Ratio Analysis

By
Prof. Uma Ghosh
 INTRODUCTION
➢ Ratio Analysis is a form of Financial Statement Analysis that is used to
obtain a quick indication of a firm's financial performance in several
key areas

➢ Ratio Analysis is the process of computing and presenting the

relationship between the items in the financial statements

➢ Financial ratios are used as tools in financial analysis

• The analysis of financial statements aims to study the relationship

amongst various factors in a business as disclosed in the financial
statements for a particular period

• Trend of these factors can be studied through the examination of such

financial statements over a period of time

• Accounting ratios are very useful in assessing the financial position &
profitability of a business enterprise
Modes or Forms of Accounting Ratio
➢ Simple or Pure Ratio:
A Simple or Pure Ratio is a simple division of one number by
another. The relationship between Current Assets & Current
Liabilities is expressed in this way. If the current assets are Rs.
2,00,000 and current liabilities Rs. 1,00,000 the ratio is derived by
dividing Rs. 2,00,000 by Rs. 1,00,000. It will be expressed as 2:1.
➢ Percentage:
The relationship between profit and sales is expressed as percentage.
For example, if sales are Rs. 4,00,000 and profit after tax is Rs.
2,00,000 then it is expressed as profit after tax being 50% of sales.
➢ Rate:
Ratios are also expressed as rates i.e. ‘number of times’ over a certain
period. Relationship between stock (inventory) and sales is expressed
in this way. If stock turnover rate is said to be ‘8’ times in a year, it
means that the stock is converted into sales for 8 times in 12 months.
 Functional Classification of Ratios
Liquidity Ratios Solvency/ Activity/ Profitability Valuation
Capital Structure Ratios Turnover Ratios Ratios
1. Current Ratio 1. Stock-Turnover Ratio 1. Earnings Per Share
2 . Quick ratio 2. Inventory holding period 2. Dividends Per Share
Net W C 3. Debtors’ Turnover Ratio 3. Price Earning Ratio
1. Debt Equity Ratio 4. Debtors Collection Period 4. Dividend Payout
2. Capital Gearing Ratio 5. Creditors’ Turnover Ratio 5. Dividend Yield
3. Proprietary Ratio 6. Creditors’ Payment Ratio 6. Earning Yield
4. Solvency Ratio 7. Working Capital Turnover Ratio
5. Interest Coverage Ratio 8. Capital Turnover Ratio
6. Debt-Service Coverage

Sales Investment
1. Net Profit Ratio 1. Return on Capital employed
2. Expense Ratios 2. Return on Proprietors Fund
3. Return on Equity Share Capital
 1. Liquidity Ratios
1. Current Ratio = Current Assets
Current liabilities
• This ratio expresses the relationship between Current Assets & Current
liabilities
• It serves as an index of short term liquidity
• As an index of the strength of working capital of an organization
• Current Assets – which are converted into cash within one accounting
period
• Current liabilities – which will be paid within one accounting period
• An ideal Current Ratio is 2:1. The ratio of 2 is considered as a safe
margin of solvency
 2. Quick Ratio = Quick Assets
Current liabilities
• This ratio indicates the liquid financial position of an enterprise and
ability to meet its immediate obligations promptly- an indicator of
short-term liquidity of the company
• Quick ratio measures the immediate liquidity of the business &
indicate the availability of liquid cash to meet its immediate
commitments
• It measures the relationship between Quick Assets & Current liabilities
& also known as Liquid ratio or Acid-test ratio
• Quick Assets – Current Assets less Inventories & Prepaid Expenses
(which can be realised immediately)
• An ideal Quick Ratio is 1:1, considered as a fairly good solvency
position
 Net working Capital
• Working capital is the liquidity of a company and has two definitions
namely Gross working capital and Net working capital.
• Gross working capital is the total of all current assets and does not hold
much significance for the investors
Gross Working Capital = Total Current Assets
• Net working capital is the excess of current assets over current
liabilities of a company which is why it is an important indicator of
company’s financial health.
Net Working Capital = Total Current Assets less Total Current liabilities
• A company should have enough working capital to meet its operational
needs, but there is also such a thing as having too much working
capital.
• If a company has an excessive amount of working capital, chances are
that some of its current assets, such as cash, could be put to better use.
2. Solvency/ Capital Structure
Ratios
 1. Debt Equity Ratio = Total Debt
Total Equity
• This ratio expresses the relation between borrowed capital &
owners capital
• Total Debts = Non Current Liability + Current Liability+
Redeemable Preference Shares
• Total Equity = Equity Share Capital + Convertible Preference
Shares + Other Equity
Redeemable Preference shares are considered as Debt,
Convertible Preference shares are considered as Equity, Long
Term Borrowings includes Redeemable Preference share Capital
• It shows long term Capital Structure
• It is said that 2/3 of the total funding should come from Debts and
balance 1/3 from Equity, an ideal ratio of 2:1
• The low ratio is favourable, as it reveals high margin of safety to the
Creditors. The higher ratio is unfavourable, higher the ratio greater
will be the risk involved to Creditors, indicates too much dependence
on Long Term Debts
 2. Capital Gearing Ratio = Net Debt
Total Equity
• This ratio brings out the relationship between Net Debt and Total
Equity. Also known as “Leverage ratio” or “Capital Structure ratio’
• Net Debt = Total Debt - Cash & Cash Equivalent - Bank Balances
other than cash & Cash equivalent
• Total Equity = Equity Share Capital + Convertible Preference
Shares + Other Equity
• The Company’s policy is to keep the gearing ratio between 20% and
40%.
• Highly geared company - Fixed Interest bearing loans & borrowings
are greater than Equity Shareholders’ funds, Low geared company –
vice versa
• It is the mechanism to ascertain whether a co. is practicing “Trading
on Equity” and if to what extent. “Trading on Equity” occurs when
borrowed capital is employed in the business.
•
 3. Proprietary = Proprietors Funds or or Shareholders Funds or
/ Net worth Ratio Total Equity * 100
Total Assets
• This ratio determines the long term solvency of the company, it
indicates financial and credit strength of the company. It relates
Shareholders’ funds (Proprietors Funds) to Total Assets
• This ratio determines the proportion of Shareholders’ funds in the
total assets employed in the business. Also known as “Net worth to
Total Assets Ratio” or “Equity Ratio”
• Proprietors Funds/ Total Equity = Equity Share Capital +
Convertible Preference Shares + Other Equity
• The relationship is expressed as a pure ratio or %. The closer is the
ratio to 100%, the stronger is the long -term solvency of the company
(65% to 75%), a ratio below 50% may be alarming for the Creditors.
The higher the ratio, the better it is.
 4. Solvency Ratio = Total Debt * 100
Total Assets
• A Solvency ratio measure an enterprise’s ability to meet its debt
obligations and its financial health. An unfavorable ratio can indicate
that a company will default on its debt obligations.
• Solvency ratio is often used by prospective lenders when evaluating a
company's creditworthiness as well as by potential bond investors.
• The solvency ratio measures a company’s Total Debt to its
Total Assets. It measures a company's leverage and indicates how
much of the company is funded by debt versus assets, and therefore,
its ability to pay off its debt with its available assets.
• A higher ratio, indicates that a company is significantly funded by debt
and may have difficulty meetings its obligations.
 5. Interest Coverage Ratio = EBIT
Interest
• This ratio measures the firm’s ability to make interest payments or the
Debt servicing capacity of a firm as fixed interest on long term loan
• Also known as “Time-interest-earned” ratio
• EBIT is Earning/Profit Before Interest & Tax = PAT + Taxes + Interest
• This ratio shows the number of times the interest charges are covered by
funds available to pay interest charges
• The higher the ratio, better for the firm & lenders -
• For the firm, the probability of default in payment of interest is reduced
• For the lenders, the firm is considered to be less risky
• A too high ratio indicates the firm is not using debt or unused debt
capacity
• A low ratio indicates the excessive use of debt, it is a danger signal that
the firm is using excessive debt & does not have the ability to offer
assured payments of interest to the lenders
 6. Debt-Service Coverage PAT+ Interest+Dep+OA
Ratio = Installment (Principal+Int)
• This ratio indicates that the company’s revenue is sufficient to cover its
Debt-Service
• Debt-Service is the act of making Interest & Principal payments on debt
• This ratio is a benchmark used to measure the cash producing ability of a
business to cover its debt payments
• It provides the value in terms of the number of times the total debt
service, consisting of Interest & repayment of Principal in installments
are covered by the Total Operating funds available after the payment of
taxes: PAT+ Interest + Depreciation+ Other non cash expenses
• Other non cash expenses (OA) like Amortisation, Patent etc
• In general, lending financial institutions consider 1.5 to 2:1 as
satisfactory ratio. The higher the ratio, better it is. A ratio less than 1
indicates that a company is unable to generate enough income to cover
its payments (to service debt), may be taken as a sign of long term
solvency problem
• A higher ratio makes it easier to obtain a loan
 3. Activity/ Turnover Ratios
1. Stock-Turnover Ratio = Cost of goods sold
Average/ Closing Inventory
• This ratio signifies the liquidity of the inventory, indicates how fast
inventory is sold. Also known as “Inventory Turnover ratio”.
• This ratio indicates whether investment in inventory is efficiently used
or not and with in proper limits or not.
• Cost of goods sold = Cost of Raw Materials Consumed + Purchase of
Stock in Trade + Changes of Inventories (Finished Goods, WIP &
Stock in Trade) + Employee Benefit Expenses ( Wages) + Other All
Direct Expenses
• Average Inventory = Opening Inventory + Closing Inventory / 2
• A high ratio is good from the viewpoint of liquidity and a low ratio
would signify that inventory does not sell fast. A high Inventory ratio
indicates over- trading and a low ratio indicates under – trading.
• Difficult to establish a standard Inventory ratio as Inventory levels
differ from industry to industry.
 2. Inventory holding period = 365 days/ 12 months/ 52 weeks
Inventory Turnover ratio
• Inventory holding period is an indicator of how well the business is
doing in terms of inventory, as managing inventory is very important in
a company that sells products to make profit.
• This ratio indicates the holding of inventory in the form of number of
days
• No standard ratio, the ratio depends upon the nature of the business
• The ratio has to be compared with the ratio of the industry, other firms
or past ratio of the same firm
• When inventory days are high, this may indicate that there is less
demand for the goods being sold.
• A low days inventory ratio indicate that the inventory is taking less time
to be sold, which is good.
3.Debtors’ Turnover Ratio = Net Credit Sales
Average / Closing Accounts Receivables

• This ratio evaluates liquidity of Accounts Receivables & efficiency of

credit policies
• It shows how quickly Debtors & Receivables are converted into cash
• This ratio is a test of the liquidity of the Debtors of a firm, because the
quality of Debtors to a great extent determines a firm’s liquidity
• Net Credit Sales = Gross Sales less Cash Sales, Sales Returns, Sales
Tax, VAT
• Average Accounts Receivables = Average of Trade Debtors & Bills
Receivable (Opening balance + Closing balance / 2)
• Accounts Receivables should not include Debtors or bills arising from
non-operating transactions, means activities other than trading, like
Debtors for sale of scrapped assets should not be considered
• Higher ratio is favourable, it indicates that debts are being collected
more promptly, lower ratio indicates inefficiency
 4. Debtors Collection = 365 days/ 12 months/ 52 weeks
Period Debtors’ Turnover Ratio
• This ratio indicates promptness in recovery of debts from Debtors
• Shows period of holding of Debtors & indicates effectiveness of
collection department (shows the speed in collection of debt from
customers)
• Difficult to lay down a standard collection period for Debtors
• As a general rule, the ratio should not be more than 3 to 4 months credit
sales
• A shorter collection period implies prompt payment by Debtors,
minimises the chances of Bad Debts
• Larger collection period implies liberal policies & inefficient credit
collection performance, an increase in the period will result in greater
blockage of funds
 5. Creditors’ Turnover Ratio = Net Credit Purchase
Average / Closing Accounts Payable
• Shows promptness in payment to suppliers and how well credit policy is
utilized
• It indicates the speed with which the payments for Credit Purchases are
made to the Creditors
• Net Credit Purchase = Gross Credit Purchase less Purchase returns
• Average Accounts Payable = Average of Trade Creditors & Bills
Payable (Opening balance + Closing balance / 2)
• A higher Creditors’ Turnover Ratio signifies that the Creditors are being
paid promptly, thus enhancing the credit worthiness of the company
• A low Creditors’ Turnover Ratio reflects liberal credit terms granted by
suppliers, while a high ratio shows that accounts are to be settled rapidly
 6. Creditors’ Payment = 365 days/ 12 months/ 52 weeks

Period Creditors’ Turnover Ratio

• Reflects liberal credit policy by suppliers
• The ratio gives the average credit period enjoyed from the Creditors
• Creditors’ Payment Period indicates the number of days the Creditors
are outstanding for payment
• Both the Creditors’ Turnover Ratio & Creditors’ Payment Period Ratio
indicate about the promptness in making payment of credit purchases
• A lower period signifies that the Creditors are being paid promptly, it
enhances the credit worthiness of the company and indicates liquidity of
the firm
• If the period is more, it indicates the firm is defaulting in payments &
enjoying longer period of credit from the suppliers
 7. Working Capital Turnover = Revenue from Operations
Ratio Average / Closing Working Capital
• The working capital turnover compares a company’s net sales to its net working capital
to measure its operating efficiency and determines how effectively a business utilizes
its working capital to generate revenue. This ratio reveals the number of times working
capital is recirculated during a year.
• Companies that have a greater working capital turnover ratio are more efficient in their
operations and revenue generation. On the other hand, a lower working capital turnover
ratio would suggest the company’s working capital spending and day-to-day
management are inefficient.
• A high working capital turnover ratio indicates that a company’s short-term assets and
liabilities are being used effectively to drive sale and a business is running smoothly. A
high ratio may provide the company a competitive advantage over similar businesses.
A higher working capital turnover ratio is good, it means that the company is
generating a huge amount of sales.
• A low ratio indicate that a company is investing too much on accounts receivable and
inventory assets to sustain its sales. This could result in a high number of bad debts or
obsolete inventory write-offs.
 8. Capital Turnover Ratio = Revenue from Operations
Average / Closing Capital Employed
• Capital turnover is the measure that indicates an organization’s efficiency about the
utilization of capital employed in the business, and the proportion of revenue that a
company can generate with a given amount of capital employed.
• It measures that how efficiently the company is managing the capital employed in the
company to generate revenues and indicates the efficiency of the organization with
which the capital employed is being utilized.
• The higher the ratio, the better is the utilization of capital employed. A high capital
turnover ratio indicates the capability of the organization to achieve maximum sales
with minimum amount of capital employed. Higher the capital turnover ratio better
will be the situation.
• If the ratio is high, it shows that the company efficiently utilizes the amount of capital
invested. If the ratio is low, it indicates that the company is not managing its capital
investment efficiently to generate the required revenue.
 4. Profitability Ratios – (a) Sales
1. Net Profit Ratio = PBT/ PAT* 100
Revenue from Operations (Net Sales)
• Also known as “Net Margin Ratio” and expressed as a % of Net Sales
• This ratio indicates the overall efficiency of the management in cost of
goods sold, manufacturing, administering & selling the products
• It is a measure of overall profitability & is very useful to the proprietors
& investors in judging the prospects of return on their investments
• It is an effective measure to check the profitability of a business and has
direct relationship with the return on investment
• Profit before Tax (PBT) = Total Revenue – Total Expenses
• If the ratio is high, with no change in investment, return on investment
would be high, if there is fall in profits, return on investment would also
go down
• An increase in the ratio indicates improvement in the operational
efficiency
 2. Expense Ratios =
a) Cost of Materials consumed = Cost of Materials consumed *100
ratio Net Sales
b) Purchase of Stock in Trade = Purchase of Stock in Trade * 100
ratio Net Sales
c) Changes in inventories = Changes in inventories *100
ratio Net Sales
d) Employee benefits expense = Employee benefits expense * 100
ratio Net Sales
e) Finance costs = Finance costs * 100
ratio Net Sales
f) Depreciation and amortization expense = Depreciation and
ratio amortization expense *100
Net Sales
 4. Profitability Ratios – (b)Investment
3. Return on Capital employed = EBIT * 100
(ROCE) Capital Employed
• This ratio explains the relationship between Total Profits earned by the
business & Total Investments made or Total Capital employed. Return
on Capital employed is also called Return on Investment Ratio (ROI).
• This ratio measures the overall effectiveness of management in
generating profits with its available assets and efficiency of the business
operations & always expressed as a %
• Capital Employed = Owners’ equity/ Proprietors’ funds & Long term
borrowings
• EBIT = Net Profit before Interest and Taxes
• Thus, the ratio provides sufficient insight into how efficiently the Long
term funds of Owners and lenders are being used
• The higher the ratio, the more efficient is the use of Capital Employed
 4. Return on Proprietors’ = Net Profit after Taxes * 100
Fund Proprietors’ Fund/ Shareholder’ Equity
• This ratio measures the return on the owners (Equity shareholders)
investment in the firm, & expressed as a %
• This ratio indicates earning capacity & reveals how profitably the
owners’ funds have been utilized by the firm
• Net Profit = Net Profit after tax
• Shareholder’ Equity/ Proprietors Funds = Equity Share Capital and
Other Equity (Reserves & Surplus)
• The ratio used for comparison of similar ratio of another company to
make choice of company for investment decision
• If the ratio is higher, investors feel confident & encouraged to invest in
the company
 5. Return on Equity Share = Net Profit after Taxes
Capital (ROE) less Preference Dividend * 100
Equity Share Capital
• This ratio indicates the rate of earning on the Equity Share Capital,
expressed as a %. Return on Equity Share Capital is also called
Return on Net Worth Ratio (RONW). This ratio measures the return
on the total equity funds of Equity shareholders
• Net Profit after tax less Preference Dividend
• Equity Share Capital without adding the Other Equity (Reserves &
Surplus)
• This ratio also indicates the practice of “Trade on Equity”. “Trading on
Equity” occurs when borrowed capital is employed in the business.
• This is the most important ratio to judge whether the firm has earned a
satisfactory return for its equity shareholders or not
 5. Valuation
1. Earnings Per Share = Net Profit after Taxes
(EPS) less Preference Dividend
Number of Equity Shares
• EPS is calculated to find out overall profitability of the company,
represents earnings of the company whether or not Dividends are declared
• It measures the profit available to the Equity shareholders on a per share
basis
• This is the most widely used ratio. Higher ratio indicates higher over all
profitability
• Higher ratio signifies that the company may pay Dividend at a higher rate
in future & also indicates the possibility of issue of bonus shares in future
• This ratio is used by the investors for evaluating the investment
opportunities & also shows effective utilisation of equity capital
2. Dividends Per Share = Dividends (Interim Dividend + Final
(DPS) Dividend) paid to Equity shareholders
Number of Equity Shares
• This ratio shows what % share of the Net Profits after Taxes &
Dividend paid to the Equity shareholders, Interim Dividend and Final
Dividend
• DPS is the Dividends paid to the Equity shareholders on a per share
basis
• DPS is the net distributed profit belonging to the Equity shareholders
divided by the Number of Equity Shares outstanding
• DPS shows what exactly is received by the owners
 3. Price Earning Ratio = MPS (Market Price of Share)
(P/E) EPS (Earnings Per Share )
• This ratio indicates the number of times the EPS is covered by its Market
Price
• P/E ratio reflects the price currently being paid by the market for each
rupee of currently reported EPS
• This ratio indicates investor’s judgment or expectations about the firm’s
future performance
• This ratio measures the amount investor are willing to pay for each rupee
of earnings
• Generally higher P/E ratio, the better it is for the management of that
firm and the larger the investors confidence in the firm’s future
• It also helps in knowing whether the shares of a company are under or
overvalued and is useful in financial forecasting
4. Dividend Payout Ratio = DPS (Dividends Per Share) * 100
(D/P) EPS (Earnings Per Share )
• The purpose of this ratio is to find out the proportion of earning used for
payment of dividend & the proportion of earning retained
• This ratio measures the proportion of dividends paid out of earnings per
share (EPS) or earning available to shareholders
• Higher ratio signifies that the company has utilised larger proportion of
its earning for payment of dividend to equity shareholders & lesser
amount of earnings has been retained
• Lower ratio indicates that small portion of earning has been utilised for
payment of dividend & larger portion has been retained, which shows
stronger financial position of a company & indicates brighter chances of
future growth & expansion & greater possibility of appreciation in the
value of shares
• If the D/P ratio is subtracted from100, Retention ratio is obtained
 5. Dividend Yield
➢ Dividend Yield = DPS (Dividends Per Share) * 100
MPS (Market Price of Share)
• Dividend Yield ratio is calculated to evaluate the relationship between the
Dividend paid per share (DPS) & the market value of the share (MPS)
• While the EPS & DPS are based on the book value per share, the Yield is
expressed in terms of the market value per share
• The ratio helps an intending investor in knowing the effective return he is
going to get on the proposed investment
 6. Earning Yield Ratio = EPS (Earnings Per Share )
MPS (Market Price of Share)
• Earning Yield ratio is calculated by dividing the Earnings per share
(EPS) and the market value of the share (MPS).
• This ratio is the opposite of the P/E ratio, it measures the Earnings per
share (EPS) that a company generates for each Rupee invested into its
shares.
• The Earning Yield helps investors know how much he has earned per
share. The earnings yield can be used to compare different shares.
• For investors, the ratio can be informative in terms of to understand
how much of the Company’s earnings investors will be receiving for
each Rupee invested in the company’s issued shares.
• Investors prefer the company with the higher earnings yield. The
Earning Yield helps the investors compare and make investment
decisions across for selecting shares.