RATIO

ANALYSIS
 • The persons who have advanced 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.
SOLVENC • Solvency of business is determined by its
Y RATIO ability to meet its contractual obligations
towards stakeholders, particularly towards
external stakeholders, and the ratios
calculated to measure solvency position are
known as ‘Solvency Ratios’.
• These are essentially long-term in nature
• The following ratios are normally
computed for evaluating solvency
of the business.
1. Debt-Equity Ratio;
2. Debt to Capital Employed Ratio;
3. Proprietary Ratio;
4. Total Assets to Debt Ratio;
5. Interest Coverage Ratio.
 • Debt-Equity Ratio measures the relationship
between long-term debt and equity.
• If debt component of the total long-term
funds employed is small, outsiders feel more
secure.
Debt-Equity
• From security point of view, capital structure
Ratio with less debt and more equity is considered
favorable as it reduces the chances of
bankruptcy.
• Normally, it is considered to be safe if debt
equity ratio is 2 : 1
• Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus + Money
received against share warrants + Share application money pending allotment
• Shareholders’ Funds (Equity) = Non-current Assets + Working capital – Non-current
liabilities
• Working Capital = Current Assets – Current Liabilities
 • The Debt to capital employed ratio refers to
the ratio of long-term debt to the total of
external and internal funds (capital
Debt to employed or net assets).
Capital • It is computed as follows:

Employed Debt to Capital Employed Ratio = Long-term

Debt/Capital Employed (or Net Assets)
Ratio Capital employed is equal to the long-term
debt + shareholders’ funds.
• Alternatively, it may be taken as net assets
which are equal to the total assets – current
liabilities
 • Proprietary ratio expresses relationship of
proprietor’s (shareholders) funds to net
assets and is calculated as follows :
• Proprietary Ratio (Liability approach) =
Shareholders’ Funds/Capital employed (or
Proprietary net assets)
Ratio • Proprietary Ratio (Asset approach) =
Shareholders’ Funds/Total assets
• Higher proportion of shareholders funds in
financing the assets is a positive feature as it
provides security to creditors.
Total Assets to Debt
Ratio
• This ratio measures the extent of the coverage of long-
term debts by assets. It is calculated as:
• Total assets to Debt Ratio = Total assets/Long-term
debts
• The higher ratio indicates that assets have been mainly
financed by owners' funds and the long-term loans is
adequately covered by assets.
Interest Coverage Ratio

• It is a ratio which deals with the

servicing of interest on loan. It is a
measure of security of interest payable
on long-term debts.

• It expresses the relationship between

profits available for payment of interest
and the amount of interest payable.
Activity or Turnover Ratio

• These ratios indicate the speed at which,

activities of the business are being performed.
• The activity ratios express the number of times
assets employed, or, for that matter, any
constituent of assets, is turned into sales
during an accounting period.
• Higher turnover ratio means better utilisation
of assets and signifies improved efficiency and
profitability
• The important activity ratios
calculated under this category
are
1. Inventory Turnover
2. Trade receivable Turnover
3. Trade payable Turnover
4. Net assets or Capital
Employed Turnover
5. Fixed assets Turnover
6. Working capital Turnover
 • It determines the number of times inventory
is converted into revenue from operations
during the accounting period under
consideration.
Inventory • The formula for its calculation is as follows:
Turnover Inventory Turnover Ratio = Cost of Revenue
from Operations / Average Inventory
Ratio • Where average inventory refers to:
(Opening inventory + closing inventory)/2
• The cost of revenue from operations means:
Revenue from operations - gross profit
Trade Receivables
Turnover Ratio
• It expresses the relationship between credit revenue from
operations and trade receivable.
• Trade Receivable Turnover ratio = Net Credit Revenue from
Operations/Average Trade Receivable
• Where Average Trade Receivable = (Opening Debtors and
Bills Receivable + Closing Debtors and Bills Receivable)/2
• It needs to be noted that debtors should be taken before
making any provision for doubtful debts.
• This ratio also helps in working out the average collection
period.
• Avg. collection period = No. of days or Months/Trade
receivables turnover ratio
Trade Payable Turnover Ratio

• As trade payable arise on account of credit

purchases, it expresses relationship between
credit purchases and trade payable
• Trade Payables Turnover ratio = Net Credit
purchases/ Average trade payable
• Where Average Trade Payable= (Opening
Creditors and Bills Payable + Closing
Creditors and Bills Payable)/2
• This ratio also helps in working out the
average Payment period.
• Average Payment Period = No. of days or
months / Trade Payables Turnover Ratio
 Net Assets or Capital Employed Turnover
Ratio
• It reflects relationship between revenue from operations
and net assets (capital employed) in the business.
Net Assets or Capital Employed Turnover ratio = Revenue
from Operation/Capital Employed
• Capital employed turnover ratio which studies turnover
of capital employed (or Net Assets) is analysed further by
following two turnover ratios :
• (a) Fixed asset turnover Ratio = Net Revenue from
Operation/ Net Fixed Assets
• (b) Working Capital Turnover Ratio = Net Revenue from
Operation/ Working Capital
 Profitability Ratios
• The profitability or financial performance is mainly
summarised in the statement of profit and loss.

• Profitability ratios are calculated to analyse the

earning capacity of the business which is the outcome
of utilisation of resources employed in the business.

• There is a close relationship between the profit and

the efficiency with which the resources employed in
the business are utilised.
• The various ratios which are commonly
used to analyse the profitability of the
business are:
• Gross profit ratio
• Operating ratio
• Operating profit ratio
• Net profit ratio
• Expenses ratio
• ROI or ROCE
• Return on Net Worth (RONW)
• Return on Equity (ROE)
• Earnings per share
• Book value per share
• Dividend payout ratio
• Retention Ratio
• Price earnings ratio.
 Gross Profit Ratio
• Gross profit ratio as a percentage of revenue from
operations is computed to have an idea about gross
margin.
• It indicates gross margin on products sold. It also
indicates the margin available to cover operating
expenses, non-operating expenses, etc.
• Change in gross profit ratio may be due to change in
selling price or cost of revenue from operations or a
combination of both.
• A low ratio may indicate unfavourable purchase and
sales policy. Higher gross profit ratio is always a good
sign.
• It is computed as follows:
Gross Profit Ratio = Gross Profit/Net Revenue of
Operations × 100
 • It is computed to analyse cost of operation in relation to
revenue from operations. It is calculated as follows:

Operating Ratio = (Cost of Revenue from Operations +

Operating Expenses)/ Net Revenue from Operations ×100

Operating • Operating expenses include office expenses, administrative

Ratio expenses, selling expenses, distribution expenses,

depreciation and employee benefit expenses etc.

• Cost of operation is determined by excluding non-operating

incomes and expenses such as loss on sale of assets, interest
paid, dividend received, loss by fire, speculation gain and so
on.
 Operating Profit Ratio
• It is calculated to reveal operating margin. It may be
computed directly or as a residual of operating ratio.
Operating Profit Ratio = 100 – Operating Ratio
• Alternatively, it is calculated as under:
Operating Profit Ratio = Operating Profit/ Revenue
from Operations × 100
• Where Operating Profit = Revenue from Operations
– Operating Cost
• Operating ratio is computed to express cost of
operations excluding financial charges in relation to
revenue from operations.
• It helps to analyse the performance of business and
throws light on the operational efficiency of the
business. Lower operating ratio is a very healthy
sign.
Net Profit Ratio
• Net profit ratio is based on all-inclusive
concept of profit.
• It relates revenue from operations to net
profit after operational as well as non-
operational expenses and incomes.
• It is calculated as under:
Net Profit Ratio = Net profit/Revenue from
Operations × 100
Generally, net profit refers to profit after tax
(PAT).
• It is a measure of net profit margin in
relation to revenue from operations.
• It reflects the overall efficiency of the
business, assumes great significance from
the point of view of investors.
Return on Capital Employed or Investment

• It explains the overall utilisation of funds by a

business enterprise.
• Capital employed means the long-term funds
employed in the business and includes
shareholders’ funds, debentures and long-term
loans.
• Alternatively, capital employed may be taken as
the total of non-current assets and working
capital.
• Profit refers to the Profit Before Interest and Tax
(PBIT) for computation of this ratio.
• Thus, it is computed as follows:
Return on Investment (or Capital Employed) =
PBIT/ Capital Employed × 100
Return on Shareholders’
Funds
• This ratio is very important from shareholders’ point of
view in assessing whether their investment in the firm
generates a reasonable return or not.
• It should be higher than the return on investment
otherwise it would imply that company’s funds have not
been employed profitably.
• A better measure of profitability from shareholders point
of view is obtained by determining return on total
shareholders’ funds.
• It is also termed as Return on Net Worth (RONW) and is
calculated as under :
Return on Shareholders’ Fund = Profit after Tax (PAT)/
Shareholders’ Funds × 100
Return on Equity (ROE)
• This ratio is very important from Equity shareholders’
point of view in assessing whether their investment in
the firm generates a reasonable return or not.
• The return on equity is a measure of the profitability
of a business in relation to the equity.
• It is calculated as under :
Return on Equity = Profit after Tax (PAT)/ Equity
Shareholders’ Funds × 100
Where as
Equity Shareholders’ Funds = Equity share capital +
Reserves & surplus
 Earnings per Share (EPS)
• This ratio is very important from equity shareholders
point of view and for the share price in the stock
market.
• This also helps comparison with other to ascertain its
reasonableness and capacity to pay dividend.
• The ratio is computed as:
EPS = Profit available for equity shareholders/Number
of Equity Shares
• In this context, earnings refer to profit available for
equity shareholders which is worked out as:
Profit after Tax – Dividend on Preference Shares.
Book Value per Share
• This ratio is again very important from equity
shareholders point of view as it gives an idea
about the value of their holding and affects
market price of the shares.
• This ratio is calculated as :
Book Value per share = Equity shareholders’
funds/Number of Equity Shares
• Equity shareholder fund refers to:
Shareholders’ Funds – Preference Share Capital
Dividend Payout Ratio &
Retention Ratio

• DPR refers to the proportion of earning that

are distributed to the shareholders.

• It is calculated as –

Dividend Payout Ratio = Dividend per

share/Earnings per share * 100

• Retention ratio refers to the proportion of

earning that are retained by the company.

Retention ratio = 100 - DPR

Price / Earnings
Ratio
• It reflects investors expectation about the
growth in the firm’s earnings and
reasonableness of the market price of its shares.
• P/E Ratio vary from industry to industry and
company to company in the same industry
depending upon investors perception of their
future.
• The ratio is computed as –
P/E Ratio = Market Price of a share/earnings per
share
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YOU