Ratio Analysis

Rishi Taparia
Faculty
 Define Ratio?
• A ratio is the relationship between two or
more variables.
• In financial analysis, a ratio is used as a
benchmark for evaluating the financial
position and performance of a company.
 Standards of Comparison
• Time Series Analysis
– Comparison of current year ratios with the
past year ratios.
– It gives an indication of the direction of
change and reflects whether the company’s
financial performance has improved, declined
or remained same over time.
• Cross-Sectional Analysis
– Comparison of ratios of one company with
some selected companies in the same
industry.
– This is also known as inter-firm analysis.
• Industry Analysis
– Comparison of the ratios of the company with
the industry average ratios.
– It helps in ascertaining the financial standing
and capability of the company vis-à-vis other
companies in the industry.
 Profitability
• Profitability is not the same as profits.
• Profit is an absolute measure
 sales revenue minus costs
• Profitability is a relative measure
 profit relative to what created profit
• Profitability is measured in terms of the key profitability ratios.
 Profitability Ratios
• These ratios show how profitable is the business.
• They are a measure of overall performance of the company.
• These ratios examine the profits made by the firm and
compare these figures with the size of the firm, the assets
employed by the firm or its level of sales.
• Profitability ratios can be used to examine how well the firm
is operating or how well current performance compares to
past records or to other firms.
 Types of Profitability Ratios
• Gross Profit Ratio
• Net Profit Ratio
• Operating Ratio
• Operating Profit Ratio
• Return on Equity (ROE)
• Return on Assets (ROA) or Return on
Investments (ROI) or Return on Capital
Employed (ROCE)
 Gross Profit Ratio
GP Ratio = [Gross Profit / Net Sales] x 100

• This ratio reflects the efficiency with which the

company produces each unit of product.
• It reflects the spread between the COGS and the
revenue.
• Higher the GPR, the better for the company.
• Lower GPR reflects the higher COGS due to
firm’s inability to purchase raw material at
reasonable price, inefficient utilisation of plant &
machinery or over investment in plant &
machinery.
 Net Profit Ratio
NP Ratio = [Net Profit / Net Sales] x 100

• This ratio establishes the relationship

between net profit and net sales.
• This ratio indicates the rupees in income
that the firm earns on each rupee sales.
• Higher the NPR, the better for the
company.
 Operating Expense Ratio
= [Operating Expense / Net Sales] x 100
• This ratio reflects the operating efficiency of the
company.
• A higher operating expense ratio is unfavourable since it
leaves small amount of operating income to meet the
financial cost like interest, dividends etc.
• This ratio when compared from year to year will throw
light on the managerial policies and programmes. For
eg. Increasing selling expenses, without a sufficient
increase in sales….implies uncontrolled sales
promotional expenses, inefficiency of the marketing
department, introduction of better substitutes by
competitors etc.
• Lower the ratio, the better for the company.
 Operating Profit Ratio
= [Operating Profit / Net Sales] x 100

• Operating Profit = Net Profit + Non-

Operating Expenses – Non-Operating
Income.
• Operating Profit = Gross Profit + Non-
Operating Income – Non-Operating
Expense.
• Lower the ratio, the better for the
company.
 Return on Equity
= [(PAT – PD) / Shareholders’ Equity] x 100
• This ratio indicates what return a company is
generating on the owners’ investment.
• Shareholders’ Equity is also known as Net Worth
which includes Paid-up Share Capital +
Reserves & Surplus.
• This ratio is of great interest to the present as
well as the prospective shareholders and also a
great concern to management as they have a
responsibility of maximising the owners’ welfare.
 Return on Investment (ROI)
= [PBIT / Capital Employed] x 100
• Capital Employed = NFA + NWC
• OR Capital Employed = Paid-up Equity Share Capital +
Preference Share Capital + Debentures + Loan from
Banks / FIs + Other borrowings + Retained Earnings –
accumulated losses.
• This is an important ratio for companies in deciding
whether or not to initiate a new project.
• The basis of this ratio is that if a company is going to
start a project, they expect to earn a return on it, ROI is
the return they would receive.
• Simply put, if ROI is above the rate that the company
borrows at then the project should be accepted, if not
then it is to be rejected.
 Problem
• The following figures relate to the trading
activities of Hind Traders Limited for the
year ended June 30, 20X1.
• You are required to compute:
• Gross Profit Ratio
• Net Profit Ratio
• Operating Expense Ratio
 Liquidity Ratios
• These ratios measure the company’s
ability to meet it’s short-term obligations.
• A company should ensure that it does not
suffer from lack of liquidity and also does
not have excess liquidity.
Consequences of Good & Bad Liquidity
• The failure of company to meet its obligations
due to lack of liquidity, will result in a poor
creditworthiness, loss of creditor’s confidence or
entering into legal issues resulting in the closure
of the company.
• A very high degree of liquidity is also bad
because idle funds earn nothing.
• Therefore, the company must have a proper
balance between excess and lack of liquidity.
 Current Ratio
= Current Assets / Current Liabilities
• This ratio measure the company’s short term
solvency.
• It indicates the availability of current assets for
every one rupee of current liabilities.
• An ideal current ratio is 2:1 that means for every
1 current liability, the company has 2 current
assets.
• Higher the current ratio, greater the margin of
safety; the larger the amount of CA in relation to
CL, the more the company’s ability to meet its
current obligations.
 Liquid Ratio / Quick Ratio
= Liquid Assets / Current Liabilities
• Liquid Assets = CA – stock – prepaid expenses.
• An asset is liquid if it can be quickly converted into cash.
• An ideal liquid ratio is 1:1 that means for every 1 current
liability, the company has 1 liquid assets.
• It should be remembered that all book-debts may not be
liquid, and cash may be immediately required to pay
operating expenses.
• A company with high quick ratio can suffer from the
shortage of funds if it has slow-paying, doubtful and long
duration book debts.
• Whereas, a company with low liquid ratio may be
prospering and paying its current obligations in time if it
has been turning inventories into cash efficiently.
 Activity Ratios
• These ratios are employed to evaluate the
efficiency with which the company
manages and utilises its assets.
• These ratios are also called TURNOVER
ratios because they indicate the speed
with which assets are being converted or
turned over into sales.
 Types of Activity Ratios
• Inventory Turnover Ratio (ITR)
• Days of inventory holdings (DIH)
• Debtors Turnover Ratio (DTR)
• Debt Collection Period (DCP)
• Working Capital Turnover Ratio.
• Fixed Assets Turnover Ratio.
• Net Assets Turnover Ratio.
 Inventory Turnover Ratio (ITR)
= Cost of Goods Sold / Average Inventory
• This ratio shows how rapidly the inventory
is turned over into through sales.
• A high ITR is an indication of good
inventory management.
• A low ITR indicate poor sales which
implies excessive inventory levels or a
slow-moving or obsolete inventory.
• Higher the ITR, the stronger the sales and
the better it is for the company.
 Days of Inventory Holdings (DIH)

= 365 / ITR

• Lower the DIH, the better it is for the

company and vice - versa.
 Debtors Turnover Ratio (DTR)
= Credit Sales / Average Accounts Receivables
• This ratio indicates the number of times
debtors turned over in a year.
• This ratio measures the company’s ability
to collect payment from its customers.
• Higher the DTR, the better it is for the
company.
• Higher DTR indicates the company’s
ability to collect the payments from their
customers.
 Debt Collection Period (DCP)
= 365 / DTR OR = 12 / DTR
• DCP measures the quality of debtors since it
indicates the speed of their collection.
• Shorter the DCP, the better the quality of
debtors because a short DCP indicates prompt
payment by the customers.
• Longer DCP indicates liberal credit policy which
increases sales, in turn increases collection
expenses and also increases the chances of
Bad Debts and finally decreases the profits of
the company.
 Total Assets Turnover Ratio
= Sales / Total Assets

• This ratio indicates how much revenue is

generated for every Rs.1 of assets.
• Higher the ratio, the more efficient the
company is with its assets.
Working Capital Turnover Ratio

= Sales / Net Working Capital

• This ratio indicates how well the company

has utilised its working capital to generate
sales.
• Higher the ratio, the better it is for the
company.
 Market Value Ratios
• Earning Per Share (EPS)
• Price-Earning Ratio (P/E Ratio)
• Dividend Per Share (DPS)
• Dividend Payout Ratio (D/P ratio)
• Dividend Yield
 Earning Per Share (EPS)
= (PAT – PD) / Number of shares outstanding
• The essence of this ratio is that if you own
one share of the company, how much of
the profit is designated to your share.
• EPS is closely watched because there is a
strong correlation between EPS and the
share price i.e. when EPS climbs, the
share price will appreciate.
• EPS is one of the most popular variables
in valuing a company.
 Price – Earning Ratio (P/E Ratio)
= MPS / EPS
• This ratio reflects investors expectations about
the growth in the company’s earnings.
• The more attractive the company is to the
investor, the higher is its P/E ratio.
• An unusually low P/E ratio indicates that
investors perceive a share to be fairly risky.
• An unusually high P/E ratio indicates that
investors have high expectations for growth in
earnings and share prices.
• Companies with negative earnings do not have a
P/E.
 Inventory Turnover Ratio (ITR)
= Cost of Goods Sold / Average Inventory
• This ratio shows how rapidly the inventory
is turned over into through sales.
• A high ITR is an indication of good
inventory management.
• A low ITR indicate poor sales which
implies excessive inventory levels or a
slow-moving or obsolete inventory.
• Higher the ITR, the stronger the sales and
the better it is for the company.
 Dividend Payout Ratio
= DPS / EPS

• Earnings not distributed are retained in the

business.
• Thus, retention ratio = 1 – D/P Ratio.
• Higher D/P Ratio means that the company
do not have profitable business
opportunity in future and therefore, the
company distributed the profit as dividend.
 Dividend Yield

= DPS / MPS

• This ratio evaluate the shareholder’s

return in relation to the market value of the
share.
 Capital Structure Ratios /
Solvency Ratios
• These ratios measure the ability of the company
to survive over a long period of time.
• Long-term creditors or Debenture holders are
interested in a company’s ability to pay interest
as it becomes due and to repay the principal
amount of debt at maturity.
• These ratios indicate the mix of debt and equity
in the capital structure of the company.
• These ratios calculate the financial risk of the
company.
 Total Debt Ratio
= Total Debt / Capital Employed
• Total Debt includes short and long-term
borrowings from FIs, debentures, deferred
payment arrangements for buying capital
equipments, bank borrowings, public deposits
and any other interest bearing loan.
• Capital Employed = TD + Net Worth = NFA +
NWC
• If this ratio is 0.646, it means that lenders have
finance 64.6% and the rest is finance by the
owners itself.
 Interest Coverage Ratio
= EBIT / Interest
• This ratio shows the number of times the interest
charges are covered by funds that are ordinarily
available for their payment.
• A higher ratio is desirable because it indicates
that the firm is very conservative in using debt.
• A low ratio is bad because it indicates excessive
use of debt.
• The company should try to retire debt to have
comfortable coverage ratio.
 Problem 1
• Financial information for Brooker Inc. is
presented below:
Particulars 31/12/2003 31/12/2002

Current assets 125000 100000

Plant & Machinery (Net) 400000 330000
Current Liabilities 91000 70000
Long Term Liabilities 144000 95000
Share Capital (Rs.1 par) 155000 115000
Retained Earning 135000 150000

Prepare horizontal and vertical analysis.

 Problem 2
• Selected condensed data taken • Calculate:
from a recent balance sheet of
Essex Farms are as follows:
Cash Rs. 82,41,000 a) NWC
Marketable Securities Rs. 19,47,000
Accounts Receivable Rs.1,25,45,000
Inventories Rs.1,48,14,000
Other Current Assets Rs. 53,71,000 b) Current Ratio
Total Current Assets Rs.4,29,18,000
Total Current Liabilities Rs.4,08,44,000

c) Quick Ratio
 Problem 3
• The assets of ABC • Share Capital Rs.199500
Limited consist of fixed • Working Capital Rs.45000
assets and current
assets while its current • GP Ratio 20%
liabilities consist of bank • ITR 6 Times
credit and trade credit in • DCP 2 months
the ratio of 2:1. From the • Current Ratio1.5
following ratios and
figures relating to the • Quick Ratio 0.9
company for the year • Reserves &
1995, prepare the Surplus to cash 3
balance sheet.
Working notes should form
part of your answer