2. Meaning of ratio analysis
• Ratio analysis is a powerful technique of financial
analysis. It refers to the relationship expressed in
arithmetical terms between inter-related figures.
• According to J.Balty, “ The term ‘accounting
ratios’ is used to describe significant relation ship
between figures shown on a balance sheet, in a
profit & loss account , in a budgetary control
system or in any other part of the accounting
organisation.”
3. Ratio can be expressed in three ways
1. PROPORTION:- In this , figures of the two
items a used for computing the ratio are
expressed in common denominator. For
example, the current assets of the business is
Rs. 3,00,000/- and the current liabilities of
the business is Rs.100000/- the ratio of
current assets to current liabilities is
Rs.300000:Rs.100000 or simply 3:1 .
4. Cont.
2. Rate or Times: In this , ratio is expressed in
the form of rate or times which is obtained by
dividing one item by another. For Instance, in
the above example, the current ratio can be
expressed as follows:
= Rs. 300000/Rs. 100000 i.e., current assets are
3 times of current liabilities.
3. PERCENTAGE:- 300000/100000*100=300%
5. Classification Of Ratios
• Ratio can be classified in to different group
depending upon the basis of classification as
discussed below:
A. Traditional classification: the traditional
classification of ratios is done on the basis of
financial statements. on this basis the ratio could
be classified as:
(a) Profit and loss account Ratios :The ratio are
calculating on the basis of profit and loss account
e.g., Gross profit ratio, operating profit ratio, net
profit ratio, stock turn over ratio, etc.
6. Cont.
(b) Inter- statement Ratios: These are the ratios which are based on
the figures in both profit and loss account and balance sheet e.g.
return on investment ratio, return on proprietor's Fund ratio
,earning per share etc.
(B) Functional or purpose- wise classification: The analysis of financial
statements is done with specific purpose. An analyst can compute a
number of ratios on the basis of financial statements , but a clear
understanding of the purpose helps in better analysis and
interpretation of financial statements with the help of ratio analysis.
Each ratio serves specific purpose. Functional or purpose wise
classification of accounting ratios is therefore most popular and
useful basis of classification. On the basis of the purpose, the
accounting ratios can be categorized into following four categories:
7. Cont.
1. Liquidity Ratio
2. Activity Ratios/Turnover Ratios
3. Financial and leverage Ratios
4. Profitability Ratios
8. Liquidity Measurement Ratios
• The first ratios we'll take a look at in this tutorial are the
liquidity ratios. Liquidity ratios attempt to measure a
company's ability to pay off its short-term debt obligations.
This is done by comparing a company's most liquid assets
(or, those that can be easily converted to cash), to its short-
term liabilities. In general, the greater the coverage of
liquid assets to short-term liabilities the better as it is a
clear signal that a company can pay its debts that are
coming due in the near future and still fund its ongoing
operations. On the other hand, a company with a low
coverage rate should raise a red flag for investors as it may
be a sign that the company will have difficulty meeting
running its operations, as well as meeting its obligations.
9. (a)Current Ratio
The current ratio is a popular financial ratio used to test a
company's liquidity (also referred to as its current or
working capital position) by deriving the proportion of
current assets available to cover current liabilities. The
concept behind this ratio is to ascertain whether a
company's short-term assets (cash, cash equivalents,
marketable securities, receivables and inventory) are
readily available to pay off its short-term liabilities
(notes payable, current portion of term debt, payables,
accrued expenses and taxes). In theory, the higher the
current ratio, the better.
11. Quick Ratio or Acid Test Ratio
• The quick ratio - aka the quick assets ratio or the
acid-test ratio - is a liquidity indicator that further
refines the current ratio by measuring the
amount of the most liquid current assets there
are to cover current liabilities. The quick ratio is
more conservative than the current ratio because
it excludes inventory and other current assets,
which are more difficult to turn into cash.
Therefore, a higher ratio means a more liquid
current position.
12. Formula
Quick assets
• Quick Ratio = Quick liabilities
• Quick assets = current assets – stock - prepaid
expense
• Quick liabilities = Current Liabilities – Bank
overdraft
13. Absolute Liquidity Ratio
• Absolute liquidity Ratio = cash + Bank +Marketable securities
Quick Liabilities
14. Activity or Turnover Ratio
Activity ratios are also called turnover ratios or
assets utilisation ratio or efficiency ratios. It is
concerned with measuring the efficiency ratios
with which asset is managed. It is measure of
movement and reflects how frequently an asset
has moved or turned over during the period. It
refers to the speed and rapidity with which assets
are converted into sales. The greater is the rate of
turnover or conversion, the more efficient is the
utilization or management of the asset.
15. Some important activity ratio
1. Stock (inventory) turnover ratios
2. Debtors turnover ratios
3. Creditors turnover ratios
4. Other turnover ratios
16. Stock(inventory) Turnover Ratio
• It is also called ‘stock-velocity ratio’ and
establishes the relationship between the cost
of goods sold during a given period and
average inventory held during the year by the
firm. It is calculated as follows:-
• Stock turnover ratio=Cost of goods sold/Average inventory
where, Average inventory = opening stock + closing stock
• 2
• Cost of goods sold = Purchases + opening stock – closing stock
• OR
• = Net sales – Gross Profit
17. Debtors Turnover Ratio
• It is also known as the ‘Receivable Turnover
Ratio’ or ‘Receivables velocity Ratio’. It
establishes the relation ship between net
credit sales of the year and the average
debtors. It indicates how well receivables are
turning in to cash. It refers to the speed with
which receivables are converted in to cash ,
thus important for analyzing the liquidity
position of the firm.
18. This ratio may be calculated using the
following formula:
• Debtors Turnover ratio = Net credit sales during the
year/Average accounts receivable
• The term receivables here includes both the trade debtors and bills
receivable.
• Average Accounts Receivable =
opening (Debtors + Bills Receivable) + closing (Debtors + B/R)
2
In case information about credit sales and average debtors is not
available, this ratio may be calculated on the basis of total sales and
closing balance of receivables.
Debtors’ Turnover Ratio = Total sales / Accounts Receivable (closing)
19. References
• ACCOUNTING FOR MANAGERS Dr. Sakshi
Vasudeva Galgotia publishing company
(Theory & Practice).Chapter no. 16 Ratio
Analysis . Page no. 447.
