RATIO ANALYSIS

Dr. R. S. Aurora
M.Com, MFM, D.H.E., Ph.D., UGC- NET, AISTD,AIMCI, AAIMA
Faculty in Finance, IBS- Mumbai

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What is a Ratio?

• Refers to the establishment of relationship between any two

inter-related variables.

• While determining a ratio, it is desirable to divide the more

favorable or desirable or significant variable by the less
favorable or desirable one.

• Is an effective tool or a device to diagnose the financial and

operational weaknesses of business enterprises

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Classification of Ratios:

• Long-term solvency ratios

• Short-term solvency ratios

• Profitability ratios

• Activity ratios

• Operating ratios

• Market Test ratios

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Long-term Solvency Ratios
• Helps determine the long-term financial stability of the firm

• Can be used to assess ability of the firm to meet all its

liabilities.

Debt Equity Ratio:

• Analyses the extent to which the assets are financed by the
outsiders and the owners.

• If the proportion of debt to equity is low, a company is said

to be low geared and vice versa.

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• Higher the gearing more volatile is the returns to the shareholders

• Financial institutions for financing of projects accept a debt

equity ratio of 2:1.

Debt
• Debt Equity Ratio = ---------
Equity

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Shareholder Equity ratio:

• Ratio establishes the relation between share capital and total

tangible assets

• Shareholders funds represent both equity and preference capital

plus reserves and surplus less losses

• Reduction in the shareholders funds indicates over dependence

on outside sources for long-term financial needs and this
obviously carries greater risk.

Share Capital
• Proprietary Ratio = --------------------
Total Assets 6
Capital Gearing Ratio:

• Ratio reflects the proportion of fixed interest bearing securities to

equity shareholders funds

• Fixed interest bearing securities include debentures, long-term

loans and preference share capital

• Ratio indicates whether the firm is trading on equity or otherwise

• A firm that has higher proportion of fixed interest bearing funds is

aid to be trading on equity and vice versa.

Debentures + Loans + Pref. Share Capital

• Capital Gearing Ratio = -------------------------------------------------------------
Equity Shareholder’s Funds

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 Proprietary Ratio:

• Ratio expresses the relationship between net worth and total assets

• Net Worth includes Equity Capital + Preference Capital + Reserves

- Fictitious assets

• Reserves earmarked for a particular purpose not to be included in

calculating the Net worth

• Total assets on the other hand include Fixed Assets + Current assets

• Higher the ratio the better it is for it indicates a strong financial

position of the business

Net Worth
• Proprietary Ratio = -------------------
Total Assets
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Interest Cover ratio:

• Ratio shows how any times interest charges are covered by funds
that are available for payment of interest.

• Financial institutions consider a ratio of 2:1 as appropriate

• High ratio indicates that the firm is conservative in using debt and
a low ratio indicates that the firm uses debt excessively.

Profit before Interest, Depreciation and Tax

• Interest Cover Ratio = ----------------------------------------------------------------
Interest
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Short-term Solvency Ratios:
• Helps in measuring the ability of the firm to meet its maturing
short-term obligations

Current ratio:
• Establishes the relation between the current assets and current
liabilities

• Current assets are those assets that can be converted into cash
within a year and include Sundry Debtors, Bills Receivable¸ Cash,
Bank balance, Prepaid expenses, Outstanding Income and Stock

• Current liabilities are those liabilities that are payable within a year
and include Sundry Creditors, Bills Payable, Bank Overdraft,
Outstanding Expenses and Income received in advance 10
 Current Assets
• Current Ratio = -------------------------
Current Liabilities

• Standard current ratio is 2:1 and it indicates a highly short-term

solvency position.

• Banks accept a current ration of 1.33:1 for providing working

capital to firms.

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Liquid Ratio
• Ratio is concerned with the establishment of relationship between
quick assets and quick liabilities

• Liquid assets are those that can be converted into cash without loss
of time and money

• Liquid Assets include Current Assets – Stock and Prepaid

Expenses.

• Liquid Liabilities are Current liabilities – Bank Overdraft

Liquid Assets
• Quick Or Liquid Ratio = --------------------------
Quick Liabilities

• Standard ratio is 1:1 12

Profitability Ratios:

Gross Profit Ratio

• Establishes the relationship between gross profit on sales and

net sales

• Measures the efficiency of the company’s operations and can be

compared with the previous year’s figures to ascertain
improvements if any.

• High ratio indicates the organization’s successful attempt to

produce the product at a relatively lower cost

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• In case of multi-product situation, it is advisable to compute the
rate for each product separately

• If this is not done the loss arising in one product may be concealed
by the high gross margin in another.

Gross Margin
• Gross profit ratio = -------------------- X 100
Net Sales

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Operating Profit :

• Ratio takes into account the aggregate of manufacturing cost

of goods sold and other operating expenses on one hand and the
net sales revenue on the other

• Operating Expenses include administrative overheads and selling

and distribution overheads and finance overheads

• A high operating ratio means the firm is left with a small margin
to absorb its other expenses like tax, dividend, etc

COGS + Operating Expenses

• Operating Profit Ratio = ----------------------------------------- X 100
Net Sales

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Net Profit Ratio:

• Ratio establishes the relationship between the amount of net profit

and the sales revenue

• Net profit is ascertained as Operating Profit + Non-operating

profits – Non-operating losses

Profit after Taxes

• Net Profit Ratio = ------------------------- X 100
Net Sales

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 Return on Capital Employed

• Ratio is useful in ascertaining the profit that has been earned on

the capital employed

• Return on capital employed can be increased by increasing the

profit margin, increasing the investment turnover or by increasing
both profit margin and investment turnover

Profit after tax

• ROCE = -------------------------
Capital Employed

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Earnings Per Share:

• Value is maximized when the market price of equity shares is

maximized

• Helps in ascertaining the net profit earned per share

• A steady growth in EPS year after year indicates a good track

record as far as the profitability of the firm is concerned.

PAT and preference dividend

• EPS = ------------------------------------------
Number of Equity Shares

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 Activity Ratios:

• Measures the effectiveness with which the firm has employed

its resources

• Ratios help in ascertaining the speed with which various accounts

are converted into sales or cash

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Inventory Ratio or Stock Turnover Ratio

• Ratio establishes the relation between the cost of goods sold during
a given period and the average stock

• Higher the stock turnover ratio indicates that the sales are
improving and inventory is dropping

• Reflects the improving liquidity position of the firm..

Cost of Goods Sold

• Stock turnover ratio = ------------------------------
Average stock

Where average stock is Opening stock + Closing stock / 2

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Debtors Turnover Ratio

• Establishes the relation between net credit sales and the average
receivables

• Useful in ascertaining the efficiency with which the company

converts its debtors into cash

Net Credit Sales

• Debtor’s Turnover Ratio = -------------------------
Average debtors

• Where average debtors are opening debtors + closing debtors / 2

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 Creditors Turnover Ratio:

• Ratio shows the average time taken to pay for the goods and
services purchased by the company

• Longer the credit period the better it is. In other words this ratio
should be high

Credit Purchases
• Creditors Turnover Ratio= -----------------------
Average Creditors

• Average creditors are Opening Creditors + Closing Creditors

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 Assets Turnover Ratio:

• Ratio measures the ability of the firm to generate sales revenue

in relation to the size of the asset investment

• A low asset turnover may be remedied by increasing the sales or

by disposing of some of the fixed assets or both

Sales
• Fixed Assets Turnover Ratio = --------------------
Fixed Assets

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Operating Ratios :

• Ratio of all operating expenses to sales is operating ratio.

• Analysis of the operating ratio helps to understand whether the cost

content is high or low in relation to the sales

• Indicative of the operational efficiency or inefficiency of the firm.

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Expenses Ratio:

• Ratio is calculated to determine the relationship between sales

and their operating expense, either as a total or individually

Operating Expenses
• Expenses Ratio = ------------------------------ X 100
Net Sales

• Numerator can also be substituted by (i) Administrative Expenses

(ii) Selling Expenses or (iii) Finance Expenses.

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Stock Working Capital Ratio :

• Ratio establishes the relationship between closing stock and the

working capital of the company

Closing Stock
• Stock Working Capital Ratio = ----------------------
Working Capital

• Standard ratio is 1:1

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Market Test Ratios:

• Ratios relate the firms’ stock price to its earnings and the book
value of the shares

• Reflects the investor’s perception of the firm and its future prospects

• If the profitability, solvency and turnover ratios are high, the

market test ratios will show a positive trend and accordingly
these ratios are expected to be high

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Dividend Payout Ratio:

• Indicates the net profit distributed to the shareholders

• A high ratio reflects that the firm is liberal in dividend distribution

and vice versa.

Dividend per share

• Dividend Payout Ratio: ---------------------------
Earnings per share

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Dividend Yield Ratio:

• Ratio reflects the percentage yield that an investor receives on

the investment at the current market price of the shares

Dividend per share

• Dividend Yield ratio = --------------------------------- X 100
Market price per share

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Book Value Per Share:

• Ratio reflects the net worth per equity share.

• Reflects the past earnings and the distribution policy of the company

• A high ratio indicates that the firm was conservative in declaring

dividend and has huge reserves.

• Such a firm may declare a bonus in the near future.

• A low ratio indicates that the firm has been liberal in declaring
dividend or alternatively the profitability track record is poor.

Equity Capital + Reserves - P and L (Debit balance)

• Book Value = --------------------------------------------------------------------------
Total number of Equity Shares
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Price Earnings Ratio:

• Ratio measures the number of times the earnings of the latest

year at which the share price is quoted.

• Reflects the market’s assessment of the future earning potential

of the company. Obviously a high P/E ratio is preferred.

Current Market Price

• P/E Ratio = --------------------------------
Earnings Per Share

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 Advantages of Ratio Analysis:

• Help to summarize and simplify the voluminous financial data

• Helpful in discharging managerial duties and responsibilities such

as planning, controlling, etc. by providing insight into the financial
data

• Trend ratios help the analysts to find out whether the company has
been improving its performance or not over the years

• Capable of identifying the factors that are responsible for the

failure of the company

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• Help the analysts to assess the performance of the company
from the of profitability, liquidity, long-term solvency, etc.

• By establishing the standards for each ratio, management can

compare the actual with the standards that act as the targets

• Help the companies to undertake intra-company and

infra-company comparisons

• Are a tool for both minimizing costs and maximizing revenue and
profits

• Help formulate the policies for future including the capital

expenditure decisions
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 Limitations Of Ratio Analysis :

• Portray the relationship between two items of the financial

statement. Prior to the interpretation of the ratios, it is necessary to
study the factors, reasons, policies, etc. that have influenced the
figures used for calculating the ratios.

• Based on the accounts that are prepared on the basis of the

historical data

• Are as correct as the financial statements on which they are based

• Have no established standards

• Difficult and for that matter wrong to compare the results of two
companies on the basis of ratios
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Cautions in Using Ratio Analysis:

• Difficult out find out a proper basis of comparison

• Price level changes make the interpretation of ratios difficult

• Comparison of the ratios of two companies becomes difficult and

meaningless when they are operating in different situations

• While the analyst is interested in the future, ratios analyze the past

• Ratios at a moment of time suffer from temporary changes

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YOUR QUESTIONS
PLEASE ????

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THANK YOU

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