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Ratio Analysis

B.V.Raghunandan, SVS College, Bantwal-Karnataka India

Meaning of Ratio Analysis


It is an analysis of strength and weakness of an organisation by establishing the quantitative relation among the items of Balance Sheet or Income Statement of such an organisation

Purpose/Importance/Advantages
Analysis of financial Position Simplification of Accounting Figures Assessment of Operational Efficiency Determining Trends in the long-run Identification of Strength & Weakness Taking Remedial Measures Comparison of Performance

Limitations of Ratio Analysis


Based on Historical Data Change in Real Value of Monetary Unit No Standard Interpretation Ignoring Qualitative Aspects Difference in Accounting Methods make comparison difficult Ambiguity in Terms Used

Classification of Ratios
A. Liquidity Ratios B. Solvency Ratios

C. Activity Ratios D. Profitability Ratios


E. Shareholders' Ratios

A. Liquidity Ratios
Used to study the ability of the organisation in meeting short-term payments or obligations Includes: 1) Current Ratio, 2) Acid Test Ratio and 3) Working Capital Turnover Ratio

1) Current Ratio
Relation between current assets and current liabilities Long Term Sources Financing the Current assets give a stable base for the liquidity of the organisation Normally , the ratio should not be less than 2 i.e., the current assets should be double the size of current liabilities

Measurement of Current Ratio

CurrentAssets Current Ratio = CurrentLiabilities

2) Acid Test Ratio/Quick Ratio


It is the ratio between quick assets and quick liabilities Quick assets include current assets except inventory and pre-paid expenses Quick liabilities include current liabilities other than bank overdraft A 1:1 ratio is healthy Healthy indicator of cash management

Measurement of Acid Test Ratio

Acid Test Ratio =

QuickAssets QuickLiabilities

3) Working Capital Turn-over Ratio


Shows the efficiency of usage of working capital Relation between Sales and Working Capital Determination of number of times the working capital is turned over to achieve the maximum profit

Measurement of Working Capital Turnover Ratio

NetSales AverageWor kingCapital

B. Solvency Ratios
Measure long-term liquidity ratio Reflect the ability of the firm to pay interest and repayment of loans at due dates on the long-term loans taken Avoidance of over-borrowing (overleverage) Avoidance of bankruptcy by maintaining healthy solvency ratios

Types of Solvency Ratios


1) Interest Coverage Ratio 2) Debt Ratio 3) Debt-Equity Ratio 4) Capital Gearing Ratio 5) Proprietary Ratio

1.Interest Coverage Ratio


Pr ofitBefore Interest & Tax InterestonLong TermDebt

2. Debt Ratio (Debt to Total Funds ratio)

LTDebt LTDebt ShareholdersFunds

3) Debt-Equity Ratio

LongTermDebt ShareholdersFunds

4) Capital Gearing Ratio

FixedIncomeBearingSecurities EquityShareholdersFund

5) Proprietary Ratio

ShareholdersFunds TotalAssets

C] Activity Ratios
1) 2) 3) 4) 5) 6) Inventory Turnover Ratio Debtors Turnover Ratio Average Collection Period Fixed Assets Turnover Ratio Total Assets Turnover Ratio Capital Turnover Ratio

1) Inventory Turnover Ratio

CostofGood sSold AverageStock


CostofGood sSold AverageStock

2) Debtor Turnover Ratio

CreditSales AverageDebtors

3) Average Collection Period

365(day sin aYear) / 12(months) DebtorTurnoverRatio

4) Fixed Assets Turnover Ratio

NetSales NetFixedAssets

5) Total Assets Turnover Ratio

NetSales TotalAssets

6) Capital Turnover Ratio

NetSales Long TermFunds

D] Profitability Ratios
1) Net Profit Ratio 2) Gross Profit Ratio 3) Return on Total Assets 4) Return on Equity

1) Net Profit Ratio

Pr ofitAfterT ax X 100 NetSales

2) Gross Profit Ratio

Gross Pr ofit X 100 Sales

3) Return on Total Assets

Pr ofitAfterT ax X 100 TotalAssets

4) Return on Equity

Pr ofitAfterT ax X 100 Shareholders ' Funds

E) Shareholders Ratio
1) Earning per Share (EPS) 2) Price-Earning Ratio (PE Ratio) 3) Dividend Yield Ratio 4) Dividend Pay-out Ratio

1) Earning per Share

Pr ofitAfterT ax NumberofEq uityShares

2) PE Ratio

Mar ker Pr iceperShare EarningperShare

3) Dividend Yield Ratio

DividendperShare X 100 Market Pr iceperShare

4) Dividend Pay-out Ratio

DividendperShare X 100 EarningperShare

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