FINANCIAL RATIO ANALYSIS:
A ratio is an arithmetical relationship between two figures.
Financial ratio analysis is a study of ratios between various
items or groups of items in financial statements. Ratios can
be classified according to statements mainly they are profit
and loss ratios or income statement ratios, balance sheet
ratios or position statement ratios, mixed ratio or inter
INTERPRETATION OF THE RATIOS
Single Absolute Ratio.
Group of Ratio.
GUIDELINES FOR USE OF RATIOS
Accuracy of Financial Statements
Objective or Purpose of Analysis
Selection of Ratios
Use of Standards
Caliber of the Analyst
SIGNIFICANCE OF RATIO ANALYSIS
•Managerial Uses of Ratio analysis
•Helps in decision-making
•Helps in financial forecasting and planning.
•Helps in communicating.
•Helps in co-ordination.
•Helps in controlling.
•Useful to Shareholders/Investors
•Useful to Creditors
•Useful to Employees.
•Useful to Government
LIMITATIONS OF RATIO ANALYSIS
• Limited Use of a Single Ratio.
• Lack of Adequate Standards.
• Inherent Limitations of Accounting.
• Change of Accounting Procedure.
BALANCE SHEET RATIO
It deals with the relationship between two balance sheet items: these can
be mainly classified as liquidity ratio, long term solvency or leverage ratio.
These ratios are calculated to comment upon the short term paying
capacity of a firm or concerns ability to meet its current obligation. The
important liquidity ratios are current ratio ,quick ratio & absolute liquid
It is a measure of general liquidity and is used to make the analysis of a
short-term financial position or liquidity of an organization
Current Ratio = Current Assets/Current Liabilities
Rules of thumb=2:1
Find out Current ratio
Land and building-100000
Current Ratio= Current Assets/Current Liabilities
The CR of 2.24 means that current assets are 2.24 times of current Liabilities
It is also known as acid test ratio Quick Ratio= Quick Assets/Current
Quick Asset=Current Asset-(Inventory+prepaid expenses)
Rules of thumb=1:1
Calculate quick ratio from the information given below
Land and building-100000
Short term investment-150000
It is also known as acid test ratio Quick Ratio= Quick Assets/Current Liabilities
Current Liabilities =150000+20000+10000=180000
ABSOLUTE LIQUID RATIO
Absolute liquid ratio=cash,bank & marketable securities/current liabilities
Rules of thumb=0.5:1
Calculate absolute liquid ratio from the information given below
Cash in hand -45000
Cash at bank-30000
Land and building-400000
Absolute liquid ratio=225000/250000=.9
To judge the long-term financial position, leverage or capital structure
ratios are calculated. Leverage ratios can calculate from the balance sheet
to determine the portion of debt in total financing.
DEBT EQUITY RATIO
Debt Equity ratio is calculated to measure the relative
claims of outsiders and the extent to which debt financing
has been used in the organization. In this ratio the debt has
been taken as the long-term debt and net worth has been
calculated by adding share capital with reserves and surplus
Debt Equity Ratio=Debt/Net worth
Debt Equity Ratio
FUNDED DEBT TO TOTAL CAPITALIZATION RATIO
(Funded debt/Total capitalisation)
Funded debt=Long term loan
Total capitalisation=Total liabilities-current liabilities
PROPRIETARY RATIO OR EQUITY RATIO
Shareholders fund/Total asset
PROFIT AND LOSS RATIO
These ratios deal with relationship between profit and loss accounts items
The main profitability ratios are gross profit ratio,operating ratio
Operating profit ratio,expenses ratio and net profit ratio .
GROSS PROFIT RATIO
Gross profit ratio measures the relationship of gross profit to net sales.
Gross Profit ratio=(Gross Profit/Net Sales)x100
Gross profit=Sales-cost of goods sold
Operating ratio=(Operating cost/Net sales )*100
Operating cost=Cost of goods sold+operating expenses.
Cost of goods sold=op.stock+purchase+wages-cl.stock
OPERATING PROFIT RATIO
Operating profit ratio shows the relationship between operating profit and
Operating Profit ratio =(Operating Profit/Net Sales)x100
Operating Profit=Net sales-(cost of goods sold+ administrative & office
Cost of goods sold ratio=(cost of goods sold/Net sales)x100
expenses /Net sales)x100
Selling &distribution expenses ratio= Selling &distribution expenses /Net
NET PROFIT RATIO
Net profit ratio establishes a relation ship between net profit (profit after
tax) and indicates the efficiency of the management.
Net Profit ratio =(Net Profit/Net Sales)x100
MIXED RATIO OR INTER STATEMENT RATIOS
These ratios exhibit the relationship between profit and loss item and
balance sheet item.
The coverage ratio shows the firm’s ability to pay interest and principals
INTEREST COVERAGE RATIO
It properly measures the margin of safety the organization enjoys with
respect to its interest burden. The interest coverage ratio indicates the
number of times interest is covered by the profits available to pay the
Interest coverage ratio=Profit Before Interest and Taxes/Interest
DEBT SERVICE COVERAGE RATIO
Debt service coverage ratio gives picture of long-term liquidity position.
Debt service coverage=(Profit After Tax+ Depreciation+ Interest on Long
Term Loans)/(Interest+ Long Term Loans)
ACTIVITY RATIO OR CURRENT ASSETS
Activity ratios are calculated to measure the efficiency with
which the resources of a firm have been employed. These
ratios are also called turnover ratios because they indicate
speed at which the assets are being turned over into sales.
The important turnover ratios are debtor’s turnover ratio
,inventory turnover ratio, creditor turnover ratio ,working
capital turnover ratio, fixed assets turnover ratio & total
assets turnover ratio.
DEBTOR TURNOVER RATIO
It indicates the velocity of debt-collection of an
organization. In simple words, it indicates the number of
times debtors (receivables) are turned over during a year.
Generally high turnover ratio is the more efficiency of
management of debtors .
Debtor Turnover Ratio=Net Credit Sales/Average Trade
AVERAGE COLLECTION PERIOD
It represents the average number of days in which its debtors converted
into cash. The short collection period implies quick payment by the
Average Collection Period= Total Trade Debtor/Sales Per Day or
365/Debtor turnover ratio
CREDITOR TURNOVER RATIO
In course of business operations an organization has to make credit
purchases and incurred short-term liabilities. Suppliers of goods naturally
interested in finding out how much time the organization is likely to take
to repay the creditors.
Creditors Turnover Ratio=Net Credit Purchase/Average Trade Creditor
AVERAGE PAYMENT PERIOD
Average payment period represent the average number of days the
organization has to pay its creditors.
Average payment period=Total Trade Creditors/Average Daily Purchases
or 365/creditor turnover ratio
INVENTORY TURNOVER RATIO
Organization has to maintain the inventory of finished
goods so as to able to meet the requirement of the business.
But the level of inventories should not either too high or too
Inventory Turnover Ratio=Costs Of Goods Sold/ Average
Inventory at costs
Inventory conversion period=365/ Inventory Turnover
PROFITABILITY RATIO IN RELATION
Return on investment is one of the important ratios used to
measure the efficiency of the organization, as the objective
of the organization is to maximize it’s earning.
Return on investment = Profit Before Interest&
Capital Employed=net fixed asset+net working capital
RETURN ON EQUITY
Return on Equity is calculated to see the profitability of the
owner’s investment. It is regarded as an important measure
because it reflects the productivity of the ownership in the
organization. It is affected by several factors like earning
power, debt equity ratio, cost of debt and tax rate.
Return on Equity=Profit After Tax/Net Worth
DIVIDEND PER SHARE.
The profit after tax belongs to shareholders. But income,
which they really received, is the amount earning received
as cash dividend. Therefore a large number of present and
potential investors are interested in the Dividend Per Share.
Dividend Per Share=Dividend Paid/Number of Shares
EARNING PER SHARE
Earning Per Share is a small variation of equity capital and
is calculated by dividing the net profit after tax and
preference dividend by the total number of equity shares.
EPS calculated for a number of years indicates the earning
power of the company has increased or decreased.
Earning Per Share=Profit After Tax/Number of Shares