Ratio Analysis

Ratio: It is an arithmetical expression of relationship between two related or

interdependent items.

Accounting Ratios: It is a mathematical expression that shows the relationship

between various items or groups of items shown in financial statements.

Objectives of Ratio Analysis:

(i) To know the areas of an enterprise that needs more attention.
(ii) To know about the potential areas that can be improved.
(iii) Helpful in comparative analysis of the performance.
(iv) Helpful in budgeting and forecasting.
(v) To provide analysis of the liquidity, solvency, activity and profitability of an
enterprise.
(vi) To provide information useful for making estimates and preparing the plans for the
future.

Advantages of Ratio Analysis:

(i) It is useful in analysis of financial statements.
(ii) Helps in simplifying accounting figures.
(iii) Useful in judging the operating efficiency of business.
(iv) Helps in identification of problem areas.
(v) Helpful in comparative analysis.

Limitations of Ratio Analysis:

(i) Accounting ratios ignore qualitative factors.
(ii) Absence of universally accepted terminology.
(iii) Ratios are affected by window-dressing.
(iv) Effects of inherent limitations of accounting.
(v) Misleading results in the absence of absolute data.
(vi) Price level changes ignored.
(vii) Affected by personal bias and ability of the analyst.

Classification of Accounting Ratios:

In view of the requirements of various users, the accounting ratios may be classified
as under

LIQUIDITY RATIOS:
Liquidity ratios measure the firm‘s ability to fulfil its short-term financial obligations.

a) Current Ratio/Working Capital Ratio:

This ratio establishes a relationship between current assets and current liabilities and
is used to assess the short- term financial position of the business concern. Current
ratio of 2:1 is considered to be ideal.

Current Ratio = Current Assets / Current Liabilities

Items Included in Current Assets:
a) Current investments
b) Inventories (Excluding loose tools, stores and spares)
c) Trade receivables (Bills receivable and Sundry debtors less provision for doubtful
Debts
d) Cash and cash equivalents (cash in hand, cash at bank, cheques/drafts in hand)
e) Short-term loans and advances
f) Other current assets (prepaid expenses, Accrued /outstanding income)

Items Included in Current Liabilities:

a) Short-term borrowings
b) Trade payables (Bills payable and sundry creditors)
c) Other current liabilities (current maturities of long-term debts, interest, accrued but
not due on borrowings, interest accrued and due on borrowings, outstanding
expenses, unclaimed dividend, calls-in- advance, etc.)
d) Short-term provisions

b) Liquid Ratio/Quick Ratio/Acid Test Ratio:

This ratio establishes a relationship between liquid assets and current liabilities and is
used to measure the firm‘s ability to pay the claims of creditors immediately. This ratio
is a better indicator of liquidity and ratio 1: 1 is considered to be ideal.
Liquid Ratio = Liquid/Quick Assets / current liabilities
Liquid Assets = Current Assets - (Inventory + Prepaid Expenses)

Items Included in Liquid/Quick Assets

a) Current investments.
b) Trade receivables (bill receivables, debtors less provisions for doubtful debts)
c) Cash and cash equivalents.
d) Short-term loans and advances.
e) Other current assets except prepaid expenses.
f) Items excluded in liquid assets are inventories, prepaid expenses.

Items Included in Current Liabilities

a) Short-term borrowings.
b) Trade payables (bills payable and sundry creditors).
c) Other short-term liabilities.
d) Short-term provisions.

SOLVENCY RATIOS
Solvency ratios judge the long-term financial position of an enterprise i.e. whether the
business is able to pay its long-term liabilities or not.

a) Debt to Equity Ratio: (also called Leverage ratio)

It establishes the relationship between long-term debt (external equities) and the
equity (internal equities) i.e. shareholders‘ funds.

It is computed to ascertain the soundness of the long-term financial position of the

firm. Generally, the ratio of 2:1 is considered as an ideal.
Debt to Equity Ratio = Long-term Debts / Equity or Shareholders‘ Fund

Items Included in Long-term Debts:

a) long-term borrowings and
b) long-term provisions.

Items Included in Equity or Shareholders‘ Funds:

a) Equity Share Capital
b) Preference Share Capital
c) Reserves and Surplus
Or
Non-current Asset (Tangible assets + Intangible assets + Non-current trade
investments + Long-term loans and advances) + Working Capital – Non-current
Liabilities (Long-term borrowings + Long-term provisions)

Working Capital= Current Assets – Current Liabilities

b) Total Assets to Debt Ratio:

It establishes a relationship between total assets and total long-term debts.

Items Included in Total Assets:

(i) Non-current Assets [Fixed assets (Tangible and intangible assets) + Non- current
Investments + Long-term Loans and Advances

(ii) Current Assets [Current investments + Inventories (including spare parts and loose
tools) + Trade Receivables + Cash and Cash Equivalents + Short- term Loans and
Advances + Other Current Assets]

Items Included in Long-term Debts

Non-current Asset (Tangible assets + Intangible assets + Non-current trade
investments + Long-term loans and advances) + Working Capital – Non-current
Liabilities (Long-term borrowings + Long-term provisions)

c) Proprietary Ratio:
It establishes the relationship between proprietors‘ funds and total assets.

Proprietary Ratio = Proprietors‘ Funds or Shareholders‘ Funds / Total assets

Proprietors‘ Funds or Shareholders‘ Funds:-

By Liabilities Approach:
Share Capital + Reserves and Surplus

By Assets Approach:
Non-current Assets (Tangible assets + Intangible assets + Non-current trade
investments + Long-term loans and advances) + Working Capital – Non- current
Liabilities (Long-term borrowings + Long-term provisions)
Total assets includes
Non-current Assets [Fixed assets (Tangible and intangible assets) + Non- current
Investments + Long-term Loans and Advances
Current Assets [Current investments + Inventories (including spare parts and loose
tools) + Trade Receivables + Cash and Cash Equivalents + Short- term Loans and
Advances + Other Current Assets]

ACTIVITY RATIOS
a) Inventory Turnover Ratio:
It establishes a relationship between Cost of Revenue from Operations and average
inventory carried during that period.

Inventory Turnover Ratio: Cost of Revenue from operations / Average Inventory

Cost of Revenue from Operation = Revenue from Operations–Gross Profit

OR
Opening Inventory + Net Purchases + Direct Expenses (Assume to be given) – Closing
Inventories
OR
Cost of materials consumed + purchase of stock- in-trade + change in Inventory
(Finished Goods; Work in Progress & Stock-in-trade) + Direct Expenses (Assume given)

Average Inventory = Opening Inventory + Closing Inventory/2

b) Trade Receivable Turnover Ratio:

It establishes the relationship between Credit Revenue from Operations and Average
Trade Receivables.

Trade Receivable Turnover Ratio = Net credit revenue from operations / Average Trade
Receivable

Net Credit Sales = Total Sales – Cash Sales

OR

Credit Revenue from Operation = Revenue from Operation – Cash Revenue from
Operation

Average Trade Receivables = (Opening Debtors + Trade Receivable + Closing Debtors +

trade Receivable) / 2

Trade Receivables = Debtors + Bills Receivables

Debt Collection Period = 365 / 360 Days or 12 Months/ Trade Receivables turnover
Ratio
c) Trade Payables / Creditors Turnover Ratio:
It indicates the speed with which the amount is being paid to creditors. The higher the
ratio, the better it is.

Trade Payables / Creditors Turnover Ratio = Net Credit Purchases / Average Trade
Payables

Average Trade Payables = (Opening Creditors + Trade Payable + Closing Creditors +

trade Payables) / 2

Average Payment Period = 365 or 12 / Trade Payables Turnover Ratio

In the absence of opening creditors and bills payable, closing creditors and bills
payable can be used in the above formula. Also, if credit purchases are not given, then
all purchases are deemed to be on credit.

d) Working Capital Turnover Ratio:

This ratio shows the number of times the working capital has been rotated in
generating sales.
These ratios measure the profitability of a business assessing and help in overall
efficiency of the business.

Working Capital Turnover Ratio = Revenue from Operations / Working capital

Working Capital = Current assets - Current liabilities

PROFITABILITY RATIOS

a) Gross Profit Ratio:

Gross profit ratio shows the relationship between the net sales gross profit to net sales
(revenue from operations)

Gross profit ratio = Gross profit / revenue from Operations*100 = …..%

Cost of Revenue from Operation = Revenue from Operations–Gross Profit

OR
Opening Inventory + Net Purchases + Direct Expenses (Assume to be given) – Closing
Inventories
OR
Cost of materials consumed + purchase of stock- in-trade + change in Inventory
(Finished Goods; Work in Progress & Stock-in-trade) + Direct Expenses

Gross Profit = Revenue from operations - Cost of Revenue from operations

In case, a statement of profit and loss is given, cost of revenue from operations i.e. cost
of goods sold is computed by adding cost of materials consumed, purchases of stock-
in-trade, changes in inventories of finished goods, work-in- progress and stock-in-
trade and direct expenses.
b) Operating Ratio:
Operating ratio establishes the relationship between operating cost and revenue from
operations i.e. net sales. = (Cost of Revenue from operations + Operating Expenses) /
revenue from Operations *100
Cost of Revenue from Operations = Cost of Materials Consumed + Purchases of Stock-
in trade + Change in Inventories of Finished Goods, Work-in-progress and Stock in-
trade + Direct Expenses
Or
Revenue from Operations – Gross Profit.

Operating Expenses = Employees Benefits Expenses + Other Expenses (Other than

non-operating expenses) + Depreciation and Amortization Expenses
Or
Office expenses, administrative expenses, selling and distribution expenses, employees
benefit expenses, depreciation and amortization expenses.

Alternatively operating cost may be calculated as follows:

Operating Cost = Cost of Materials Consumed + Purchases of Stock-in-trade + Change
in Inventories of Finished Goods, Work-in-progress and Stock-in-trade + Employees
Benefits Expenses + Other Expenses (Other than non-operating expenses)

Operating Profit Ratio: Operating profit ratio establishes the relationship between the
operating profit and i.e. (revenue from operations) net sales.

c) Operating Profit Ratio:

Operating profit ratio is an indicator of operational efficiency of the business.

Operating Profit Ratio = Operating Profit / revenue from Operations * 100 = …..%

Operating Profit = Gross profit + Other Operating Income - Other Operating Expenses
Or
Net Profit (before tax) + non- Operating Expenses/Losses - Non - Operating Income

Or

Revenue from Operations - Operating Cost

d) Net Profit Ratio:

Net profit ratio shows the relationship between net profit and revenue from operations
i.e. net sales. Net profit ratio is an indicator of overall operational efficiency of the
business.

Net Profit Ratio = Net profit after tax / Revenue from operations * 100 = ….. %
Net Profit = Revenue from operations - Cost from Revenue from Operations - Operating
Expenses - Non- operating Expenses + Non-operating Income - Tax

e) Return on Investment/Capital Employed:

It establishes the relationship between net profit before interest, tax and preference
dividend and capital employed (equity + debts).
Return on Investment =
Net Profit before interest, Tax and Dividend / capital Employed * 100 = …..%

Capital employed can be calculated from liabilities side approach and assets side
approach as follows:
When Liabilities Approach is Followed, It is computed by adding
(a) Shareholders‘ funds (i.e. share capital, reserves and surplus).
(b) Non-current liabilities (i.e. long-term borrowings and long-term provisions).

When Assets Approach is Followed, It is computed by adding

1. Non-current assets
2. Working capital, i.e. current assets – current liabilities.

NOTE: Since, non-operating assets are excluded while determining capital employed,
income from non-operating assets should also be excluded from profit.