Unit II

Ratio Analysis
 Meaning of Ratio analysis
Ratio analysis is one of the important tool in the hands of
management to analyze the financial statement.

It highlights the relationship between different figures in

financial statement like Balance Sheet on Income
statement.
Ratio analysis is a technique of analysis and
interpretation of financial statement.
According to Myres,Ratio analysis is a “study of
relationship among the various financial factors in a
business”.

Thus, Ratio analysis measures the profitability,

efficiency, and financial soundness of the business.
 For example
If we say that a firm has earned a net profit
Of Rs ten lakh, it looks very impressive but the
firm’s performance can be said to be good or
bad only when the net profit figure is related to
the firm’s total investment or turnover.
Thus the relationship between two accounting
figure, expressed mathematically is known as a
financial ratio (or simply as a ratio).
The ratio can be calculated by dividing one
figures by the other.
 User of ratio analysis
• Top management
• Auditor
• Creditors
• Banks
• Investors
• Government
 Objects of Ratio analysis
• Relative study:- The facts and figures
expressed in financial statements if
studied in isolation, may make no sense
but if two related items are studied in
comparison to others may suggest
something significant thus any two
figures with out any significant basis of
comparison will not be meaningful for
analysis.
•
• Conciseness:- With the help of ratios large
figures or group of figures are presented
precisely so as to make them
understandable.
• Analysis of business activities:- on the
basis of comparative study of ratios the
results related to the progress or failure of
a business concern can be easily
obtained.
Measuring the profitability:- The profitability of the
business can be measured by calculating gross
profit, net profit expenses ratio and other.

Measuring the efficiency of business:- The

operational efficiency of the business can be
ascertained by calculating operating ratio.

Measuring the financial soundness:- We can know

the short term and long term financial position
of the business by calculating current and liquid
ratio as a short term financial position and debt
equity ratio and proprietor ratio as a long term
financial position.
Limitations of ratio analysis
1. If the data received from financial
accounting is incorrect, then the
information derived from the ratio analysis
could not be reliable.
2. Unauthenticated data may lead to
misinterpretation of ratio analysis.
3. Future prediction may not be always
dependable, as ratio analysis is based on
past performance.
4.To get a conclusive idea about the
business a series of ratios is to be
calculated. A single ratio can not serve the
purpose.
5.It is not necessary that a ratio can give
the real present situation of a business as
the result is based on historical data.
6.Trend analysis is done with the help of
various calculated ratios that can be
distorted due to the changes in price level.
7.Ratio analysis is effective only where same
accounting principles and policies are
adopted by other concern too, otherwise
inter-company comparison will not disclose
a real picture at all.
8.Through ratio analysis special events can
not be identified.
For example, maturity of debentures can not
be identified with ratio analysis.
9.Ratio analysis is a useful tool only in the
hands of an expert.
 WHY FINANCIAL
ANALYSIS
Lenders’ need it for carrying out
the following
• Technical Appraisal
• Commercial Appraisal
• Financial Appraisal
• Economic Appraisal
• Management Appraisal
 HOW A RATIO IS
EXPRESSED?
 As Percentage - such as 25% or 50% .
example if net profit is Rs.25,000/- and the sales is
For
Rs.1,00,000/- then the net profit can be said to be
25% of the sales.
 As Proportion - The above figures may
be
expressed in terms of the
relationship between net profit to
sales as 1 : 4
 As Times - The same can also be
expressed in an
alternatively way such as the sale is 4 times of the net
profit.
 FORMAT OF BALANCE SHEET FOR RATIO
LIABILITIES
ANALYSIS ASSETS
NET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS : LAND & BUILDING, PLANT
Share Capital/Partner’s Capital/Paid up & MACHINERIES
Capital/ Owners Funds Original Value Less Depreciation
Reserves ( General, Capital, Revaluation & Net Value or Book Value or Written down value
Other Reserves)
Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED NON CURRENT ASSETS
FUNDS : Term Loans (Banks & Institutions) Investments in quoted shares & securities
Debentures/Bonds, Unsecured Loans, Fixed Old stocks or old/disputed book debts
Deposits, Other Long Term Liabilities Long Term Security Deposits
Other Misc. assets which are not current or
fixed in nature
CURRENT LIABILTIES CURRENT ASSETS : Cash & Bank Balance,
Bank overdraft Marketable securities/ Debtors / Stock of all
Sundry /Trade Creditors/Creditors/Bills types (Raw materials, work in progress and
Payable, Short duration loans or deposits finished goods) / Bills receivable / Prepaid
Income received in advance / Unclaimed expenses
dividend / Provision for taxation

INTANGIBLE ASSETS
Patent, Goodwill, Debit balance in P&L A/c,
Preliminary or Preoperative expenses
 Classification of Ratios
Turnover
Liquidity Solvency Profitabilit
or Activity
Ratio Ratios y
Ratio
Ratio

1. Stock 1.Gross
1.Debt equity Ratio Turnover profit Ratio
2.Debts to total Ratio 2.Net profit
1.Current Ratio 2. Capital
fund Ratio Ratio
3.Proprietary Ratio Turnover 3.Operating
2.Liquid Ratio Ratio
4.Interest Ratio
coverage 3. Fixed Assets 4.Expenses
Ratio Turnover Ratio Ratio
4.Working 5. R.O.I
capital 6. E.P.S
Ratio
5. Debtors
 Liquidity Ratios
 Liquidity refers to the solvency of the firm's overall financial
position, i.e. a "liquid firm" is one that can easily meet its short-
term obligations as they come due.
Liquidity show whether the firm can pay its short term
obligations out of short term resources or not.
Liquidity refers to the ability of a concern to meet its current
liabilities.
A firm should ensure that it does not suffer from lack of liquidity
or on the other hand it is not highly liquid.
A low liquidity may result in the failure of meeting firm’s short
term liabilities which may carry a bad name to the firm.
A very high degree of liquidity is also bad because the
funds are unnecessarily tied up in current assets
which earn nothing.
 1. Current Ratio : It is the relationship between
the current assets and current liabilities of a
concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a
concern are Rs.4,00,000 and Rs.2,00,000 respectively,
then the Current Ratio will be :
Rs.4,00,000/Rs.2,00,000 = 2 :1
The ideal Current Ratio is 2 : 1

OBJECTIVE : The objective of current ratio is to measure the safety margin

available For short – term creditors
 2. ACID TEST or QUICK RATIO : It is the ratio between Quick Current
Assets and Current Liabilities. This should be at least equal to 1.

Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly

realizable securities such as Govt. Securities or quickly marketable/quoted shares and
Bank Fixed Deposits

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities The ideal

Quick ratio is 1 :1

Objective :- The objective of Acid Test / Quick Ratio is to measure the

ability of the Firm to meet its short – term obligations as and when due
with out relying upon The realization of stock.
 Solvency Ratios
These ratios indicates long term solvency
position of the firm it indicates the ability of
concern to meet its long term debt out of long
term sources. It is also called capital
structure ratio and it is used to judge the long
term financial position of the firm. These
includes –
(i)Debt equity ratio
(ii)Debt to total fund ratio
(iii)Proprietary ratio
(iv)Interest coverage ratio
 1.DEBT EQUITY : It is the relationship between
borrower’s
RATIOfund (Debt) and Capital (Equity). It is
calculated to know the long Owner’sterm financial position and
soundness of long term financial policies of the firm.

Debt equity ratio = Debt/ Equity OR Long term

loan / Share holder’s fund

The ideal ratio is 2: 1

Debt means: Long term loans which includes debenture + long term
loans from bank and financial institution.

Equity means: Share holder’s fund which includes: equity share

capital + preference share capital + Reserves & surplus + P&L
A/c (Cr.) Balance +( - P&L A/c (Dr.) Balance)
2. Debt to total fund ratio : - This ratio
expresses the relationship between debts
(long term loans) and total funds (long
term loans + share holder’s funds).
If higher portion is financed through debt
component it becomes risky as it is the
obligation of the firm to pay interest at a
fixed rate which may leads to reduction of
profit..
Debt to total fund = Debt / Total fund
3. Proprietary Ratio :- This ratio expresses
the relation ship between share
holder’s funds and total assets if higher
portion is financed through ownership
funds that it becomes less risky but in
that case firm may not be using trading
on equity. So a firm should try to
maintain balance between two sources
of finance.
Proprietary Ratio = Shareholder’s funds/
Total fund (Assets)
4. Interest coverage ratio:- This ratio
indicates whether a firm will be capable to
pay off its fixed interest bearing charges
out of current year profit or not.

Interest coverage ratio = Net profit before

interest and tax / Interest on long term
loans
 Turnover or activity ratios
Activity ratios measure the efficiency or
effectiveness with which a firm manages
its resources or assets these ratio are
called turnover ratios because they
indicate the speed with which assets are
converted or turned over in to sales or
cash.
 1. STOCK/INVENTORY TURNOVER
RATIO :

Stock turnover ratio = Cost of goods sold / Average

stock
Cost of goods sold = opening stock + net purchase + all direct
expenses – closing stock

Average Inventory or Stocks = (Opening Stock + Closing

Stock)
-----------------------------------------
2
. This ratio indicates the number of times the inventory is
rotated during the relevant accounting period
2. DEBTORS TURNOVER RATIO : This is also called Debtors
Velocity
or Average Collection Period or Period of Credit given .

(Average Debtors/Sales ) x 365 for days

(52 for weeks & 12 for months)

3. ASSET TRUNOVER RATIO : Net Sales/Tangible Assets

4. FIXED ASSET TURNOVER RATIO : Net Sales

/Fixed Assets

5. CURRENT ASSET TURNOVER RATIO : Net Sales

/ Current Assets
6. CREDITORS TURNOVER RATIO : This is also called Creditors Velocity
Ratio, which determines the creditor payment period.

(Average Creditors/Purchases)x365 for days

(52 for weeks & 12 for months)
7. Working capital turnover ratio : Net sales / working capital
 PROFITABILITY RATIOS
The main purpose of business unit to make profit. The
profitability ratios are computed to throw light on the
current operating performance and efficiency of the
business firm unless it is related to some other figures
such as sales, cost of goods sold, operating
expenses capital invested.
Some of profitability ratios are following:-
(i) Gross profit ratio
(ii) Net profit ratio
(iii) Operating ratio
(iv) Expenses ratio
(v) Return on investment ratio
(vi) Earning per share ratio
1. GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net
Sales we can arrive at the Gross Profit Ratio which indicates
the
manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of

Goods Sold, it can also be interpreted as below :

Gross Profit Ratio = [ (Sales – Cost of goods sold)/ Net Sales]

x 100
A higher Gross Profit Ratio indicates efficiency in production of the unit.
2. OPERATING PROFIT RATIO :

It is expressed as => (Operating Profit / Net Sales ) x

100 Higher the ratio indicates operational efficiency

3. NET PROFIT RATIO :

It is expressed as => ( Net Profit / Net Sales ) x 100

It measures overall profitability.

4. Expenses Ratio:
It is expressed as => (Expenses / Net sales ) x 100
5. RETRUN ON ASSETS : Net Profit after Taxes/Total
Assets

6. RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share capital

and long term funds provided by the owners and the creditors of the
firm at the beginning and end of the accounting period.
7. RETRUN ON EQUITY CAPITAL (ROE) :
Net Profit after Taxes / Tangible Net Worth

8. EARNING PER SHARE : EPS indicates the quantum of net profit

of the year that would be ranking for dividend for each share of
the company being held by the equity share holders.

Net profit after Taxes and Preference Dividend/ No. of Equity

Shares