Ratio analysis

Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV
1 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM
Ratio Analysis
Ratio: Relationship between two numbers.
Accounting of Ratio: Relationship between accounting figure.
Ratio Analysis: It is a process of computing and presenting
the relationship between the items in the financial
statements.
Ratio analysis is the important tool of financial analysis
because it helps to the study the financial performance and
position of the firm.
Why ratios are used?
Ratio speaks about a business
 Is profitable?
 Is assign its assets efficiency?
 Has a gearing problem?
 Can the employee be paid higher wages?
 Is a target/investor?
List of Users
1. Investors 5. Employees
2. Managers 6. Customers
3. Government 7. Other agencies
4. Suppliers & trade creditors.
 Has a business made a good profit compared to the
turnover? profitability

 Does a business have enough money to pay its bill?
Liquidity
 Have a business made a enough profit as compared to
assts and capital employed? Return ratio
 How has a company used its fixed and current assets?
Turnover, activity & uses
Forms of Ratio Analysis
 Pure Ratio - Relationship between current assets &
current liabilities.
 Percentage - Profit & Sales
 Rates – number of items
Classification of Ratio
1. Based on financial statement
2. Based on function
3. Based on users
1. Based on Financial Statement
 Based on Balance Sheet
Liquidity ratio, quick ratio, proprietary ratio, debt equity
ratio, working capital, capital gearing ratio.
 Based on Revenue Statement
Gross profit ratio, net profit ratio, operating ratio, stock
turnover, Net-operating profit ratio.

 Based on composite Ratio
Return on capital employed, return on equity capital,
debtor turnover ratio, creditor turnover ratio, dividend
payout, debt service coverage ratio.
2. Based on function
 Liquidity / Solvency
 Leverage Ratio
Debt equity Ratio
Proprietary Ratio
Capital Gearing
 Activity Ratio (turnover or productivity)
Inventory turnover Ratio
Debtor turnover Ratio
All turnover Ratios.
 Profitability Ratio
Gross profit Ratio relation of profit
Net profit Ratio & sales
Expenses Ratio
Return on Investment relation of profit
&Return on capital employed investment
 Coverage Ratio
Debt service coverage Ratio
Dividend payout Ratio

Based on Users
 For short term Creditors
Current ratio, quick ratio, working capital ratio
 Long term Creditors
Debt equity ratio, return on capital employed
 For management
Operating ratio, expenses ratio, return on capital employed,
turnover ratio
 For shareholders
Return on equity, return on proprietor fund
Current ratio
“Comparison between current assets & current liabilities”
“Pure ratio”
Formula: Current Assets
Current Liabilities
Components of Current Assets
 Debtors (less provision)
 Income accrued (due)
 Bill receivable
 Cash & bank balance
 Marketable investment and securities
 Closing stock of row material, work in progress, finished goods,
stores & spare.
 Any prepaid expenses
 Short term loan & advances
 Advance tax payment

Components of Current Liabilities
 Creditors
 Bill payable
 Any outstanding expenses
 Unclaimed and proposed dividend
 Provision for any taxation
 Income received in advance
 Bank overdraft
Purpose
“Help to understanding the ability of the firm to meet its short
term obligation”
Uses
“It is used by creditor to judge the safety margin available,
which help them to ascertain the amount and the term of the
credit”
Limitation
 Ignores comparison of working capital
EX: company A & company B have the same current ratio,
company A has more of stock and company B has more
cash. Company B has a better liquidity and solvency.
 Ignores quality
EX: company A and company B have a same current ratio
and the same amount of stock & debtor, but the company
A has more stock and doubtful debts than company B has
a better liquidity.

1.Current Ratio
“This ratio has to be studied with ‘Quick Ratio’ and ‘stock
to working capital Ratio’ for judging the short term
solvency”
2:1 is standard ratio.
When result are higher than standard?
 Good short term liquidity position
 It might significance excess stock
 Bad debts –credit prepaid may be more
 Idle cash
 Under treading –not utilised full capacity
When results are lower than standard?
 Unsatisfactory liquidity
 Over trading
 Lower stocks
 Idle cash
2.Quick Ratio
 Used to check liquidity of the firm.
 Also define as a pure ratio
Formula:
Quick Assets
Quick Liabilities
 Quick Assets = Current assets – (Stock + Prepaid expenses)
A. Stock is executed because it is uncertain as to when & how it
will be realise.
B. Prepaid expenses are executed because they can’t be
converted into cash.
 Quick Liabilities = Current Liabilities – Bank Over Draft

A. Bank over draft is excluded because it is a permanent
arrangement & it is not required to be paid as long as the firm
exists.
Purpose:
It is a solvency ratio which indicates the ability of the firm to
meet its short term liabilities without selling the stock.
How it is helpful?
 It measures the immediate solvency of the firm.
 It overcomes the limitation of current ratio.
i.e. It considers both the composition and quality of
working capital.
 It emphasises of quality of Current Assets rather than the
quantity.
The standard of this is 1:1
Higher Than Standard:
 It indicates very good day to day solvency/liquidity.
 Idle cash balance.
 Under investment.
Lower Than Standard:
 Not satisfactory day to day liquidity/solvency.
 Low cash balance.
 High investment.

3.Debt Equity Ratio
This ratio compares a long term debts with shareholder
funds. It is also expressed as a Pure Ratio.
FORMULA:
Debt => Borrowing Funds
Equity proprietor’s fund
Borrowing Funds Proprietor’s Fund
 Debenture - Equity Share Capital
 Loans - Preference Share
- Reserve & Surplus – (losses +
item not written off)
Purpose or Function:
This ratio is a solvency ratio which indicates the proportion of
debt & equity in financing the assets of the firm.
Helpful:
 It helps to understand and analyse margin of safety for long
term credits.
 Standard is 2:1
 It also helps to ascertain the balance between debt & equity.
 Low safety margin for lender.
 More interest payment.
 Low scope for loan.
 Treading on equity.

4.Gross Profit Ratio
This ratio compares gross profit with net sales. It is
expressed in form of percentage.
FORMULA:
Gross Profit * 100
Net Sales
Gross Profit = sales – cost of goods sold
Cost of goods sold in treading firm =
Opening stock+ purchase+ direct exp. – closing stock
Cost of goods sold for manufacturing firm =
Opening stock+ cost of materials+ labour+ exp. – closing stock
Net Sales = Sales – (sales return + any allowances)
It is profitability ratio. This ratio helps to judge-
 How efficiently the firm is managing its production,
purchase, selling & inventory.
 How good is the control over direct cost?
 How productive the firm is?
 How much amount is left to meet other expenses & earn
net profit?
Higher Then Standard:
 It indicates higher efficiency in managing purchase production
labour, sales & inventory.
 High productivity.
 Large amount available to meet other expenses.

5.Stock Turnover/ Inventory Turnover Ratio
This ratio shows the relationship between the costs of
goods sold and average stock this ratio is normally expressed as
time or rate.
FORMULA:
Cost of Goods sold
Average Stock
Average stock = opening stock + closing stock
2
NOTE: in the absence of information, closing stock can be used
instead of average stock.
Stock holding period
Month = 12
STR
Days = 365
STR
Function or Purpose:
This is an activity ratio, which shows the relationship between
sales & stock. Its purpose is to:
 Calculate the speed at which stock is being turned over into
sales.
 Calculate the stock holding period.
 To judge how efficient the stock are managed and utilised to
generate sales.

 Stock sold out very quickly.
 Working capital requirement is less.
 Over trading.
6.Operating Ratio
This ratio expresses the relationship between total
operating cost and net sales. It is expressed by the way of
percentage.
FORMULA:
Cost of goods sold + operating expenses * 100
Net sales
Operating expenses = office & administration exp., selling &
distribution exp., financial exp. (OD)
Function or Purpose:
 This ratio indicates cost of operations.
 Its purpose to measure and ascertain efficiency of management
with regard to operations.
Helpful:
 This ratio helps to judge how much amount of sales revenue is
used in carrying the operation if the firm.
 Operating ratio shows total of all cost in all the area such as
administration, sales etc. It is advisable to break it up into
various expenses ratio so that we can identify which
expenditures are increasing disproportionately.
 This ratio has to be studied with expenses ratio and operating
net profit ratio before commenting on profitability of the firm.

 Low efficiency in managing purchase, production, labour,
inventory & sales.
 Low productivity.
 Small amount available to meet other expenses.
7.Return on Capital Employed Ratio (ROCE) or Return
on Investment (ROI)
The ratio measures the relationship between profit
(before interest & tax) and the capital to earn it. The ratio is
also known as return on investment (ROI).
FORMULA:
Profit before Interest & Tax * 100
Capital Employed
Capital employed =
Equity capital + preference share + reserve & surplus +credit
balance of P&L + debenture + long term loans – debit balance
of P&L.
 It is a profitability ratio.
 It purposes is to measure overall profitability from the total
funds made available by the owners and lenders.
Helpful:
 The ratio helps to judge how efficiently the firm is managing
the funds at its disposal.

Higher than Standard:
 It signifies more profit on each of the rupee invested.
 Scope to attract fresh fund both from owner & lender.
 It signifies higher amount of sales.
 High increase in net worth.
 Large amount of appropriation (interest, taxes, dividend)
8.Dividend Payout Ratio
This ratio shows the relationship between the dividends
paid to equity shareholders out of the profit available.
It is expressed in percentage.
FORMULA:
Dividend Paid * 100
Profit Available to Equity Shareholder
(PAT)
Profit availability to equity share holder means net profit
after interest, income tax & Preference dividend.
 This ratio is type of coverage ratio.
 A coverage ratio shows the relationship between the profit and
the claim of outsider to be paid out if such profits.
 Its purpose is to measure to dividend paying capacity of the
firm.

 Scope to issue fresh equity share at a higher price.
Called FPO: follow up public offering.
 High price in stick exchange.
 During merger high price of shares.
 Very high dividend makes shirt term equity holders happy.
 Less reserve may mean low growth in future.
 No possible of bonus issue.
9.Debt Service Coverage Ratio
 This ratio shows the relation between net profit and interest +
instalment payable on loan. It is expressed as pure number.
 Coverage means availability of profits for debts servicing.
FORMULA:
Cash profit available for debt servicing
(Interest + instalment due on loan)
Cash profit available for debt servicing
 PAT + non cash debits
 CFAT / no pat / NCF
Purpose:
 It helps to measure debt service capacity of the company.

 Strong capacity to pay interest as and when due.
 Further loans easily available at the lower rate.
 Large amount of profit available for taxes & dividend.
 It also signifies that the firm is not treading on equity.
10. Debtor Turnover Ratio
This ratio shows the relationship between credit sales &
average debtors. It is expressed as a rate or as a time.
Formula:
Credit Sales
Average Debtor
Average Debtor = Bill Receivable + Debtor
Debtor Collection Period
12 OR 365
DTR DTR
Purpose:
 To calculate speed at wage debtor get settled on an average
during the year.
 It calculates the debtor collection period which helps to
indicate the period of credit allowed who an average debtor.
 It helps to judge how efficiently the debtors are managed.

 Debts are collected at lower rate.
 More chances of bad debts.
 More credits are provided.
11. Creditors Turnover Ratio
This ratio shows the relationship between credit purchases
and average creditors. This also expressed in the form of rates or
times.
Formula:
Credit Purchase
Average Creditors
Average Creditors = Bills payable + Creditors
Creditors Payment Period:
12 OR 365
CTR CTR
Purpose:
 It helps to analyse as to how quickly the creditors are paid off
on an average during the year.
 It helps to calculate the period taken to pay off creditors.
Note: This ratio should be studied with STR & DTR to understand the
combined effect over the operating cycle.

 It signifies slow rate of payment.
 More credit is available from creditors.
 Working capital requirements is less.
Operating Cycle = STR + DTR – CTR
12. Stock to Working Capital Ratio
This ratio shows the relationship between the closing stock
and working capital. It helps to judge the quantum of
inventories in relation to the working capital of the business. It
is expressed as a percentage. It is also known as inventory
working capital ratio.
Formula:
Stock * 100
Working Capital
Stock = closing stock
Purpose:
 It is liquidity ratio.
 It indicates the composition and quality of the working capital
and also helps to study the salvage of the firm.
 It shows the extant of the funds blocked in stock.
 If investment of stock is higher it signifies that the amount of
liquid assets is lower.
 This ratio should be studied with stock turnover ratio, current
ratio and quick ratio.

 More other current assets are available to pay current
liabilities.
13. Return on Equity Capital
This ratio measures the relationship between net profit
(after interest, tax & preference dividend) and the equity share
holders.
Formula:
Net Profit * 100
Equity Share Holders Funds
Equity Share Holders Funds = equity capital and reserve & surplus.
This ratio is expected as a percentage.
Purpose:
 It is a profitability ratio.
 Its purpose is to calculate the amount of profit available to take
care of equity dividends, transfer to reserve etc.
 It is used by the present or perspective investor for deciding
whether to purchase, keep or selling the equity shares.
 This ratio should be studied with capital gearing ratio to know
the effect of gearing on EPS.

 Large amount of appropriations (reserve & surplus, dividend,
etc.)
 Higher EPS, in case of merger & acquisition it gives batter
purchase consideration.
 Higher increase in net worth in the company.
14. Capital Gearing Ratio
Gearing means the process of increasing equity
shareholders return through the case of debt. Equity share
holders earn more when the rate of return on the capital is
more than the rate of interest on debt. This is also known as
leverage or treading on equity. This ratio shows the
relationship between two type of capital, equity capital
increasing reserves & preference share capital and long term
borrowings. It is usually expressed as a pure ratio. This is also
known as capital structure ratio.
Formula:
Preference Capital + Borrowed Funds
Equity Funds
Purpose:
 It indicates the proportion of debt & equity in the financing of
assets of a firm.
 Higher return for the shareholder if rate of the fixed return is
less than return on investment.

15. Return on proprietor’s Fund
This ratio measures the relationship between profit
(after interest & tax) & the proprietor’s capital. It is
usually expressed as a percentage. It is also known as
return on net worth.
Formula:
Net Profit (after tax)
Proprietor’s Fund
Proprietor’s fund = equity, reserve & surplus and preference capital
Purpose:
 It is profitability ratio.
 It measures the rate of return on the total funds made available
from owners.
 It helps to judge how efficiently the firm is managing the
owners fund at the disposal.
 This ratio should be studied with debt equity ratio to know the
effect of capital structure on earnings of the proprietors.
Higher Than Standards:
 Large amount available for appropriation.
 Scope to attract fresh funds from the owner.

16. Net Profit Ratio
The ratio indicates the relationship between net profit
and sales. It is usually expressed in the form of percentage.
Formula:
Net Profit (before tax)
Sales
Net profit before tax:
Net operating profit
Add: non operating income
Less: non operating expenses.
Purpose:
 It is profitability ratio.
 It indicates net profit for all types or activities of the entire
business.
 It measures the overall profitability from:
- Operating activities of buying or selling the products.
- Financing activity of borrowing or lending.
- Buying or selling of investment.
 This ratio helps to judge:
- How efficiently the firm is managing all its activities of
operations, financing & investments.
- How much amount is available for appropriations?
 This ratio is studied with return on capital employed & return
on proprietor’s fund.
 Good control over all expenses.
 Large amount available for appropriation.
 Strong capacity to face bad economic condition.
 High increase in net worth.
 It signifies unusual gain.

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