# RATIO ANALYSIS Accounting ratios express figures in the financial statement in terms of each other.

RATIO ANALYSIS compares ratios of the business over the years(trend analysis) or across the industry to assess its strengths and weaknesses (interfirm comparison). Ratios can be divided into four main types:     Profitability ratios show how successfully the business is trading and managing its expenses Liquidity/Solvency : ability of the business to settle its debts in the short term Gearing: how much indebted is the business Investment: how the business is faring in the stock market – how market prices for a share reflect company’s performance

A firm will have different categories of users of accounts e.g. shareholders, creditors, management, potential investors. Each user group will be interested in specific ratios as shown below:

Examples of parties with an immediate interest Potential suppliers of goods on credit; lenders, e.g. bank managers and debenture holders; management Shareholders( actual and potential); potential take-over bidders; management ; competitive firm; tax authorities; employees Shareholders, creditors, lenders Shareholders( actual and potential); potential take-over bidders; management

Type of ratio Liquidity

Profitability and use of assets

Gearing Investment

USES OF RATIOS Ratios are, therefore, used to enable comparisons to be made:   to compare the performance of the business with previous years. to compare the actual performance of the business with the budgeted or planned performance to compare results with the performance of similar businesses.  It can be used by banks as a measure to grant or deny loans

Advantages of Ratio Analysis Ratio analysis is a tool or a technique through which one can do the analysis of the financial statements of the company. There are many advantages of ratio analysis: 1. Liquidity ratio can be helpful in measuring the liquidity position of the company that is whether a company will able to meet the obligations as and when they arise. 2. Since ratio is a simplified figure of complex financial statements it can be easily understood by a person who does not have the accounting knowledge.

having a higher value relative to a competitor's ratio or the same ratio from a previous period is indicative that the company is doing well. it is easy to make comparison of a company with other companies in the same industry and determine the position of the company with respect to its competitors. 6. 4. however some people may think it is not adequate. With the help of ratio analysis one can do trend analysis that is whetherthe financial position of the company is improving or getting worse over the years. Since ratio analysis is done from the data in the financial statements like profit and loss and balance sheet. With the help of ratios. the larger the margin of safety that the company possesses to cover short-term debts. For most of these ratios. Investment ratios: a wide array of ratios that can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation. As ratios are easy to understand it becomes easy for a company to communicate the ratios to those who are interested in the financial performance of the company. in case of any mistakes in those financial statements will reflect in the ratios also. Limitations of ratio analysis Though ratio analysis is an important tool for analyzing the financial statements of the company and has many advantages. 2. Types of ratios  Profitability ratios: A class of financial ratios that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. So for example it may possible that company may have higher current ratio indicating that liquidity position of the company is good. window dressing refers to presenting of better picture of the company than what it is.  Solvency ratios: A class of financial ratios that is used to determine a company's ability to pay off its short-terms debts obligations. 5. 3.  Debt and Gearing ratios: ratios which show the extent to which the long term funding of the business is provided from outside sources. So a current ratio of 2:1 may be good for some people. 5.  . Since Ratios are easy to manipulate they are misused by managers for window dressing. Let’s look at some of the limitations of the ratio analysis – 1. Ratios are not same for everybody that is different people have different perception regarding the ratios. however it has certain limitations. While ratio analysis can be great for comparison between companies. it only presents the figures as they are. The various profitability ratios help in judging the operation efficiency of the company and also whether or not company using the resources judiciously. 4. however if large portion of those current asset includes inventory then it does not mean a sound liquidity position. Generally. however if there is only one company then ratio analysis can be misleading. Ratio analysis does not take into account the qualitative factors.3. the higher the value of the ratio.

i. add back interest] Significance: × 100 NP ratio is used to measure the overall profitability and hence it is very useful to proprietors. Omission of purchase invoices from accounts. Unfavorable purchasing or markup policies. Increase in the selling price of goods sold without any corresponding increase in the cost of goods sold. low demand. the decrease in the gross profit ratio may be due to the following factors. 5. 2. Inability of management to improve sales volume. This ratio also indicates the firm's capacity to face adverse economic conditions such as price competition.. Causes/reasons of increase or decrease in gross profit ratio: INCREASE: better It should be observed that an increase in the GP ratio may be due to the following factors. The ratio is very useful as if the net profit is not sufficient. Obviously. REASONS FOR INCREASE/DECREASE Increase: better  Efficient control of expenses . without corresponding decrease in the cost of goods sold. 4. DECREASE : worse 1. 4. 3. the firm shall not be able to achieve a satisfactory return on its investment. On the other hand.PROFITABILITY RATIOS (i) Gross Profit Ratio (margin) (also known as Gross Profit percentage) = Mark up = Gross Profit × 100 Cost of Sales Significance: Gross Profit Net Sales/Revenue × 100 This ratio shows the business's ability consistently to control its production costs or to manage the margins its makes on products its buys and sells. 1.e. etc. Over valuation of opening stock or under valuation of closing stock (ii) Net Profit Ratio (also known as Net Profit percentage) = Net profit before interest and tax Net Sales Revenue can also be expressed as Net Profit(after interest) Net Sales/Revenue [Uses NPBI – Net Profit before interest. But while interpreting the ratio it should be kept in mind that the performance of profits also be seen in relation to investments or capital of the firm and not only in relation to sales. Under valuation of opening stock or overvaluation of closing stock. or omission of sales. Increase in the cost of goods sold without any increase in selling price. Decrease in the selling price of goods. Decrease in cost of goods sold without corresponding decrease in selling price. 2. 3. higher the ratio the better is the profitability.

A ratio that measures a company's earnings before interest and taxes (EBIT) against its total net assets. The smaller the ratio. however. (1) CURRENT RATIO Current ratio may be defined as the relationship between current assets and current liabilities. such as inventory. the more effectively that company is said to be using its assets (vi) Operating expenses to Revenue Ratio = Operating Expenses × 100 Revenue A ratio that shows the efficiency of a company's management by comparing operating expense to net sales. This ratio is also known as " working capital ratio". sundry debtors.prepaid expenses. accrued expenses. because a high ratio indicates the business has less money tied up in fixed assets for each unit of currency of sales revenue.. bills payable. investors should be aware that it doesn't take debt repayment or expansion into account. income tax payable. the higher the ratio. The greater a company's earnings in proportion to its assets (and the greater the coefficient from this calculation). A declining ratio may indicate that the business is over-invested in plant. The ratio is considered an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid. Generally speaking. This ratio is a general and quick measure of liquidity of a firm. the greater the organization's ability to generate profit if revenues decrease. Short-term usually means one year or less. bank overdraft. the better. It is a measure of general liquidity and is most widely used to make the analysis for short term financial position or liquidity of a firm. Current liabilities are those obligations which are payable within a short period of tie generally one year and include outstanding expenses. sundry creditors. It is also an index of technical solvency and an index of the strength of working capital. It is an index of the firms financial stability. generally. . Formula: Following formula is used to calculate current ratio: Current Ratio = Current Assets / Current Liabilities Or Current Assets : Current Liabilities Components: The two basic components of this ratio are current assets and current liabilities. etc. Current assets include cash and those assets which can be easily converted into cash within a short period of time. It represents the margin of safety or cushion available to the creditors. It is calculated by dividing the total of the current assets by total of the current liabilities. LIQUIDITY RATIOS Liquidity is a business firm's ability to repay its short-term debts and obligations on time. one year. (vii) Non-Current Asset Turnover = Net Sales Revenue Total Net Book Value of Non Current Assets It indicates how well the business is using its fixed assets to generate sales. short term advances. or other fixed assets. equipment. When using this ratio.

generally. It is used as a complementary ratio to the current ratio. The idea of having double the current assets as compared to current liabilities is to provide for the delays and losses in the realization of current assets.600 Current Liabilities = 270 + 500 + 150 + 750 = 1.800. Liquid Assets = 180 + 1. However. therefore. As a convention. 1. An equal increase in both current assets and current liabilities would decrease the ratio and similarly equal decrease in current assets and current liabilities would increase current ratio. (2) Liquid or Liquidity or Acid Test or Quick Ratio: Liquid ratio is also termed as "Liquidity Ratio". because of more stock and work in process which is not easily convertible into cash. and bank overdraft (only if payable on demand). the rule of 2 :1 should not be blindly used while making interpretation of the ratio. Creditors \$500 Accrued expenses \$150. If a firm's current assets include debtors which are not recoverable or stocks which are slow-moving or obsolete. therefore firm may have less cash to pay off current liabilities. bills payable. An increase in the current ratio represents improvement in the liquidity position of the firm while a decrease in the current ratio represents that there has been a deterioration in the liquidity position of the firm. sundry creditors. It is crude ratio because it measure only the quantity and not the quality of the current assets. bank and trade receivables. Limitations of Current Ratio: This ratio is measure of liquidity and should be used very carefully because it suffers from many limitations. short term advances.600 / 1. a quick ratio of "one to one" (1:1) is considered to be satisfactory. and. Valuation of current assets and window dressing is another problem. . Debtors \$1. This ratio can be very easily manipulated by overvaluing the current assets. This is because of the reason that current ratio measures the quantity of the current assets and not the quality of the current assets.e. Similarly. calculate liquid ratio. the current ratio may be high but it does not represent a good liquidity position. Tax payable \$750. a relatively low current ratio represents that the liquidity position of the firm is not good and the firm shall not be able to pay its current liabilities in time without facing difficulties. Components: The two components of liquid ratio (acid test ratio or quick ratio) are liquid assets and liquid liabilities.420 = 1. Formula of Liquidity Ratio / Acid Test Ratio: [Liquid Ratio = Liquid Assets / Current Liabilities] Example: From the following information of a company. 2.A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time and when they become due. 3. On the other hand. "Acid Test Ratio" or "Quick Ratio". Inventories cannot be termed as liquid assets because it cannot be converted into cash immediately without a loss of value. It measures the firm's capacity to pay off current obligations immediately and is more rigorous test of liquidity than the current ratio.420. It is.. It is the ratio of liquid assets to current liabilities. A ratio equal to or near 2 : 1 is considered as a standard or normal or satisfactory. Cash \$180. outstanding expenses. The true liquidity refers to the ability of a firm to pay its short term obligations as and when they become due.958 : 1 The quick ratio/acid test ratio is very useful in measuring the liquidity position of a firm. Bills payable \$270. Liquid liabilities means current liabilities i. suggested that it should not be used as the sole index of short term solvency. Even if the ratio is favorable. In other words they are current assets minus inventories (stock) . inventory \$1. income tax payable. Liquid assets normally include cash. the firm may be in financial trouble. Usually a high liquid ratios an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand a low liquidity ratio represents that the firm's liquidity position is not good.670 = 0.670 Liquid Ratio = 1. Firms having less than 2 : 1 ratio may be having a better liquidity than even firms having more than 2 : 1 ratio. Liquid ratio is more rigorous test of liquidity than the current ratio because it eliminates inventories as a part of current assets.

a firm having a high liquidity ratio may not have a satisfactory liquidity position if it has slow-paying debtors. On the other hand.000 + \$60. This ratio is a relationship between the cost of goods sold during a particular period of time and the cost of average inventory during a particular period. the interpretation of this ratio also suffers from the same limitations as of current ratio. In the same manner. A liquid ratio of 1:1 does not necessarily mean satisfactory liquidity position of the firm if all the debtors cannot be realized and cash is needed immediately to meet the current obligations. The opening stock is \$40. Stock turn over ratio/Inventory turn over ratio indicates the number of time the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory.Although liquidity ratio is more rigorous test of liquidity than the current ratio . Calculate inventory turnover ratio Calculation: Inventory Turnover Ratio (ITR) = 500.000* = 10 times This means that an average one dollar invested in stock will turn into ten times in sales *(\$40. a low liquid ratio does not necessarily mean a bad liquidity position as inventories are not absolutely non-liquid. It is expressed in number of times. A firm having a low liquid ratio may have a good liquidity position if it has a fast moving inventories. A . Formula of Stock Turnover/Inventory Turnover Ratio: The ratio is calculated by dividing the cost of goods sold by the amount of average stock atcost. This ratio indicates whether investment in stock is within proper limit or not. yet it should be used cautiously and 1:1 standard should not be used blindly. (3) Inventory turnover Definition: Stock turn over ratio and inventory turn over ratio are the same.000) / 2 Significance of ITR: Inventory turnover ratio measures the velocity of conversion of stock into sales. Average inventory is calculated by adding the stock in the beginning and at the end of the period and dividing it by two. all the monthly balances are added and the total is divided by the number of months for which the average is calculated.000 = \$50. Inventory Turnover Ratio = Cost of goods sold / Average inventory at cost Example: The cost of goods sold is \$500. Components of the Ratio: Average inventory and cost of goods sold are the two elements of this ratio. A low inventory turnover ratio indicates an inefficient management of inventory.000 and the closing stock is \$60. the lesser amount of money is required to finance the inventory. Usually a high inventory turnover/stock velocity indicates efficient management of inventory because more frequently the stocks are sold.000 (at cost). Though this ratio is definitely an improvement over current ratio. In case of monthly balances of stock. Hence.000 / 50.000.

The norms may be different for different firms depending upon the nature of industry and business conditions. Return inwards \$1. accumulation of obsolete and slow moving goods and low profits as compared to total investment.000 x 360 = 60 Days **For calculating this ratio usually the number of working days in a year are assumed to be 360.000.low inventory turnover implies over-investment in inventories. stock accumulation.000.000/ 24. It may also be mentioned here that there are no rule of thumb or standard for interpreting the inventory turnover ratio. If it increases it is worse.000. The inventory turnover ratio is also an index of profitability. Formula of Average Collection Period: Following formula is used to calculate average collection period: Trade Debtors / Net Credit Sales x 365 = x days Trade debtors/ Net Credit Sales x 52 = x weeks Example: Credit sales \$25. poor quality of goods. Debtors \$4. The lower the better because this is an indication that stock is moving faster leading to higher profits and better liquidity position. Sometimes. where a high ratio signifies more profit. Calculate average collection period. Rate of inventory turnover ROI = Average inventory/ Cost of sales x 365 It shows the average number of days taken to turnover stock. (4) Average Collection Period Ratio/ Dectors collection period Definition: The Debtors/Receivable Turnover ratio when calculated in terms of days is known as Average Collection Period or Debtors Collection Period Ratio. a low ratio signifies low profit. of Working Days) / Net Credit Sales 4. Similarly a high turnover ratio may be due to under-investment in inventories. Calculation: Average collection period can be calculated as follows: Average Collection Period = (Trade Debtors × No. The average collection period ratio represents the average number of days for which a firm has to wait before its debtors are converted into cash. . However the study of the comparative or trend analysis of inventory turnover is still useful for financial analysis. dull business. a high inventory turnover ratio may not be accompanied by relatively a high profits.

 It's an indicator of the company's efficiency in managing its important working capital assets. It reduces the chances of bad debts. ( 5) Creditors Days: Definition and Explanation: This ratio is similar to the debtors collection period. It signifies the credit period enjoyed by the firm in paying creditors. Similarly. It compares creditors with the total credit purchases. A lower credit period ratio signifies that the creditors are being paid promptly. However a very favorable ratio to this effect also shows that the business is not taking the full advantage of credit facilities allowed by the creditors. Average payment period ratio gives the average credit period enjoyed from the creditors. It can be calculated using the following formula: Average Payment Period = (Trade Creditors / Net Credit Purchase) x 365 (In case information about credit purchase is not available total purchases may be assumed to be credit purchase. The shorter this cycle. The WCC measures the number of days a company's cash is tied up in the the production and sales process of its operations and the benefit it gets from payment terms from its creditors.Significance of the Ratio: This ratio measures the quality of debtors. Formula: WCC = Stock turnover (days) + Debtors days – Creditors Days Example: Stockturnover 280 days Debtors days +58 days Creditors days -63 days Cash Operating cycle 275 days Commentary: The cash conversion cycle is vital for two reasons.) Significance of the Ratio: The average payment period ratio represents the number of days by the firm to pay its creditors. the more liquid the company's working capital position is. (6) WORKING CAPITAL CYCLE(WCC) / CASH OPERATING CYCLE This ratio expresses the length of time (in days) that a company uses to sell inventory. The WCC is also known as the "cash" or "operating" cycle. A short collection period implies prompt payment by debtors ( efficient credit control). ( poor credit control)It is difficult to provide a standard collection period of debtors. collect receivables and pay its accounts payable. a longer collection period implies too liberal and inefficient credit collection performance. This situation enhances the credit worthiness of the company. .