Ratio Analysis

Learning outcomes
• Analyse and interpret the financial statements.

• Appraise the liquidity position of the business entities.

• Recommend how businesses could improve their liquidity

position.
 Meaning
Ratio is a:
• mathematical number calculated as a reference to

• relationship of two or more numbers and can be

• expressed as a fraction, proportion, percentage and a

number of times
 Ratio Analysis
• Ratio analysis is the use of relationships among financial
statement accounts to gauge the financial condition and
performance of a company.

Copyright © 2013 CFA Institute 4

 I) LIQUIDITY RATIOS
• Calculated to measure the
– short-term solvency of the business
– firm’s ability to meet its current obligations.

• These are analysed by looking at current assets and

current liabilities in the balance sheet.
What are various current assets?
 What are various Current Liabilities?
a) Creditors
b) Bills payables
c) Bank overdraft
d) Short – tem loans
e) Outstanding expenses
f) Incomes received in Advance
Types of Liquidity Ratios

1.)
Current
Ratio

2.) Acid – 3.) Cash

test Ratio Ratio

Copyright © 2013 CFA Institute 8

 1.) Current Ratio

• Ideal ratio = 2:1 (twice the current assets to pay off the
current liabilities)
 Poll
• The current ratio of the limited company is 2.4:1.

• Which of the following statements are ‘true’ with regard to liquidity

position of the company?
a) The company is earning good amount of profits.
b) The company is purchasing more fixed assets.
c) It can pay off its current liabilities easily.
d) The company is earning sufficient revenue from its’ operations.
Analysis of Current Ratio
 Interpretation of Current Ratio
Very high current ratio = BAD SIGN
• Implies heavy investment in current assets
• Under utilisation or improper utilisation of resources.

Low current ratio = BAD SIGN

• Endangers the business
• Firm will not be able to pay its short-term debt on
time
 2.) Quick Ratio or Liquid Ratio
• Also known as Acid – Test ratio
• It is expressed as follows:-
Quick assets
Current liabilities

Quick assets = Current Assets – Stock – Prepaid expenses

a) Better/Strict measure of liquidity position
b) Ideal ratio = 1:1
 Poll
• The company is having cash balance $10, bank balance $50,
Stock $40, prepaid expenses $15, creditors $10 and short term
loan $20.
• In such case the quick ratio of the company is:
a) 2.5:1
b) 3:1
c) 3.8:1
d) 2.75:1
 3.) Cash Ratio or Absolute Liquid Ratio
• Ability to satisfy current liabilities using only cash and cash
equivalents.

• Ideal Ratio = 0.5:1

= It is expressed as follows:-
Cash and cash equivalents
Current liabilities
 Problem Solving
•Cash balance = $100
•Rent paid in advance = $50
•Short term investments = $20
•Creditors = $70
•Stock = $70
•Payables = $30
•Outstanding expenses = $10
Calculate all the liquidity ratios and comment on liquidity position of
the company.
Case Analysis

• The following data is given for 2 companies relating to their current assets
and current liabilities.
• Both the companies have same current ratio, analyse which of the 2
companies is at the better position?
 Practical Problem – II

• Following information is given for a company:

Particulars Amount ( in Rs.)
Plant and Machinery 400,000
Marketable securities 150,000
Bills receivable 40,000
Cash in hand 45,000
Cash at bank 30,000
Inventories 75,000
Bank overdraft 70,000
Sundry creditors 60,000
Bills payable 90,000
Outstanding expenses 30,000

You are requires to calculate the liquidity ratios and interpret the
same.
 Learning Outcomes
• Appraise the solvency position of the business entities.

• Recommend how businesses could improve their long –

term solvency position.

• Analyse and interpret the financial statements.

 Solvency Ratios
Safety of ‘Repayment’
Fund
‘interest’ of their
Providers
payments capital

• These ratios are calculated to determine the ability of the business to

service its debt in the long run.
 Liquidity Vs. Solvency

Liquidity Solvency
Whether
Whether CA enough
can pay off Assets, to pay
CL? off Long term
loans?

Long – term
Short – term
basis (more
basis (a year)
than a year)
1.) Debt – equity ratio
• Meaning
Establishes the relationship b/w long term debts and shareholder’s
funds used in financing the firm’s assets

• Objective
To measure the proportion of debt and equity in the firm

• Formula
Long – term debts (Outsider Funds)
Shareholder funds (Insider Funds)

IDEAL RATIO = 1:2

 Poll
• The company is having the following items on the liability side of
the balance sheet in the FY 2019 (in Rs. ‘000).
• Equity share capital = 1000, preference share capital = 800, long
term loans = 400, debts = 200 and reserves = 100.
• The ‘total debt’ of the company is:
a) Rs. 1400
b) Rs. 1200
c) Rs. 1300
d) Rs. 1500
 Interpretation
• Ratio less that 1 i.e. reflects the low – debt equity ratio.
– This shows more security available to creditors.
– This also implies a more financially stable business.
– Companies with low – debt equity ratio are less risky to creditors.
• Ratio greater that 1 i.e. reflects the high – debt equity ratio
– This shows that company has raised more debt compared to equity to
buy its’ assets.
– More debt means that the company is highly leveraged.
– The company is taking advantage of trading on equity.
– Companies with a higher debt to equity ratio are considered more risky
to creditors and investors
2.) Proprietary ratio or equity ratio
• Meaning
Establishes the relationship b/w shareholder funds to total
assets in the company.

• Formula
Shareholder Funds *100
Total assets
 Interpretation
• The proprietary ratio shows the contribution of shareholders in
total capital of the company.

• A high ratio indicates a strong financial position of the company

and greater security for creditors.

• A low ratio proprietary indicates that the company is already

heavily depending on debts for its operations.

• A large portion of debts in the total capital increases interest

expenses and also the risk of bankruptcy.
3.) Interest Coverage ratio
 ICR of Marico
• The EBIT of Marico is 1468 Crores
rupees.
• The total interest to be paid by the
company is 50 crores rupees.

ICR = 1468
50
29.36 times
 Poll
• The earnings before interest and tax is $1000. The company has
paid interest on loan $400 and taxes of $700.
• The interest coverage ratio of the company is:
a) 3.4 times
b) 4.2 times
c) 2.5 times
d) 4.4 times
 Interpretation
• This ratio is expressed in times.

• It indicates number of times interest is covered by profits available

to pay interest charges.

• Long term creditors are interested in knowing the company’ ability

to pay interest charges.

• Higher the ratio, more safety available to creditors.

 Problem Solving
• Calculate and interpret the ‘interest coverage ratio’ from
the following information of the company.
• Net profit after tax = 500,000
• 10% long – term loan = 200,000
• 10% debentures = 100,000
• Tax amount = 40000
Turnover Ratios (Efficiency Ratios)
 Learning Outcomes
• Appraise the efficiency position of the business entities.

• Recommend how businesses could improve their

efficiency position.

• Analyse and interpret the financial statements.

II) TURNOVER RATIOS OR ACTIVITY RATIOS

• Also known as efficiency ratios.

• Measures the efficiency with which a firm manages its

resources or assets.

• Indicate the speed with which resources or assets are

being turned ( or converted) into sales.

• Expressed in ‘Times’.
 Types of Turnover Ratios

Working
Inventory Debtors Creditors Fixed assets
capital
turnover ratio turnover ratio turnover ratio turnover ratio
turnover ratio

Inventory Average Average

conversion collection payment
period period period
1.) Stock or inventory turnover ratio

• Meaning
Establish relationship b/w cost of goods sold and average
inventory.
• Objective
To determine the efficiency with which inventory is
converted into sales.
• Formula
Stock Turnover Ratio = COGS
Average Stock
 Components of ITR

COGS Average Inventory

 Poll
• The opening stock available in business is 100$. Additional
purchases made during the year for $50. The closing stock left in
the business at the year end was $20.
• In such case, the COGS of business was:
a) $150
b) $120
c) $130
d) $170
Interpretation of Stock Turnover Ratio
Very high turnover
High turnover ratio Low turnover ratio
ratio

Efficiency of firm in Inefficiency in

Low inventory levels
managing its’ stock managing its’ stock

Shows fast moving

Slow moving stock
stock

Stock is quickly Excessive cash tied

converted into cash up in stock

Poor inventory
management
 Poll
• Which of the following statements is ‘true’ with regard to the
company having ‘high inventory turnover’ ratio?
a) It represents slow moving stock
b) It shows poor inventory management by the company
c) It highlights quick sales made by company
d) It shows excess cash is tied up in stock
 B.) Inventory Conversion Period
Number of days/months/year
Inventory turnover ratio
Time
Taken

Produce Sell to
to product product
 Poll
• A company is having inventory turnover ratio of 5 times.
• In how many days, the stock of the company is produced,
sold and then its’ sale is converted into cash?
a) 70 days
b) 73 days
c) 80 days
d) 65 days
Evaluating Stock Turnover Ratio
Evaluating Stock Conversion Period
 Problem Solving – 1
• Donny’s Furniture Company sells industrial furniture for office
buildings.
• During the current year, Donny reported cost of goods sold on its
income statement of $1000. Donny’s beginning inventory was
$300 and its ending inventory was $400.
• You are required to:
– Calculate the Inventory Turnover Ratio and
– Make suitable interpretation of the same.
Problem solving – II

• From the following information, calculate the inventory turnover

ratio of Company X which is in retail sector:

Inventory in the beginning 18000

Inventory at the end 22000
Net purchases 46000
Wages 14000
Carriage inwards 4000

• Company Y, also in the retail sector is having the inventory

turnover ratio of 7 times.
• Interpret the results with suitable justifications.
2) Debtors Turnover Ratio

• Meaning
Establishes relationship b/w net credit sales and average
debtors.
• Objective
To determine the efficiency with which debtors are
converted into cash
• Formula
Debtors turnover ratio = Net credit sales
Average debtors
 Poll
• The company has made total sales of $500, out of which
cash sales are $100. the average debtors are $50.
• In such case the debtor turnover ratio of the company will
be:
a) 5 times
b) 6 times
c) 7 times
d) 8 times
Interpretation of Debtors Turnover Ratio

Very High Debtors Turnover Ratio

• Restrictive credit and collection policy

High Debtors Turnover Ratio

• Shorter collection period
• Prompt payment by debtors

Low Debtors Turnover Ratio

• Longer collection period
• Delayed payments by debtors

Very Low Debtors Turnover Ratio

• Liberal and inefficient collection policy
• Risk of bad debts
 2.1) Debt collection period (or debtors velocity)

• Shows the speed with which money/dues are collected from

debtors
Formula
• Debt collection period = 12 months/52 weeks/365 days
Debtors Turnover Ratio
 Problem Solving
• Total sales = $100, out of which Cash sales = $30
• Opening debtors = 20$
• Closing debtors = 30$

• Calculate:
a) Debtors turnover ratio
b) Debt collection period
 3.) Creditors turnover ratio
• Meaning
Establishes relationship b/w net credit purchases and
average creditors
• Objective
To determine the efficiency with which creditors are paid
with cash
• Formula
Creditors turnover ratio = Net credit purchases
Average creditors
 Interpretation of Creditors Turnover Ratio

High creditor turnover Low creditor turnover

ratio ratio
• Shorter payment • Larger payment period
period enjoyed by the firm

• Availability of less • Availability of more

credit credit
• Early payments are • Delay in payments by
made by the firm the firm
3.1) Debt payment period (or creditors velocity)
• Shows an average period for which credit purchases remains
outstanding or average credit period availed by the firm

• Average debt payment period = 365 days/52 weeks/12 months

Creditor Turnover Ratio
Problem solving
• From the following particulars, calculate the creditors turnover
ratio and average payment period of Company X for the year
2017:
Particulars Amount (in Rs.)
Total purchases 400,000
Cash purchases (included in above) 50000
Purchases returns 20000
Creditors at the beginning 60000
Creditors at end 20000

• For the year 2016, the creditor turnover ratio was 6.9 times and
average payment period was 94 days.
• Analyse the results for 2 years and make the suitable
interpretation.
 4.) Fixed assets turnover ratio
• Meaning
Establishes the relationship b/w net sales & fixed assets
• Objective
To determine the efficiency with which fixed assets are utilized, number of
times an asset is used to generate sales
• Components
Net sales & Net assets
• Formula
Fixed assets turnover ratio = Net sales
Net fixed assets
 Interpretation
High fixed assets
turnover ratio Low fixed assets
turnover ratio

Efficient Inefficient
management management
and utilization and utilization
of fixed assets of fixed assets
Problem solving
Following are the details of the Company A (in rupees lakhs) for the year 2019:
• Total gross sales = 100
• Cash sales (included in above) = 20
• Sales Returns = 7
• Total debtors at beginning of the period = 5
• Total debtors at beginning at the end of the period = 13
• Bill receivable at beginning of the period = 5
• Bill receivable at the end of the period = 15
Calculate the a) Debtors Turnover Ratio and b) Average Collection Period
In last year 2017, company was having the debtor turnover ratio of 9 times and
average collection period was 45 days.
• Analyse the results for 2 years and make the suitable interpretation.
 5.) Working capital turnover ratio
• Meaning
Establishes the relationship b/w net sales & working capital
• Objective
To determine the efficiency with which working capital are utilized
• Components
Net sales & Working capital
• Formula
Working capital turnover ratio = Net sales
Working capital
 Interpretation
High working • Efficient management
capital turnover
ratio and utilization of working
capital

• Inefficient management
Low working capital
turnover ratio and utilization of working
capital
PROFITABILITY RATIOS
 Learning Outcomes
• Analyse and interpret the financial statements.

• Appraise the profitability position of the business entities.

• Recommend how businesses could improve their

profitability position.
 PROFITABILITY RATIOS
• Profitability ratios are financial metrics used by analysts
and investors
• to measure and evaluate the ability of a company to
Generate income (profit) relative to
– revenue, 
– Assets,
– Operating costs, and 
– Shareholder’s equity
Overview of Profitability Ratios
 1.) Gross Profit Ratio
• Meaning
Measures the relationship b/w gross profit & net sales
• Objective
It measures the cost of operations on every Rs. 100 sales
• Formula
Net Sales – COGS *100
Net sales
 Interpretation
• High GP ratio => low cost of production & high sales

• Low GP ratio => high cost of production & low selling

price
 Poll
• A company manufactures each widget for $80 and sells it
in market for $120.
• In such case the gross profit ratio of the company will be:
a) 35%
b) 33%
c) 36%
d) 37%
 2.) Operating Ratio
• Meaning
Measures the relationship b/w operating cost & net sales
• Objective
It measures the cost of operations on every Rs. 100 sales
• Formula
Operating cost *100
Net sales
 Interpretation
For example:-
• Operating ratio is 65% = On every sale of Rs. 100, Rs. 65 is
consumed in the operating costs of the company.

• Operating ratio, if high = less favourable for the company as,

small margin (operating profit) left. In the above example, it is only
35%.

• Lower the ratio, better it is for the company.

• Indian railways have the operating ratio of 95-110%. This is highly
unfavourable.
News Analysis

Railways’ operating ratio in FY 19 was at its worst ever

• It signifies:
–It does not have money for capital investments. Therefore,
–laying new railway lines,
–deploying more coaches and
–similar modernisation efforts cannot be carried out.
 3.) Operating Profit Ratio
• Meaning
Measures the relationship b/w operating profit & net sales
• Objective
To determine the operational efficiency of the firm
• Formula
Operating profit *100
Net sales
 Interpretation
• Shows revenues left after all the operating costs have been paid.

• Shows operating profit earned on sale of Rs. 100.

• For example:- if operating profit ratio of a company is 40%. [On

every sale of Rs. 100, 60% = operating expenses and 40% =
operating profit].

• Higher the ratio, better it is for the firm.

 Poll
• Following results are shown by the income statement of the
company during the year 2019 (in $ ‘000).
• Advertising expenses = $50, COGS = $70, Sales = $200, office
expenses = $30.
• The operating profit ratio during the year will be:
a) 50%
b) 35%
c) 30%
d) 25%
 4.) Net profit Ratio
• Meaning
Measures the relationship b/w net profit & net sales
• Objective
To determine the overall profitability of the firm
• Formula
Net profit
Net sales
 Interpretation
• Ratio indicates the net profit earned on sale of Rs. 100

• It measures the overall profitability of the firm

• It shows:-
• What amount is left to pay dividend to shareholders
• Firm’s capacity to withstand adverse economic condition.
Problem solving
• From the following information, calculate:
– Operating Ratio
– Operating profit Ratio
– Net profit ratio
• Opening stock = 2600
• Purchases = 8000
• Wages = 2400
• Manufacturing expenses = 1600
• Sales = 16000
• Closing stock = 3800
• Selling expenses = 400
• General expenses = 2400
• Loss of furniture due to fire = 80
• Compensation received for land acquisition = 480
 4.) Expense Ratio
• Shows the relationship of various expenses to net sales.
It indicates the proportion of each expense consumed in
sales of Rs. 100.
• Lower the ratio, better it is
 Various types of expense ratio
• Cost of goods sold ratio = cost of goods sold *100
net sales
• Office expenses ratio = office expenses *100
net sales
• Administrative expenses ratio = Administrative expenses *100
net sales
• Selling & distribution expense ratio = Selling & distribution expense *100
Net sales
PROFITABILITY RATIOS (OWNER’S VIEW POINT)
 Poll
• A company is having the following information given on the liability
side of the balance sheet for the FY 2019 (in $000):
• Equity share capital $1000, Reserves $600, Long – term loans
$800, preference share capital $200.
• The total ‘outsider’s funds’ available with the company are:
a) $1600
b) $1800
c) $1000
d) $1200
1) Return on Investment (ROI)

• Formula

Earnings (before interest and tax) *100

Total funds

• Indicates the return that investors could receive on their investment in a

company.

• Indicates the ‘overall efficiency’ of the firm.

• Primary objective of business is to maximise the earnings of its’ investors, this

ratio indicates to what extent this primary objective has been achieved.

• Higher the ratio, better it is

 Poll
• A company is having Equity share capital $3000, Reserves $600,
Long – term loans $400.
• The Earnings after tax are $2900. Tax paid by company is $100
• The ROI of the company is:
a) 75%
b) 25%
c) 50%
d) 35%
2) Return on Equity capital (ROEC)/Shareholder Funds

• Also known as ‘Return on Net Worth’.

• The profitability & performance of company is judged using this
ratio.
• Ratio used by equity shareholders.

• Formula:
Net profit after tax – Preference dividend *100
Shareholder Funds

• Higher ratio is favourable as it means that the company is efficient

in generating income on investment.
Interpretation

• Measures overall efficiency of the business.

• Owners are interested in knowing the profitability of business in

relation to their money invested in it.

• High ROCE will satisfy the shareholders (or owners).

• Low ROCE indicates low profitability of the company.

Profitability in FMCG Sector
3) Earning Per Share (EPS)

• Measures the net income (in rupees) earned by each share

• Formula
Net profit after tax – Preference dividend
Number of equity shares outstanding

Higher the ratio, better it is as it means

• the company is more profitable and
• the company has more profits to distribute to its shareholders.
• the company has strong financial position.
• it is the reliable company to invest money.
4) Price earning ratio (P/E ratio)

• Relationship b/w stock price and earnings of the

company

• Shows how much amount an investor is willing to pay to

buy 1 share based on its’ earnings.

• Formula
Market price per share (MPS)
Earnings per share (EPS)
Interpretation

• For example:- if the P/E ratio = 10 times, this means that the
market price of the share of the company is 10 times the earnings
of the company.

• High P/E ratio indicates that the share of the company is sold in
the stock market at a high price and the investors have high
expectations.

• Low P/E ratio indicates low profits of the company as the EPS
(denominator) is less.
5) Return on Assets Ratio (ROA Ratio)

• Shows the relationship between net profits (after taxes)

and assets employed to earn the profits.

• This ratio measures the profitability of the firm in relation

to assets employed.

• Formula
Net Profit After Tax
Average Total Assets
 Poll
• If EPS is Rs. 0.12 and market price of the share is Rs. 3.60, then
the P/E ratio will be:
a) 0.3
b) 3 times
c) 30
d) 3.33%
6) Dividend per share Ratio

• Shows amount of profit which is distributed to

shareholders per share
• Formula
Dividend paid
Number of shares
 Problem solving
• From the following information (in Rs.), calculate
a) Return on Investment and,
b) Return on Shareholder Funds
• Equity share capital = 400,000
• Preference share capital = 100,000
• 10% debenture = 400,000
• General reserve = 184,000
• Net profit after interest and after tax = 150,000
• Tax amount = 50,000
 Problem solving
• From the following information calculate
(i) Earning per share
(ii) Price earning ratio
• 70,000 equity shares of Rs 10 each = Rs. 700,000
• Net Profit after tax = Rs. 1,75,000
• Market price of a share = Rs. 13
 DuPont Analysis
• DuPont Analysis is an extended examination of Return on Equity
(ROE).

• It breaks down ROE into three parts

a) Net Profit Margin
b) Asset Turnover
c) Financial Leverage.

• This analysis was developed by the DuPont Corporation in the

year 1920.
 DuPont Analysis
Return on Equity

Financial
Net Profit Margin Asset Turnover
Leverage

Net Profit Net Sales Total Assets

Net Sales Total Assets Total equity
 DuPont Analysis
Return on Equity

Net Profit Net Sales Total Assets

Net Sales Total Assets Total equity

Net Profit
Total Equity
 Interpretation – DuPont Analysis
• The company can increase its Return on Equity if it:

1) Generates a high Net Profit Margin.

2) Effectively uses its assets so as to generate more sales

3) Has a high Financial Leverage

Problem solving
• From the following information, calculate the:
a)Debt – equity ratio
b)Proprietary ratio
• Equity share capital = 400,000
• Reserves and surplus = 100,000
• Long term borrowings = 150,000
• Current liabilities = 50,000
• Fixed assets = 400,000
• Investments = 100,000
• Current assets = 200,000
 Problem Solving
• Following information is given for the company:
Particulars Amount Particulars Amount
Equity share capital (40,000 400,000 Current liabilities 100,000
shares of Rs. 10 each)
12% Preference Share Capital 100,000 Fixed assets 950,000
General reserve 184,000 Current assets 234,000
10% debentures 400,000
• Net profit after tax = 150,000, tax amount = 50,000, market price of share =
Rs. 34
• Calculate:
a) Return on investment
b) Return on equity capital
c) EPS and;
d) P/E ratio