Financial and

Management
Accounting By:
BITS Pilani Dr. Vaishali Pagaria
vaishali.pagaria@wilp.bits-pilani.ac.in
Work Integrated Learning
Programmes Division
 BITS Pilani
Work Integrated Learning
Programmes Division

9. Ratio Analysis: Theory

Analysing the Financial
Statements
• Overall objective of a business is to create value for its
shareholders while maintaining a sound financial
position.
• Financial Statement Analysis is the collective name for
the tools and techniques that are intended to provide
relevant information to decision-makers.
• The purpose of the analysis is to assess a company’s
financial health and performance.
• It consists of comparations for the same company over
period of time and for different companies n the same
industry or different industries.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Ratio Analysis

• Ratio analysis involves establishing a relevant financial

relationship between components of financial
statements.
• It helps in identifying significant relationships between
financial statement items for further investigation.
• It is a powerful tool for recognizing a company’s
strengths as well as its potential trouble spots.
• Mainly analyse
• Balance Sheet
• Profit and Loss Account
• Cash Flow Statement

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Types of Ratio

1. Liquidity Ratios
2. Solvency or Leverage Ratios
3. Turn over Ratio or Efficiency Ratio
4. Profitability Ratios

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Liquidity Ratio

• Liquidity ratios measure a firm’s ability to meet its maturing

financial obligations.
• The focus is on short-term solvency as if the firm were
liquidated today at book value.

1. Current Ratio: provides an indication of a firm’s ability to

pay short-term claims with short-term assets.

Current Ratio = Current Assets/Current Liabilities

CR = CA/CL

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Current Ratio

• In principal we would like to see the CR > 1 because it

suggests that the CA to be liquidated this year are sufficient
to cover the CL that will come due this year.
• If the CR < 1, then the CA will be unable to service the
maturing obligations as measured by CL.
• CR < 1 does not mean that a firm will not be able to meet
its maturing obligations.
• The firm may have access to other resources that can be
used to help meet maturing obligations such as earnings
from operations, long-term assets that could be liquidated,
debt which could be restructured, and/or investments in
depreciating assets which can be delayed.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Liquidity Ratio

2. Quick ratio, (or sometimes the acid-test ratio):

provides an indication of firm’s availability of readily
available liquid assets to make payments to suppliers

Quick Ratio = Current Assets – Inventory

Current Liabilities

QR = CA-INV
CL

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Solvency or Leverage Ratio

• Solvency or Leverage ratios measure the relative

amount of funds supplied by equity and debt holders.
• The focus is on the long-term solvency of the firm.
• Usually, the higher the amount of debt financing relative
to equity financing, the more leveraged the firm is and
the greater the risk its owner faces.
• Why do owners’ face greater risk?
• Higher leverage is usually associated with higher
expected returns.
• Why would you expect this?

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Solvency or Leverage Ratio

1. Debt-Equity Ratio: sometimes just called the debt ratio, measures

the relative proportions of debt and equity funds used to finance the
firm’s assets and is defined as:
Debt Ratio = Debt/Capital Employed*
Debt-Equity Ratio = Total Debt/Net Worth**

* Capital employed = Total Debt + Net Worth

** Net Worth = Share capital + Reserves

• The wise mix of debt and equity can increase the return on equity for
two reasons:
• Debt is generally cheaper than equity
• Interest expense is tax-deductible, whereas dividends are paid from PAT; in addition,
dividend payment attracts dividend distribution tax.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Debt-Equity Ratio

• Excessive debt financing is risky, as company may

unable to make the required interest and principal
disbursements on time and the creditors may force
liquidation of the company.
• The ratio indicates the extent of use of financial
leverage.
• A high debt-to-equity ratio indicates aggressive use of
leverage, and highly leveraged company is more risky
for creditors.
• A low ratio, suggests that the company has a small
degree of leverage and is too conservative.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Solvency or Leverage Ratio

2. Liabilities-to- Equity Ratio: indicates dependency on

liabilities

Liabilities-to-Equity Ratio = All Liabilities

Equity
3. Equity-Asset Ratio: expresses the percentage of assets
financed by equity funds.

Equity-Asset Ratio = Equity

Assets

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Solvency or Leverage Ratio

4. Equity Multiplier Ratio: measures the number of rupees

of assets that are supported by each rupees of equity funds.

Equity Multiplier Ratio = Assets

Equity

• Both the equity-asset ratio and the equity multiplier contain the
same information as the debt-asset and debt-equity ratios.
• The decision regarding which measure(s) to report depends
on reporting purpose and your preferences for interpreting the
amount of leverage.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Solvency or Leverage Ratio

Repayment Capacity Ratio: examines the debt of a firm in

terms of flows (income statement relationships).
• The idea is to measure the extent to which a firm’s income
is able to satisfy the firm’s fixed payment obligations.

5. Times interest earned (Interest Cover) measures the

extent to which a firm’s earnings can decline before the firm
cannot make its interest payments.

Times interest earned ratio = EBIT

INT Exp

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Solvency or Leverage Ratio

• where INT represents the firm’s interest payments during

the period.
• The TIE ratio measures the number of times the firm can
make its interest payments using the firm’s operating
profits (EBIT).
• In general, TIE > 1, otherwise the firm won’t even be
able to make its interest payments using the current
income.
• Also recognize that taxes don’t impact the TIE ratio
because interest is paid with before-tax rupees.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Turn Over Ratio

• Turn Over ratio or Efficiency ratios or Asset Management

ratios, measure the efficiency with which a firm manages its
assets.
1. Inventory Turn Over Ratio: measures how well the firm
manages its inventory

ITO = Sales/INV or COGS/INV

Where, ITO represents the inventory turnover ratio

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Inventory Turn Over Ratio
• The COGS version of the ratio is usually a better measure than sales
because inventory is carried at cost on the balance sheet and gives a better
measure of the cumulative amount of inventory sold during the period.
• However, industry figures are sometimes reported at market price, and we
would need to use the market price version of the ITO ratio (Sales/INV)
make a valid comparison.
• It is also better to use some type of average measure for inventory over the
sales time period to avoid possible difficulties with seasonal effects.
• Remember….. the inventory numbers from the balance sheet reflect
inventories at a particular point in time while sales were generated across
the time period.
• The ITO can be too small and would suggest excess inventory levels are
being held given the level of sales.
• Likewise, the ITO ratio can be too high and may signal potential "stockouts"
which could result in lost sales if the firm is unable to meet sales demand.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Turn Over Ratio

2. Average Collection Period: measures the number of days

before a firm’s sales made today will be collected

ACP = AR = AR
CS/day Annual CS/365

Where, ACP represents average collection period, AR is accounts

receivable, and CS represents credit sales.
• If CS are not available, we often use total sales as an estimate of
CS.
• Please note that if all sales were cash sales, then ACP = 0.
• Once again, it is better to use an average measure of AR to
dampen any seasonal effects.
08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD
Average Collection Period
• The length of the ACP typically reflects a firm’s credit policy.
• If the ACP is too low, the firm may have too tight of credit policy and might be losing
sales.
• On the flip side, remember that AR must be financed by either debt or equity funds.
• If the ACP is too high, the firm is extending a lot of credit to other firms, and the
financing cost may become high.
• Another concern is that the longer a firm extends credit, the greater the risk that
something will happen that results in no payment ever being received.
• In some cases, it is useful to construct a schedule that breaks AR down by the length
of time each amount has been outstanding.

For example, the schedule might break the AR into: 1) the amount that is less than 30
days outstanding, 2) the amount that is 30-60 days outstanding, and 3) the amount
that is more than 60 days outstanding.

• This breakdown provides additional information on the risk of the firm’s AR and the
likelihood of repayment

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Turn Over Ratio

3. Debtors Turnover Ratio (DTR): measures the number of

times receivables turn over in a year relative to sales.

DTR = Sales/Trade Receivables

• This determines the time between a sale and actual

collection.
• The credit terms and quality of receivables can be
measured using this ratio relative to the industry.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Turn Over Ratio

4. Day’s Receivables Ratio (DRR): tells how many days on

average it takes to collect on sales.

Days Receivables = 365/ DTR

• If this number is high, it indicates that there are some

accounts that are aging and may never be collected.
• It may also indicate loose credit policies and poor collection
processes.
• In some extreme cases, it can reveal poor internal controls
and processes in accounting such as cash collection and
reconcilement of accounts.
08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD
Turn Over Ratio

5. Working Capital Turnover Ratio: provides a measurement

of how well working capital, the difference between current
assets and current liabilities, is being utilized within the
organization.

Working Capital Turnover Ratio = Net sales

Net working capital

• The long- term survival of an organization is partially

dependent on how well it manages current operations.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Turn Over Ratio

6. Total asset (TAT) and Fixed asset turnover (FAT) ratios: measure the
amount of sales generated by a given level of total assets and fixed
assets, respectively.
TAT = Sales/Total Assets
FAR = Sales/Fixed Assets
• The more sales generated with a given level of assets, the more
efficient the firm is operating.
• If the turnover ratios are too large, however, the firm may lose sales
because of the lack of necessary assets.
• Also, note that high asset turnover ratios tend to favour old assets that
have been depreciated over time and may be obsolete or inefficient
today.
• A small turnover ratio may indicate the firm’s assets can be used more
efficiently or are, perhaps, obsolete or that the firm has recently made a
major investment in new assets.
08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD
Profitability Ratio

• Profitability ratios measure the firm’s efficiency in

generating profits.
• Remember the operating profit is measured by the firm’s
EBIT and Net Income is measured by PAT.

1. Profit Margin Ratio : measures the proportion of each

rupee of sales that is retained as profit after taxes.

Profit Margin Ratio = PAT/Sales

Gross Margin Ratio = Gross Profit*/Sales
Operating Margin Ratio = EBIT/Sales
* Gross Profit = Sales - COGS
08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD
Profitability Ratio

• The Profit Margin, Gross Margin and the Operating Margin

represent a company's ability to translate sales into profit.
• The Profit Margin measures company’s ability to generate
net profit from its sales.
• The Gross Profit Margin is an accurate measurement in
terms of the company's ability to control costs of goods
sold.
• The Operating Profit Margin measures overall operating
efficiency. It incorporates all expenses associated with the
operations of the business.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Profitability Ratio

2. Return on Assets Ratio: measures the amount of profit

generated by each rupee of assets.
ROA = PAT /Total Assets

3. Return on Equity Ratio: measures the amount of profit

generated by each rupee of equity.
ROE = PAT /Equity

4. Return on Investment (ROI) Ratio: measures the amount

of profit generated by each rupee of shareholders funds or
investment.
ROI = Net Profit After Interest  And Taxes
Shareholders Funds or Investments 
08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD
Profitability Ratio

5. Return on Capital Employed Ratio (ROCE): measures

the amount of profit generated by each rupee of capital
employed.
ROCE = Net Profit after Taxes
Gross Capital Employed

6.Dividend Pay-out Ratio (DPR): measures the amount of

dividends (as withdrawals) generated as a proportion of
profits.
Dividend Pay-out Ratio = Dividend
PAT

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Profitability Ratio

7. Dividend Yield Ratio (DYR): measures how much a

company pays out in dividends in each year against its
market price of share.

DYR = Dividend Per Share

Market Value Per Share

8. Earning Per Share (EPS): shows the profit earned by each

share of common stock in a business organized as a
corporation.

EPS = PAT/No. of Equity Shares

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

Profitability Ratio

9. Price Earning Ratio (P/E): measures the value of a

publicly traded firm’s stock relative to the firm’s current
earnings.
P/E Ratio = Market Price per Share
Earning per Share

• The higher the value relative to current earnings, the

greater the expected increase in future earnings and/or the
lower the perceived risk in future earnings.

08/24/2022 Dr. Vaishali Pagaria BITS Pilani, WILPD

 BITS Pilani
Work Integrated Learning
Programmes Division

Thank you!!