Meaning of Ratio and Ratio analysis.
Ratio is mathematical yardsticks that measure the relationships between two
figures, which are related to each other and mutually inter-dependent. A ratio is simply
one number expressed in terms of another number. In other words, a ratio expressed
mathematical relationship between one number and another. Ratio analysis is attempted
to derive quantitative measures or guides concerning the financial health and profitability
of a business enterprise. Ratio analysis can be used both in trend and static analysis.
There are several ratios at the disposal of an analyst but the group of ratio he would
prefer depends on the purpose and objective of analysis. In simple words a ratio is one
figure expressed in terms of another figure. For example the ratio of 200 to 100 is
expressed as 2:1 or as 2. Thus a ratio is calculated one figure into another.
Example: Gross Profit = Rs. 20,000
Sales = Rs. 1,00,000
Ratio of Gross profit to sales = Gross Profit 20,000
Sales 1,00,000 0.2: 1 or simply as 0.2
Certain ratio between two numbers coveri8ng a definite period of time are
expressed as a rate e.g. stock turnover is five times a year.
An accounting ratio shows the mathematical relationship between two figure
which have meaningful relation with each other e.g. gross profit and sales, net profit and
sales, current asset and current liability etc. No useful purpose is served if ration are
calculated between two figure, which are not, related at all to each other e.g. purchase
and premiums on the issue of the share.
There are three forms of ratio-
1) Pure Ratio-This is a simple form of ratio. In this case numerator is divided by
denominator. Pure ratio is expressed inform of relationship. For e.g. Ideal current
ratio is 2:1.
2) Percentage form- In this case numerator is divided by denominator and multiplied
by 100. For e.g. G.P. Ratio is 41%.
3) Rate Form- In this case numerator is divided by denominator; it is followed by the
word times. For e.g. Debtors Turnover 4 times.
Ratio analysis is the methods or process by which the relationship of items or
group of items in financial statements are computed, determined and presented.
Ratio analysis is the best-known and most widely used tool of financial analysis.
In financial analysis a ratio is used as an index or yardstick for evaluating the financial
performance of a firm. The absolute accounting figure contained in the financial
statement may not be very meaningful. For example, a profit of Rs. 5,00,000 may look
impressive. But the performance of the firm cannot be judged without the comparing this
net profit figure with the total amount invested to earn this profit. If this profit of Rs. 5
lakhs has been earned on an investments of Rs/. 1 corer, then the ratio of the net profit to
total capital is only 5 lakhs20 lakhs multiply by 100 = 5%, which is not reasonable return
on capital employed.
Interpretation of RatioInterpretation of Ratio
Broadly speaking, ratio may be interpreted in four different ways to follows:
An individual's ratio may have significance of its own. For example a
ratio of 25% of net profit on capital employed shows a satisfactory returns.
Ratio may be interpreted by making comparisons over time. For example,
ratio of net profit on capital employed is 25%. This ratio may be compared with the
similar ratios of a number of past years. Such comparison will indicate the trend of
rise, decline or stability of the ratio.
Ratios of any one firm may be compared with the ratio of others firms in
the same industry. This is known as inter-firm comparison. Such comparison shows
the efficiency of a firm as compared to other firms.
Ratio may be interpreted by considering a group of several selected ratios.
For example, the utility of current ratio is enhanced if it used along with other related
ratio like quick ratio or acid test ratio, stock turnover ratio, etc. Similarly various
profitability ratios may be considered in relations to each other.
CLASSIFICATION OF RATIOCLASSIFICATION OF RATIO
Ratio may be classified in a variety of ways. Some of the possible methods are given
1) Balance sheet ratio These ratio deals with the relationship between two items
appearing in the balance sheet e.g. current ratio, liquid ratio, debt equity ratio etc.,
2) Profit and loss ratio: This type of ratio show the relationship between two items
which are in the profit and loss account itself, e.g. gross profit ratio, net profit
ratio, operating ratio etc.
3) Combined and composite ratio: These ratios show the relationship between
items one of which is taken from profit and loss account and the other from the
balance sheet e.g. Rate of return on capital employed, debtor turnover ratio, stock
turnover ratio etc.
Meaning of Current Assets. Current assets includes: a) Cash in Hand and at bank.
(b) Readily marketable securities (c) Bill Receivable (d) Debtor less provision for bad
and doubtful debts (e) Stock in trade (f) Prepaid Expenses (g) Any other asset, which
in the normal courses of business, will be converted in cash in year's time.
Meaning of Current liability. These include all obligations maturing within a year
such as: (a) Sundry creditors (b) Bills payable (c) Bank overdraft (d) Income Tax
Payable (e) Dividend Payable (f) Outstanding expenses (g) Provision for taxation
Significance and objectives: Current ration throws good light on the short-term
financial positions and policy. It is an indicator of a firm's ability to promptly meet
its short-term liabilities. On the other hand a relatively low current ratio indicates that
the firm will find it difficult to pays its bills.
Normally a current ratio of 2:1 is considered satisfactory In other words current assets
should be twice the amount of current liabilities If the current ratio is 1:1 it means that
the funds yielded by current assets are just sufficient to pay the amount due to various
creditors and there will be nothing left to meet the expenses which are being currently
incurred. Thus the ratio should always be more than 1:1 A very high current ratio is
also not desirable because it indicates idleness of funds which is not a sign of efficient
(A) BALANCE SHEET / FINANCIAL POSITION RATIOS
1) Current Ratio-
Current ratio is also known as “working capital ratio’ or “solvency ratio” or
“2:1” Ratio. This ratio expresses the relationship between current assets and current
Current Ratio = Current Assets
Purpose: The main purpose of this ratio is to determine a short-term financial
strength of the company.
2) Liquid Ratio / Near Money Ratio-
Liquid ratio is also known as “Quick Ratio” or “Acid Test Ratio” or “1:1”
Ratio. This indicates the liquid financial position of an organization. This ratio shows
the ability to meet its immediate liabilities. It measures the relationship between quick
assets and quick liabilities.
Quick / Liquid Ratio = Quick Assets
• Quick Assets = Current Assets – Stock – Prepaid Expenses –
• Quick Liabilities = Current Liabilities – Bank Overdraft
Meaning of quick assets and quick liabilities
The quick assets include cash, debtors (excluding bad debts) and securities, which
can be realized without difficulty. Stock is not included in quick assets for the purpose of
this ratio. Similarly prepaid expenses are also
Excluded, as they cannot be converted into cash. Liquid or quick liabilities refer to all
current liabilities except bank overdraft.
Significance and objective.
Quick ratio is a more rigorous test of liquidity of a firm than the current ratio.
When quick ratio is used along with current ratio, it gives a better picture of the firm’s
ability to meet its short-term liabilities out of its short-term assets. This ratio is of great
importance for banks and financial institutions. Generally a quick ratio of 1:1 is
considered to represent a satisfactory current financial position.
Purpose: The purpose of liquid ratio is to measure the immediate solvency of the
business and indicate the availability of cash to meet its immediate liabilities.
3) Proprietary Ratio-
Proprietary Ratio is a test of the financial and credit strength of the business. It is related
with shareholders funds and total assets. This ratio determines the long term or ultimate
solvency of the business. It is also called “Net Worth to Total Assets Ratio” or “Equity
Ratio” or “Assets Backing Ratio” or “Net Worth Ratio"
Shareholders funds comprise of ordinary share capital, preference share capital and all
items of reserves and surplus. Total assets include all tangible assets and only those
intangible assets which have a definite realizable value.
Proprietary Ratio = Proprietors Funds
Proprietors Fund = Equity Share Capital + Pref. Capital + Capital Reserve +
Rev. Res. – Fictitious Assets
Total Assets = All Fixed Assets + All Current Assets + Investments.
PROPRIETARY RATIO = Proprietors’ Funds
Total Funds = Owned Funds + borrowed Funds
Significance and Objectives
Proprietary ratio shows the extent to which shareholders own the
business and thus indicates the general financial strength of the business. The higher
the proprietary ratio, the greater the long term stability of the company and
consequently greater protection to creditors. However, a very high proprietary ratio
may not necessarily be good because if funds of outsiders are not used for long term
financing, a firm may not be able to take advantage of trading equity.
4) Stock- Working Capital Ratio-
Stock Working Capital Ratio brings out the relationship between stock and working
capital. It is also known as “Inventory Net Current Assets Ratio”.
Stock Working Capital Ratio = Stock
This ratio is calculated in percentage form. The standard ratio is “Less than 100%”.
The purpose of this ratio is to show the extend to which working capital is blocked in
• Working Capital = Current Assets – Current Liabilities
5) Capital Gearing Ratio-
Capital Gearing Ratio brings out the relationship between two types of capital, which
are capital carry fixed rate of interest, & capital that does not carry fixed rate of
interest. This ratio is also known as “Leverage Ratio” or “Capital Structure Ratio”.
Capital Gearing Ratio = Capital Carrying Fixed Rate of Interest / Dividend
Capital Not carrying Fixed Rate Of Interest / Dividend
• Capital carrying fixed rate of interest includes preference
share capital + debentures + bank loan + Bonds.
A company is said to low geared when its fixed assets bearing securities are lesser than
equity shareholders funds. Te purpose of this ratio is to see the capital structure of the
6) Debt – Equity Ratio –
It expresses the relationship between long-term debt and total funds. This ratio shows
long-term capital structure.
Debt Equity Ratio = Long Term Debts OR Long Term Debts
Total Funds Eq. Share Funds
Note – Long-term debts include redeemable preference shares also.
• Total Funds = Shareholders’ Funds + long Term Liability
Sometimes this ratio is expressed in percentage form.
(B) OPERATING / REVENUE STATEMENTRATIO/ PROFITABILITY
1) Gross Profit Ratio-
Gross profit ratio brings out the relationship between gross profit and net sales. It is
also know as “Turnover Ratio” or “Gross Margin Ratio” It is expressed as a
percentage of net sales. Gross Profit Ratio indicates the basic profitability of the
Gross Profit Ratio = Gross Profit x 100
1) Gross Profit = Net Sales – Cost of goods sold
2) Net Sales = Gross Sales + Credit Sales
3) Gross Sales = Cash Sales = Credit Sales
4) Cost of Goods Sold = Opening Stock = Purchase = Direct Expenses – Purchases
Returns – Closing Stock.
A low gross profit ratio indicates inefficiency of purchase department, increased
expenses or inability to increase sales. A high gross profit ratio indicates the
efficiency of sales department, purchase department and effective control over
Significance: Gross profit ratio indicates the average margin on the goods sold. It
shows whether the selling prices are adequate or not. It also indicate the extent to
which selling price may be reduced without resulting in losses. A low gross profit
ratio may indicate a higher cost of goods sold due to higher cost of production. It
may also be due to low selling price.
2) Operating Ratio- operating ratio brings out the relationship between total
operating cost and net sales. This is expressed as percentage.
Operating Ratio = Operating cost
Operating Cost = Cost of goods Sold + Office Administrative Expenses + Selling &
Distribution Expenses + Finance Expenses + Amortisation.
The purpose of operating ratio is to ascertain the efficiency of the management with
regard to the business operations.
A low operating ratio shows the better operating efficiency of the business.
A high operating ratio shows the lower profits, which is not favorable for business.
Hence, inefficiency of the management.
3) Expenses Ratio:-
The ratio of each items expense to net sales is known as an "Expenses Ratio" and such
ratio are collectively known as "Expenses Ratios" These are as under-
1) Cost of goods sold ratio= Cost of goods sold
2) Office & Administrative Exp. Ratio= Office & Admn. Exp.
3) Selling & Distribution Exp. Ratio= Selling & Dist. Exp.
4) Finance Expenses Ratio= Finance Expenses
Expenses ratio brings out the relationship between various elements of operating cost
and net sales.
Significance & Objectives- The operating ratio is the yardstick to measure the efficiency
with which a business is operated. It shows the percentage of net sales that is absorbed
by cost of goods sold and operating expenses. A high operating ratio is considered
unfavorable because it leaves a smaller margin of profit to meet non-operating expenses.
On the other hand a lower operating ratio is considered a good sign.
4) Net Profit Ratio: -
Net profit ratio indicates the relationship between net profit and net sales. Net profit
can be either operating net profit or net profit before tax or net profit after tax. This
ratio is also known as "Net margin on sales ratio"
Net Profit Before Tax ratio = Net Profit Before Tax
Net Profit after Tax Ratio= Net profit After Tax
Significance & Objective: The net profit ratio is the overall measure of a firm's
ability turns each rupee of sale into profit. It indicates the efficiency with which a
business is managed. A firm with a high net profit ratio is in as advantageous
position to survive in the face of rising cost of production and falling selling price.
5) Net operating Profit Ratio: Net operating profit ratio is also known as
"Operating profit ratio" This ratio established the relationship between net
operating profit and net sales, which is expressed in percentage.
Net Operating Profit Ratio = Net Operating Profit
6) Stock -Turnover Ratio
Stock turnover ratio is also known as "Inventory Turnover Ratio" or Stock Velocity
Ratio" This ratio Measure the number of times stock rotate or turns or flows in an
Stock-Turnover Ratio = Cost of Goods Sold
The ratio indicates the relationship between inventory and cost of goods sold. It is
expressed in number of times in a year.
Average Stock = Opening Stock + Closing Stock
Significance and Objectives
Inventory or Stock Turnover Ratio indicates the efficiency of a firm’s inventory
management. This ratio gives the rate at which stocks are converted into sales and
then into cash. A low inventory turnover ratio is an indicator of dull business,
accumulation of inventory, over investment in inventory or unsaleable goods etc.
generally speaking, a high stock turnover ratio is considered better as it indicates that
more sales are being produced by each rupee of investment in stock but a higher stock
turnover ratio may not always be an indicator of favorable results. It may be the result
of a very low level of stock which results in frequent out of stock positions. Such a
situations prevents a company from meeting customer’s demands and the company
cannot earn maximum profits.
Thus too high and too low inventory turnover ratio may not be good and should be
investigated further. A company should have a proper inventory turnover ratio so that
it is able to earn a reasonable margin of profit.
Note: If in the problem Opening Stock is not given then closing stock figure is
considered as Average stock.