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# Ratio Analysis

## 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

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

## 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

## 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

## 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

## 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

## CostofGood sSold AverageStock

CostofGood sSold AverageStock

## 2) Debtor Turnover Ratio

CreditSales AverageDebtors

## 4) Fixed Assets Turnover Ratio

NetSales NetFixedAssets

## 5) Total Assets Turnover Ratio

NetSales TotalAssets

## NetSales Long TermFunds

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

## 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

2) PE Ratio

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