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RATIO ANALYSIS

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.

BROAD CATEGORIES OF RATIOS :

The ratios are generally classified into four groups, namely:-

(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.

It is also called Acid Test ratio.


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 :

Type of Ratio How to Calculate Remarks


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.

Inventory Turnover = Cost of goods sold / This ratio is important


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

A low ratio on the other hand


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.

A higher ratio indicates the


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.

An increasing ratio indicates


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 :

Type of Ratio How to Calculate Remarks


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.

DSCR of 2:1 and above is


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

Type of Ratio How to Calculate Remarks


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 trend may be due to :


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.

Sometimes, profit 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.

High ratio indicates good


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.

It is quite important from the


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.