ACMA-2

Unit-03: Ratio Analysis

By,
Deepika S B
Assistant Professor
VVFGC, Mysore
Meaning of Ratio Analysis
• It is a method or process by which the relationship of
items or groups of items in the financial statements are
computed, and presented.

• It is an important tool of financial analysis.

• It is used to interpret the financial statements so that

the strengths and weaknesses of a firm, its historical
performance and current financial condition can be
determined.
Ratio
• A mathematical yardstick that measures the
relationship between two figures or groups of figures
which are related to each other and are mutually
inter-dependent’.
• It can be expressed as a pure ratio, percentage, or as a
rate.
• A ratio is not an end in itself. They are only a means
to get to know the financial position of an enterprise.
Objectives of Ratio Analysis
•Measuring the profitability
•Measuring Efficiency
•Solvency of the Business
•Financial Status of the Company
•Comparative Analysis
Classification of Ratios

Ratio can be broadly classified into 4

groups
1. Financial Ratios
2. Turnover Ratios
3. Profitability Ratios
I) FINANCIAL RATIOS OR SOLVENCY
RATIOS OR BALANCE SHEET RATIOS
• These ratios are concerned with the
solvency of the company as such these
ratios indicate the financial strength of a
concern.
• These are generally expressed as pure
ratios.

These ratios are further classified as under:

A) Short term solvency ratios
B) Long term solvency ratios.
A) Short term solvency ratio or Liquidity
ratio:
• These are those ratios which express the relationship
between current assets and current liabilities.
• These ratios indicate the liquidity or short term solvency of
an enterprise.
• These ratios signify whether the enterprise meets its short
term obligation out of its short term resources or not.
1) Current ratio or working capital ratio: It is the ratio
which expresses the relationship between current assets and
current liabilities. Symbolically:
Current Ratio = Current assets
Current liabilities
Note: Ideal Current Ratio=2:1
Current Assets are;
• Cash in hand
• Cash at bank
• Sundry debtors
• B/R
• Readily marketable securities (Temporary or short
term investment)
• Advances granted to staff and others
• inventories (stock)
• Prepaid expenses
• Outstanding incomes etc.
Current Liabilities are;
• B/P
• Sundry creditors,
• Short term loans
• Advances taken from bank
• Long term liabilities repayable within a year
• Outstanding expenses
• Income received in advance
• Provision for income tax
• Unclaimed dividends
• Proposed dividends
• Bank over draft and cash credits etc.
Note: Net working capital= Current Assets-Current Liabilities
2) Quick ratio or Liquid ratio or Acid test ratio:

• It is the ratio which expresses the relationship between

liquid assets and liquid liabilities. Symbolically:
• Quick Ratio = Liquid assets
Liquid liabilities
(or)
Quick assets
Quick liabilities
• Where quick assets = Total current assets – [stock +prepaid
expenses]
• Quick liabilities= Total current liabilities-[BOD + Cash credits]
• Quick Ratio is considered to be 1:1.
3) Absolute liquid Ratio (or) super quick ratio
• This ratio expresses the relationship between
immediate cash items and current liabilities.
Symbolically:
• Absolute liquid = Absolute Liquid assets
Ratio Current liabilities

Where Absolute liquid assets = Cash in hand + cash

at bank + Short term marketable securities
B) Long term Solvency Ratios or Leverage
Ratios or Capital Structure Ratios:
• These ratios are used to analyze long term solvency position of a
business concern. The long term solvency ratios show:
i. Ability of the concern to repay the principal amount barrowed.
ii. Regular payment of interest.

Some of the long term solvency ratios are as under:

1. Debt Equity Ratio Or Internal External Ratio: This ratio
expresses the relationship between long term liabilities and the
share holders funds of the concern. Symbolically:
Debt Equity ratio = Long Term Debt
Share holders funds
(or)
External Funds
Internal Funds

Note: Where: a) Long term debt = Debentures + Long term loans

b) Share holders’ funds = Equity share capital + Preference share
capital + Reserves and surplus – Fictitious Assets.
2.Proprietary Ratio or Net Worth Ratio or
Equity Ratio:
This ratio measures the relationship
between share holders funds and total
realizable assets. Symbolically :

Net Worth Ratio = Net Worth

Total Assets

Note:
Where: Net Worth = share holders funds.
Total Assets = All current assets +
Realizable fixed assets + Investments
3.Capital gearing ratio:
The ratio establishes the relationship
between Equity share capital and fixed
interest bearing securities with Preference
shares. Symbolically:
Capital gearing Ratio =
Eq. Sh. Cap + R & S
• Equity capital
• Where
• Equity capital =Prefernce Share Capital +
Long Term Debt
4.Fixed asset ratio:
It is the ratio which express the
relationship between net fixed assets and
capital employed. Symbolically:

Fixed assets Ratio= Net fixed assets

Capital employed

Where capital employed = fixed assets +

investment + working capital or net
worth +Debt.
II. TURN OVER RATIOS (OR) PERORMANCE
RATIOS OR ACTIVITY RATIOS.
 These ratios are calculated to assess a firm’s
efficiency in employing its assets. The important
turnover ratios are as under;
• 1. Inventory turnover ratio or stock turnover
ratio: It is the ratio which indicates the number of
items the stock is turned over (i.e sold) during a
year. In other words it is a ratio between stock &
cost of goods sold.
Stock turn over Ratio= Cost of goods sold

Average stock

Where , cost of goods sold = a) Sales – G/P

(or) = b) opening stock + Purchases
+ direct expenses – closing stock.
Inventory turnover ratios
NOTE:
1. Stock includes opening & closing stocks of raw materials,
work in progress and finished goods.
2. If opening stock is not given then closing stock itself is
assumed as average stock & vice versa.
3. In the absence of complete information the inventory turnover
ratio can also be calculated as under.
Inventory turnover ratio = Net sales
Average inventory at selling price
4. Stock velocity: When the inventory ratio is represented in
terms of time period (i.e., in terms of days, weeks, or months)
then it is said to be stock velocity. It is obtained as under: Stock
velocity = Average stock X 365 days or 12 months or 52 weeks
Cost of goods sold
2) Debtors turnover ratio or receivables
turnover ratio
 It is a ratio which indicates the relationship between
debtors and sales. It indicates the number of times debt
is collected within a year. Symbolically:
Debtors turnover ratio = Net credit sales
Average Debtors
Where net credit sales= Total sales - cash sales –
returns inwards.
Average debtors = (op. debtors + B/R) + (cls. debtors
+B/R)
2
NOTE:
 If cash sales is not given separately then the entire sales is
considered as credit sales.
 If opening debtors (or) B/R is not given, then closing debtors
& B/R itself is considered as average debtors & vice versa.
3) Debtors velocity (or) Debt collection period:

When the debtors turnover ratio is

represented in terms of time period (i.e.,
in terms of days, months or weeks). Then
it is said to be debtors velocity, it is
calculated as under. Symbolically:
Debtors velocity = Average Debtors X 365 d/12 m/52
w
Ratio Net credit sales

If you are ask to calculate debtors turnover

ratio, then calculate Both i.e., Debtors
turnover ratio & debtors velocity.(This
applies even for creditors turnover ratio
& stock turnover ratio.)
4.Creditors turnover ratio
 It is the ratio which indicates the number of times
the creditors are paid in a year, thus it shows the
relationship between creditors & purchases.
Creditors turnover ratio = Net credit
Purchases
Average
creditors
Where net credit purchases = total credit purchases –
purchase returns
Average creditors = (op. creditors + B/P) + (cls
creditors +B/P) 2

NOTE:
• If cash purchase is not given then the entire purchases given is
5.Creditor velocity or debt
payment period ratio

When the creditors turnover ratio is

represented in terms of time period, it is said
to be creditors velocity & it is obtained as
under:

Creditors velocity=Average creditors X

365d/12m/52w
Net credit purchase
6.Fixed assets turnover ratio
It is the ratio between fixed assets & net
sales. Symbolically:

Fixed asset turnover ratio = Net sales

Net fixed
assets

Where net sales = net credit sales + cash

sales
7.Working capital turnover ratio:
 This ratio establishes the relationship between Net sales
and working capital. It indicates the extent of efficiency in
the utilisation of working capital in achieving sales.
Symbolically:
Working capital = Net sales
turnover ratio Working capital

8.Capital turnover ratio: This ratio represents the

relationship between net sales & capital employed in the
business. Symbolically:
Capital turnover ratio = Net sales
capital employed

9.Total assets turnover ratio: This ratio expresses the

relationship between the total assets and net sales.
Symbolically
III. Profitability ratios
 These ratios measure the operating
efficiency of the firm and its ability to
ensure adequate returns to its shareholders.
 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
(iii) Market test ratios or Earning ratios
A) PROFITABILITY RATIOS BASED ON SALES
1.G/P Ratio: This ratio expresses the relationship between G/P & sales. It is
obtained as under.
G/P ratio = G/P X 100
Net sales
2.Net profit ratio or operating profit ratio: It is the Net profit ratio or
operating profit ratio: It is that ratio between operating profits & net sales
It is calculated as under:
Net profit ratio = Net profit X 100
Net sales
Where Net Profits= Net operating profits + Non operating Income – Non-
operating expenses.
Note: Separately a net operating Profit ratio is calculated considering only
Net operating Profits which is as under: Net operating profits X 100
Net sales
Where Net operating Profits = G/P – administrating &selling expenses
3) Operating ratio or operating cost Ratio
 This ratio express the relationship between
operating cost & sales and it is expressed as under:
Operating ratio = Operating cost X100
Net sales
Where, operating cost = COGS+ Office &
Administration Expenses + Selling & Distribution
expenses.
Expenses ratio can be obtained.
a) Factory expenses Ratio = Factory expenses X 100
Net sales
b) Office & administration= Office administration
Exp.X100 expenses Ratio Net
sales
B) PROFITABILITY RATIOS BASED ON CAPITAL EMPLOYED ON
INVESTMENT
1) Return on investment Ratio [ROI] or
overall profitability ratio or return on
capital employed ratio.
It is the ratio which expresses the
relationship between net profits & capital
employed. Symbolically
ROI Ratio = EBIT X 100
Capital employed
Where EBIT i.e., taken to mean operating profits &
Capital employed = Fixed assets (including
investments) + working capital
[or] = Debt + equity.
2) Returns on equity ratio or return on share
holders’ funds Ratio
 This ratio establishes the relationship between share
holders funds & net profits after tax. Symbolically
Return on = Net profits after tax X 100
equity Ratio Share holder funds

3) Return on total assets ratio or return on total

resources ratio:
This ratio expresses the relationship between net
profit after tax & total realizable assets. Symbolically

Return on total assets = Net profits after tax X

100
Total assets
C) MARKET TEST RATIOS OR EARNING RATIOS
1) Earning per share ratio:This ratio shows the
relationship between divisible profits & number of
equity shares.
EPS = Divisible profits
Number of equity shares
Where divisible profits = profits after tax &
preference dividends.

2)Dividend payout ratio or payout ratio: It is a

ratio between dividend per equity share and EPS.
Payout ratio = dividend per equity share
EPS
Note: This ratio indicates as to what portion of EPS
as been used for paying dividends and what
portion has been retained as reserves.
3) Price earnings ratio: This is the ratio
between market price per share and EPS.
It indicates the number of times EPS is
covered by its market price.
Price earnings ratio = Market price per equity
share
EPS

4) Dividend Yield ratio: It is the ratio

which expresses the relationship between
dividend per share & the market price per
share. This ratio measures the real rate of
returns on shares.
Dividend yield ratio = Dividend per share
Market price per