RATIO ANALYSIS

WHY FINANCIAL ANALYSIS

Lenders’ need it for carrying out the

following
 Technical Appraisal
 Commercial Appraisal
 Financial Appraisal
 Economic Appraisal
 Management Appraisal
 RATIO ANALYSIS

A ratio is a simple arithmetical expression of

the relationship of one number to another. It
an expression of the quantitative relationship
between two numbers.
Ratio analysis is a technique of analysis
and interpretation of financial statements. It is
the process of establishing in interpreting
various ratios for helping in making certain
decision
How a Ratio is expressed?
As Percentage - such as 25% or 50% . For
example if net profit is Rs.25,000/- and the sales is
Rs.1,00,000/- then the net profit can be said to be
25% of the sales.
As Proportion - The above figures may be
expressed in terms of the relationship between net
profit to sales as 1 : 4.
As Pure Number /Times - The same can also be
expressed in an alternatively way such as the sale is
4 times of the net profit or profit is 1/4th of the sales.
USE OF RATIO ANALYSIS
 Useful to Management
Helps in decision-making
Helps in financial forecasting and planning
Helps in communication
Helps in control
 Useful to Shareholders
 Useful to Creditors
 Useful to Employees
 Useful to Government
 Tax Audit Requirements
LIMITAION OF RATIO ANALYSIS

 Limited use of single ratio

 Lack of adequate standard
 Inherent limitation of accounting
 Change of accounting procedure
 Window dressing
 Personal bias
 Incomparable
 Price level changes
Classification of Ratios
Balance Sheet P&L Ratio or Balance Sheet
Ratio Income/Revenue and Profit & Loss
Statement Ratio Ratio

Financial Ratio Operating Ratio Composite Ratio

Current Ratio Gross Profit Ratio Fixed Asset
Quick Asset Ratio Operating Ratio Turnover Ratio,
Proprietary Ratio Expense Ratio Return on Total
Debt Equity Ratio Net profit Ratio Resources Ratio,
Stock Turnover Ratio Return on Own
Funds Ratio,
Earning per Share
Ratio, Debtors’
Turnover Ratio,
 Format of balance sheet for ratio analysis
LIABILITIES ASSETS
NET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS : LAND & BUILDING, PLANT
Share Capital/Partner’s Capital/Paid up Capital/ & MACHINERIES
Owners Funds Original Value Less Depreciation
Reserves ( General, Capital, Revaluation & Net Value or Book Value or Written down value
Other Reserves)
Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED NON CURRENT ASSETS
FUNDS : Term Loans (Banks & Institutions) Investments in quoted shares & securities
Debentures/Bonds, Unsecured Loans, Fixed Old stocks or old/disputed book debts
Deposits, Other Long Term Liabilities Long Term Security Deposits
Other Misc. assets which are not current or
fixed in nature
CURRENT LIABILTIES CURRENT ASSETS : Cash & Bank Balance,
Bank Working Capital Limits such as Marketable/quoted Govt. or other securities,
CC/OD/Bills/Export Credit Book Debts/Sundry Debtors, Bills Receivables,
Sundry /Trade Creditors/Creditors/Bills Stocks & inventory (RM,SIP,FG) Stores &
Payable, Short duration loans or deposits Spares, Advance Payment of Taxes, Prepaid
Expenses payable & provisions against various expenses, Loans and Advances recoverable
items within 12 months
INTANGIBLE ASSETS
Patent, Goodwill, Debit balance in P&L A/c,
Preliminary or Preoperative expenses
Some important notes
 Liabilities have Credit balance and Assets have Debit balance
 Current Liabilities are those which have either become due
for payment or shall fall due for payment within 12 months
from the date of Balance Sheet
 Current Assets are those which undergo change in their
shape/form within 12 months. These are also called Working
Capital or Gross Working Capital
 Net Worth & Long Term Liabilities are also called Long Term
Sources of Funds
 Current Liabilities are known as Short Term Sources of
Funds
 Long Term Liabilities & Short Term Liabilities are also called
Outside Liabilities
 Current Assets are Short Term Use of Funds
Some important notes
 Assets other than Current Assets are Long Term Use of Funds
 Installments of Term Loan Payable in 12 months are to be taken
as Current Liability only for Calculation of Current Ratio & Quick
Ratio.
 If there is profit it shall become part of Net Worth under the
head Reserves and if there is loss it will become part of
Intangible Assets
 Investments in Govt. Securities to be treated current only if
these are marketable and due. Investments in other securities
are to be treated Current if they are quoted. Investments in
allied/associate/sister units or firms to be treated as Non-
current.
 Bonus Shares as issued by capitalization of General reserves
and as such do not affect the Net Worth. With Rights Issue,
change takes place in Net Worth and Current Ratio.
TYPES OF RATIOS

 Liquidity Ratios
 Long-term solvency Ratios
 Activity Ratios
 Profitability Ratios
 CLASSIFICATION OF RATIOS
LIQUIDITY LONG TERM ACTIVITY PROFITABILITY
SOLVENCY &
LEVERAGE
RATIOS
Current Ratio Debt Equity Ratio Inventory Turnover (A) In relation to Sales
Liquid Ratio Debt to Total Capital Ratio Gross Profit
Absolute liquid Ratio Ratio Debtors Turnover Operating
Interest Coverage Ratio Operating Profit
Ratio Fixed Assets
Net profit
Turnover Ratio
Expenses
Total Assets
(B) In relation to
Turnover Ratio
Investment
Working Capital
Return On
Turnover Ratio
Investment
Return on Equity
Earning Per Share
Price Earning Ratio
LIQUIDITY RATIOS
Liquidity refers to the ability of a concern to
meet its current obligations as and when these
become due. The short-term obligations are
met by realizing amounts from current, floating
or circulating assets. To measure liquidity of a
firm the following ratios can be calculated.
i) Current Ratios
ii) Quick Ratio/Acid Test Ratio/Liquid Ratio
iii) Absolute Liquid Ratio / Super Quick Ratio / Cash
position Ratio
CURRENT RATIO
Current Ratio may be defined as the
relationship between current assets and
current liabilities. This ratio, also commonly
known as working capital ratio, is a measure
of general liquidity

Current Ratio = Current Assets / Current Liabilities

A relatively high current ratio is an indication that the firm is

liquid and has the ability to pay its current Obligations in time
when they become due. A ratio equal or near to rule of thumb of
2:1 is considered to be satisfactory.
 Components of Current Ratio
Current Assets Current Liabilities
Cash in Hand Outstanding Expenses /
Cash at bank Accrued Expenses
Marketable securities Bill Payable
(Short term) Sundry Creditors
Short – term Investment Short-term Advances
Bills Receivable Income-tax Payable
Sundry Debtors Dividend Payable
Inventories (Stock) Bank overdraft (if not a
Work-in-progress permanent arrangement)
Prepaid Expenses
1. Current Ratio : It is the relationship between the current
assets and current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a concern
are Rs.4,00,000 and Rs.2,00,000 respectively, then the
Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
The ideal Current Ratio preferred by Banks is
1.33 : 1

2. Net Working Capital : This is worked out as surplus of

Long Term Sources over Long Tern Uses, alternatively it
is the difference of Current Assets and Current Liabilities.
NWC = Current Assets – Current Liabilities
QUICK OR ACID TEST OR LIQUID RATIO

Quick ratio may be defined as the relationship between quick/liquid assets and
current Liabilities. An asset is said to be liquid if it can be converted into cash
in a short period of time without loss of value. Inventories and prepaid
expenses cannot be converted in cash within a short period without loss of
value). As a thumb rule 1:1 is standard ratio.

Components of Current Ratio

Quick / Liquid Assets Current Liabilities
Cash in Hand Outstanding Expenses / Accrued
Cash at bank Expenses
Marketable securities (Short term) Bill Payable
Short – term Investment Sundry Creditors
Bills Receivable Short-term Advances
Sundry Debtors Income-tax Payable
Dividend Payable
Bank overdraft (if not a permanent
arrangement)
ABLOSUTE LIQUID OR CASH RATIO

Although receivable, debtor's and bills receivable are

generally more liquid than inventories, yet there may be
doubts regarding their realization into cash immediately or in
time
Absolute Liquid Assets includes cash in hand and at
bank and marketable securities or temporary investments.
Absolute Liquid Ratio = Cash & Bank + Short –term
Securities / Current Liabilities
The acceptable norm for this ratio is .05 : 1 or 2:1
3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current
Assets and Current Liabilities.

Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months +

Quickly realizable securities such as Govt. Securities or quickly marketable/quoted
shares and Bank Fixed Deposits

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example :
Cash 50,000
Debtors 1,00,000
Inventories 1,50,000 Current Liabilities 1,00,000
Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3:1

Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1
LONG TERM SOLVENCY RATIOS AND
LEVERAGE RATIOS
Long term solvency ratios convey a firms ability
to meet the interest costs and repayment
schedules of its long-term obligations. Leverage
ratios show proportion of debt and equity in
financing of the firm. These ratios measure the
contribution of financing by owners as compared
to financing by outsiders. The leverage ratios
can be further classified into (i) Financial
Leverage, (ii) Operating Leverage, (iii)
Composite Leverage.
LONG TERM SOLVENCY RATIOS AND LEVERAGE RATIOS

 Debt – Equity Ratio =

Long term Debt / Share holders
Fund
This ratio indicates the relationship
between loan funds and net worth of the
company, which is known as “Gearing” .If
the porting of debt to equity is low, a
company is said to be low-geared and vice
versa. A ratio of 2:1 is the accepted ratio.
4. DEBT EQUITY RATIO : It is the relationship between
borrower’s fund (Debt) and Owner’s Capital (Equity).

Long Term Outside Liabilities / Tangible Net Worth

Liabilities of Long Term Nature

Total of Capital and Reserves & Surplus Less Intangible Assets

For instance, if the Firm is having the following :

Capital = Rs. 200 Lacs

Free Reserves & Surplus = Rs. 300 Lacs
Long Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1

 Proprietary Ratio =
Shareholders Funds / Total Assets
(Tangible)

This Ratios is also known as Equity Ratio,

Shareholders to Equity ratio, or Net worth to
Total Assets. In this ratio the relationship is
established between the shareholders fund
and the total assets.
Share Holders Funds (or Net Worth) = (Equity
Share capital + Preference Share Capital +
Undistributed Profits + reserve and surplus)
 Capital Gearing Ratio
= Fixed Interest Bearing Funds / Equity
share holders Funds
This ratio indicates the degree of vulnerability of
earnings available for equity shareholders.
 Fixed Interest Bearing Funds includes
(Debentures, Long – term loan, Preference
share capital).
 Equity share holders Funds includes (Equity
share capital and reserve and surplus)
 Interest Cover = PBDIT / Interest
This ratio indicates how many times interest charges are
covered by funds that are available for payment of interest.
A ratio of 2:1 is acceptable. A high ratio indicates that the
firm is conservative in using debt and a very low ratio
indicates excess use of debt.

 Dividend Cover = NPAT / Dividend

This ratio indicates the number of times the dividends are
covered by net profit.

 Debt Service Coverage Ratio =

= PAT + Depreciation & Interest / Interest + Loan
installment.
This ratio indicates whether the business is earning
sufficient profits to pay not only the interest charges, but
also loan installments
ACTIVIY / TURN OVER RATIOS

Activity ratios are calculated to measure

the efficiency with which resources of a
firm have been employed. These ratios
indicate the speed with which assets are
being turned over into sale, e.g. Debtors
turnover ratio.
 Inventory turn over ratio
= Cost of Gods Sold / Avg. inventory
*Avg. Inventory = (Opening stock + Closing Stock)/ 2

OR
Net Sales / Avg. inventory (If COGS is not given)
OR
Net Sales / Closing stock (If COGS & Opening
stock is not given )
This ratio is also known as Stock turn over ratio or
Stock velocity. This ratio indicates whether inventory
is efficiently used or not.
 Inventory conversion period (No. of days)
= 365(Days in a year) / Inventory turn over ratio
 Debtors Receivable) turn over ratio/Velocity
= Credit Sales / Avg. Trade Debtors
Trade Debtors = Sundry Debtors + Bills Receivables &
Accounts receivable
Avg. Trade Debtors = (Opening Trade Debtors + Closing
Debtors) / 2
Note: Debtors should always be take at Gross Value. No
provisions for bad and doubtful debts to be deducted. If
information about opening and closing balances of trade
debtors and credit sales is not given it can be calculated as
= Total sale / Debtors (inclusive of B/R)
 9. STOCK/INVENTORY TURNOVER RATIO :

(Average Inventory/Sales) x 365 for days

(Average Inventory/Sales) x 52 for weeks
(Average Inventory/Sales) x 12 for months

Average Inventory or Stocks = (Opening Stock + Closing

Stock)
-----------------------------------------
2
. This ratio indicates the number of times the inventory is
rotated during the relevant accounting period
 Average Collection Period
= Avg. Debtors (Drs + B/R)/ Credit Sales * 365
It measures how long it take to collect amount from
debtors.

 Creditors Turnover Ratio

= Credit Purchases / Avg. Creditors (Crs+B/P)

 Creditors Payment Period

= Avg. Creditors / Purchases * 365
 Fixed assets Turn over
= Sales / Fixed Assets
 Total Assets Turn over
= Sales / Total Assets
 Working Capital Turn over
= Sales / Working Capital
PROFITABILITY RATIOS

These ratios measure the results of

business operations or overall
performance and effectiveness of the
firm, e.g. , Gross profit ratio, operating
ratio, return on capital employed.
Profitability ratio can be calculated
(i) In relation to sales
(ii) In relation to Investments
PROFITABILITY RATIOS
 Gross Profit Ratio:
The gross profit is the difference between Net sale and
Cost of goods soled.

= Gross Profit / Sale * 100

This Ratio shows the margin left after meeting the

manufacturing costs. It measures the efficiency of
production as well as pricing. A high gross profit means a
high margin for covering other expenses, other than cost
of goods soled, therefore higher the ratio, the better it is.
Net Profit Ratio:= Net Profit / Sales * 100

It shows earnings left for shareholders. It measures the overall efficiency

of all the functions of a business firm like production, administration,
selling, financing, pricing , tax management. This ratio is very useful for
prospective investors because it reveals the overall profitability of the
concern. Higher the ratio better.

Operating Net Profit Ratio = Operating Net profit / Sale * 100

This ratio establishes the relationship between operating net profit and
sales. The concept of operating net profit is different from the concept of
net profit.

Operating net profit = Net Profit + Non operating expenses – non operating
incomes.
Alternatively this profit can be calculated by deducting only
operating expenses from gross profit.
Operating Ratio:

= Cost of Goods Sold + Operating expenses / Net sale * 100

Return on Equity :

= Net profit after interest, tax and preference dividend / Equity

capital + Reserve & surplus

This ratio is also known as return on share holders funds or return on

proprietors funds or return on net worth, indicates the percentage of
net profit available for equity shareholders

Return on total assets:= NPAT / Total Assets* 100

This ratio compares NPAT with total assets

Market Test Ratio

 Dividend pay out Ratio

 Dividend yield
 Book value
 Price/Earnings Ratio
Dividend pay out ratio:

= Dividend per share / EPS*100

This ratio indicates the percentage of profit distributed as dividend to

share holders.

Dividend yield ratio :

= Dividend per share / Market price per share * 100

This ratio compares the dividend per share with the market price of
the share and important for the investors.

Earning Per Share : = Net profit after tax & preference dividend /
No of equity shares
This ratio indicates the amount of net profit available to equity
share holder

Price Earnings (P/E) Ratio : = Market Price per equity share / EPS
EXERCISE 1

LIABILITES ASSETS
Capital 180 Net Fixed Assets 400
Reserves 20 Inventories 150
Term Loan 300 Cash 50
Bank C/C 200 Receivables 150
Trade Creditors 50 Goodwill 50
Provisions 50
800 800

a. What is the Net Worth : Capital + Reserve = 200

b. Tangible Net Worth is : Net Worth - Goodwill = 150
c. Outside Liabilities : TL + CC + Creditors + Provisions = 600

d. Net Working Capital : C A - C L = 350 - 250 = 50

e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1
f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1
 EXERCISE 2

LIABILITIES 2005-06 2006-07 2005-06 2006-07

Capital 300 350 Net Fixed 730 750
Assets
Reserves 140 160 Security Electricity 30 30
Bank Term Loan 320 280 Investments 110 110
Bank CC (Hyp) 490 580 Raw Materials 150 170
Unsec. Long T L 150 170 S I P 20 30
Creditors (RM) 120 70 Finished Goods 140 170
Bills Payable 40 80 Cash 30 20
Expenses Payable 20 30 Receivables 310 240

Provisions 20 40 Loans/Advance 30 190

s
Goodwill 50 50
1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390
Total 1600 1760 1600 1760
2. Current Ratio for 2 Year : (170 + 20 + 240 + 2+ 190 ) / (580+70+80+70)
nd

820 /800 = 1.02

3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
Exercise 3.

LIABIITIES ASSETS
Equity Capital 200 Net Fixed Assets 800
Preference Capital 100 Inventory 300
Term Loan 600 Receivables 150
Bank CC (Hyp) 400 Investment In Govt. 50
Secu.
Sundry Creditors 100 Preliminary Expenses 100
Total 1400 1400

1. Debt Equity Ratio will be : 600 / (200+100) = 2:1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) /

200
= 11 : 2
4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1
 Exercise 4.

LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Current Ratio ? Ans : (125 +128+1+30) / (38+26+9+15)

: 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW

= 100 / ( 362 – 30)
= 100 / 332 = 0.30 : 1
 Exercise 4. contd…

LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100

[ (362 - 30 ) / (550 – 30)] x 100
(332 / 520) x 100 = 64%
Q . What is the Net Working Capital ?
Ans : C. A - C L. = 255 - 88 = 167

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover
Ratio in Times ? Ans : Net Sales / Average Inventories/Stock
1500 / 128 = 12 times approximately
 Exercise 4. contd…
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12

= 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?

Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
Exercise 5. : Profit to sales is 2% and amount of profit is say
Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100

2 = (5 x100) /Sales
Therefore Sales = 500/2 = Rs.250 Lac
Exercise 6. A Company has Net Worth of Rs.5 Lac, Term
Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and
Current Assets are Rs.25 Lac. There is no intangible Assets
or other Non Current Assets. Calculate its Net Working
Capital.
Answer
Total Assets = 16 + 25 = Rs. 41 Lac
Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac
Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L

= 25 – 26 = (- )1 Lac
Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net
Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities

hence the NWC would be NIL

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What

is the amount of Current Assets ?

Answer : 4 x - 1 x = 30,000
Therefore x = 10,000 i.e. Current Liabilities is Rs.10,000
Hence Current Assets would be 4x = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per

month, monthly average interest on TL is Rs.5000/-. If the amount
of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What
would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment

= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2
Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio
is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune
of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long
Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac
i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current
Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net
Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity
Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs.
Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being

Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10
Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10
i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure
which should be Rs. 10 Lac
 Questions on Fund Flow Statement

Q . Fund Flow Statement is prepared from the Balance sheet :

1.Of three balance sheets

2.Of a single year
3.Of two consecutive years
4.None of the above.

Q. Why this Fund Flow Statement is studied for ?

1.It indicates the quantum of finance required

2.It is the indicator of utilisation of Bank funds by the concern
3.It shows the money available for repayment of loan
4.It will indicate the provisions against various expenses

Q . In a Fund Flow Statement , the assets are represented by ?

1.Application of Funds
2.Sources of Funds
3.Surplus of sources over application
4.Deficit of sources over application