Financial Ratio Analysis

07/20/2020 1
 SIGNIFICANCE OF RATIO ANALYSIS

‘A’ earns Rs 50,000

‘B’ earns Rs 40,000

Which is more efficient? A or B

‘A’ has emp Rs 4,00,000

‘B’ has emp Rs 3,00,000

Profit as a % of Capital emp

‘A’ = (50,000/ 4,00,000) * 100 =12.50%
‘B’ = (40,000/ 3,00,000) * 100 =13.33%

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 RATIO

A ratio is a statistical yardstick that provides

a measure of the relationship between two
variables or figures.
 Meaning
• A ratio is a simple arithmetical expression of
the relationship of one number to another.
• It may be defined as the indicated quotient of
two mathematical expressions.
 Example
• Current Assets =Rs.500000
• Current Liabilities=Rs. 250000

Ratio = 500000/250000
=2
 Expression Of Ratio
• Percentage (%)
• Proportion (2:1)
• Time (5 times)
 WHY BOTHER WITH RATIOS?

• A comparison is more useful than mere Nos

• Analysis of financial ratios involves two types of comparisons:
– Present ratio with the past ratios & expected future ratios
– Ratios of one firm with those of similar firms or with industry averages
at same point of time
• Essential to consider nature of business
(apples cannot be compared with oranges)

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 Classification of Ratios
• Liquidity Ratios

• Leverage or Capital Structure Ratios

• Activity Ratios

• Profitability Ratios
 Liquidity Ratios
• Liquidity means the ability of a concern to
meet it current obligations.

Current Ratio=Current Assets/Current

Liabilities
• Standard 2:1
Acid Test Ratio/Quick Ratio/Liquid Ratio

• Quick Ratio = Quick Assets/Current

Liabilities
• Quick Assets=Current Assets
-(Inventories + Prepaid
Expenses)
Standard =1:1
 CURRENT RATIO (CR)

• Measure of company’s ability to meet short term requirements

• Indicates whether current liabilities are adequately covered by current
assets
• Measures safety margin available for short term creditors
• CR = Current assets/Current liabilities

• If Net Working Capital is to be positive, CR >1

• Indian avg for non banking industries is 2

 Current assets = 681

 Current liabilities = 399
 CR = 681/399
07/20/2020 = 1.71 11
 CURRENT RATIO (CR) - IMPORTANCE

• Higher ratio ensures firm does not face problems in meeting

increased working capital requirements
• Low ratio implies repeated withdrawls from bank to meet liquidity
requirements
• High CR as compared to other firms implies advantage of lower int
rates from banks

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 ACID TEST RATIO/QUICK RATIO(QR)

• Used to examine whether firm has adequate cash or cash equivalents to meet
current obligations without resorting to liquidating non cash assets such as
inventories
• Measures position of liquidity at a point of time
• QR = Quick Assets / Current Liabilities
 Quick assets = Current assets – (inventories + prepaid expenses)

= 681–(355+64) = 262
 Current liabilities = 399

• QR = 262/399 = 0.66
• As a thumb rule ideal QR = 1; should not be less than 1
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 Following is the balance Sheet of X Ltd as on 31 March, 2013
Liabilities Rs Assets Rs
Equity Share Capital 1,50,000 Land & Building 1,00,000
Capital reserve 1,00,000 Plant and machinery 1,00,000
Reserve for 1,00,000 Loose Tools 15,000
contingencies
15% Bank Loan 1,00,000 Patents 10,000
Taxation Closing Stock 2,00,000
Current 20,000 Debtors 1,08,000
Future 30,000 Less Provision for 1,00,000
Doubtful debt 8,000
Trade Creditors 34,000 Cash 30,000
Outstanding Salaries 5,000 Marketable Securities 20,000
Bank Overdraft 25,000 Income Tax Paid in 10,000
Advance
Dividends Payable 36,000 Share Issue 15,000

Calculate the Liquidity Ratios and Comment on the short term financial Position of
the firm
• Current assets of a company are 3,60,000. Its
Current Ratio is 2.4:1 and acid test ratio is
1.3:1. Calculate the value of Current Liabilities,
liquid assets and stock.
• Working Capital of the company is 30,000. Its
current ratio is 2.5:1. Calculate the value of I
Current Assets II Current Liabilities III Acid test
Ratio, assuming stock of 26,000
 ACTIVITY / TURN OVER RATIOS

These Ratios are calculated on the basis of sales or

cost of sales and therefore these ratios are also
called Turnover Ratios. Turnover indicates the speed
or number of time the capital employed has been
rotated in the process of doing business.

These ratios indicate how efficiently the capital is

being used to obtain sales, how efficiently the fixed
assets are being used to obtain sales, an how
efficiently the working capital and the stock is being
used to obtain sales.

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 Classification Of Activity Ratios
• Stock/Inventory Turnover Ratio
• Debtors or Receivable Turnover Ratio
• Average Collection Period
• Creditors or Payable Turnover Ratio
• Average Payment Period
• Fixed Asset Turnover Ratio
• Working Capital Turnover Ratio
 Stock Turnover Ratio

Every firm should have sufficient level of

Inventory. It should neither be too high nor
too low.
This ratio indicates the number of times the
stock has been turned over during the period
and evaluates the efficiency with which a firm
is able to manage its inventory.
• Stock Turnover Ratio= COGS/Average
Stock
COGS =Cost Of Goods Sold
= Net Sales – Gross Profit
OR = Opening Stock + Purchases +Direct
Expenses-Closing Stock
AV. Stock = Opening Stock + Closing Stock
2
• Inventory Holding Period (Average Time taken
to clear the stock)

= 365/52/12
Stock/Inventory Turnover Ratio
 Interpretation
• A high inventory turnover indicates efficient management of
inventory because more frequently the stocks are sold, the
lesser amount of money is required to finance the inventory.
• In a business where stock turnover ratio is high goods can be
sold at a low margin of profit and even then the profitability can
be high.
• A low inventory turnover implies over-investment in inventories,
dull business, stock accumulations, poor quality of goods, slow
moving goods and low profits as compared to investments.
• This ratio can be used for comparing the efficiency of sales policy
of two companies doing same business. The stock policy of the
management of that firm whose stock turnover ratio is high will
be treated more efficient.
Problem 1
Opening Stock 29,000 Closing Stock 31,000 Sales 3,20,000 Gross
Profit ratio 25% on Sales. Calculate Inventory Holding Period,
Stock Turnover Ratio and Purchases
From the following information calculate the a) COGS b)
Opening Stock & Closing Stock c) Quick Assets and Current
Assets

1) Stock Turnover Ratio 5 times

2 ) Stock at the end is Rs 5000 more than the stock at the
beginning
3) Sales (all credit) Rs 2,00,000
4) Gross Profit Ratio ¼ on cost
5) Current Liabilities Rs 60,000
6) Quick Ratio 0.75
 Debtors Or Receivables Turnover
• Debtors or Receivables Turnover
= Net Credit Annual Sales
Average Debtors + Average B/R
Average collection Period
= 365/52/12
DTR
Average Debtors & B/R
= O D+ O B/R+ C D+ C B/R
2
 Interpretation
• This ratio Indicates the speed with which the
amount is collected from debtors.
• Generally, higher the value of debtors
turnover the more efficient is the
management of debtors
• The more quickly the debtors pay the less are
the chances of Bad Debts.
• A very high this ratio may imply firm’s inability
due to lack of resources to sell on credit
thereby losing sales and profits.
 Average Collection Period
• This ratio indicates the time within which the
amount is collected from debtors and bills
receivables. This ratio is computed by the
following formula:
= Debtors + Bills Receivable
Credit Sales per day
Credit Sales per day = Net Credit
Sales of the year
365
ACP = Average Debtors * 365
 Significance
• This Ratio shows the time in which customers
are paying for credit sales.
• Increase in this ratio indicates the excessive
blockage of funds with debtors which increase
the chances of bad debts.
• A higher debt collection period is thus an
indication of inefficiency and negligence on
the part of management.
Calculate Debtors Turnover Ratio, from the
following
Total Sales for the year 4,00,000
Cash Sales: being 25% of the Credit sales
Closing Debtors 1,00,000
Excess of Closing Debtors over
Opening Debtors 40,000
 Creditors Or Payables Turnover Ratio

• Creditors Turnover Ratio

= Net Credit Annual Purchases
Average Creditors + Average Bills Payable
Average Payment Period
= 365/52/12
CTR
 Interpretation

• This ratio indicates the relationship between

credit purchase and average creditors during
the year.
• This ratio indicates the speed with which the
amount is being paid to creditors.
• The higher the ratio, the better it is , since it will
indicate that the creditors are being paid more
quickly which increases the credit worthiness of
the firm.
 Average Payment Period
• This ratio indicates the period which is normally
taken by the firm to make payments to its
creditors.
• Average Payment period
= Creditors + B/P
Credit Purchase per Day
= 12 months or 365 days
Credit turnover ratio
The lower the ratio better it is, because a shorter
payment period implies that the creditors are
being paid rapidly.
 Fixed Asset Turnover Ratio
• This ratio is of practical importance in
manufacturing concerns where the
investment in fixed asset is high.
• This ratio reveals how efficiently the fixed
assets are being utilized.
• Compared with the previous year, if there is a
fall in this ratio, it will show fixed assets have
not been significantly used.
• Fixed Asset Turnover Ratio
= Cost of Goods Sold
Net Fixed Assets
• Fixed Assets Turnover= Net sales/ Net Fixed
Assets

From the following information, calculate Fixed Assets Turnover

Ratio:
Gross fixed asset Rs. 4,00,000; Accumulated Depreciation Rs.
1,00,000; Marketable securities Rs. 20,000; Current Assets Rs.
1,30,000; Miscellaneous expenditure Rs, 20,000; Current
Liabilities Rs. 50,000; Gross sales Rs. 18,30,000; sale return Rs.
30,000
 Working Capital Turnover Ratio:
• This ratio is of practical importance for non-
manufacturing concerns where current assets
play a major role in generating sales.
• This ratio reveals how efficiently working
capital has been utilized in making sales.
• A high working capital turnover ratio shows
efficient use of working capital.
• WCTR = COGS/WC OR NET Sales/WC
• WC = Current Assets-Current Liabilities
 Profitability Ratio
• Every business must earn sufficient profits to sustain the
operations of the business and to fund expansion and growth.
• Profitability ratios are calculated to analysis the earning capacity
of the business which is the outcome of utilization of resources
employed in the business. There is a close relationship between
the profit and the efficiency with which the resources employed
in the business are utilized. There are two major types of
• Profitability Ratios.

• Profitability in relation to sales

• Profitability in relation to investment.
Following are the important Profitability ratio

• Gross Profit Ratio

• Net profit Ratio
• Operating Ratio
• Return on Investment (ROI) or Return on Capital
Employed (ROCE)
• Earnings per Share
• Price Earning Ratio.
• Dividend Payout Ratio
 Gross Profit Ratio or Gross margin

• Gross profit ratio establishes relationship

between Gross Profit and Net sale. It
determines the efficiency with which
production, purchase and selling operations
are being carried on. It is calculated as
percentage of sales. It is computed as follows:

• Gross Profit Ratio = Gross Profit/ Net Sales × 100

 Interpretation
• The ratio measures the margin of profit
available on sales. Gross profit should be
adequate enough not only to cover the
operating expense but also to provide for
depreciation, interest on loans, dividends etc.
 Conclusions Drawn
This ratio is compared with earlier years ratio and if
there is decline important conclusions are drawn from
such comparisons.
1) Price of material purchased, freight, wages and
other direct charges have gone up but the selling
price may not have gone up in proportion to
increase in cost.
2) Selling price may have fallen but the prices of
material, freight wages and other direct charges may
not have fallen.
3) There is fall in sales of more profitable varieties of
goods.
4) There is a fall in price of unsold goods there by
reducing the price of closing stock.
 Question
• Calculate Gross Profit ratio from the following
information:
• Opening stock Rs. 50,000; closing stock Rs.
75,000; cash sale Rs. 1,00,000; credits sales Rs
1,70,000; Returns outwards Rs. 15,000;
purchased Rs. 2,90,000; advertisement
expenses Rs. 30,000; carriage inwards Rs.
10,000.
 Solution

• Cost of goods sold = Opening stock + net purchases + direct expenses – closing stock
= Rs. 50,000 + (Rs. 2,90,000- Rs. 15,000) + Rs. 10,000 -
Rs. 75,000
= Rs. 2,60,000
 
• Total Sales = Cash Sales + Credits Sales
= Rs. 1,00,000 + Rs 1,70,000
= Rs. 2,70,000
 
• Gross profit = Total Sales - Cost of goods sold
= Rs. 2,70,000- Rs. 2,60,000
= Rs. 10,000
 
• Gross profit Ratio = 10,000 X 100
2,70,000

= 3.704 %
 Net Profit Ratio or Net Margin

• This ratio establishes the relationship between

net profit and net sale . It indicates
managements’ efficiency in manufacturing,
administering and selling the product. It
calculates as a percentage of sale. it is computed
as under

• Net Profit Ratio = Net profit / Net Sales × 100

 Interpretation:
• This ratio measures the firms’ ability to turn
each rupee sales into net profit. A firm with
high net profit margin would be in an
advantageous position to survive in the face of
falling selling price.
• An increase in this ratio over the previous year
shows improvement in the overall efficiency
and profitability of the business
• Sales Rs. 6,30,000; sales Returns
Rs. 30,000; Indirect expenses Rs.
50,000; Cost of goods sold
Rs.2,50,000. Calculate Net Profit
Ratio.
 Solution
• Net Sales = Total Sales – sales Returns
= Rs. 6,30,000 – Rs. 30,000
= Rs.6,00,000
• Gross Profit = Net Sales – Cost of goods sold
= Rs. 6,00,000 - Rs.2,50,000
= Rs. 3,50,000
• Net Profit = Gross Profit - Indirect expenses
= Rs. 3,50,000 – Rs. 50,000
= Rs. 3,00,000
• Net Profit Ratio= Net Profit
Net sale
= Rs. 3,00,000 X 100
Rs. 6,00,000
= 50 %
 Operating Ratio
• Operating Ratio establishes relationship
between operating cost and net sales. It
determine the operational efficiency with the
production , purchase and selling operations
are being carried on. It is calculated as follows:
 
• Operating Ratio = (Cost of Goods Sales + Operating Expense)/ Net Sales × 100

• Operating expenses include office expenses,

administrative expenses, selling expenses and
distribution expenses.
 Interpretation
• This ratio indicates the extent of sales that is
absorbed by the cost of goods sold and
operating expense.
• Lower the Operating ratio, the better it is,
because it will leave higher margin of profit on
sales.
 Excercise
• Calculate the Gross profit Ratio, Net Profit
Ratio and Operating Ratio from the given the
following information:
 
• Sales Rs. 4,00,000
• Cost of Goods Sold Rs. 2,20,000
• Selling expenses Rs. 20,000
• Administrative Expenses Rs. 60,000
 Solution

• Gross Profit = Sales – Cost of goods sold

= Rs. 4,00,000 – Rs. 2,20,000
= Rs. 1,80,000
• Gross Profit Ratio = Gross s Profit X 100
Sales
= Rs. 1 ,80,000 X 100
Rs 4 ,00,000
= 45 %
• Net Profit = Gross Profit – Indirect expenses
= Rs. 1,80,000 – (Rs. 20,000 + Rs. 60,000)
= Rs. 1,00,000
• Net Profit Ratio = Net profit / Sales × 100
= Rs.(1,00,000/ 4,00,000) X 100
= 25 %
 
• Operating Expenses = Selling Expenses + Administrative
Expenses
= Rs. 20,000 + 60,000
= Rs. 80,000
 
• Operating Ratio = Cost of goods + Operating Expenses X 100
Net Sa les
= Rs. 2 ,20,000 + Rs. 80,000 X 100
Rs 4, 00,000
= 75 %
Profitability Ratio Based on Investment
• These ratios reflect the true earning capacity
of the resources employed in the enterprise.
Some times profitability ratio based on sales
are high whereas profitability ratios based on
investment are low. Since capital is employed
to earn this profit these ratios are the real
measure of the success of the business and
managerial efficiency.
Return on Capital Employed or Return on
Investment (ROCE or ROI)
This ratio reflects the overall profitability of the
business. It is calculated by comparing the profit
earned and capital employed to earn it. The term
‘Capital employed’ here refers to long term funds
deployed in the enterprise.
Return on Investment = Profit before Interest and
Tax/Capital Employed × 100
Capital Employed = Fixed Assets + Working Capital
 Interpretation :
• It explains the overall utilisation of fund by a
business. It reveals the efficiency of the
business in utilisation of funds entrusted to it
by, share holders , debenture-holders and
long-term liabilities. For inter-firm
comparison, it is considered good measure of
profitability.
 Calculate Return on Capital employed

Liabilities Rs. Assets Rs.

Equity Share 10,00,000 Fixed assets (Net) 14,00,000
Capital (1,00,000
equity share of Rs.
10 each)
Reserves 2,50,000 Current Assets 12,50,000
10 % Debentures 5,00,000 Preliminary 1,00,000
Expenses
Current Liability 7,50,000    
Profit for the year 2,50,000    
  27,50,000   27,50,000
• Return on Investment = Profit before Interest and
Tax/Capital Employed × 100
 
• Profit before Interest and Tax:
Profit for the year = Rs. 2,50,000
• Add interest (10 % of 5,00,000) = Rs. 50,000
• Profit before interest and tax = 3,00,000
 
• Capital Employed = Net Assets + working Capital
= Rs. 14,00,000 + Rs ( 12,50,000 – Rs 7,50,000)
= Rs. 19,00,000
 Return on Shareholders Fund
• Return on shareholders fund measures only
the profitability of the fund invested by the
shareholders. Return on shareholders fund is
also termed as return on shareholder’s equity.
Return on Total Shareholders Fund
• This ratio reveals how profitability the proprietor’s
fund have been utilized by the firm. A comparison of
this ratio with that of similar firms will throws light
on the relative probability and strength of the firm.
= Net Profit after interest and tax
Total Shareholder’s Funds
TSF = Equity Share Capital+ Preference Share
Capital + All Reserves + P& L A/c Balance-
Fictitious Assets
 Return on Equity Shareholder’s Fund
• Equity Shareholders of the company are more
interested in knowing the earning capacity of
their funds in business. As such, this ratio
measures the profitability of the funds belonging
to the equity shareholders. Since the profit
available to equity shareholder will be the profit
left after payment
= Net Profit ( After I, T and Preference Dividends)/ Equity Shareholders Funds * 100
Equity Shareholders fund
= Equity Share capital + All Reserves + P & L Balance- Fictitious Assets
 Earning Per Share
• This ratio measures the profit available to the equity
shareholders on a per share basis. All profits left
after payment of tax
Earning Per Share = Profit available for equity
shareholders/ No. of Equity
Shares
Profit Available for equity Share Holders
=Profit after Tax – Dividend on Preference Shares
 Calculate the earning per share
Net Profit before tax 1,44,000
Tax Rate 50 %
20,000 Equity 2,00,000
Shares of Rs 10
each
12 % Preference 1,00,000
Share Capital
 Dividend Per Share
• Profit remaining after payment of tax and
preference dividends are available to equity
shareholders. But all of these are not
distributed among them as dividend. Out of
these profit a portion is retained in business
and remaining is distributed among equity
shareholders as dividend.
• DPS = Dividend paid to equity shareholders
Number of Equity Shares
 Dividend Payout Ratio
• It is also known as payout ratio. It measures the
relationship between the earnings available to
the equity shareholders and the dividends
distributed among them.
• It shows what percentage of profit after tax and
preference dividends is paid as dividend to
equity shareholders.

= Dividend Per Share X 100

Earning Per Share
 D P Ratio
• D.P. = Dividend paid to Equity Share Holders X 100
Total Net Profit belonging to Equity
Share holders
 Leverage or Capital Structure Ratios:
• These ratio are used to judge the long term
financial soundness of any business. Long term
Solvency means the ability of the enterprise to
meet its long term obligation on the due date. Long
term lenders are basically interested in two things:
payment of interest periodically and repayment of
principal amount at the end of the loan period.
Usually the following ratios are calculated to judge
the long term financial solvency of the concern.
 Classification
• Debt Equity Ratio
• Total Assets to Debt Ratio
• Proprietary Ratio
• Capital Gearing Ratio
 Debt to Equity Ratio
• Debt Equity Ratio measures the relationship between
long-term debt and shareholders’ funds. It measures the
relative proportion of debt and equity in financing the
assets of a firm.
• It is computed as follows:

• Debt-Equity ratio
= Long-term Debt’s/ Share holders funds
Where
Long- term Debt = Debentures + Long – term loans
Shareholders Funds =
Equity Share Capital + Preference Share Capital +
Reserves and Surplus– Share Issue Expense
 Interpretation
• A low debt equity ratio reflects more security to long term creditors.
From security point of view, capital structure with less debt and more
equity is considered favorable as it reduces the chances of bankruptcy.

• A high ratio, on the other hand, is considered risky as it may put the
firm into difficulty in meeting its obligations to outsiders. However,
from the perspective of the owners, greater use of debt, firm can enjoy
the benefits of trading on equity which help in ensuring higher returns
for them if the rate of earning on capital employed is higher than the
rate of interest payable. But it is considered risky and so , with the
exception of a few business , the prescribed ratio is limited to 2:1.
 
 Problem
• Calculate Debt Equity Ratio , from the following information:
• 10,000 preference share of Rs. 10 each Rs. 1,00,000
• 5,000 equity shares of Rs. 20 each Rs. 1,00,000
• Creditors Rs. 45,000
• Debentures Rs. 2,20,000
• Profit and Loss accounts(Cr.) Rs. 70,000
 Solution
• Debt = Debentures = Rs. 2,20,000
• Equity = Equity share capital + Preferences Share Capital +
profit and Loss accounts
• = Rs. 1,00,000 + Rs. 1,00,000 + Rs. 70,000
• = Rs. 2,70,000
 
• Debt Equity Ratio
= Long term debt/ shareholders’ funds
= Rs. 2,20,000 / Rs. 2,70,000
= 0.81:1
 Total Assets to Debt Ratio

• This Ratio established a relationship between

total assets and long debts. It measures the
extent to which debt is being covered by
assets. It is calculated as
• Total Assets to Debt Ratio
= Total assets
Long-term Debt
 Interpretation
• This ratio primarily indicated the use of
external funds in financing the assets and the
margin of safety to long-term creditors. The
higher ratio indicated that assets have been
mainly financed by owners’ funds , and the
long- tem debt is adequately covered by
assets. A low ratio indicated a grater risk to
creditors as it means insufficient assets for
long term obligations.
 Problem
• Shareholders’ funds Rs. 80,000; Total
debts Rs. 1,60,000; Current liabilities
Rs. 20,000. Calculate Total assets to
debt ratio.
 Solution
• Long term debt = Total Debt - Current liabilities
= Rs. 1,60,000- Rs. 20,000
= Rs. 1,40,000

• Total Assets = Shareholders’ funds + Total debt

= Rs. 80,000 + Rs. 1,60,000
= Rs. 2,40,000

• Total Assets to debt ratio = Total Assets/ Debt

= Rs. 2,40,000 / Rs. 1,40,000
= 12:7
= 1.7:1
 Proprietary Ratio

• Proprietary ratio establishes a relationship

between shareholders funds to total assets It
measures the proportion of assets financed by
equity. It is calculated as follows.
 
• Proprietary Ratio = Shareholders Funds/ Total assets
 Interpretation
• A higher proprietary ratio indicated a larger safety
margin for creditors. It tests the ability of the
shareholders’ funds to meet the outside liabilities. A
low Proprietary Ratio , on the other hand , indicated
a grater risk to the creditors. To judge whether a
ratio is satisfactory or not, the firm should compare
it with its own past ratios or with the ratio of similar
enterprises or with the industry average.
 
From the following balance sheet of a company, calculate debt equity ratio, total assets to debt ratio and proprietary ratio

• Balance Sheet of X ltd as on 31.12.2007

Preference Share Capital 7,00,000 Plant and 9,00,000
Machinery
Equity Share Capital 8,00,000 Land and Building 4,20,000
Reserves 1,50,000 Motor Car 4,00,000
Debentures 3,50,000 Furniture 2,00,000
Current Liability 2,00,000 Stock 90,000
    Debtors 80,000
    Cash and Bank 1,00,000
    Discount on Issue 10,000
of Shares

  22,00,000   22,00,000
 Formula
• Debt equity Ratio = Long-term Debt/Equity
 
• Total Assets Ratio= Total Assets / long term
Debt
 
• Proprietary Ratio = Shareholders Funds/Total
assets
 Solution
• Debt equity ratio = Rs. 3,50,000/Rs. 16,40,000
= 0.213

• Total Assets Ratio= Rs. 21,90,000/ Rs. 3,50,000

= 6.26

• Proprietary Ratio = Rs. 16,40,000/Rs. 21,90,000 = 0.749