RATIO ANALYSI

Module 2

The notes are just indicative and as per the syllabus of MBA recommended for Dr Vishwanath Karad MITWPU School of

Dr. Rupali Gupta

 RATIO ANALYSIS

Various methods and techniques are used for the analysis of financial statements and “Ratio
Analysis” is one of them.

Meaning of Ratio:

A ‘Ratio’ is an arithmetical expression of relationship between two related and inter-

dependent items. It expresses a magnitude by which one quantity os a multiple or a part of
another similar quantity. When the concept of ratio is explained with respect to the items
shown in the financial statements, then it is called ‘accounting ratio’.

Meaning of ‘Accounting Ratios

Accounting ratio means ratios based on accounting data.

According to J. Betty, “The term accounting ratio is used to describe significant relationship
which exists between figures shown in a balance sheet, in a profit and loss statement, in a
budgetary control system or in any part of the accounting organisation.” The relationship of
accounting ratios is very significant because it is based on cause and effect relationship and
does help in finding out specific results on the basis of such relationship.

For example: gross profit ratio is an expression of relationship between gross profit and net
sales.

Forms/ Expression of Ratios

Simple /
Pure ratio

Expression
of ratios

Rate or
Percentage
Time
Meaning of Ratio Analysis

Ratio analysis is a technique of analysis, comparison and interpretation of financial

statements. It is a process through which various ratios are calculated and on that basis
conclusions are drawn which becomes the base of managerial decisions. It involves
following steps:

Selection of relevant data is selected from the

financial statements depending on the
Relevant Data objective of analysis

appropriate ratios are calculated

Calculation of on the basis of objectives or
ratios needs

calculated ratios are compared with past

Comparison ratios of the same firm, or the ratios of
other forms or ideal standard of relevant
of Ratios ratios

Interpretatio At the end conclusions are

n of Ratios drawn on the basis of study
and comparison of ratio

Advantages/ Objectives/ Importance of Ratio Analysis:

 Useful in simplifying accounting figures

 Useful in financial position analysis’
 Useful in assessing the operational efficiency
 Helpful in financial planning and forecasting
 Useful in locating the weak points of the business
 Useful in comparative study
 Helpful on communication and coordination
 Useful in control

Ratio analysis is a tool of management for measuring achievements in efficiency and guiding
business policies.

Limitations of Ratio Analysis:

 Limited use of single ratio: single ratio cannot furnish complete data. A number of
ratios need to be calculated for proper analysis and interpretation.
 Effect of incorrect original: Ratios are calculated from the figures appearing the
financial statements. If the figures are not true and fair, the analysis gives a confusing
picture of the affairs.

 Different meaning to accounting terms: in accounting terminology different

meanings can be assigned to the same term. For example: profit for the purpose of
calculating ratios may be taken as profit before interest and tax or profit after tax but
before interest. Similarly the term capital employed has various meanings and
turnover ratios can be calculated on the basis of sales or cost of sales. Hence, unless
the meanings of relevant terms are properly defined, the use of ratios may lead to
wrong comparisons and conclusions.

 Variations in accounting policies: it is possible that different firms may use different
accounting policies and these differences may be in the form of method of
depreciation, valuation of inventories, etc.

 Effect of price level changes: ratios may give false results if changes in price level
are not considered. For example, if fixed assets were purchased in 2005, the ratio of
sales to total assets in 2015 would be much higher than in 2005 because sales will be
considered at current price and fixed assets at the price of 2005.

 Misleading results in the absence of absolute data: Ratios may sometimes give
misleading picture in the absence of absolute data. For example, the sale of one firm
increases from ₹ 10,000 to ₹ 20,000 i.e. increase of 100% while the sales of another
firm increases from ₹ 50,000 to ₹ 70,000 i.e. increase of 40%. It seems that the first
firm is more active while from the point of view of absolute increase in sales, the
second firm is more active.

 Ignores qualitative factors

 Historical analysis: it is based on past figures, while predictive analysis is also

required for managerial decisions and planning.

 Difficulty in evolving standard ratios: It is bit difficult to evolve standard or ideal

level of various accounting ratios which may be acceptable to all industries under all
circumstances and even to all firms in the same industry. It makes comparison of
ratios difficult and misleading.

 Personal Bias: different analyst may interpret the same ratios in different ways

 Not a substitute if financial statements: ratios are meaningless if detached from the
details from which they are derived.
  Window dressing: Ratios may be affected by window dressing means concealing
vital facts and presenting the financial statements in such a fashion as to show the
business in a better position than it actually is.

CLASSIFICATION OR TYPES OF RATIOS

Accounting ratios may be classified into number of ways keeping in view the purpose of
study. The major classifications are given as under:

Types of Ratios

Efficiency/
Liquidity Ratios Profitability Ratios Turnover Ratios Valuation Ratios
Solvency Ratios

. Gross Profit . Inventory

Ratio Turnover Ratio . Debt-Equity . Earnings Per
. Debtors Ratio Share
. Current ratio . Net Profit Raio
Turnover Ratios . Propreitory . P/E Ratio
. Quick/ Liquid . Operating profit
. Creditors Ratio
Ratio Ratio . Dividend Payout
Turnover ratios. . Capital Gearing Ratio
. Absolute Ratio . Return on
. Working Capital Ratio
Investment . Dividend Yield
Turnover ratio . Interest ratio
. Return on Coverage Ratio
Capital Employed . Fixed Assets
Turnover Ratio

I. Liquidity Ratios:

Liquidity refers to the ability of the firm to meet its current obligations as and when they
vecome due. It is essential for the smooth conduct of the business activities because if a firm
has possr liquidity position, it may not be able to make timely payments to creditors and in
effect will not be in a a position to purchase goods or services on favorable terms. In other
words, liquidity ratios measure the short term solvency position of the firms.

(i) Current Ratio: also known as ‘working capital ratio’. It can be defined a sthe relationship
between current assets and current liabilities. Current ratio throws light on the firm’s ability
to pay its current liabilities out of current assets. Generally the ratio of 2:1 is considered to be
satisfactory but it is not applicable to all cases. It represents a margin of safety for current
liabilities (if the current assets are reduced to half, then also the creditors will be able to get
their payments in full.

Current Assets
Current Ratio=
Current Liabilities

It should be noted that while using current ratio as a measure of liquidity, one should be
careful about ist limitations because:

(a) it is a crude ratio because it measures only the quantity and not the quantity of current
assets.

(b) This ratio can easily be manipulated by over-valauing the current assets or excluding
certain current liabilities.

(ii) Liquid Ratio/ Acid Test Ratio/ Quick Ratio

This ratio measures the short term liquidity of the firm in its strict meaning because it
measures the current liabilities with liquid or quick assets and not with current assets. Liquid
assets are those assets which can be converted into cash within a short span of time without
the loss of value. Stocks and inventories is not considered liquid asset because it cannot be
converted into cash immediately without sufficient loss of value. Prepaid expenses are also
not included in liquid assets because they are used up in operations rather than converted into
cash. The ideal level of liquid ratio is 1:1.

Liquid Assets = Current Assets – (Prepaid Expenses + Stock or Inventories)

Liquid Assets
Liquid Rati o=
Current Liabilities

Sometimes a variation of the above formula is also used. Instead of total current liabilities,
only those current liabilities are taken in the denominator which are really payable within a
period of one year. So the amount of bank overdraft which is by nature a current laibility, but
which is ussually availed by the firm on more or less a regular bias, and is not payable on real
sense, is therefore deducetd from the amount of total current liabilities. So

Liquid Assets
Liquid Rati o=
Liquid Liabilities

 Liquid liabilities = Current Liabilities – Bank Overdraft

(iii) Absolute Liquidty Ratio (Super Quick Ratio).

This ratio establishes reltaionship between absolute liquid assets and liquid liabilities.
 Absolute Liquid Assets
Absolute Liquid Ratio=
Current Liabilities

Absolute liquid assets = Cash in Hand + Cash at Bank + Marketable Securities

The ideal level of absolute liquid ratio is 0.5:1

II. Profitability Ratios

Profitablity of business enterprise is an important measurement of its operational efficiency,

which, to the owners a measure of worth of their investments; to the creditors, the margin of
safety; to employees, a base of proper wages and faclities; to customers, a hint to demand for
price cuts and better quality and finally to an enterprise, an easy source of finance for
expansion.

(i) Gross Profit Ratio:

Is is also called as ‘Gross Profit Margin’ or ‘Gross Margin to Net Sales. This ratio establishes
relationship between gross profit and net sales of a firm.

Gross Profit
Gross Proft Ratio= ×100
Net Sales

 Net Sales = Total sales (Cash Sales + Credit Sales) – sales Return
 If gross profit is not given in the question, is can be obtained as Sales – Cost of Goods
Sold (COGS)
 If COGS is not known; then Gross Profit = Opening stock + Purchases + Direct
Expenses – Closing Stock.
 If net profit is given in the question, it can be converted into gross profit by adding
indirect expenses and interest to it.

(ii) Net Profit Ratio

It establishes relationship between ‘net profit’ and ‘net sales’. It shows the net contributions
made by every 1 rupee of sales to the owner funds.

Net Profit
Net Proft Ratio= × 100
Net Sales

 Net profit means net profit after taxes.

 Net profit is derived by deducting administrative expenses, selling expenses, finance
charges, etc. from the gross profit
  If non-operating income and expenses are also given in the question, net
operating profit should also be computed in order to judge the business
efficiency of the firm and for this purpose following formula can be used:

Net operating Profit EBIT

Net Operating Proft Ratio= ×100 or × 100
Net Sales Net Sales

 Net Operating Profit = Net Profit – non-operating income + non-operating expenses

 Operating profit ratio can help identify the corrective measures to improve the
profitability

(iii) Operating ratio

This ratio established the relationship between operating cost and net sales. Operating cost
means cost of goods sold plus operating expenses. Operating expenses include all those
expenses which have matching relationship with sales and in this context administrative
expenses and selling expenses are included mainly. In other words, non-operating income and
expenses which do not have any bearing on production and sales are excluded. These items
cover interest and dividend on investment, profit or loss on sales of fixed assets, etc.

Operating Cost
Operating Ratio= ×100
Net Sales

Or

COGS+operating Expenses
¿ × 100
Net Sales

 Operating ratio + net operating profit ratio =100

 Operating expenses = administrative expenses + selling expenses + distribution
expenses

(iv) Return on Proprietors’ Funds or Shareholder’s Investment:

This ratio is also called as ‘Return on Net Worth’ or ‘Return on Shareholders’ Funds’. This
ratio determines the earning capacity related to owners’ capital or investment.

Net Profit (after interest ∧tax)

Returnon Shareholder s ' Fund= × 100
Shareholder s' Fund

 If there is no information related to interest or tax in the question, then the net profit
as given in the question is used in the formula. But if profit before interest and tax is
given in the question, then the amount of interest and tax would be deducted from the
amount of net profit given in the question.
 o Shareholders’ Fund or Net worth1 = Equity Share Capital+ Preference Share
Capital+ Reserves and Surplus – Accumulated Loss and Fictitious Assets.

(v) Return on Equity (Equity Shareholders’ Fund)

This ratio is very important from the equity shareholder’s point of view because dividends on
equity shares depend upon the profits available for equity shareholders. This ratio is also
called as ‘Return on Owners’ Equity’.

Net Profit (after tax∧ preference divdiend )

Returnon Equity ( Shareholder s' funds ) = ×100
Equity Shareholder s ' Fund

 Common share holder equity = equity share capital + reserves and surplus

(vi) Return on Capital Employed

It establishes relationship between profits and the capital employed. It measures the overall
profitability and performance of business firm. Term capital employed refers to the total long
term sources of funds (shareholder funds + long term debts). It can also be defined as fixed
assets + net working capital.

Net Profit (before Interest ∧Tax)

Returnon Capital Employed= ×100
Capital Employed

 Long term Capital employed = owners funds+ borrowers funds

 Capital employed = total assets – current liabilities
 Capital employed = fixed assets + current assets – current liabilities
 Capital employed = fixed assets + working capital

III. Turnover Ratios

These ratios are also called as ‘Activity Ratios’ or ‘Performance Ratios’. The main aim of these ratios
is to judge the work performance of the enterprise and effectiveness of managerial decisions. In other
words, these ratios help to evaluate how well facilities and services available at the disposal of the
firm are being used to measure the effectiveness with which a firm uses the resources at its disposal
and implements its purchase, sales and other financial policies. These ratios are usually calculated on
the basis of sales or cost of sales and are expressed in integers or times or rate of turning over or
rotation.

(i) Stock/ Inventory Turnover ratios:

1
As per Section 2(57) of the Companies Act 2013, Net worth means aggregate value of the paid up capital and
all reserves created out of profits an securities premium account, after deducting the aggregate values of the
accumulated losses, deferred expenditure and miscellaneous expenditure not written off but does not include
reserves created out of revaluation of assets, write back of depreciation and amalgamation.
 This is also called a ‘stock velocity’. This ratio establishes relationship between cost of goods sold
during a given period and the average amount of inventory carried during that period. This ratio
would tell whether the stocks have been used efficiently or not and also to check whether only the
required minimum amount has been invested in stocks. If the stock turnover is high i.e. , the concern
is able to generate higher volume of sales with lower quantum of stocks, then marketing efficiency of
the concern would be considered sound and high. Concerns with too high stock turnover ratio may be
operating with low margin of profits and vice-versa. Also, too high stock turnover may be a symptom
of over-trading. If the stock turnover ratio is low then it is an indication of slump in business or over-
investment in stock.

Cost of Goods Sold

Stock orInventory Turnover Ratio=
Average Inventory

 Cost of goods sold (COGS) = Sales – Gross profit

 COGS = Opening stock + Purchases + Direct Expenses – Closing Stock
 Average Stock = (opening stock + closing stock)/ 2
 If COGS is not given in the question and it cannot be computed from the information
given, then ‘Net Sales’ may be used in place of COGS
 If average stock cannot be ascertained due to non-availability of required information,
closing stock may be treated as average stock.

(ii) Debtors / Trade Receivable/ Accounts Receivables Turnover Ratio

This is also called as ‘Debtors Velocity’. It establishes the relationship between credit sales
and average debtors of the year and indicates the number of times on the average receivables
turn into cash in each year. This ratio measures the economy and efficiency in collection of
amounts due from debtors. The higher the ratio, the better it is, since it would indicate that the
debts are being collected promptly. Such prompt collection not only provides additional
funds to the firm but also reduces the amount of bad debts.

Net Credit Sales

Debtors Turnover Ratio=
Average Debtors

 Net credit sales = Sales – Cash sales- sales returns

 Average Debtors or Accounts Receivable = (Opening debtors+ Closing debtors)/2
 Accounts Receivables = Debtors+ Bills Receivables
 If credit sales are not available, then all sales figure can be taken as credit sales
 If details regarding opening and closing debtors or receivables are not available,
closing debtors may be taken as average debtors.

Average collection period: an important calculation associated with debtors’ turnover ratio is
average collection period which indicates the average period (in days or months) of collection
of due from debtors. This period measures the quality of debtors. Shorter the collection
period, better the quality of debtors and vice versa.
 Average Debtors∨Trade Receivables
Average Collection period= × 100
Net Credit Sales

 The above formula gives answer in number of days. It is important that some authors
use 360 in place of 365. So, we can use 360 or 365 keeping in mind the nature of
business.
 If average collection period is required in months the multiplication has to be done by
12 in place of 365.
 The amount of ‘Bad Debts’ or ‘Reserve for Doubtful Debts’ may be given in the
question but these figures do not affect the calculation of debtors turnover ratio or
average collection period.
 However, if closing stock has to be calculated, then amount of bad debts is taken into
account.

(iii) Creditors Turnover Ratio or Trade Payables Turnover ratio

This ratio establishes relationship between net credit purchases and average creditors during a
year. It indicates the number of times the Payables rotate in a year or velocity with which the
payments for credit purchases are made to creditors.

Net Credit Purchases

Creditors Turnover Ratio=
Average Creditors∨ Accounts Payables

 Accounts Payable = Creditors + Bills Payable

 Net Credit Purchases = Total Purchases – Cash Purchases – Purchase Returns
 If the information about credit purchase is not given, the figure of total purchase may
be taken as the numerator
 If opening and closing balances of creditors are not known, the balance of creditors
given in the question may be taken to calculate the ratio.

Average Payment Period/ Average Credit Period:

The average payment period presents the average number of days taken by the firm to pay its
creditors. Generally, lower the period, the better is the liquidity position of the firm and
higher the period, less liquid is the position of the firm. However, a higher payment period
indicates greater credit period enjoyed by firm and larger is the benefit reaped from suppliers.

AverageCreditors∨Trade Payables
Average payment period= ×100
Net Credit Puchases

 If average payment period is required in months the multiplication has to be done by

12 in place of 365.

(iv) Working Capital Turnover Ratio

This ratio indicates the velocity of utilisation of net working capital. It indicates the number
of times the working capital is rotated in the course of a year. This ratio measures the
efficiency with which the working capital is being used by the firm. In fact working capital of
a firm is directly related to its sales because the current assets like cash, stock, debtors, bills
receivables, etc. change with increase or decrease in sales.

Cost of Goods Sold

Working Capital Turnover Ratio=
WorkingCapital

 Working capital = Current Assets – current Liabilities

 If the figure of Cost of Goods sold is not available or cannot be calculated with the
available information, figure of sales/cost of sales can be used instead.

(v) Assets Turnover Ratio

Net sales∨COGS
(a) Total Assets Turnover Ratio=
Total Assets

Net Sales∨COGS
(b) ¿ Assets Tu rnover Ratio=
¿ Assets

Net sales∨COGS
(c ) Current Assets Turnover Ratio=
Current Assets

IV. Solvency Ratios

Solvency means ability of the firm to pay off its liabilities as an when they become due.

Types of Solvency

Long term solvency

Short Term Solvency (ability of the firm to pay
(Assessed through off its long term liabilities,
liquidity ratios) at due time). Assessed
through stability ratios

(i) Debt –Equity Ratio

This ratio reflects long term financial position of a firm and is calculated in the form of
relationship between external equities or outsider’s funds and internal equities or
shareholder’s funds. Generally a ratio of 2:1 is considered to be satisfactory.
 Debt LongTerm Debts
Debt −Equity Ratio= ∨
Equity Shareholde r ' s Funds

Long term debts = debentures + loans+ other long term liabilities

Shareholders’ Funds = Equity Share Capital + Preference Share Capital + Reserves &
Surplus

Losses and fictitious assets such as preliminary expenses, discount on issue of debentures
etc., are deducted.

(ii) Proprietary Ratio

ratio is also called as ‘Equity Ratio’ or ‘Net Worth to Total Assets Ratio’. Creditors always want that
shareholders should have more stakes in the business. Thus greater the proprietor’s fund better is the
position of the creditors.

Proprietor Funds∨Shareholder Funds

Proprietary Ratio=
Total Assets

(iii) Capital Gearing Ratio

The ratio establishes relationship between fixed cost bearing capital (Preference share capital
+ debentures+ long term loans) and Equity Share capital Fund ( Equity Share capital and
Reserves & Surplus).

Equity ShareCapital + Reserves∧Surplus

Capital Gearing Ratio=
Preference ShareCapital + Interest Bearing Finance

Gearing the capital is a technique of raising finance for the enterprise through preference
capital and fixed interest bearing debentures or loans. If total of preference capital and fixed
interest bearing loan is more than the equity, gearing is high and if it is lees gearing is low.
During initial period of a firm low gearing is considered beneficial but with the expansion of
business high gearing becomes more profitable.

(iv) Interest Coverage or debt service ratio

This ratio indicates the ability of the firm to pay the interest due. Whenever any concern
procures loan, the creditor wants to be satisfied that interest will be received regularly and
easily. It measures as to how many times the interest liability of the firm is covered with the
operating profits of the firm. It gives an idea as to how much fall in EBIT, the firm can
sustain before it commits a default in the payment of interest liability. Higher the IC ratio, the
better it is both for the firm and the lenders.

Earnings Before Interest ∧Tax

Interest Coverage Ratio= ( Long term ) Loans∨Debentures ¿
Interest on ¿

V. Valuation Ratios

(i) Earnings per Share (EPS)

The ROE measures the profitability in terms of total funds and explains the returns as
percentage of funds. The profitability of the firm can also be measured in terms of number of
equity shares.

PAT −Preference Dividend

EPS=
Number of Equity Shares

The EPS Calculations in time series analysis indicate whether the firm’s EPS is increasing or
decreasing. Interpretation of EPS is subject to two considerations:

(a) If the firm has issued bonus shares in the particular year then the number of outstanding
equity shares at the end of the year will increase and consequently the EPS of that year will
be affected. Hence, EPS for that year and all subsequent years needs to be adjusted.

For example, a firm having 10,000 equity shares has reported a PAT of Rs 1,00,000. Hence
EPS would be Rs 10. Next year the firm earns a PAT of Rs 1,50,000 and the EPS is Rs 15.
However, if the firm issues bonus shares in the ratio of 2:5 during the next year then the
number of equity shares would be 14,000 and the EPS would be Rs 10.70 i.e. (Rs 150000 /
14,000).

(b) The increase in EPS over the years does not necessarily mean increase in profitability.
Over the years firm might have retained the profits as a result of which total funds have
increased. The percentage ROE even if constant will result in greater absolute amount of
PAT which divided by constant number of equity shares indicates an increasing EPS. This
increase is erroneous in the sense that real earnings (ROE) have not increased.

(ii) Dividend per Share (DPS)

Sometimes the equity shareholders may not be interested to know the EPS but in the return
that they are actually receiving from the firm in the form of dividends. The amount of profits
distributed to shareholders per share is known as DPS.

Total Profits Distributed

DPS=
Number of Equity Shares
Generally, companies declare dividend in terms of percentage of paid up capital. For
example, if a company declares dividend of 25% on equity shares of face value of Rs 100
each then the DPS is Rs 25. In this case, if the paid up value is Rs 80, then the DPS is Rs 20
i.e. (25% of Rs 80). In the time series analysis of DPS, the analyst should make adjustments
for bonus shares as discussed earlier.

(iii) Dividend Payout Ratio

The DP ratio is the ratio between DPS and EPS i.e. it refers to the portion of EPS which has
been distributed as dividend by the company. For example, if a company has an EPS of Rs 10
and DPS of Rs 4, then the DP ratio is 40%.

DPS
DP Ratio= × 100
EPS

Since objective of financial management is defined as the maximisation of shareholders

wealth as reflected in market price of shares, the profitability of the firm may also be viewed
in terms of market price or market expectations. For this purpose following ratios based on
market price are available.

(iv) Price Earnings Ratio (PE Ratio)

This ratio established relationship between EPS and Market Price of Shares (MPS).

MPS
P/ E Ratio=
EPS

PE ratio shows the expectations of the equity investors about the earnings of the firm.
Companies having high growth prospects have higher PE ratio as compared to non-growth or
slow growth firms. Thus a high PE ratio may indicate:

(a) that the share has low risk and therefore the investors are content with low prospective
return or

(b) the investors expect high dividend growth and are ready to pay a higher price for the share
at present.

(v) Yield:

With reference to equity shares, the yield may be defined as the rate of return on market price
of equity shares. In order to find out the yield on an equity share, the market price may be
compared with EPS or DPS to find out the Earnings Yield or Dividend Yield respectively as
follows:

E PS
Earnings Yield=
MPS
 DPS
Dividend Yield=
MPS

It may be observed that the Earnings Yield is the inverse of the PE Ratio. Earnings Yield is
also known as Earnings Price Ratio. Earnings Yield and Dividend Yield evaluate the
profitability of the firm in terms of market price of shares and hence are useful from the point
of view of prospective investor who is evaluating a share worth to take a buy or not to buy
decision.