2. RATIO ANALYSISRATIO ANALYSIS
Ratio analysis is the process of determining andRatio analysis is the process of determining and
interpreting numerical relationship based oninterpreting numerical relationship based on
financial statements. It is the technique offinancial statements. It is the technique of
interpretation of financial statements with the helpinterpretation of financial statements with the help
ofof accountingaccounting ratiosratios derived from the balancederived from the balance
sheet and profit and loss account.sheet and profit and loss account.
3. Basis Of ComparisionBasis Of Comparision
Trend Analysis involves comparison of a firm over a
period of time, that is, present ratios are compared with
past ratios for the same firm. It indicates the direction of
change in the performance – improvement, deterioration
or constancy – over the years.
Interfirm Comparison involves comparing the ratios of a
firm with those of others in the same lines of business or
for the industry as a whole. It reflects the firm’s
performance in relation to its competitors.
Comparison with standards or industry average
4. Ways To Interpret AccountingWays To Interpret Accounting
RatiosRatios
Single absolute ratio.Single absolute ratio.
Group ratio.Group ratio.
Historical comparision.Historical comparision.
Inter-firm comparision.Inter-firm comparision.
Projected ratios.Projected ratios.
5. Classification Of RatiosClassification Of Ratios
Analysis of Short Term Financial PositionAnalysis of Short Term Financial Position
or Test of Liquidity.or Test of Liquidity.
Analysis of Long Term Financial PositionAnalysis of Long Term Financial Position
or Test of Solvency.or Test of Solvency.
Activity Ratios.Activity Ratios.
Profitability Ratios.Profitability Ratios.
6. I. Test Of LiquidityI. Test Of Liquidity
The liquidity ratios are used to test the short termThe liquidity ratios are used to test the short term
solvency or liquidity position of the business.solvency or liquidity position of the business.
It enables to know whether short term liabilities can beIt enables to know whether short term liabilities can be
paid out of short term assets.paid out of short term assets.
It indicates whether a firm has adequate workingIt indicates whether a firm has adequate working
capital to carry out routine business activity.capital to carry out routine business activity.
It is a valuable aid to management in checking theIt is a valuable aid to management in checking the
efficiency with which working capital is beingefficiency with which working capital is being
employed.employed.
It is also of importance to shareholders and long termIt is also of importance to shareholders and long term
creditors in determining to some extent the prospectscreditors in determining to some extent the prospects
of dividend and interest payment.of dividend and interest payment.
7. Important Ratios In Test OfImportant Ratios In Test Of
LiquidityLiquidity
Current ratio.Current ratio.
Quick ratio.Quick ratio.
Absolute liquid ratio.Absolute liquid ratio.
8. Current RatioCurrent Ratio
It is the most widely used of all analytical devices based
on the balance sheet. It establishes relationship between
total current assets and current liabilities.
Current assetsCurrent assets
Current ratio=Current ratio=
Current liabilitiesCurrent liabilities
Ideal ratio:Ideal ratio: 2:12:1
High ratio indicates under trading and overHigh ratio indicates under trading and over
capitalization.capitalization.
Low ratio indicates over trading and under capitalization.Low ratio indicates over trading and under capitalization.
9. Quick Ratio or Acid Test RatioQuick Ratio or Acid Test Ratio
It establishes relationship between liquid assets andIt establishes relationship between liquid assets and
liquid liabilities. It is a refinement to current ratio andliquid liabilities. It is a refinement to current ratio and
second testing device for working capital.second testing device for working capital.
Quick assetsQuick assets
Quick ratio=Quick ratio=
Current liabilitiesCurrent liabilities
Ideal ratioIdeal ratio: 1:1: 1:1
Usually, a high acid test ratio is an indication that theUsually, a high acid test ratio is an indication that the
firm is liquid and has ability to meet its current or liquidfirm is liquid and has ability to meet its current or liquid
liabilities in time and on the other hand a low quick ratioliabilities in time and on the other hand a low quick ratio
represents that the firm’s liquidity position is not good.represents that the firm’s liquidity position is not good.
10. Absolute Liquidity RatioAbsolute Liquidity Ratio
This ratio establishes a relationship between absoluteThis ratio establishes a relationship between absolute
liquid assets to quick liabilities.liquid assets to quick liabilities.
Absolute liquid assetsAbsolute liquid assets
Absolute liquid ratio=Absolute liquid ratio=
Quick liabilitiesQuick liabilities
Ideal ratioIdeal ratio: 1:2: 1:2
It means that if the ratio is 1:2 or more than this theIt means that if the ratio is 1:2 or more than this the
concern can be taken as liquid. If the ratio is less thanconcern can be taken as liquid. If the ratio is less than
the standard of 1:2, it means the concern is not liquid.the standard of 1:2, it means the concern is not liquid.
11. II. Test Of SolvencyII. Test Of Solvency
Long term solvency ratios denote theLong term solvency ratios denote the
ability of the organisation to repay the loanability of the organisation to repay the loan
and interest.and interest.
When an organization's assets are moreWhen an organization's assets are more
than its liabilities is known as solventthan its liabilities is known as solvent
organisation.organisation.
Solvency indicates that position of anSolvency indicates that position of an
enterprise where it is capable of meetingenterprise where it is capable of meeting
long term obligations.long term obligations.
12. Important Ratios In Test OfImportant Ratios In Test Of
SolvencySolvency
Debt-equity ratio.Debt-equity ratio.
Proprietary ratio.Proprietary ratio.
Solvency ratio.Solvency ratio.
Fixed assets to net worth ratio.Fixed assets to net worth ratio.
Current assets to net worth ratio.Current assets to net worth ratio.
Current liabilities to net worth ratio.Current liabilities to net worth ratio.
Capital gearing ratio.Capital gearing ratio.
Fixed assets ratioFixed assets ratio
Debt servicing ratio.Debt servicing ratio.
Dividend coverage ratio.Dividend coverage ratio.
13. Debt Equity RatioDebt Equity Ratio
It Is calculated to measure the relative claims ofIt Is calculated to measure the relative claims of
outsiders and the owners against the firm’s assets. Thisoutsiders and the owners against the firm’s assets. This
ratio indicates the relationship between the outsidersratio indicates the relationship between the outsiders
funds and the shareholders’ funds.funds and the shareholders’ funds.
Outsiders fundsOutsiders funds
Debt equity ratio=Debt equity ratio=
Shareholders fundsShareholders funds
Ideal ratioIdeal ratio: 2:1; It means for every 2 shares there is 1: 2:1; It means for every 2 shares there is 1
debt. If the debt is less than 2 times the equity, it meansdebt. If the debt is less than 2 times the equity, it means
the creditors are relatively less and the financialthe creditors are relatively less and the financial
structure is sound. If the debt is more than 2 times thestructure is sound. If the debt is more than 2 times the
equity, the state of long term creditors are more andequity, the state of long term creditors are more and
indicate weak financial structure.indicate weak financial structure.
14. Proprietary Ratio or Net WorthProprietary Ratio or Net Worth
RatioRatio
It establishes relationship between the proprietors fundIt establishes relationship between the proprietors fund
or shareholders funds and the total assetsor shareholders funds and the total assets
Proprietary funds Capital employedProprietary funds Capital employed
Proprietary ratio= orProprietary ratio= or
Total assets Total liabilitiesTotal assets Total liabilities
Ideal ratioIdeal ratio: 0.5:1: 0.5:1
Higher the ratio better the long term solvency (financial)Higher the ratio better the long term solvency (financial)
position of the company. This ratio indicates the extentposition of the company. This ratio indicates the extent
to which the assets of the company can be lost withoutto which the assets of the company can be lost without
affecting the interest of the creditors of the companyaffecting the interest of the creditors of the company
15. Solvency RatioSolvency Ratio
It expresses the relationship between total assets andIt expresses the relationship between total assets and
total liabilities of a business. This ratio is a small varianttotal liabilities of a business. This ratio is a small variant
of equity ratio and can be simply calculated asof equity ratio and can be simply calculated as
100-equity ratio100-equity ratio
Total assetsTotal assets
Solvency ratio=Solvency ratio=
Total liabilitiesTotal liabilities
No standard ratio is fixed in this regard. It may beNo standard ratio is fixed in this regard. It may be
compared with similar, such organisations to evaluatecompared with similar, such organisations to evaluate
the solvency position. Higher the solvency ratio, thethe solvency position. Higher the solvency ratio, the
stronger is its financial position and vice-versa.stronger is its financial position and vice-versa.
16. Fixed Assets To Net WorthFixed Assets To Net Worth
It is obtained by dividing the depreciated book value ofIt is obtained by dividing the depreciated book value of
fixed assets by the amount of proprietors funds.fixed assets by the amount of proprietors funds.
Net fixed assetsNet fixed assets
Fixed assets to net worth ratio=Fixed assets to net worth ratio=
Net worthNet worth
Ideal ratioIdeal ratio: 0.75:1: 0.75:1
A higher ratio, say, 100% means that there are noA higher ratio, say, 100% means that there are no
outside liabilities and all the funds employed are those ofoutside liabilities and all the funds employed are those of
shareholders. In such a case the return to shareholdersshareholders. In such a case the return to shareholders
would be lower rate of dividend and this is also a sign ofwould be lower rate of dividend and this is also a sign of
over capitalization.over capitalization.
17. Fixed Assets To Net WorthFixed Assets To Net Worth
This ratio shows the extent to which ownershipThis ratio shows the extent to which ownership
funds are sunk into assets with relatively lowfunds are sunk into assets with relatively low
turnover. When the amount of proprietor'sturnover. When the amount of proprietor's
funds exceed the value of fixed assets, apart offunds exceed the value of fixed assets, apart of
the net working capital is provided by thethe net working capital is provided by the
shareholders, provided there are no other non-shareholders, provided there are no other non-
current assets, and when proprietor’s funds arecurrent assets, and when proprietor’s funds are
less than the fixed assets, creditors obligationless than the fixed assets, creditors obligation
have been used to finance a part of fixedhave been used to finance a part of fixed
assets. The Yardstick for this measure is 65%assets. The Yardstick for this measure is 65%
for industrial undertakings.for industrial undertakings.
18. Current Assets To Net Worth RatioCurrent Assets To Net Worth Ratio
It is obtained by dividing the value of current assets byIt is obtained by dividing the value of current assets by
the amount of proprietor’s funds. The purpose of thisthe amount of proprietor’s funds. The purpose of this
ratio is to show the percentage of proprietor’s fundratio is to show the percentage of proprietor’s fund
investment in current assets.investment in current assets.
Current assetsCurrent assets
Current assets to net worth ratio=Current assets to net worth ratio=
Proprietor’s fundProprietor’s fund
A higher proportion of current assets to proprietor’s fund,A higher proportion of current assets to proprietor’s fund,
as compared with the proportion of fixed assets toas compared with the proportion of fixed assets to
proprietor’s funds is advocated, as it is an indicator ofproprietor’s funds is advocated, as it is an indicator of
the financial strength of the business, depending on thethe financial strength of the business, depending on the
nature of the business there may be different ratios fornature of the business there may be different ratios for
different firms. This ratio must be read along with thedifferent firms. This ratio must be read along with the
results of fixed assets to proprietor’s funds ratio.results of fixed assets to proprietor’s funds ratio.
19. Current Liabilities To Net WorthCurrent Liabilities To Net Worth
It is expressed as a proportion and is obtained byIt is expressed as a proportion and is obtained by
dividing current liabilities by proprietor's fund.dividing current liabilities by proprietor's fund.
Current liabilitiesCurrent liabilities
Current liabilities to net worth ratio=Current liabilities to net worth ratio=
Net worthNet worth
Ideal ratioIdeal ratio:1:3:1:3
This ratio indicates the relative contribution of short termThis ratio indicates the relative contribution of short term
creditors and owners to the capital of an enterprise. Ifcreditors and owners to the capital of an enterprise. If
the ratio is high, it means it is difficult to obtain long termthe ratio is high, it means it is difficult to obtain long term
funds by the business.funds by the business.
20. Capital Gearing RatioCapital Gearing Ratio
It expresses the relationship between equity capital andIt expresses the relationship between equity capital and
fixed interest bearing securities and fixed dividendfixed interest bearing securities and fixed dividend
bearing shares.bearing shares.
Fixed interest bearing securities + fixed dividendFixed interest bearing securities + fixed dividend
bearingbearing
sharesshares
CGR=CGR=
Equity shareholders fundsEquity shareholders funds
Components of fixedComponents of fixed
interest bearing securitiesinterest bearing securities
Components of equityComponents of equity
shareholders fundsshareholders funds
DebenturesDebentures
Long-term loansLong-term loans
Long-term fixed depositsLong-term fixed deposits
Equity share capitalEquity share capital
Accumulated reserves &Accumulated reserves &
profitsprofits
Less losses and fictitiousLess losses and fictitious
assetsassets
21. Interpretation Of Capital GearingInterpretation Of Capital Gearing
RatioRatio
When fixed interest bearing securities and fixedWhen fixed interest bearing securities and fixed
dividend bearing shares are higher than equitydividend bearing shares are higher than equity
shareholders funds, the company is said to be ‘highlyshareholders funds, the company is said to be ‘highly
geared’.geared’.
Where the fixed interest hearing securities and fixedWhere the fixed interest hearing securities and fixed
dividend bearing shares share equal to equity sharedividend bearing shares share equal to equity share
capital it is said to be ‘evenly geared’.capital it is said to be ‘evenly geared’.
When the fixed interest bearing securities and fixedWhen the fixed interest bearing securities and fixed
dividend bearing shares are lower than equity sharedividend bearing shares are lower than equity share
capital it is said to be ‘low geared’.capital it is said to be ‘low geared’.
If capital gearing is high, further raising of long termIf capital gearing is high, further raising of long term
loans may be difficult and issue of equity shares mayloans may be difficult and issue of equity shares may
be attractive and vice-versabe attractive and vice-versa
22. Fixed Assets RatioFixed Assets Ratio
It establishes the relationship between fixed assets andIt establishes the relationship between fixed assets and
capital employedcapital employed
Fixed assetsFixed assets
Fixed assets ratio=Fixed assets ratio=
Capital employedCapital employed
Ideal ratioIdeal ratio: 0.67:1: 0.67:1
This ratio enables to know how fixed assets are financedThis ratio enables to know how fixed assets are financed
i.e. by use of short term funds or by long term funds.i.e. by use of short term funds or by long term funds.
This ratio should not be more than 1.This ratio should not be more than 1.
23. Fixed Charges cover or DebtFixed Charges cover or Debt
Service RatioService Ratio
This ratio is determined by dividing net profit by fixedThis ratio is determined by dividing net profit by fixed
interest charges.interest charges.
Net profit before deduction of interestNet profit before deduction of interest
and income taxand income tax
Debt service ratio=Debt service ratio=
Fixed interest chargesFixed interest charges
Ideal ratioIdeal ratio: 6 or 7 times; if the ratio is high it means: 6 or 7 times; if the ratio is high it means
there is higher margin of safety for the long term lendersthere is higher margin of safety for the long term lenders
and as such it is not difficult for the business to obtainand as such it is not difficult for the business to obtain
further long term funds and vice-versa.further long term funds and vice-versa.
This ratio indicates the financial ability of the enterpriseThis ratio indicates the financial ability of the enterprise
to meet interest payment out of current earningsto meet interest payment out of current earnings
24. Dividend Cover RatioDividend Cover Ratio
It is the ratio between disposable profit and dividend.It is the ratio between disposable profit and dividend.
Disposable profit refers to profit left over after payingDisposable profit refers to profit left over after paying
interest on long term borrowing and income tax.interest on long term borrowing and income tax.
Net profit after interest and taxNet profit after interest and tax
Dividend cover ratio=Dividend cover ratio=
Dividend declaredDividend declared
This ratio indicates the ability of the business to maintainThis ratio indicates the ability of the business to maintain
the dividend on shares in future. If this ratio is higher isthe dividend on shares in future. If this ratio is higher is
indicates that there is sufficient amount of retained profit.indicates that there is sufficient amount of retained profit.
Even if there is slight decrease in profit in the future itEven if there is slight decrease in profit in the future it
will not affect payment of dividend in futurewill not affect payment of dividend in future
25. III. Activity RatioIII. Activity Ratio
Activity ratios indicate the performance of anActivity ratios indicate the performance of an
organisation.organisation.
This indicate the effective utilization of theThis indicate the effective utilization of the
various assets of the organisation.various assets of the organisation.
Most of the ratio falling under this category isMost of the ratio falling under this category is
based on turnover and hence these ratios arebased on turnover and hence these ratios are
called as turnover ratios.called as turnover ratios.
26. Important Ratios In Activity RatioImportant Ratios In Activity Ratio
Stock turnover ratio.Stock turnover ratio.
Debtors turnover ratio.Debtors turnover ratio.
Creditors turnover ratio.Creditors turnover ratio.
Wording capital turnover ratio.Wording capital turnover ratio.
Fixed assets turnover ratio.Fixed assets turnover ratio.
Current assets turnover ratio.Current assets turnover ratio.
Total assets turnover ratio.Total assets turnover ratio.
Sales to networth ratio.Sales to networth ratio.
27. Stock Turnover RatioStock Turnover Ratio
This ratio establishes the relationship between the costThis ratio establishes the relationship between the cost
of goods sold during a given period and the averageof goods sold during a given period and the average
sock holding during that period. It tells us as to howsock holding during that period. It tells us as to how
many times stock has turned over (sold) during themany times stock has turned over (sold) during the
period. Indicates operational and marketing efficiency.period. Indicates operational and marketing efficiency.
Helps in evaluating inventory policy to avoid overHelps in evaluating inventory policy to avoid over
stocking.stocking.
Cost of goods soldCost of goods sold
Inventory turnover ratio=Inventory turnover ratio=
Average stockAverage stock
Cost of goods sold= sales-gross profitCost of goods sold= sales-gross profit
= opening stock + purchases –= opening stock + purchases –
closingclosing
stockstock
Opening stock + Closing stockOpening stock + Closing stock
Average stock=Average stock=
28. Interpretation Of Stock TurnoverInterpretation Of Stock Turnover
RatioRatio
Ideal ratioIdeal ratio: 8 times; A low inventory turnover may: 8 times; A low inventory turnover may
reflect dull business, over investment in inventory,reflect dull business, over investment in inventory,
accumulation of stock and excessive quantities ofaccumulation of stock and excessive quantities of
certain inventory items in relation to immediatecertain inventory items in relation to immediate
requirements.requirements.
A high ratio may not be accompanied by a relativelyA high ratio may not be accompanied by a relatively
high net income as, profits may be sacrificed inhigh net income as, profits may be sacrificed in
obtaining a large sales volume (unless accompaniedobtaining a large sales volume (unless accompanied
by a larger total gross profit). It may indicate underby a larger total gross profit). It may indicate under
investment in inventories. But generally, a high stockinvestment in inventories. But generally, a high stock
turnover ratio means that the concern is efficient andturnover ratio means that the concern is efficient and
hence it sells its goods quickly.hence it sells its goods quickly.
29. Debtor Turnover RatioDebtor Turnover Ratio
This ratio explains the relationship of net credit sales ofThis ratio explains the relationship of net credit sales of
a firm to its book debts indicating the rate at which casha firm to its book debts indicating the rate at which cash
is generated by turnover of receivables or debtors.is generated by turnover of receivables or debtors.
The purpose of this ratio is to measure the liquidity of theThe purpose of this ratio is to measure the liquidity of the
receivables or to find out the period over whichreceivables or to find out the period over which
receivables remain uncollected.receivables remain uncollected.
Net credit salesNet credit sales
Debtor turnover ratio=Debtor turnover ratio=
Average DebtorsAverage Debtors
Opening balance + closing balanceOpening balance + closing balance
Average debtors=Average debtors=
22
Debtors include bills receivables along with book debtsDebtors include bills receivables along with book debts
30. Average Collection PeriodAverage Collection Period
Number of working day in yearNumber of working day in year
Average collection period=Average collection period=
Debtor turnover ratioDebtor turnover ratio
The average collection period represents the averageThe average collection period represents the average
number of days for which a firm has to wait before itsnumber of days for which a firm has to wait before its
receivables are converted into cashreceivables are converted into cash
31. Interpretation Of Debtor TurnoverInterpretation Of Debtor Turnover
RatioRatio
Ideal ratioIdeal ratio: 10 to 12 times; debt collection: 10 to 12 times; debt collection
period of 30 to 36 days is considered ideal.period of 30 to 36 days is considered ideal.
A high debtor turnover ratio or low collectionA high debtor turnover ratio or low collection
period is indicative of sound managementperiod is indicative of sound management
policy.policy.
The amount of trade debtors at the end ofThe amount of trade debtors at the end of
period should not exceed a reasonableperiod should not exceed a reasonable
proportion of net sales. Larger the tradeproportion of net sales. Larger the trade
debtors greater the expenses of collection.debtors greater the expenses of collection.
32. Creditors Turnover RatioCreditors Turnover Ratio
This ratio indicates the number of times the creditors areThis ratio indicates the number of times the creditors are
paid in a year. It is useful for creditors in finding out howpaid in a year. It is useful for creditors in finding out how
much time the firm is likely to take in repaying its trademuch time the firm is likely to take in repaying its trade
creditors.creditors.
Net credit purchasesNet credit purchases
Creditors turnover ratio=Creditors turnover ratio=
Average creditorsAverage creditors
Opening balance + closing balanceOpening balance + closing balance
Average creditors=Average creditors=
22
Number of working daysNumber of working days
Average payment period=Average payment period=
Creditors turnover ratioCreditors turnover ratio
33. Interpretation Of Creditor TurnoverInterpretation Of Creditor Turnover
RatioRatio
Ideal ratioIdeal ratio: 12 times; debt payment period of: 12 times; debt payment period of
30 days is considered ideal.30 days is considered ideal.
Very less creditors turnover ratio, or a high debtVery less creditors turnover ratio, or a high debt
payment period may indicate the firms inabilitypayment period may indicate the firms inability
in meeting its obligation in time.in meeting its obligation in time.
34. Working Capital Turnover RatioWorking Capital Turnover Ratio
This ratio indicates the number of times the workingThis ratio indicates the number of times the working
capital is turned over in the course of the year.capital is turned over in the course of the year.
Measures efficiency in working capital usage. ItMeasures efficiency in working capital usage. It
establishes relationship between cost of sales andestablishes relationship between cost of sales and
working capitalworking capital
Cost of salesCost of sales
Working capital turnover ratio=Working capital turnover ratio=
Average working capitalAverage working capital
Opening + closing workingOpening + closing working
capitalcapital
Average working capital=Average working capital=
22
35. Interpretation of Working CapitalInterpretation of Working Capital
Turnover RatioTurnover Ratio
A higher ratio indicates efficient utilizationA higher ratio indicates efficient utilization
of working capital and a low ratio indicatesof working capital and a low ratio indicates
inefficient utilization of working capital.inefficient utilization of working capital.
But a very high ratio is not a good situationBut a very high ratio is not a good situation
for any firm and hence care must be takenfor any firm and hence care must be taken
while interpreting the ratio.while interpreting the ratio.
36. Fixed Assets Turnover RatioFixed Assets Turnover Ratio
This ratio establishes a relationship between fixedThis ratio establishes a relationship between fixed
assets and sales.assets and sales.
Net salesNet sales
Fixed assets turnover ratio=Fixed assets turnover ratio=
Fixed assetsFixed assets
Ideal ratioIdeal ratio: 5 times: 5 times
A high ratio indicates better utilisation of fixed assets.A high ratio indicates better utilisation of fixed assets.
A low ratio indicates under utilisation of fixed assets.A low ratio indicates under utilisation of fixed assets.
37. Total Asset Turnover RatioTotal Asset Turnover Ratio
This ratio establishes a relationship between total assetsThis ratio establishes a relationship between total assets
and sales. This ratio enables to know the efficientand sales. This ratio enables to know the efficient
utilisation of total assets of a business.utilisation of total assets of a business.
Net salesNet sales
Total assets turnover ratio=Total assets turnover ratio=
Total assetsTotal assets
Ideal ratioIdeal ratio: 2 times: 2 times
High ratio indicates efficient utilization and ratio less thanHigh ratio indicates efficient utilization and ratio less than
2 indicates under utilization.2 indicates under utilization.
38. IV. Profitability RatioIV. Profitability Ratio
Profitability ratios indicate the profit earningProfitability ratios indicate the profit earning
capacity of a business.capacity of a business.
Profitability ratios are calculated either inProfitability ratios are calculated either in
relation to sales or in relation to investments.relation to sales or in relation to investments.
Profitability ratios can be classified into twoProfitability ratios can be classified into two
categories.categories.
a) General Profitability Ratios.a) General Profitability Ratios.
b) Overall Profitability Ratios.b) Overall Profitability Ratios.
40. Gross Profit RatioGross Profit Ratio
It expresses the relationship of gross profit to net salesIt expresses the relationship of gross profit to net sales
and is expressed in terms of percentage. This ratio is aand is expressed in terms of percentage. This ratio is a
tool that indicates the degree to which selling price oftool that indicates the degree to which selling price of
goods per unit may decline without resulting in losses.goods per unit may decline without resulting in losses.
Gross profitGross profit
Gross profit ratio= X 100Gross profit ratio= X 100
Net salesNet sales
A low gross profit ratio may indicate unfavorableA low gross profit ratio may indicate unfavorable
purchasing, the instability of management to developpurchasing, the instability of management to develop
sales volume thereby making it impossible to buy goodssales volume thereby making it impossible to buy goods
in large volume.in large volume.
Higher the gross profit ratio better the results.Higher the gross profit ratio better the results.
41. Net Profit RatioNet Profit Ratio
It expresses the relationship between net profit afterIt expresses the relationship between net profit after
taxes to sales. Measure of overall profitability useful totaxes to sales. Measure of overall profitability useful to
proprietors, as it gibes an idea of the efficiency as wellproprietors, as it gibes an idea of the efficiency as well
as profitability of the business to a limited extent.as profitability of the business to a limited extent.
Net profit after taxesNet profit after taxes
Net profit ratio= X 100Net profit ratio= X 100
Net salesNet sales
Higher the ratio better is the profitabilityHigher the ratio better is the profitability
42. Operating RatioOperating Ratio
This ratio establishes a relationship between cost ofThis ratio establishes a relationship between cost of
goods sold plus other operating expenses and net sales.goods sold plus other operating expenses and net sales.
This ratio is calculated mainly to ascertain theThis ratio is calculated mainly to ascertain the
operational efficiency of the management in theiroperational efficiency of the management in their
business operations.business operations.
Cost of goods sold + operating expensesCost of goods sold + operating expenses
Operating ratio=Operating ratio=
Net salesNet sales
Higher the ratio the less favorable it is because it wouldHigher the ratio the less favorable it is because it would
leave a smaller margin to meet interest, dividend andleave a smaller margin to meet interest, dividend and
other corporate needs. For a manufacturing concern it isother corporate needs. For a manufacturing concern it is
expected to touch a percentage of 75% to 85%. Thisexpected to touch a percentage of 75% to 85%. This
ratio is partial index of over all profitability.ratio is partial index of over all profitability.
43. Operating Profit RatioOperating Profit Ratio
This ratio establishes the relationship betweenThis ratio establishes the relationship between
operation profit and net sales.operation profit and net sales.
Operating profitOperating profit
Operating profit ratio= X 100Operating profit ratio= X 100
Net salesNet sales
Operating profit ratio= 100-operating ratioOperating profit ratio= 100-operating ratio
Operating profit= Net sales – ( cost of goods sold +Operating profit= Net sales – ( cost of goods sold +
Administrative and office expenses + selling andAdministrative and office expenses + selling and
distributive expenses.distributive expenses.
44. Expenses RatioExpenses Ratio
It establishes relationship between individual operationIt establishes relationship between individual operation
expenses and net sales revenue.expenses and net sales revenue.
Cost of goods soldCost of goods sold
1. Cost of goods sold ratio= X 1001. Cost of goods sold ratio= X 100
Net salesNet sales
Office and admin expOffice and admin exp
2. Admin. and office exp ratio= X1002. Admin. and office exp ratio= X100
Net salesNet sales
Selling and dist. expSelling and dist. exp
3. Selling and distribution ratio= X 1003. Selling and distribution ratio= X 100
Net salesNet sales
Non operating expenseNon operating expense
4. Non-operating expense ratio= X 1004. Non-operating expense ratio= X 100
Net salesNet sales
45. Test Of Overall ProfitabilityTest Of Overall Profitability
Return on shareholders investment or NetReturn on shareholders investment or Net
worth ratio.worth ratio.
Return on equity capital.Return on equity capital.
Return on capital employed.Return on capital employed.
Return on total resources.Return on total resources.
Dividend yield ratio.Dividend yield ratio.
Preference dividend cover ratio.Preference dividend cover ratio.
Equity dividend cover ratio.Equity dividend cover ratio.
Price covering ratio.Price covering ratio.
Dividend pay out ratio.Dividend pay out ratio.
Earning per share.Earning per share.
46. Return On ShareholdersReturn On Shareholders
InvestmentInvestment
Shareholders investment also called return onShareholders investment also called return on
proprietor’s funds is the ratio of net profit to proprietor’sproprietor’s funds is the ratio of net profit to proprietor’s
funds. It is calculated by the prospective investor in thefunds. It is calculated by the prospective investor in the
business to find out whether the investment would bebusiness to find out whether the investment would be
worth-making in terms of return as compared to the riskworth-making in terms of return as compared to the risk
involved in the business.involved in the business.
Net profit (After tax and int)Net profit (After tax and int)
Return on shareholders investment=Return on shareholders investment=
Proprietors fundsProprietors funds
47. Return On ShareholdersReturn On Shareholders
InvestmentInvestment
This ratio is of great importance to the present andThis ratio is of great importance to the present and
prospective shareholders as well as the management ofprospective shareholders as well as the management of
the company. As this ratio reveals how well thethe company. As this ratio reveals how well the
resources of a firm are being used, higher the ratio,resources of a firm are being used, higher the ratio,
better are the results. The return on shareholdersbetter are the results. The return on shareholders
investment should be compared with the return of otherinvestment should be compared with the return of other
similar firms in the same industry. The inter firmsimilar firms in the same industry. The inter firm
comparision of this ratio determines whether theircomparision of this ratio determines whether their
investments in the firm are attractive or not as theinvestments in the firm are attractive or not as the
investors would like to invest only where their return isinvestors would like to invest only where their return is
higher. Similarly, trend ratios can also be calculated forhigher. Similarly, trend ratios can also be calculated for
a number of years to get5 an idea of the prosperity,a number of years to get5 an idea of the prosperity,
growth of deterioration in the company’s profitability andgrowth of deterioration in the company’s profitability and
efficiency.efficiency.
48. Return On Equity CapitalReturn On Equity Capital
This ratio establishes the relationship between net profitThis ratio establishes the relationship between net profit
available to equity shareholders ad the amount of capitalavailable to equity shareholders ad the amount of capital
invested by them. It is used to compare the performanceinvested by them. It is used to compare the performance
of company's equity capital with those of otherof company's equity capital with those of other
companies, and thus help the investor in choosing acompanies, and thus help the investor in choosing a
company with higher return on equity capital.company with higher return on equity capital.
Net profit – preference dividendNet profit – preference dividend
Return on equity capital=Return on equity capital=
Equity share capital (paid up)Equity share capital (paid up)
49. Return On Capital EmployedReturn On Capital Employed
This ratio is the most appropriate indicator of the earningThis ratio is the most appropriate indicator of the earning
power of the capital employed in the business. It alsopower of the capital employed in the business. It also
acts as a pointer to the management showing theacts as a pointer to the management showing the
progress or deterioration in the earning capacity andprogress or deterioration in the earning capacity and
efficiency of the business.efficiency of the business.
Net profit before taxes andNet profit before taxes and
interest on long – term loans and debenturesinterest on long – term loans and debentures
Return on capital employed=Return on capital employed=
Capital employedCapital employed
Ideal ratioIdeal ratio: 15%: 15%
If the actual ratio is equal ratio is equal to or above 15%If the actual ratio is equal ratio is equal to or above 15%
It indicates higher productivity of the capital employedIt indicates higher productivity of the capital employed
and vice versaand vice versa
50. Return of total resourcesReturn of total resources
This ratio acts as an yardstick to assess the efficiency ofThis ratio acts as an yardstick to assess the efficiency of
the efficiency of the operations of the business as itthe efficiency of the operations of the business as it
indicates the extent to which assets employed in theindicates the extent to which assets employed in the
business are utilised to results in net profitbusiness are utilised to results in net profit
Net profitNet profit
Return on total recourses = X 100Return on total recourses = X 100
Total assetsTotal assets
51. Dividend Yield RatioDividend Yield Ratio
It refers to the percentage or ratio of dividend paid perIt refers to the percentage or ratio of dividend paid per
share to the market price per share. This ratio throwsshare to the market price per share. This ratio throws
light on the effective rate of return on investment, whichlight on the effective rate of return on investment, which
potential investors may hope to earn.potential investors may hope to earn.
Dividend paid per equity shareDividend paid per equity share
Dividend yield ratio =Dividend yield ratio =
Market price per equity shareMarket price per equity share
52. Preference Dividend CoverPreference Dividend Cover
It indicates how many times the preference dividend isIt indicates how many times the preference dividend is
covered by profits after tax. This ratio measures thecovered by profits after tax. This ratio measures the
margin o safety for preference shareholders. Suchmargin o safety for preference shareholders. Such
investors normally expect their dividend to be coveredinvestors normally expect their dividend to be covered
about 3 times by profits available for dividend purpose.about 3 times by profits available for dividend purpose.
Profit after taxProfit after tax
Preference dividend cover =Preference dividend cover =
Annual programme dividendAnnual programme dividend
53. Equity Dividend CoverEquity Dividend Cover
This ratio indicates the number of times the dividend isThis ratio indicates the number of times the dividend is
covered by the amount of profit available for equitycovered by the amount of profit available for equity
shareholders.shareholders.
Net profit after tax - pref dividendNet profit after tax - pref dividend
Equity dividend cover =Equity dividend cover =
Dividend paid on equity capitalDividend paid on equity capital
Earning per equity shareEarning per equity share
==
Dividend per equity shareDividend per equity share
Ideal ratioIdeal ratio: 2 times; i.e. for every Rs. 100 profits: 2 times; i.e. for every Rs. 100 profits
available for dividend, Rs. 50 is retained in the businessavailable for dividend, Rs. 50 is retained in the business
and Rs. 50 is distributed. Higher the ratio higher isand Rs. 50 is distributed. Higher the ratio higher is
extent of retained earnings and higher is the degree ofextent of retained earnings and higher is the degree of
certainty that dividend will be repeated in futurecertainty that dividend will be repeated in future
54. Price Earning RatioPrice Earning Ratio
It shows how many times the annual earnings theIt shows how many times the annual earnings the
present shareholders are willing to pay to get a share.present shareholders are willing to pay to get a share.
This ratio helps investors to know the effect of earningsThis ratio helps investors to know the effect of earnings
per share on the market price of the share. This ratioper share on the market price of the share. This ratio
when calculated for several years can be used as termwhen calculated for several years can be used as term
analysis for predicting future price earning ratios andanalysis for predicting future price earning ratios and
therefore, future stock prices.therefore, future stock prices.
Average market price per shareAverage market price per share
Price earning ratio=Price earning ratio=
Earning per shareEarning per share
55. Dividend Pay Out RatioDividend Pay Out Ratio
This ratio indicates the proportion of earnings availableThis ratio indicates the proportion of earnings available
which equity share holders actually receive in the form ofwhich equity share holders actually receive in the form of
dividend.dividend.
Dividend paid per shareDividend paid per share
Pay out ratio =Pay out ratio =
Earning per shareEarning per share
An investor primarily interested should invest in equityAn investor primarily interested should invest in equity
share of a company with high pay out ratio. A companyshare of a company with high pay out ratio. A company
having low pay out ratio need not necessarily be a badhaving low pay out ratio need not necessarily be a bad
company. A company having income may like to financecompany. A company having income may like to finance
expansion out of the income, thus low pay out ratio.expansion out of the income, thus low pay out ratio.
investor interested in stock price appreciation may wellinvestor interested in stock price appreciation may well
invest in such a company though the pay out ratio is low.invest in such a company though the pay out ratio is low.
56. Earning Per ShareEarning Per Share
This ratio indicates the earning per equity share. ItThis ratio indicates the earning per equity share. It
establishes the relationship between net profit availableestablishes the relationship between net profit available
for equity shareholders and the number of equity shares.for equity shareholders and the number of equity shares.
Net profit available for equity share holdersNet profit available for equity share holders
Earning per share =Earning per share =
Number of equity sharesNumber of equity shares
Editor's Notes
Quick assets = Current asset-(inventories + prepaid expenses)
Quick Liabilities = Current liabilities – Bank overdraft
Absolute liquid assets include cash in hand, cash at bank, marketable securities, temporary investments.
Components of Debt Equity Ratio
outsiders funds include all debts/liabilities to outsiders, whether long term or short term or whether in the form of debentures, bonds, mortgages or bills.
shareholders funds consists of equity share capital, preference share capital, capital reserves, revenue reserves and reserves representing accumulated profits and surpluses like reserve for contingencies sinking funds. The accumulated losses and deferred expenses, if any should be deducted from the total to find out shareholders’ funds, it is called net worth and the ratio may be termed as debt to net worth ratio.
Components Of Proprietary Ratio:
Shareholders funds or Proprietary funds are equity share capital, preference share capital, undistributed profits, reserves and surpluses. Out of this amount accumulated losses should be deducted.
Total assets on other hand denote total resources of the concern.
Components of capital employed: 1.Owners funds, 2.Long-term loans, 3.Long-term deposits, 4.debentures.
When information about opening and closing balances of trade debtors are not available then the debtor turnover ratio can be calculated by dividing the total sales by the balances of debtors
Debtor turnover ratio = total sales/debtors
If information about credit purchases is not available, total purchases may be taken, if opening and closing balances of creditors are not given the balances of creditors may be taken.
Trade creditors include sundry creditors and bills payable.
If cost of sales is not given, then sales can be used. If opening working capital is not disclosed then working capital at the year end will be used.
Working capital turnover ratio= cost of sales (sales)/net working capital.
Generally non operating incomes and expenses are excluded from the net profits for calculating this ratio
Proprietors net capital employed = fixed assets + current assets – outside liabilities (both long and short term)
Significance of the ratio:
It is a prime test of the efficiency of business. It measures not only the overall efficiency of business but also helps in evaluating the performance of various departments.
The owners are interested in knowing the profitability of the business in relation to amounts invested in it. A higher percentage of return on capital employed will satisfy the owners that their money is profitably utilized.
