Ratio Analysis

RATIO ANALYSIS 1

RATIO ANALYSIS
Analysis
Meaning of Ratio Analysis
Ratio analysis is a very important tool of financial analysis. It is the
process of establishing the significant relationship between the items of
financial statement to provide a meaningful understanding of the
performance and financial position of a firm. Ratio when calculated on the
basis of accounting information are called ‘Accounting Ratio’.

Definitions:
Kennedy and Mc Mulla. “The relationship of one to another,
expressed in simple term of mathematical is know as ratio”
According to Accountant’s Handbook by Wixon, kell and Bedford, a
ratio “is an expression of the quantitative relationship between two
numbers”.

Analysis
Nature of Ratio Analysis
Ratio analysis is a technique of analysis and interpretation of financial
statements. It is the process of establishing and interpreting various ratios for
helping in making certain decisions. However, ratio analysis is not an end in
itself. It is only a means of better understanding of financial strengths and
weakness of a firm. There are a number of ratios which can be calculated
from the given information given in the financial statements, but the analyst
has to select the appropriate data and calculate only a few appropriate ratios
from the same keeping in mind the objectives of analysis. The following are
the four steps involved in the ratio analysis:
(i) Selection of relevant data from the financial statements
depending upon the objective of the analysis.
(ii) Calculation of appropriate from the above data.
(iii) Comparison of the calculated ratios with the ratios of the
same firm in the past, or the ratios developed from the
projected financial statements or the ratios of some other
firms or the comparison with ratios of the industry to which
the firm belongs.
(iv) Interpretation of the ratios.

Tutorial. School,
National Tutorial. Opp. Future Pack School, Upper Gadigarh,Jammu.
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 2

Uses/Significance/Objects
Uses/Significance/Objects or importance of ratio analysis
/Signif

The ratio analysis is one of the most powerful tools of financial
analysis. It is used as a device to analyse and interpret the financial health of
the enterprise, just like a doctor examines the patient by recording his body
temperature, blood pressure, etc. before making his conclusion regarding the
illness and before giving his treatment, a financial analyst analyses the
financial statements with various tools of analysis before commencing upon
the health or weakness of an enterprise. ‘A ratio is known as a symptom like
blood pressure, the pulse rate or the temperature of an individual.’
(A)Usefulness for short term creditors. Short term creditors are trade
creditors, bills payables, creditors for expenses etc. The concern pays
short term creditors out of its current assets. If the current assets are
quit4e sufficient to meet current liabilities then the creditor will not
hesitate in extending credit facilities. Current and acid-test ratios will
give an idea about the current financial position of the concern.
(B) Usefulness for long term creditors. Long term creditors are financial
institutions, debenture holders, mortgage creditors etc. are interested
in analysing the capacity of the unit of repay periodical interest, and
repayment of loan on schedule.
(C) Usefulness to Employees. The employees are also interested in the
financial position of the concern. Their wages increases and amount
of fringe benefits are related to the volume of profits earned by the
concern. The employees make use of information available in
financial statement. Various profitability ratios relating to gross profit,
operating ratio, net profit, etc. enable employees to put forward their
viewpoint for the increase of wages and other benefits.
(D)Usefulness to the Government. Government is interested in the
financial information of the units both at macro as well as micro
levels. Individual unit’s information regarding production, sales and
profit is required for exercise duty, sales tax and income tax purposes.
Group information for the industry is required for formulating
national policies and planning. In the absence of dependable
information, govt. plans and policies may not achieve desired results.
Government is interested to know the overall strength of the industry.
The ration may be used as indicators of overall strength of public as
well as private sector. In the absence if the reliable economic
information, governmental plans policies may not prove successful.

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 3

(E) Usefulness for investors. Investor’s first interest will be the security
of his investment and then a return in the form of dividend or interest.
The investors can determine the magnitude and direction of the
movement in firm’s earnings with the help of profitability ratios such
as earning per share, dividend yield, etc. After analyzing the relevant
ratios the present investors can decide whether to hold, sell or
purchase the shares and the prospective investor can decide whether
or not to buy the shares.
(F) Usefulness to the management

(i) Decision-making: Financial statements are prepared
primarily for decision making. Ratios help in high-lighting
the areas of deserving attention and corrective action thus
facilitating decision making.
(ii) Financial forecasting and planning: Planning and
forecasting can be done only by knowing the past and the
present. Planning is looking ahead and the ratios calculated
for a number of years work as a guide for the future.
Meaningful conclusions can be drawn for future from these
ratios.
(iii) Communication: The financial strength and the weakness
of a firm are communicated in a more easy and
understandable manner by use of ratios.
(iv) Co-ordination is facilitated: Ratio even help in co-
ordination which is of outmost importance in effective
business management. Better communication of efficiency
and weakness of an enterprise results in better co-ordination
in the enterprise.
(v) Control is more effective: Ratio analysis even help in
making effective control of the business. Standard ratio can
be based upon proforma financial statements and variances
or deviations, if any, can be found by comparing the actual
with the standards so as to take a corrective action at the
right time. The weakness or otherwise, if any, come to the
knowledge of the management which helps in effective
control of the business.
(vi) Other Uses: There are so many uses of ratio analysis. It is
an essential part of the budgetary control and standard
costing. Ratios are of immense importance in the analysis

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 4

and interpretation of financial statements as they bring the
strength or weakness of a firm.

Guidelines/Precautions/Factors considered while undertaking Ratio
Analysis.

1. Quality/Accuracy of Financial Statement: The ratios are calculated
from the data available in financial statements. The reliability of ratios
is linked to the accuracy of information in these statements. Before
calculating ratios one should see whether proper concepts and
conventions have been used for preparing financial or not.
2. Objectives/purposes of Analysis: The type of ratios to be calculated
will depend upon the purposes for which are required. The purpose of
user is also important for the analysis of ratios. Creditors, a banker, an
investor, a shareholder, all have different objects for studying ratios.
The purpose or object for which ratios are required to be studied
should always be kept in mind for studying various ratios. Different
objects may require the study of different ratios.
3. Selection of Ratios: Another precaution in ratio analysis is the proper
selection of appropriate ratios. The ratios should match the purpose
for which these are required. Only those ratios should be selected
which can throw proper light on the matter to be discussed.
4. Use of standards: The ratios will give an indication of financial
position only when discussed with reference to certain standards.
These standard may be rule of thumb as in case of current ratio (2:1)
and acid-test ratio (1:1), may be industry standards, may be budgeted
or projected ratios, etc.
5. Capability of the analyst: Analysis is a tool in the hands of analyst.
Knife in the hands of criminal may take the life but the knife in the
hands of a surgeon may give new life to a patient. Interpretation
depends on the educational background; professional skill; experience
and intuition of the professional conducting it.
6. Ratio to be used only as guide: Ratios can provide, at the best, the
starting point. The analyst, before arriving at the conclusion, should
take into consideration all other relevant factors financial and non-
financial; macro and micro.

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 5

Advantages of Ratio Analysis

Following are some of the advantages of ratio analysis:
1. Simplifies financial statements. Ratio analysis simplifies the
comprehension of financial statements. Ratios tell the whole
story of changes in the financial condition of a business.
2. Facilitates inter firm comparison. Analysis provides data for
inter firm comparison. Ratios high-light the factors associated
with successful and unsuccessful firms. They also reveal strong
firms and weak firms, overvalued and undervalued firms.
3. Makes inter-firm comparison possible. Ratio analysis also
makes possible comparison of the performance of the different
of the firm. The ratios are helpful in deciding about their
efficiency or otherwise in the past and likely performance in the
future.
4. Helps in planning. Ratio analysis helps in planning and
forecasting. Over a period of time a firm or industry develops
certain norms that may indicate future success or failure.
Thus ratios can assist management in its basic function of
forecasting, planning, co-ordination, control and
communication.

LIMITATIONS OF RATIO ANALYSIS

The ratio analysis is one of the most powerful tools of the financial
management. Ratio analysis is a widely used and useful technique to
evaluate the financial position and performance of any business unit but it
suffers from a number of limitations. These limitations must be kept in mind
by the analyst while using this technique.
1. Limited use of a Single Ratio: A single ratio, usually, does not
convey much of a sense. To make a better interpretation a number
of ratios have to be calculated which is likely to confuse the
analyst than help him to in making any meaningful conclusion.
2. Lack of adequate standards: There are no well accepted
standards or rules of thumb for all ratios which can be accepted as
norms. It renders interpretation of the ratios difficult.
3. Inherent Limitation of accounting: Like financial statements,
ratios also suffer from the inherent weakness of accounting records

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 6

such as their historical nature. Ratios of the past are not necessary
true indicators of the future.
4. Change of accounting procedure: Change in accounting
procedure by a firm often makes ratio analysis misleading, e.g., a
change in the valuation of methods of inventories, from FIFO to
LIFO increases the cost of sales and reduces considerably the value
of closing stocks which makes stock turnover ratio to be lucrative
and an unfavourable gross profit ratio.
5. Personal Bias: Ratios are only means of financial analysis and not
an end in itself. Ratios have to be interpreted and different people
may interpret the same ratio in different ways.
6. Uncomparable: Not only industries differ in their nature but also
the firms of the similar business widely differ in their size and
accounting procedures, etc. It makes comparison of ratios difficult
and misleading. Moreover, comparisons are made difficult due to
differences in definition of various financial terms used in the ratio
analysis.
7. Absolute Figures Distortive: Ratio devoid of absolute figures
may prove distortive as ratio analysis is primarily a quantitative
analysis and not a qualitative analysis.
8. Price level Changes: While making ratio analysis, no
consideration is made to the changes in price levels and this makes
the interpretation of ratio invalid.
9. Ratios no Substitutes: Ratio analysis is merely a tool of financial
statements. Hence, ratios become useless if separated from the
statements from which they are computed.
10.Clues not Conclusions: Ratios provide only clues to analysts and
not final conclusions. These ratios to be interpreted by these
experts and there are no standard rules for interpretation.

CLASSIFICATION OF RATIOS

The use of ratio analysis is not confined to financial manager only.
There are different parties interested in the ratio analysis for knowing the
financial position of a firm for different purposes.

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 7

Various accounting ratios can be classified as follows:

RATIOS

Traditional Classification Functional Classification Significance Ratios
Or Or Or
Statement Ratios Classification According To Tests Ratios According to Importance

1. Traditional Classification or statement Ratios
Traditional Classification or classification according to the statement,
from which these ratios are calculated, is as follows:

Traditional Classification or Statement Ratios

Balance Sheet Ratios Profit & Loss Account Ratio Composite /Mixed
or or or
Position Statement Ratios Revenue/Income Statement Ratios Inter-Statement ratios

Current Ratio Gross Profit Ratio Stock Turnover Ratio
Liquid Ratio Operating Ratio Debtors Turnover Ratio
Absolute Liquidity Ratio Operating Profit Ratio Payable Turnover Ratio
Debt Equity Ratio Net Profit Ratio Fixed Assets Turnover Ratio
Proprietory Ratio Cash Profit Ratio Return on Equity
Capital Gearing Ratio Expenses ratio Return on Shareholders’ Funds
Assets-Proprietorship Ratio Interest Coverage Ratio Return on Capital Employed
Capital Inventory to Capital Turnover Ratio
Working Capital Ratio Working Capital Turnover Ratio
Ratio of Current Assets to Return on Total Resources
Fixed Assets Total Assets Turnover

a) Balance Sheet or Position Statement Ratios: Balance Sheet Ratios
deal with the relationship between two balance sheet items, e.g. the

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 8

ratio of current assets to current liabilities, or the ratio of proprietors’
funds to fixed assets.
b) Profit and Loss Account or Revenue/Income Statement Ratios:
These ratios deals with the relationship between two profit and losses
account items, e.g., the ratio of gross profit to sales, or the ratio of net
profit to sales.
c) Composite/mixed ratios or Inter Statement Ratios: These ratios
exhibit the relation between a profit and loss account or income
statement item and balance sheet item, e.g., stock turnover ratio, or the
ratio of total assets to sales. The most commonly used inter-statement
ratios are given in the chart exhibiting traditional classification or
statement ratios.

2. Functional Classification or Classification According to Tests
In view of the financial management or according to the tests
satisfied, various ratios have been classified as below:
Functional Classification in View of Financial Management or Classification According to Tests

Liquidity Ratios Long-term Solvency Activity Ratios or Assets Profitability Ratios
& Leverage Ratios Management Ratios

Current Ratio Financing operating, Inventory Turnover In Relation to Sales
Liquid Ratio Composite Ratio Gross Profit Ratio
Or Debtors Turnover Operating Ratio
Acid Test ratio Debt/Equity Ratio Fixed Assets Operating Profit Ratio
Or Debt to Total Turnover Ratio Net Profit Ratio
Quick ratio Capital Ratio Total Assets Expense Ratio
Absolute Liquid Interest Coverage Turnover Ratio
Ratio Cash Flow/Debt Working Capital In relation to
Or Capital Gearing Turnover Ratio investments
Cash ratio Payables Turnover Return on Investments
Interval Measure Ratio Return on Capital
Capital Employed Return on Equity Capital
Debtors Turnover Turnover Return on Total Resources
Ratio Earnings per share
Creditors Turnover Price-Earning Ratio
ratio
Inventory Turnover
Ratio.

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 9

a) Liquidity Ratios: These are the ratios which measure the short-term
solvency or financial position of a firm. These ratios are calculated to
comment upon the short-term paying capacity of a concern or the
firm’s ability to meet its current obligations. The various liquidity
ratios are current ratio, liquidity ratio ad absolute liquid ratio.
b) Long-term Solvency and Leverage Ratios: These are meant for
testing long-term financial soundness of any unit. Primarily, these
establish and study relationship between owned funds and loaned
funds. For example, debt-equity ratio, capital gearing ratio etc., are
covered under this group.
The leverage ratios can further be classified as:
(i) Financial leverage.
(ii) Operating Leverage.
(iii) Composite Leverage.
c) Activity Ratios: 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 the
speed with which assets are being turned over into sales, e.g., debtors
turnover ratio. The various activity or turnover ratios have been
named in the chart classifying the ratios.
d) Profitability Ratios: These ratios are measure the working results of
the unit during the accounting period. Profits are compared with sales
level and investment level. The various profitability ratio have been
given in the chart exhibiting the classification of ratios according to
test. Generally, two types of profitability ratios are calculated:
(i) In relation to sales
(ii) In relation to investments.
3. Classification According to Significance or Importance
The ratios have also been classified according to their significance or
importance. Some ratios are more important than others and the firm may classify
them as primary and secondary ratios. The British Institute of Management has
recommended the classification of ratio according to importance for inter-firm
comparisons. For inter-firm comparisons, the ratios may be classified as Primary
Ratios and Secondary Ratios. The primary ratio is one which is of the prime
importance to a concern; thus return on capital employed is named as primary
ratio. The other ratios which support or explain the primary ratio are called
secondary ratios, e.g., the relationship of opening profit to sales or the relationship
of sales to total assets of the firm.

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 10

List of current assets and current liabilities.

Current Assets Current Liabilities
Cash-in-Hand Sundry Creditors
Cash-at-Bank Bills Payable
Bills Receivable Outstanding Expenses
Sundry Debtors Bank Overdraft
Less Provision for Bad debt Taxes Payable
Marketable Securities Dividend Payable
Temporary Investments Short-term advances
Stock: Income received in advance
Raw Materials Income tax Payable
Work-in-Progress
Finished Goods
Short-term investments
Recoverable Advances
Prepaid Expenses
Accrued Incomes
Advance Taxes

(I) LIQUIDITY RATIO:
Current Ratio = Current Assets
Current Liabilities
Current Assets = Total assets Fixed assets
Or
= Working Capital + Current liabilities

Liquidity Ratio/Quick Ratio/Acid Test Ratio = Liquid Assets/Quick Assets
Current Liabilities
Liquid assets/Quick Assets = Current assets Stock Prepaid Expenses

(II) SOLVENCY RATIO/CAPITAL STRUCTURE RATIO/TEST OF
LONG TERM SOLVENCY:
Debt equity Ratio = Long Term Debts
Total Shareholder’s Funds
Long term debts = Debentures + other long term loans
Shareholder’s Funds = Equity Share Capital + Preference Share Capital + Reserve &
Surplus + Profit & Loss account Preliminary expenses Fictitious Assets
Proprietary Ratio/Ratio of owner equity to total assets = Proprietor’s Funds
Total Assets
Total Assets to Debt Ratio = Total Assets
Long Term debts
Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 11

(III) ACTIVITY RATIO/TURNOVER RATIO/PERFORMANCE
RATIO/EFFICIENCY RATIO:
Stock Turnover Ratio = Cost of Goods Sold
Average Stock
Debtors/Receivable turnover Ratio = Net Credit Sale
Average debtors
Creditors/Payable turnover Ratio = Net Credit Purchase
Average Creditors
Working Capital turnover Ratio = Cost of Goods sold/Net Sales
Net Working Capital
Fixed Assets turnover Ratio = Cost of Goods Sold/Net Sales
Net Fixed Assets
Current Assets turnover ratio = Cost of Goods Sold/Net Sales
Current assets
Cost of Goods sold = Net Sales Gross Profit
Net Credit sales = Total sales Cash sale Sales return
Net Credit Purchase = Total Purchase Cash purchase Returns
Total Debtors = Sundry Debtors + B/R Provision for doubtful debts
Total Creditors = Sundry creditors + Bills Payable
Net Working Capital = Total Current assets Total Current Liabilities
Net Fixed assets = Total Assets Current Assets
Current Assets = Total Assets Fixed assets

(IV) PROFITABILITY RATIO:
Gross Profit Ratio/Gross Margin Ratio = Gross Profit
Net Sales X 100
Net Profit Ratio = Net Profit(after tax)
Net Sales X 100
Operating Ratio = Total Operating Cost
X 100
Net Sales
Operating Profit Ratio = Operating Profit
Net Sales X 100
Return on Capital Employed/Return on Investment =
= Net Profit before Tax & Dividend
X 100
Capital Employed
Earning Per Share(EPS) = Net Profit (after tax & Preference dividend)
No. of Equity Shares X 100
Dividend Per Share(DPS) = Dividend paid to equity shareholder
X 100
Number of equity shares

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

RATIO ANALYSIS 12

Price Earning Ratio(PER) = Current Marketable Equity of Equity Share
Earning Per Share X 100

Gross Profit = Net Sale Cost of Goods Sold
Net profit = Net operating Profit + Non Operating Income Non operating
Expenses
Net Profit = Gross Profit + All other incomes All expenses
Operating Cost = Cost of Goods Sold + Office & Administration Expenses +
Selling & Distribution Expenses + Financial Expenses + Repair and Maintenance
Operating Profit = Net Sales Operating Cost
Operating Expenses = Administration + Selling Expenses

Where Capital Employed = Share Capital (Equity + Preference) + Reserves
and Surplus + Long-term Loans – Fictitious Assets

Or

Capital Employed = Fixed Assets + Current Assets – Current Liabilities

Shareholders’ Funds = Equity Share Capital + Reserves and Surplus –
Fictitious Assets

Fictitious Assets = Underwriting Commission + Preliminary Expenses +
Discount or Loss on Issue of Shares/Debentures and miscellaneous Expenses

Return on Investment or Return on Capital Employed: This ratio shows
the relationship between the profit earned before interest and tax and the
capital employed to earn such profit.
Return on Equity: Return on equity is also known as return on
shareholders’ investment. The ratio establishes relationship between profits
available to equity shareholders with equity shareholders’ funds.
Earning Per Share: Earning per share is calculated by dividing the net
profit (after interest, tax and preference dividend) by the number of equity
shares.
THOUGHT
Education is not the filling of a pail, but the lighting of
Education
a fire.

Tutorial. School,
0191-
Ph. 0191-2262243 Mob. 9796228700, 9697664266, 9086036666

Ratio Analysis

More Related Content

What's hot

Viewers also liked

Similar to Ratio Analysis

Recently uploaded

Ratio Analysis