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Ratio Analysis

Financial Ratio Analysis is a study of ratios between

various items or groups of items in financial statements.

They provide in a summarized and concise form of fairly good idea about the financial position of a unit.

To identify aspects of a businesss performance to aid decision making
Facilitate the inter-firm comparisons of different sizes

5 Main Areas
1. Liquidity the ability of the firm to pay its way 2. Investment/shareholders information to enable

decisions to be made on the extent of the risk and the earning potential of a business investment 3. Leverage information on the relationship between the exposure of the business to loans as opposed to share capital 4. Profitability how effective the firm is at generating profits given sales and or its capital assets 5. Efficiency the rate at which the company sells its stock and the efficiency with which it uses its assets

Before looking at the ratios there are a number of cautionary points concerning their use that need to be identified :
a. The dates and duration of the financial statements being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn. b. The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results. c. In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.

The utility of ratio analysis will get further enhanced if following comparison is possible. 1. Between the company and its competitor 2. Between the company and the best enterprise in the industry 3. Between the company and the average performance in the industry 4.Between the company and the global average

How a Ratio is expressed?

As Percentage - such as 25% or 50% . For example if

net profit is Rs.25,000/- and the sales is Rs.1,00,000/then the net profit can be said to be 25% of the sales. As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Classification of Ratios
Balance Sheet Ratio P&L Ratio or Income/Revenue Statement Ratio
Operating Ratio

Balance Sheet and Profit & Loss Ratio

Composite Ratio

Financial Ratio

Current Ratio Quick Asset Ratio Debt Equity Ratio

Gross Profit Ratio Operating Ratio Expense Ratio Net profit Ratio Stock Turnover Ratio

Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors Turnover Ratio,

Format of balance sheet for ratio analysis LIABILITIES


NET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS : LAND & BUILDING, PLANT & Share Capital/Partners Capital/Paid up Capital/ MACHINERIES Owners Funds Original Value Less Depreciation Reserves ( General, Capital, & Other Reserves) Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED NON CURRENT ASSETS FUNDS : Term Loans (Banks & Institutions) Long Term Security Deposits Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities

CURRENT LIABILTIES Bank Working Capital Limits such as CC/OD/Bills/Export Credit Sundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or deposits Expenses payable & provisions against various items

CURRENT ASSETS : Cash & Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks & inventory (RM,WIP,FG) Stores & Spares, Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months INTANGIBLE ASSETS Patent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses

Some important notes

Current Liabilities are those which have either become due for

payment or shall fall due for payment within 12 months from the date of Balance Sheet Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital Net Worth & Long Term Liabilities are also called Long Term Sources of Funds Current Liabilities are known as Short Term Sources of Funds Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities Current Assets are Short Term Use of Funds

Some important notes

Assets other than Current Assets are Long Term Use of Funds

Installments of Term Loan Payable in 12 months are to be taken as

Current Liability only for Calculation of Current Ratio & Quick Ratio. If there is profit it shall become part of Net Worth under the head Reserves and if there is loss it will become part of Intangible Assets Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other securities are to be treated Current if they are quoted. Investments in allied/associate/sister units or firms to be treated as Non-current. Bonus Shares as issued by capitalization of General reserves and as such do not affect the Net Worth. With Rights Issue, change takes place in Net Worth and Current Ratio.



Current Ratio : It is the relationship between the current assets and current liabilities of a concern. Current Ratio = Current Assets/Current Liabilities The ideal Current Ratio preferred is 2 : 1


Net Working Capital : This is worked out as surplus of Long Term Sources over Long Tern Uses, alternatively it is the difference of Current Assets and Current Liabilities. NWC = Current Assets Current Liabilities

3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current

Assets and Current Liabilities. The should be at least equal to 1.
Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example : Cash 50,000 Debtors 1,00,000 Inventories 1,50,000 Total Current Assets 3,00,000

Current Liabilities 1,00,000

Current Ratio = > ? Quick Ratio => ?


Earnings per share profit after tax / number of shares Price earnings ratio market price / earnings per share the higher the better generally. Comparison with other firms helps to identify value placed on the market of the business. Dividend yield ordinary share dividend / market price x 100 higher the better. Relates the return on the investment to the share price.

4. DEBT EQUITY RATIO : It is the relationship between borrowers fund (Debt) and Owners Capital (Equity).
Long Term Outside Liabilities / Tangible Net Worth

Liabilities of Long Term Nature

Total of Capital and Reserves & Surplus Less Intangible Assets For instance, if the Firm is having the following : Capital = Rs. 200 Lacs Free Reserves & Surplus = Rs. 300 Lacs Long Term Loans/Liabilities = Rs. 800 Lacs Debt Equity Ratio will be => ??

DEBT SERVICE COVERAGE RATIO : This ratio is one of the most important one which indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals and forms the basis for fixation of the repayment schedule in respect of the Term Loans raised for a project. (The Ideal DSCR Ratio is considered to be 2 ) PAT + Depr. + Annual Interest on Long Term Loans & Liabilities --------------------------------------------------------------------------------Annual interest on Long Term Loans & Liabilities + Annual Installments payable on Long Term Loans & Liabilities ( Where PAT is Profit after Tax and Depr. is Depreciation)


GROSS PROFIT RATIO : By comparing Gross Profit

percentage to Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, it can also be interpreted as below :

Gross Profit Ratio = [ (Sales Cost of goods sold)/ Net Sales] x 100
A higher Gross Profit Ratio indicates efficiency in production of the unit.


It is expressed as =>

(Operating Profit / Net Sales ) x 100

Higher the ratio indicates operational efficiency NET PROFIT RATIO : It is expressed as => ( Net Profit / Net Sales ) x 100

It measures overall profitability.


Net Profit after Taxes/Total Assets


( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period.


STOCK/INVENTORY TURNOVER RATIO :. This ratio indicates the number of times the inventory is rotated during the relevant accounting period = Cost of Goods Sold ------------------------Average Inventory

Days Sales in Inventory:

= (Average Inventory/Daily Sales)

Average Inventory or Stocks = (Opening Stock + Closing Stock) -----------------------------------------

DEBTORS TURNOVER RATIO : This ratio indicates the number

of times the debtors are rotated during the relevant accounting period

Average Collection Period:

company =(Average Debtors/Daily Sales )

Compared with credit terms of



Net Sales/Tangible Assets

Net Sales /Fixed Assets


EXERCISE 1 LIABILITES Capital Reserves Term Loan Bank C/C Trade Creditors Provisions ASSETS 180 Net Fixed Assets 20 Inventories 300 Cash 200 Receivables 50 Goodwill 50 800 800 400 150 50 150 50


What is the Net Worth :

EXERCISE 1 LIABILITES Capital Reserves Term Loan Bank C/C Trade Creditors Provisions ASSETS 180 Net Fixed Assets 20 Inventories 300 Cash 200 Receivables 50 Goodwill 50 800 800 400 150 50 150 50

What is Tangible Net Worth :

EXERCISE 1 LIABILITES Capital Reserves Term Loan Bank C/C Trade Creditors Provisions ASSETS 180 Net Fixed Assets 20 Inventories 300 Cash 200 Receivables 50 Goodwill 50 800 800 400 150 50 150 50

What is Outside Liabilities