expenses –

Non operating income
Objective & significance

This ration is indicator of operational efficiencies of

management as against the net profit ration,
which reveals overall efficiency.
Example:
Sales 3,00,0000
Gross profit 120,000
Administration expenses 35000
Selling & distribution expenses 25000
Income on investment 15000
Loss by fire 9000

Operating profit ration = net operating profit x 100

Net sale

Operating profit = G.P. (Administrative Exp. + Selling exp)

= 1.2 lac – (25000+ 35000)
= 60000 X 100 = 20%
3 lac
Thais ratio establishes relationships between operating cost & net sales.
This ratio indicates the proportion that the cost of sales.

Cost of sale included direct cost of good sold & as well as other operating
expenses administration, selling & distribution expenses

Operating ratio = Cost of good sold + operating expenses X 100

Net sale

= Operating cost X 100

Net sale
Cost of good sold = opening stock + purchase + direct expenses – closing
stock – GP

Operating expenses = administrative expenses + selling & distribution

expenses
OBJECTIVE & SIGNIFICANCE
Operating ration is the test of the operational
efficiency of the business .it shows the percentage of
sales that is absorbed by the cost of sales & operating
expenses.

This ratio serves following objective

1. To determine whether the cost content has increased

or decreased in the figure of sales.

2. To determine which element of the cost has gone up.

Example:
Cost of good sales 6 lac
Operating expenses 40,000
Sales 8,20,000
Sales returns 20,000

Operating Ratio = Cost of good sold + operating expenses X 100

Net Sales

= 6 lac + 40000 X 100

820000-20000
= 640000 X 100
800000

= 80%
 Common shareholders are entittled to the residual profit.The
rate of divident is not fixed and earning may be distributed to
shareholders or retained in the business.
 A ROE is calculated to se the profitability of owner’s
investment.
 ROE indicates how well the firm has used the resources of
owners.
 It is a most important relationship in financial analysis.

Formula:
ROE= PAI .
Net Worth Equity
 It is a measure for calculating the profitability of
shareholder’s investment.
 EPS is calculated as;EPS=PAT/NO. OF
OUTSTANDING SHARES
 EPS shows the profitability of the firm on share basis,it
does’t reflect how much is paid as dividend and how
much is retained in the business? But as profitability
index as it is valuable.
 The higher the EPS,the more attractive will be the
investment plan or vice-versa
 The term investment refer to total asset or net asset.
 the conventional approach of calculating ROI is to divide PAT by
investment,investment represents pool of funds,supplied by shareholders
and lenders,
 while pat represents residue income of shareholders.
 The formulae for calculating ROI is;
 ROI=ROTA=EBIT(1-T)/ TA OR NA

 Since taxes are not controllable by management and firm’s opportunities

far availing tax incentives differ,it may be more prudent to use before tax
measure of ROI,thus the before tax ratios are;
 ROI=ROTA=EBIT/TA OR NA
• Net profit after tax = Rs. 10000

Interest charged = Rs. 2000

Provision for tax has been made at Rs. 4000

If amount of preference dividend payable is sum of Rs. 1000

Calculate:

1. interest cover

2. fixed dividend cover

 net profit ratio = net profit/ sales * 100

turnover ratio = sales/ capital employed

profitability ratio = net profit ratio * turnover ratio

net profit/ capital *100

 Working capital turnover ratio = net sales/ working capital

Debtor’s turnover ratio = credit sales/ average account receivable

Debt collection period ratio = months in year/ debtor turnover

=Average a/c receivable*months in year/ credit sales

=a/c receivable/ average monthly credit sales

Credit sales for year = Rs. 12000

Debtor = Rs. 1000

Bill receivable = Rs. 1000

Calculate:

1. debtor’s turnover ratio

2. debt collection period