a) MEANING OF A RATIO

An Accounting Ratio may be defined as the mathematical expression of the relationship between
two accounting figures.
But these figures must be related to each other (i.e., these figures must have a mutual cause and
effect relationship) to produce a meaningful and useful ratio.
Rations can be expressed as Percentage, Proportion, Fraction and Times.

b) CLASSIFICATION OF RATIOS:
In view of the requirements of various users (e.g., Short-term Creditors, Long-term Creditors,
Management, Investors) of the ratios, one may classify the ratios into the following four groups.

firm.

assets and resources.

These are indicated by activity or performance or turnover ratios E.g. Stock Turnover Ratio,
Debtors Turnover Ratio, Fixed Assets Turnover Ratio.
These indicate the ability of the firm to generate revenue (sale) per rupee of investment in its
assets.
4. Evaluation of Financial Strength:
Long-term solvency or Financial Strength is indicated by Capital Structure Ratios like Dept-
Equity Ratio, Gearing Ratio, Leverage Ratios etc.
These ratios signify the effect of various Sources of Finance E.g. Debt, Preference and Equity.
They also picture as to whether the firm is exposed to serious financial strain or is justified in
the use of debt funds.
5. Inter-Firm and Intra-Firm Comparison:
Comparison of the firm’s ratios with the industry average will help evaluate the firm’s position
vis-à-vis the industry.

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 It will help in analyzing the firm’s strengths and weaknesses and take corrective action.
Trend Analysis of ratios over a period of years will indicate the direction of the firm’s financial
policies.
6. Budgeting:
Ratios are not mere Post-mortem of operations.
They help in depicting Future Financial Positions.
Ratios have predatory value and are helpful in planning and forecasting the business activities
of a firm for future periods.
E.g. Estimation of Working Capital Requirements

LIMITATIONS OF FINANCIAL RATIOS

The limitations of financial ratios are listed below:
1) Diversified Product lines:
Many businesses operate a large number of divisions in quite different industries.
In such cases ratios calculated on the basis of aggregate data cannot be used for interfirm
comparisons.
2) Inflation:
Financial Data are badly distorted by Inflation.
Historical cost values may be substantially different from true values.
Such distortions of financial data are also carried in the financial ratios. 3) Seasonal Factors:
Seasonal Factors may also influence financial data.
4) Window Dressing:
To give a good shape to the popularly used Financial Ratios (like current ratio, debt- equity ratios,
etc.) the business man may make some year-end adjustments.
Such window dressing can change the character of financial ratios which would be different had
there been no such change. 5) Different in Accounting Policies:
Differences in Accounting Policies and Accounting Period can make the accounting data of two firms
non-comparable as also the accounting ratios.
6) No Standard Set of Ratios:
There is no Standard Set of Ratios against which a firm’s ratios can be compared.
Sometimes a firm’s ratios are compared with the industry average.
But if a firm desires to be above the average, then industry average becomes a low standard.
On the other hand, for a below average firm, industry averages become too high a standard to
achieve.
7) Difficulty to Decide:
It is very difficult to generalise whether a particular ratio is good or bad.
For example, a low current ratio may be said ‘bad’ from the point of view of low liquidity, but
a high current ratio may not be ‘good’ as this may result from inefficient working capital
management.
8) Financial ratios are inter-related, not independent:
Viewed in isolation one ratio may highlight efficiency. But when considered as a set of ratios
they may speak differently.
Such interdependence among the ratios can be taken care of through multivariate analysis.
Financial ratios provide clues but not conclusions. These are tools only in the hands of experts because
there is no standard ready-made interpretation of financial ratios.

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 RATIO ANALYSIS - FORMULAE
CATEGORY A : LIQUIDITY RATIOS
SL No RATIO FORMULA
Current Assets
1 Current Ratio / Net Working Capital Ratio Current Liabilities

Quick Ratio / Acid Test Ratio / Liquid Quick Assets

2 Ratio Current Liabilities

Cash + MS
3 Cash Ratio or Absolute liquidity Ratio
Current Liabilities
Cash + Debtors + MS
4 Basic Defense Interval (OP EXPS)/365

Current Assets – Current Liabilities

5 Excluding Short Term Bank Borrowings

CATEGORY B : CAPITAL STRUCTURE OR LEVERAGE RATIOS PART 1: CS RATIOS

SL No RATIO FORMULA
Shareholders’ Equity
1 Equity Ratio Total Capital Employed

Debt
2 Debt Ratio Capital Employed

Debt
3 Debt to Equity Ratio
Shareholders’ Equity
Debt
4 Debt to Total Assets Ratio Total Assets
CATEGORY B : CAPITAL STRUCTURE OR LEVERAGE RATIOS PART 2: COVERAGE
RATIOS
SL No RATIO FORMULA
EBIT + Depreciation
1 Debt Service Coverage Ratio Interest + instalments
EBIT
2 Interest Coverage Ratio Interest

PAT
3 Preference Dividend Coverage Ratio
PD
PS + Debentures + LT Loan
4 Capital Gearing Ratio
Equity Shareholders Funds
Fixed Assets
5 Fixed Assets To LT fund Ratio Long Term Funds

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 Prop. Funds
6 Proprietary Ratio Total Assets

Fixed Assets
7 Fixed Assets to Proprietors funds Ratio Proprietors Funds

CATEGORY C : ACTIVITY RATIOS

Sales
1 Capital Turnover Ratio Capital Employed
Sales
2 Fixed Assets Turnover Ratio FixedAssets

Sales
3 Total Assets Turnover Ratio Total Assets

Sales
4 Working Capital Turnover Ratio Working Capital
Raw Materials Consumed
5 Raw Material Turnover Ratio Average Stock of RM
Works Cost Average
6 Work In Progress Turnover Ratio WIP

FG Turnover Ratio COGS

7
(Inventory Turnover Ratio) Average stock of FG
Credit Sales Average
8 Debtors Turnover Ratio Debtors

Credit Purchases Average

9 Creditors Turnover Ratio Creditors

Average Inventory * 365

10 Inventory Holding Period
COGS
Average Collection period (ACP) Average Debtors * 365
11
Debtors Credit Period Credit Sales
Average Creditors * 365
12 Creditors Payment Period
Credit Purchases
Note:
Debtors = Credit Sales * ACP / 365
Creditors = Credit purchases * CPP / 365
FG = COGS * IHP / 365
CATEGORY D : PROFITABILITY RATIOS (INVESTORS POINT OF VIEW)
Profit After Tax *100
1 Return on Equity (ROE)
Net Worth
Earnings Available To Eq Shareholders
2 EPS
Number of Equity Shares

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 Total profits distributed to Eq Sh
Number of Equity Shares
3 DPS
Or
FV * Dividend Rate
MPS
4 Price Earnings Ratio (PE Ratio)
EPS
DPS*100
5 Dividend Payout Ratio
EPS
PROFITABILITY RATIOS BASED ON ASSETS / INVESTMENTS
EBIT * 100
1 Return on Capital Employed (ROCE) Capital Employed
Profit After Tax
2 Return on Assets (ROA) Average Total Assets

NOPAT
3 Return on Assets (ROA)
Average Total Assets
PROFITABILITY RATIOS BASED ON SALES OF THE FIRM
Gross Profit * 100
1
Sales
Contribution * 100
2 P V Ratio
Sales
Net Profit * 100
3 Net Profit Ratio
Sales
Operating Profit * 100
4 Operating Profit Ratio
Sales
Operating Expenses * 100
5 Operating Expenses Ratio
Sales
PROFITABILITY RATIOS BASED ON CAPITAL MARKET INFORMATION
DPS * 100
1 Dividend Yield Ratio
MPS
EPS * 100
2 Earnings Yield Ratio
MPS
MPS
3 Market Value to Book Value Ratio
Book value per share
Net Worth
4 Book Value per share Number of Equity Shares

ACTIVITY RATIOS
Sl
No PARTICULARS INVENTORY DEBTORS CREDITORS

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 Basis of
A Valuation COGS Credit Sales Credit Purchases

B Average Average Inventory Average Debtors Average Creditors

Turnover COGS Credit Sales Average Credit Purchases Average

C Ratio (A/B) Debtors Creditors
Average Inventory

Average Debtors * Average Creditors *

Period Average Inventory * 360 360 360
D
(B/A)*360 COGS Credit Sales Credit Purchases

FIXED ASSETS TO PROPRIETORS FUNDS RATIO

1) This ratio establishes the relationship between Fixed assets and Shareholders funds.
2) The purpose of this ratio is to indicate the percentage of owners funds invested in Fixed assets and
the percentage of owners funds invested in working capital.
3) Fixed Assets to Proprietors Funds ratio is

Fixed Assets to Proprietors funds ratio = Fixed assets

Proprietors Funds
4) For example, net block of fixed assets is Rs. 3,60,000 and the proprietors funds are Rs. 4,80,000.
5) Therefore Fixed Assets to proprietors Fund ratio is 3,60,000 / 4,80,000 = 0.75.
6) It means 75% of shareholders funds are used to procure fixed assets. Therefore, balance 25% of
proprietors funds are used to finance Working Capital.

Interpretation of the ratio:

7) If the ratio is less than 1, it implies that the proprietors’ funds are more than the fixed assets that
means a part of working capital is provided by shareholders.
8) If the ratio is more than 1, it implies that owners’ funds are not sufficient to finance fixed assets and
the firm has to depend on external borrowings to finance a portion of fixed assets.

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 RATIO ANALYSIS - PROBLEMS

Problem No. 1
The total sales (all credit) of a firm are Rs. 6,40,000. It has a gross profit margin of 15 per cent and a
current ratio of 2.5. The firm’s current liabilities are Rs. 96,000; inventories Rs. 48,000 and cash Rs.
16,000.
1) Determine the average inventory to be carried by the firm, if an inventory turnover of 5 times is
expected? (Assume a 360 day year).
2) Determine the average collection period if the opening balance of debtors is intended to be of Rs.
80,000? (Assume a 360 day year).

Problem No – 2
The following information is extracted from the books of M/s. X Ltd.
Equity Shares of Rs. 10 each Rs. 8,00,000 9%
Preference Shares Rs. 3,00,000
Additional information:
Profit (after tax at 35 per cent) Rs. 2,70,000
Depreciation is Rs. 60,000; Equity
dividend paid @ 20 per cent;
Market price of equity share is Rs. 40.
You are required to compute the following, showing the necessary workings:
(a) Dividend yield on the equity shares
(b) Cover for the preference and equity dividends
(c) Earnings per shares (d) Price-earnings ratio.

Problem No - 3
X Co. has made plans for the next year. It is estimated that the company will employ total assets of Rs.
8,00,000; 50 per cent of the assets being financed by borrowed capital at an interest cost of 8 per cent
per year. The direct costs for the year are estimated at Rs. 4,80,000 and all other operating expenses are
estimated at Rs. 80,000. The goods will be sold to customers at 150 per cent of the direct costs. Tax rate
is assumed to be 50 per cent.
You are required to calculate:
(i) Operating profit margin (before tax);
(ii) net profit margin (after tax);
(iii) return on assets (on operating profit after tax);
(iv) asset turnover and
(v) return on owners' equity.

Problem No - 4
Calculate the average collection period from the following details by adopting 360 days to a year.
Average Inventory 3,60,000 Inventory Turnover Ratio 6 times

Gross Profit Ratio 10% Credit sales to Total sales 20%

Debtors 2,30,000

Problem No. 5

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In a meeting held at Solan towards the end of 2004, the Directors of M/s HPCL Ltd. have taken a decision
to diversify. At present HPCL Ltd. sells all finished goods from its own warehouse.
The company issued debentures on 01.01.2005 and purchased fixed assets on the same day.
The purchase prices have remained stable during the concerned period. Following information is
provided to you:

2004 (Rs.) 2005 (Rs.)

Cash Sales 30,000 32,000

Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000

Less: Cost of goods sold 2,36,000 2,98,000

Gross profit 64,000 76,000

Less: Expenses

Warehousing 13,000 14,000

Transport 6,000 10,000

Administrative 19,000 19,000

Selling 11,000 14,000

Interest on Debenture 0 49,000 2,000 59,000

Net Profit 15,000 17,000

You are required to calculate the following ratios for the years 2004 and 2005.
1) Gross Profit Ratio
2) Operating Expenses to Sales Ratio.

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3) Operating Profit Ratio
4) Capital Turnover Ratio
5) Stock Turnover Ratio
6) Net Profit to Net Worth Ratio,
7) Debtors Collection Period.
Ratio relating to capital employed should be based on the capital at the end of the year. Give the reasons
for change in the ratios for 2 years. Assume opening stock of Rs. 40,000 for the year 2004. Ignore
Taxation.
Problem No - 6
The following accounting information and financial ratios of PQR Ltd. relate to the year ended 31st
December, 2006:
Accounting Information:

Gross Profit 15% of Sales

Net profit 8% of sales

Raw materials consumed 20% of COGS

Direct wages 10% of COGS

Stock of raw materials 3 months usage

Stock of finished goods 6% of COGS

Debt collection period 60 days

All sales are on credit

Financial Ratios:

Fixed assets to sales 1:3

Fixed assets to Current assets 13 : 11

Current ratio 2:1

Long-term loans to Current liabilities 2:1

Capital to Reserves and Surplus 1:4

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Problem No - 8
Complete the following annual financial statements on the basis of ratios given below.
Profit and Loss Account for the year ended 30th June, 2015
To Cost of Goods sold 6,00,000 By Sales 20,00,000

To Operating expenses --

To EBIT --

---------- ------------

---------- ------------

To Debenture Interest 10,000 By EBIT b/d

To Income tax --

To Net Profit --

------------ ------------

------------ ------------

Balance Sheet as on 30-6-2015

Share Capital -- Fixed assets --

Reserves & Surplus -- Cash 15,000

10% Debentures -- Stock --

Sundry Creditors 60,000 Sundry Debtors --

------------ ------------

------------ ------------
1) Net profit to sales 5% 2) Current ratio 1.5
3) Return on net worth 20% 4) Inventory turnover 15 times
5) Share capital to reserves 4:1 6) Rate of income-tax 50%

Problem No - 9
From the following ratios and further information given below, prepare a Trading and Profit and Loss
and a Balance Sheet of Mr. Green:
Fixed Assets/Capital 5/4 Fixed Assets 5,00,000

Capital/Liabilities ½ Net Profit/Capital 1.5

Gross Profit Ratio 25% Stock turnover ratio 10 times

Closing stock 50,000 Net Profit to Sales 20%

Fixed Assets/Total current assets 5/7

Out of Current Assets, Sundry Debtors are Rs.6,00,000. The balance represents Cash and
Closing Stock.

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Problem No – 14
Working Capital of a company 1,35,000 Current Ratio 2.5

Liquid ratio 1.5 Fixed Assets to Proprietor Funds 0.75

Bank Overdraft 30,000 Reserves and surplus 90,000

Gearing ratio (ES cap/ Pref cap) 2:1

There are no long term loans and fictitious assets. From the above, please ascertain
1) Current assets 2) Current liabilities 3) Net block
4) Proprietary fund 5) Quick liabilities 6) Quick
assets 7) Stock and 8) Preference and Equity
capital Also draw the Statement of Proprietary funds.

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Problem No – 16
With the help of the following information complete the Balance Sheet of MNOP Ltd.:
Equity share capital Rs. 1,00,000
Current ratio

Current ratio 1.8

Long-term Debt to Equity 40%

Problem No. 18
The assets of Sona Ltd consist of fixed assets and current assets, while its current liabilities comprise
bank credit in the ratio of 2:1. You are required to prepare the Balance Sheet of the company as on 31st
March, 2016 with the help of following information:
Share Capital Rs. 5,75,000

Working Capital Rs. 1,50,000

Gross Margin 25%

Inventory Turnover 5 times

Average Collection Period 1.5 month

Current Ratio 1.5 : 1

Quick Ratio 0.8 : 1

Reserves and surplus to Bank and 4 times

Cash
Assume 360 days in a year.

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Problem No. 19
Noor Ltd provides the following information for the year ending 31st March, 2014. You are required to
prepare trading and profit & loss account for the year ending 31st March, 2014.

Equity Share 25,00,000

Capital

Closing Stock 6,00,000

Stock turnover ratio 5 times

Gross Profit Ratio 25%

Net Profit / Sales 20%

Net Profit / Capital ¼

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