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A ratio can be defined the relationship between two or more variables. In finance these variables are

taken from the balance sheet or profit or loss account. Ratio Analysis is one of the most widely used

tool for the analysis of financial statements of a business entity. Ratios are usually expressed in various

mathematical terms such as percentage, no. of times, or in numbers & compared with some standards.

Ration analysis does not merely mean the calculations of ratios. It actually refers to the comparing of

different numbers from the balance sheet, income statement and cash flow statements so as to arrrive

at certain conclusions. The comparison of such ratios can be of similar ratios of two or more different

companies or against the same ratios of the same entity. Ratios of a company may also be compared

with same ratios of the industry or economy. Such comparison gives us a meaningful idea as to how

the entity has performed in the past and what are its potential in the future. Thus, we can say that ratio

analysis helps in meaningful summerisation of large number of financial data to provide a qualitative

judgement about the financial performance of a business entity.

(a) Liquidity Ratios - These ratios indicate the ability of the entity to maintain the short term liquidty

for discharing the current liabiites. A company is expected to have sufficient short term liquidity so

that it can meet its current obligations. In case it fails to meet its current obligations, it loses creditors'

confidence and is always threatened by short term insolvency. Such a situation can even lead to

closure of the unit itself. Some of the frequently used ratios which fall under this category are (i)

Current Ratio (ii) Quick Ratio and (iii) Working Capital Turnover Ratio.

(b) Activity Ratios - These ratios indicate operational efficiency of the entity in utilising the available

resources. In other words, we can say that these ratios measure the efficiency of the entity in using the

available funds, especially the funds raised on short term basis. These ratios help banker to ascertain

the working capital need of the entity. Some of the important activity ratios are (i) Inventory turnover;

(ii) Debtor turnover; (iii) Fixed assets turnover; (iv) current assets / working capital turnover. Activity

ratios indicate the efficiency of a business organisation in utilisation of funds, particularly funds of

short term nature.

(c) Solvency Ratios / Leaverage Ratios - These ratios indicate proportion of debt vis-a-vis equity,

whcih in turn points towards the long term solvency of the entity. Some of the important solvency

ratios are (i) Debt-Equity ratio (ii) Debtor service coverage ratio

(d) Profitability Ratios - These ratios indicates the capacity and efficiency of the firm to generate

profit and surplus out of the main business. Some of the important profitability ratios are (i) Return on

Equity; (ii) Return on investment or capital employed etc.

LIQUDITY RATIOS :

Type of Ratio How to Calculate Remarks

Current ratio is calculated by dividing current

assets by current liabilities. Therefore, As per RBI stipulation, the

minimum current ratio of a firm

Current Ratio= Current Assets / Current should not be less than 1.33:1

liabilities

Here current assets refers to cash and those assets However, banks consider

Current Ratio which can be converted to cash within a period of current ratio of 2:1 as

one year, whereas current liabilities are liabilities satisfactory. Usually, higher

that are to be discharged within one year. current ratio is desirable but

unreasonable high current ratio

Current assets should be reasonably higher than is undesirable as it brings down

current liabilities to take care of the firm's short the profit of the unit due to

term liquidity. Current ratio represents margin of inefficient use of current assets.

safety for creditors.

Although current assets are

considered to be liquid in

nature, but certain assets like

The quick ratio is the ratio between quick current

inventory, prepaid expenses,

assets and current liabiliites. The quick assets

unquoted shares etc. may not be

include cash / bank balances + receivables upto 6

that liquid. Thus, such assets

months + quickly realisable securities such as

may not be available for paying

government securities or quickly marketable /

off liabilities of urgent nature

quoted shares and bank fixed deposits.

immediately. So to measure the

short term liquidity more

Thus, quick ratio = quick assets / current

Quick Ratio / accurately quick ratio is used

liabilities

Acid Test Ratio where the assets which are not

very liquid are deducted from

The other way to calculate quick ratio is to divide

current assets.

all liquid assets by current liabilities.

A ratio of 1:1 is considered to

Quick ratio = Current Assets - Inventory &

be satisfactory as cash yield

Prepaid expenses / current liabilities.

from most liquid assets can be

used for discharging current

liabilities.

Working The ratio is calculated by dividing net sales by This ratio indicates how

Capital working capital employed in the firm. efficiently the liquid funds in

Turnover Ratio the business are utilised to

Working Capital Turnover Ratio= Net Sales / achieve the sales level. A good

Total Working Capital ratio shows efficient use of

working capital. But very high

ratio indicates the case of

overtrading where the sales of

business is increasing /

expanding without

corresponding increase of

working capital / liquid

resources.

Net working capital indicates

the absolute liquidity that is

available in the entity. This is

considered as margin by banker

Strictly speaking it is not a ratio, but a concept for considering the working

popular among the Bankers for calculation of capital loan to the entity.

working capital requirement of a firm. It is

calculated in the following two ways :- When the current assets of a

Net Working

firm increase there should also

Capital

Net Working Capital = Long term sources - long be corresponding increase of

term uses NWC to maintain the liquidity.

Net working capital = Current assets - current

liabilities Current ratio shows the overall

liquidity position, but firms are

able to manipulation this ratio.

However, it is difficult to

manipulate the NWC.

ACTIVITY RATIOS :

Inventory It is calculated by dividing cost of goods sold by This ratio shows as to how

Turnover Average many times the inventory

inventory. turnovers / rotates in a year.

Average inventory. especially for bankers as it

helps them to assessing the

Cost of goods can be calculated by deducting the working capital need.

gross profit from the Net sales;

A high ratio suggests lower

Average inventory is calculated by dividing level of inventory, indicating

(opening stock + closing stocks) by 2. lesser probability of stock

becoming obsolete or

unsaleable. It also indicates

better inventory control and

financial management of the

unit

indicates sluggish business or

poor inventory control. This

increases the chance of obsolete

and unsaleable stocks.

The ratio shows the rotation of

debtor in a unit.

quick realisation of debtors and

less likelyhood of doubtful

Debtors Turnover Ratio = Annual Credit Sales /

debts.

Debtors Average Debtors.

Turnover Ratio

A lower ratio indicates

When the annual credit sales is not available,

extended credit period, which

ratio can be calculated by using net sales of the

can be due to poor realisation

firm

of debt or can be due to

conscious policy of firm to

extend credit for achieving

higher sales. .

This ratio indicates as to how

fast the firm pays its trade

creditors.

that the firm is paying the

creditors quickly. However, it

can also be due to low creditors

Creditors Turnover Ratio = Annual Credit

level which may be due to poor

Creditor Purchases / Average Creditors

creditworthiness of entity.

Turnover Ratio

A decreasing ratio indicates

higher creditworthiness of party

among creditors resulting in

lesser dependence on bank

credit. However, the decreasing

ratio may be due to inability of

the entity to pay its creditors

timely.

This ratio indicates as to how

efficiently the fixed assets are

being used by entity for

generating sales.

Fixed Assets Fixed Asset Turnover Ratio = Net Sales / Net

Turnover Ratio Fixed Assets An increased trend indicate

better utilisation of fixed assets

whereas a low ratio is due to

poor utilisation or over

investment in fixed assets.

SOLVENCY / LEVERAGE RATIOS :

Debt Equity Ratio is calculated by dividing total

A lower ratio indicates the

long term liabilities by Tangible Net worth

higher stake of the promoters in

the entity .

Debt Equity Ratio= Long Term Debt / Tangible

Net Worth

However, the higher ratio

Debt Equity indicates that firm is more

Here, all long term liabilities are considered as

Ratio dependent on outside long term

long term debt. The tangible net worth refers to

iabilities.

the sum total of capital and reserves and surplus

net of intangible assets. For calculation of TNW,

Normally, bankers do not

reserves refers to free reserves created out of

accept the debt equity ratio

profit not those created for meeting specific

more than 2:1.

liabilities or revaluation reserve..

The debt service coverage ratio

indicates the ability of the firm

to generate cash accruals for

repayment of instalment and

Debt Service DSCR = (PAT+Depreciation+Interest on Long interest. DSCR provide a basis

Coverage Ratio term Debt)/(Yearly repayment of long term for fixation of repayment

(DSCR) debt+interest on long term) schedule.

usually considered satisfactory

by bankers.

This ratio is considered as an

extension of Debt-Equity Ratio

as iit includes the effects of

Total Total indebtedness Ratio = (Total Term short term debt of firm also.

Indebtedness Liability+Total Current Liability) / (Tangible Net

Ratio Worth) A lower ratio indicates the

lesser dependence of firm on

outside liability, both long term

as well as short term.

PROFITABILITY RATIOS

Gross Profit Gross Profit Ratio = (Gross Profit / Net Sales) X This ratio shows the gross

Ratio 100 profit margin available to unit

or efficiency of the firm in

producing each unit of

product.The ratio indicates the

average spread available

between cost of sales and sales

revenue.

a) higher sales price b) lower

cost of sales .

This Ratio indicates the margin

of profit on sales/operations,

indicating the operational

efficiency of a unit.

includes profit from secondary

Operating Profit Operating Profit Ratio= (Operating Profits / Net activities and are actually not

Ratio Sales) X 100 sustainable in long term. This

this ratio indirectly shows the

viability of main operation in

long run.

competitive operational

strength of the firm.

This ratio indicates a

relationship between Net Profit

and sales.

Operating Profit Ratio= (Profit After Tax / Net

Net Profit Ratio

Sales) X 100 Higher ratio indicates good net

profit margin and indicates the

firm's capacity to withstand

adverse conditions.

The ratio indicates earning

Return on

power of the investment made

Investment(ROI) ROI = (Profit before Tax and Interest / (Tangible

on long term basis and whether

/ Return on Net Worth+Term Liability)) X 100

return is commensurate with

capital employed

the investment

This ratio indicates the return

Return on Asset ROA = (Profit before Tax and Interest / (Total on the assets and their capacity

(ROA) Tangible Assets)) X 100 to generate revenues for the

unit

Return on ROE = (Profit After Tax/Net Worth) X 100 This ratio indicates the earning

Equity(ROE) or capacity of the capital or equity

Shareholder's The capital includes the original capital plus all of the proprietors /

fund the retained profit and reserves. shareholders.

shareholders point of view as

while taking the investment

decision they will like to know

the return on equity so as to

maximise their wealth which

will be indicated by this ratio.

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