Definition of ratio Analysis:

Ratio analysis consists of the calculation of ratios from financial

statements and is a foundation of financial analysis.
Classification of ratios: accounting ratios are classified on the basis of
the different parties interested in making use of the ratios. A very large
number of accounting ratios are used for the purpose of determining the
financial position of a concern for different purposes. Ratios maybe
broadly classified into:
1) Classification of ratios on the basis of balance sheet
2) Classification of ratios on the basis of profit and loss account
3) Classification of ratios on the basis of mixed statement (or) balance
sheet and profit loss account
The classification further grouped into:

 Liquidity ratio
 Profitability ratio
 Turnover ratio
 Solvency ratio
 Overall profitability ratio
The classification are discussed hereunder

1) Classification of ratios on the basis of balance sheet: balance

sheet ratios which establish the relationship between two balance
sheet item .for example current ratio, fixed asset ratio, liquidity
ratio
2) Classification on the basis of income statement: these ratios
deal with the relationship between two items or two group of items
 of the income statement. For example, gross profit ratio.
Operating ratio, operating profit ratio and net profit ratio.
3)Classification on the basis of mixed statement: these ratios
also known composite or mixed ratios .the inter statement ratios
which deal with relationship between the item of profit and loss
account and item of balance sheet.
On the basis of balance sheet, ratios are
 Current ratio
 Liquid ratio
 Absolute liquid ratio
 Debt equity ratio
 Proprietary ratio
 Capital gearing ratio
 Assets-proprietorship ratio
 Capital inventory to working capital ratio
 Ratio of current assets to fixed asset ratio
On the basis of profit and loss account ,ratios are
 Gross profit ratio
 Operating ratio
 Operating profit ratio
 Net profit ratio
 Expense ratio
 Interest coverage ratio
On the basis of profit and loss account and balance sheet ratios
are
 Stock turnover ratio
 Debtors turnover ratio
 Payable turnover ratio
 Fixed asset turnover ratio
  Returns on equity
 Returns on shareholder’s fund
 Returns on capital employed
 Capital turnover ratio
 Working capital turnover ratio
 Return on total resources
 Total assets turnover
Liquidity ratio
Liquidity ratios are an important class of financial metrics used to
determine a debtor’s ability to pay off current debt obligations
without raising external capital. Liquidity ratios measures a
company’s ability to pay debt obligations and its margin of safety
through the calculation of metrics including the current ratio ,quick
ratio absolute liquid ratio .

 Current ratio: it measures a company’s ability to pay short term

obligations for those due within one year. it tells investors and
analysts how a company can maximize the current assets on its
balance sheet to satisfy its current debt and other payables.

Current ratio =

Current asset normally means which can be easily converted into

cash within a years’ time. On the other hand current liabilities
represent those liabilities which are payable within a year.

The components of current assets are

 Cash in hand
 Cash at bank
  Sundry debtors
 Bills receivable
 Marketable securities( short-term)
 Inventories(stock of raw materials, stock of work in process,
stock of finished goods)
Interpretation of current ratio: the ideal current ratio is 2:1.it indicates
that current assets double the current liabilities considered to be
satisfactory. higher value of current ratio indicates more liquid of the
firm’s ability to pay its current obligations in time. On the other hand, a
low value of current ratio means that the firm may find it difficult to pay
its current ratio as one which is generally recognized as the patriarch
among ratios.
 Current ratio helps in understanding how cash rich a company is.
 It helps us gauge the short term financial strength of company
 Current ratio gives an idea of a company’s operating cycle.
 Current ratio shows management efficiency in meeting the
creditors demand.

Quick ratio (or) acid test or liquid ratio:

It is a type of liquidity ratio, which measures the ability of a
company to use its near cash or quick assets to extinguish or retire
its current liabilities immediately.it, establishes the relationship
between quick assets and current liabilities.
In order to compute this ratio, the below presented formula is used:
Liquid assets

( )
Liquid Ratio =
 Quick ratio can be calculated by two basic components of quick
assets and current liabilities
Quick Assets = Current Assets-(Inventories +prepaid expenses)

Interpretation of quick ratio: the ideal quick ratio of 1:1 is

considered to be satisfactory. High acid ratio is an indication that
the firm has relatively better position to meet its current obligations
in time. On the other hand a low value of quick ratio exhibiting
that the firm’s liquidity position is not good .the higher ratio, the
better company able to meet its current obligation. Lower ratio,
higher risk of meeting problem with short term obligation

 This ratio helps to measure how well current assets pay off current
liabilities more accurately
 This ratio removes the inventory from calculation.
 It provide more reliable information in the industry which is
seasonal in nature
Absolute liquid ratio: it extends the logic further and eliminates
accounts receivable (sundry debtors and bills receivables) also
.though receivables are more liquid as comparable to inventory
but still there maybe doubts considering their time and amount of
realization. Therefore absolute liquidity ratio relates cash, bank and
marketable securities to the current liabilities. Since absolute
liquidity ratio lays down very strict and exacting standard of
liquidity
Interpretation of absolute liquid ratio: the optimum value for
this ratio should be one.i.e, 1:2.it indicates that 50% worth absolute
liquid assets are considered adequate to pay the 100 % worth
current liabilities in time. If the ratio is relatively lower than one, it
represents that the company’s day to day cash management is poor.
If the ratio is considerably more than one, the absolute liquid ratio
represents enough funds on the form of cash to meet its short-term
obligation in time.

Absolute liquid ratio =

Profitability ratio
Definition: profitability ratios are a class of financial metrics that
are used to assess a business’s ability to generate earnings related
to its revenue, operating costs, balance sheet assets, and
shareholders’ equity over time, using data from a specific point in
time. The following important profitability ratios are discussed
below:

 Gross profit ratio

 Operating ratio
 Operating profit ratio
 Net profit ratio
 Return on investment ratio
 Return on capital employed ratio
 Earnings per share ratio
 Dividend payout ratio
 Dividend yield ratio
 Price earnings ratio
 Net profit or net worth ratio

 Gross profit ratio: Gross profit ratio (GP ratio) is a

profitability ratio that shows the relationship between gross
 profit and total net sales revenue. It is a popular tool to
evaluate the operational performance of the business .
Gross profit ratio = * 100
Gross profit =Sales – cost of good sold
Net sales = gross sales – Sales return (or) Return inwards
Higher gross profit ratio is an indication that the firm has higher
profitability.

 Operating ratio:
The operating ratio shows the efficiency of a company's
management by comparing the total operating expense (OPEX) of
a company to net sales. The operating ratio shows how efficient a
company's management is at keeping costs low while generating
revenue or sales.

Operating ratio = * 100

Operating cost =Cost of goods sold + Administrative expenses +Selling and

Distribution Expenses
Net sales =Sales- sales Return (or) Return inwards
 Operating profit ratio:
Operating profit ratio indicates the operational efficiency of the firm and is a
measure of ability to cover the total operating expenses.

Operating profit ratio = * 100

Operating profit =Net sales – operating cost

 Net profit ratio: Net profit ratio is a popular profitability ratio that
shows relationship between net profit after tax and net sales. It reveals
the firms overall efficiency in operating the business.
Net Profit ratio = * 100
 Return on investment ratio:
Return on investment, or ROI, is the ratio of a profit or loss
made in a fiscal year expressed in terms of an investment and
shown as a percentage of increase or decrease in the value of the
investment during the year in question.
( )
Return on investment = ( )
*100
Shareholders’ investment =Equity share capital + preference share
capital + Reserves and surplus – Accumulated Losses
Net profit =Net profit – Interest and taxes

 Return on capital employed ratio: Return on capital

employed (ROCE) is a financial ratio that measures a
company's profitability and the efficiency with which its
capital is used.
Return on capital employed ratio =

 Earnings per share ratio: Earnings per share (EPS) ratio

measures how many dollars of net income have been earned
by each share of common stock during a certain time period.
Earnings per share ratio=

Dividend payout ratio: The dividend payout ratio is the ratio of

the total amount of dividends paid out to shareholders relative to
the net income of the company. The amount that is not paid to
shareholders is retained by the company to pay off debt or to
reinvest in core operations. It is sometimes simply referred to as
the 'payout ratio.
Dividend payout ratio =
*100
Or
* 100
 Dividend yield ratio: it indicates the relationship
established between dividend per share and market value per
share.

Dividend yield ratio = * 100

Price earning ratio:

The price-earnings ratio, also known as P/E ratio, P/E, or PER, is
the ratio of a company's share price to the company's earnings per
share. The ratio is used for valuing companies and to find out
whether they are overvalued or undervalued.
Price Earnings Ratio =
Net Profit To Net Worth Ratio: This ratio is one indicator of how
well a company is using its assets to make a profit. It indicates the
established relationship between net profit and shareholders net
worth.
Net Profit to Net Worth = * 100
Shareholder Net Worth =Total tangible Net worth
Total Tangible Net worth =Company’s Net assets-Long
Term Liabilities (or) shareholders’ funds +profits retained in
business.