RATIO ANALYSIS

BY
DR ABHISHEK MAHESHWARI

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 Ratio analysis
 Is an important tool of financial analysis.
 Is the most widely used tool to interpret
quantitative relationship between two
variables of the financial statements.
 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.

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 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 time.

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 Objectives of Ratio Analysis
1. Useful in Analysis of Financial Statements
2. Useful in Simplifying Accounting Data
3. Useful in Assessing the Operating Efficiency
of Business
4. Useful for Forecasting
5. Useful in Locating the Weak Areas
6. Useful in inter-firm and intra-firm comparison

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 Limitations of Ratio Analysis
1. Qualitative Factors are Ignored
2. Lack of Standard Ratio
3. False Results if Based on Incorrect
Information
4. May not be Comparable

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 Classification of Ratios
Ratios can be broadly classified into four groups
namely:
• Liquidity Ratios
• Solvency Ratios/ Capital Structure/Leverage
Ratios
• Profitability Ratios
• Activity Ratios

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 Liquidity Ratios
These ratios analyse the short-term financial position of
a firm and indicate the ability of the firm to meet its
short-term commitments (current liabilities) out of
its short-term resources (current assets).
The ratios which indicate the liquidity of a firm are:
• Current ratio
• Liquidity ratio or Quick ratio or Acid Test ratio

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 Current Ratio
Current Ratio is an indicator of the enterprise’s
ability to meet its short term financial obligation.
It is calculated by dividing current assets by
current liabilities.
Current ratio = Current assets
Current liabilities
Conventionally a current ratio of 2:1 is
considered satisfactory

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 CURRENT ASSETS
Current assets are those assets which can be converted
into cash within a year without diluting their value.
Current assets include –
1. Inventories of raw material, WIP, finished goods,
2. Stores and spares,
3. Sundry debtors & Bills Receivables,
4. Short term loans deposits and advances,
5. Cash in hand and Bank,
6. Prepaid expenses,
7. Incomes receivables or Accrued Incomes and
8.Marketable investments and short term securities.

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 CURRENT LIABILITIES
Current liabilities are those liabilities which are payable within one
year .
Current Liabilities include –
1. Sundry creditors/bills payable,
2. Outstanding expenses,
3. Unclaimed dividend,
4. Advances received,
5. Incomes received in advance,
6. Provision for taxation,
7. Proposed dividend,
8. Short Term Provisions
9. Bank overdraft and cash credit
10. Short term borrowings
11. Current maturities of long term debts.

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 Objective and Significance
The objective of calculating Current ratio is to assess
the ability of the enterprise to meet its short-term
liabilities in time. It is a ratio computed to assess short
term solvency of the enterprise. It shows the number
of times current assets are in excess of the current
liabilities.
A high current ratio, though, may be desirable from
liquidity point of view but also indicates inefficient use
of resources. So a balance needs to be achieved- the
current ratio should neither be too high nor too low.

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 Quick Ratio or Acid Test Ratio or Liquid Ratio

This is a ratio between quick current assets and current

liabilities.
Quick ratio = Quick assets
Current liabilities
QUICK ASSETS are current assets (as stated earlier) less
prepaid expenses and inventories.
Conventionally a quick ratio of 1:1 is considered
satisfactory.

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 Objective and Significance
A part of the current assets is not readily
realizable or convertible into cash. Therefore,
the Current ratio does not indicate adequately
the ability of the enterprise to meet its current
liabilities as and when due. So quick ratio is
calculated.

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Solvency Ratios/Capital structure/ Leverage ratios

These ratios indicate the long term solvency of a

firm and indicate the ability of the firm to
meet its long-term commitment with respect
to
(i) repayment of principal on maturity or in
predetermined instalments at due dates and
(ii) periodic payment of interest during the
period of the loan.

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 Solvency Ratios/Capital structure/ Leverage ratios

The different ratios are:

– Debt equity ratio
– Proprietary ratio
– Total Asset to Debt Ratio
– Interest coverage ratio

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 Debt - Equity ratio
Debt to equity ratio is computed to assess long term
financial soundness of the enterprise. The ratio
expresses the relationship between external equities,
i.e., external debts and internal equities (i.e.,
shareholders funds) of the enterprise.

Debt equity ratio = Long-Term Debts

Shareholders funds

Normally, Debt to Equity Ratio of 2:1 is considered as

an appropriate ratio.
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LONG-TERM FUNDS are Non current Liabilities or
long-term loans whether secured or unsecured like –
debentures, bonds, loans from financial institutions,
long term borrowings ,long term provisions etc.

SHAREHOLDER’S FUNDS are equity share capital plus

preference share capital plus reserves and surplus.

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 Objective and Significance
The objective of Debt to Equity Ratio is to
measure the proportions of external funds and
shareholders funds invested in the company.
This ratio assesses long term financial position
and soundness of long term financial policies of
the enterprise. It also indicates the extent to
which the enterprise depends on external funds
for its business.

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 Total Asset to Debt Ratio
Total assets to Debt Ratio establishes
relationship between total assets and total long
term debts of the enterprise.

Total Assets To Debt Ratio = Total Assets

Long Term Debt
Long Debt includes = Long Term borrowings and
Long term provisions

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 Objective and Significance
The objective of computing the ratio is to
establish relationship between total assets and
long term debts of the business. It measures the
margin available to the lenders of long term
debts. It measures the extent to which debt is
covered by the assets. A high ratio means higher
safety for lenders to the business.

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 Proprietary Ratio
Proprietary ratio establishes the relationship between
proprietors’ funds and total assets.
This ratio is calculated by dividing proprietor’s funds by
total funds.
Proprietary ratio = Proprietor’s funds or Shareholders Funds
Total Assets

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PROPRIETOR’S FUNDS are same as explained
in shareholder’s funds

TOTAL ASSETS are all Non current assets and

all current assets.

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 Objective and Significance
The objective of computing this ratio is to
measure the proportion of total assets financed
by Proprietors Funds. This ratio is important for
creditors as they can ascertain the portion of
shareholders funds in the total assets employed
in the firm.
A high ratio means adequate safety for creditors.

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 Interest Coverage Ratio
This ratio measures the debt servicing capacity of a firm
in so far as the fixed interest on long-term loan is
concerned. It shows how many times the interest
charges are covered by PBIT out of which they will be
paid.
Interest coverage ratio = Profit before Interest And Tax
Interest on Long Term Debt
Higher the ratio greater the ability of the firm to pay
interest out of its profits. But too high a ratio may
imply lesser use of debt and/or very efficient
operations
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 Objective and Significance
The ratio is very meaningful to debenture
holders and lenders of long term funds. The
objective of calculating this ratio is to ascertain
the amount of profit available to cover interest
on long term debt. A high ratio is considered
better for the lenders as it means higher safety
margin.

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 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

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 Profitability Ratios
Profitability Ratios in relation to sales:
• Gross Profit Ratio
• Net Profit Ratio

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 Profitability Ratios
Profitability Ratios in relation to investments

• Return on Investment (ROI) or Return on capital

Employed (ROCE)
• Return on Net Worth
• Earnings per share (EPS)
• Dividend Per Share (DPS)
• Dividend Payout Ratio
• Earning Retention Ratio
• Price Earning Ratio
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 Gross Profit Ratio

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 Ratio = Gross Profit x 100
Net sales

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 Gross profit Ratio
• A firm should have a reasonable gross profit
ratio to ensure coverage of its operating
expenses and ensure adequate return to the
owners of the business ie. the shareholders.
• To judge whether the ratio is satisfactory or
not, it should be compared with the firm’s
past ratios or with the ratio of similar firms in
the same industry or with the industry
average.
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 Gross Profit Ratio
A decrease in Gross Profit ratio indicates that
the cost of producing goods for the enterprise
has increased but it is not in a position to pass
on the increased cost to the customer due to
competitive pressure.

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 Net Profit Ratio
This ratio is calculated by dividing Net Profit by
sales. It is expressed as a percentage.
This ratio is indicative of the firm’s ability to
leave a margin of reasonable compensation to
the owners for providing capital, after meeting
the cost of production, operating charges and
the cost of borrowed funds.
Net profit Ratio =
Net profit after interest and tax x 100
Net sales

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 Objective and Significance
Net profit ratio is an indicator of overall
efficiency of the business. Higher the ratio,
better the business. This ratio helps in
determining the operational efficiency of the
business. An increase in the ratio over the
previous period shows improvement in the
operational efficiency and decline means
otherwise.

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 Return on Investment (ROI) OR 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 Investment (OR) Return on capital employed =
Net Profit Before Interest and Tax x 100
Capital Employed
CAPITAL EMPLOYED denotes shareholders funds and long-
term borrowings.
To have a fair representation of the capital employed,
average capital employed may be used as the denominator.

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 Objective and Significance
ROI or ROCE assesses overall performance of the
enterprise. It measures how efficiently the
resources of the business are used.

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 Return on Net Worth
This ratio describes the return on shareholders
funds.
Return on Net Worth =
Net Profit After Interest and Tax x 100
Shareholders Funds
Higher the ratio better the return to the
shareholders.

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 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 shares

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 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

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Dividend Payout Ratio (D/P Ratio)
This ratio measures the relationship between the
earnings belonging to the ordinary shareholders
and the dividend paid to them.

Dividend pay out ratio = Dividend Per Share x 100

Earnings Per Share

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 Earning Retention Ratio
Earning Retention Ratio
= 100 – Dividend Payout Ratio

This ratio states about the earnings retained by

the company for the expansion or
modernization of the plant or to pay some long
term liabilities.

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 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

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 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. These ratios measures the
effectiveness with which the enterprise uses its
available resources. The various ratios under this
group are:
• Inventory/Stock Turnover Ratio
• Debtors Turnover Ratio
• Average Collection Period
• Creditors Turnover Ratio
• Average Payment Period
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 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
Cost of Goods Sold = Revenue from operations– Gross Profit
or
=Cost of Material Consumed + Purchase of Stock in trade+
Change in Inventories of Finished Goods, Work in Progress and
stock in trade + Direct Expenses (Assume to be given)

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Inventory /Stock Turnover Ratio
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.

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 Debtors Turnover Ratio
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 =
Net Credit sales
Average Receivables
Where, Net Credit Sales= Total Sales- Cash Sales
Average Receivable = (Opening Debtors + B/R)+(Closing Debtors +B/R)
2

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 Objective and Significance
This ratio indicates the number of times
receivables are turned over in a year in relation
to credit sales. It shows, how quickly receivables
are converted into cash and shows the efficiency
in collection of amounts due from debtors. A
high ratio is better since it indicates that debts
are collected more promptly.
A lower ratio shows inefficiency in collection and
more investment in debtors than required.
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 Average collection Period
It provides an approximation of the average time
that it takes to collect debtors.
Debtors collection period =
365 (OR) 12
Debtors Turnover

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 Debtors Turnover Ratio and Average
Collection Period
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.

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 Creditors Turnover Ratio
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 =
Net credit purchases
Average Payables & Bills Payables

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 Average Payment Period
Average payment period
= Months/Days in a year
Creditors turnover ratio

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 Creditors Turnover Ratio and Average
Payment Period

Higher creditors turnover ratio and short

credit period signifies that the creditors are
being paid promptly and it enhances the
creditworthiness of the firm.

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 Book Value Per Share
= ShareHolder’s Funds
Number of Equity Shares
The book value of equity per share is one factor that investors
can use to determine whether a stock price is undervalued. If a
business can increase its BVPS, investors may view the stock as
more valuable, and the stock price increases.
Book value per common share is a measure used by owners of
common shares in a firm to determine the level of safety
associated with each individual share after all debts are paid
accordingly.

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 Market Capitalization
= No of Equity Shares X Current Market Price

The market capitalization of a company represent the total

market value of all the shares of the company.
As the current market price of a company keeps on
fluctuating, the market capitalization also fluctuates many
times a day. A higher market capitalization is an effective
defense mechanism against any type of takeover bid, as
the acquirer will be required to pay a larger sum to acquire
the controlling stake.

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Thank You

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