RATIO ANALYSIS

The system of analysis of financial statement by means of ratio was first made in 1919 by Alexander
Wall in his book “STUDY OF CREDIT BAROMETICS”

By the help of ratio we can know the relationship of the item or group of item in the financial statement.

Relationship

ASSOCIATED RELATIONSHIP (COST AND COST OF SALE)

CAUSE – EFFECT RELATIONSHIP (PROFIT AND SALE)

Ways of expressing ratios

1) As ratio or as proportion 4/2

2) As ratio or turnover 2 TIMES
3) As percentage 200%

RATIOS

 Financial ratios
 Accounting ratios
 Structural ratios

OBJECTIVE

 Simplifies accounting figure

 Measure liquidity position
 Measure long term solvency
 Measure operational efficiency
 Measure profitability
 Facilitates inter firm or intra firm comparison
 Trend analysis
 Managerial uses
 Aid in planning and forecasting
 Aid in control
 Add in communication
 Aid in decision making

In accounting and financial management, ratios are regarded as the real test of earning capacity,
financial soundness and operating efficiency of a business concern.

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LIMITATION

Ratios are only guide in anlaysing the financial statement and not conclusive end in themselves

 Need for comparative analysis

 Qualitative factor ignored
 Possibility of window dressing
o Like postponing purchase of desired fixed assets
 Inherint limitation of accounting
 Difference in accounting method and system
 No substitute for sound management
 Lack of standard ratios
 Personal bias
 Effect of price level change

PRECAUTION IN USING RATIOS

 Ability to understand accounting data

 Speedy compilation
 Cost benefit
 Presentation
 Incorporation of change

CLASSIFICATION OF RATIOS

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LIQUIDITY RATIOS SHORT TERM SOLVANCY

1. CURRENT RATIOS

ASSETS ASSETS
CURRENTLIABITIERS

If current ratio good for creditor and bad for management

IDLE 2:1

2. LIQUIDITY RATIO

LIQUID ASSETS
LIQUID LIABILITIES

Liquid assets = current assets- stock- prepaid expenses

Liquid liability= current liabilities- bank overdraft- cash credit

Liquid ratio is an indication of a firm’s ability to meet unexpected demand of

working capital

A high liquid ratio compared to current ratio may indicate under stocking while
a low liquid ratio indicates over stocking.

IDLE 1:1

3. ABSOLUTE LIQUIDITY RATIO

MARKETABLE SECURITEIS∨QUICK ASSETS ∨ABSOLUTE LIQUID ASSETS

¿ ¿
LIQUID LIABILITIES

Debtor and receivable will not be included

Bank overdraft and cash credit will not be included

IDLE 0.5: 1

4. BASIC DEFENCE INTERVAL

It says that if the revenue of the company is suddenly ceased then how
much days company will continue its operation

CASH + RECEIVABLE+ MARKETABLE SECURITIES

(OPERATING exp .+∫ + I /T )/365

OR

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 LIQUID ASSETS
EXPENSES PER DAY

5. NET WORKING CAPITAL RATIO

NET WORKING CAPITAL

NET ASSETS

CURRENT ASSETS CURRENT LIABITIES

BANK OVERDRAFT CASH AND BANK
creditor debtor
Bills payable Bills receivable
Income tax payable Short term investment
Unclaimed dividend Marketable securities
Outstanding expenses Prepaid expenses
Proposed dividend Advance payment

LEVERAGE OR CAPTAL STRUCTURE RATIO LONG TERM SOLVANCY

Leverage ratio reflect for a firm its ability to assure the long term creditors and owner with regards to

 Payment of interest business risk

 Payment of principal financial risk

1. EQUITY RATIO

SHARE HOLDER FUND

TOTALCAPITAL EMPLOYEED

In total capital employed we also include long term loan and debenture

2. DEBT RATIO

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 TOTAL DEBT
CAPITAL EMPLOYEED

3. DEBT EQUITY RATIO

EXTERNAL EQUITY
INTERNAL EQUITY

OR

TOTAL DEBT
SHARE HOLDER FUND∨NET WORTH

OR

LONGTERM DEBTS
SHAREHOLDER FUND∨NET WORTH

↑RATIO safety to creditors

↓ RATIO claim of creditors are higher than owner

IDLE 1:1

This is indicator of leverage

4. PROPRIETORY RATIO

Owner equity to total assets

Net worth to total assets

PROPRIETO R' SFUND

TOTAL ASSETS

↑ RATIO more secured is the position of creditors

↓ ratio greater risk to the creditors

IDLE 50%

If current assets increase then equity reduce and vice versa

5. SOLVENCY RATIO

6
 IFXED ASSETS
LONGTERM FUND

OR

TOTAL ASSETS
TOTAL EXTERNAL LIABITIES

6. FIXED ASSETS RATIO

CAPITAL EMPLOYEED TO FIXED ASSETRS RATIO

CAPITAL EMPLOYEED
¿ ASSETS

Relationship between long term fund or capital employed and fixed assets of the firm.

IDLE 1.5:1

7. INTEREST COVERAGE RATIO OR DEBT SERVICE RATIO

EBIT
INTEREST

IDLE 6 OR 7 TIMES

8. DEBT SERVICE COVERAGE RATIO

EARNING AVAILABLE FOR DEBT SERVICE

INTEREST + INSTALLMENT

9. DIVIDEND COVERAGE RATIO

EAT
PREFERENCE DIVIDEND

10. GEARING RATIO

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 P . S .CAPITAL+ LONG TERM DEBT
EQUITY SHARE HOLDER FUNDDEND

EBIT
INTEREST + PREFERENCE DIVIDEND

OR

EBIAT
INTEREST + PREFERENCE DIVIDEND

ACTIVITY OR EFFICIENCY RATIO

The funds of creditors and owners are invested in various assets to generate sale and profit. Better the
management of these assets the larger the amount of sale and profit.

These ratios indicate the speed with which assets are being converted or turned over into sale. That is
why these ratios are called turnover ratios or sales ratio.

An activity ratio is the relationship between sales or cost of goods sold and investment in various assets
of the firm.

1. INVENTORY TURNOVER RATIO

COST OF GOODS SOLD

AVERAGE INVENTORY

Inventory turnover ratio normally establish a relationship between cost of sale and average inventory

This ratio reveals the number of times finished stock is turned over during a given accounting period in
relation to sale.

High ratio is better

High ratio reflect more profit

High ratio is also good from the view point of liquidity

STOCK VELOCITY

The inventory turnover ratio indicate the stock velocity with which stock moves
through the business

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 365/52/12
TURN
STOCK
RATIO

OR

AVERAGE INVENTORY
∗365 /52 /12
COST OF SALE

2. DEBTOR OR RECEIVABLE TURNOVER RATIO

NET CREDIT SALE

AVERAGE RECEIVABLE ¿ ¿

The debtor turnover ratio throws lights on the collection and credit policies of the firm

Debtors = debtors + B/R +discounted B/R + sales tax

Sales = net credit sales + sales tax

Provision for doubtful debts shall not be deducted

High ratio efficiency in collection

Debtors are being collected more promptly

AVERAGE COLLECTION PERIOD

365 /52/12
TURN
DEBTOR
RATIO

OR

AVERAGE DE BTOR
∗365/52/12
NET CREDIT SALES

Average collection period means the number of days over which debtors and bills receivables remain
uncollected

3. CREDITOR OR PAYABLE TURNOVER RATIO

NET CREDIT PURCHASE

AVERAGE PAYABLE ¿ ¿

AVERAGE COLLECTION PERIOD

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 365/52/12
TURN
CREDITORS
RATIO

OR

AVERAGE CREDITOR
∗365 /52 /12
NET CREDIT PURCHASE

↑ shorter payment period lesser liquidity

↓ high payment period better liquidity

4. TOTAL ASSETS TURNOVER RATIO

COST OF GOODS SOLD

TOTAL ASSETS

Total assets = fixed assets after dep.+ current assets + intangible assets(goodwill , patent)

Not include FICTITIOUS Assets like loss, discount on issue on debenture

Only operating assets→→ so Investment not considered

↑RATIO →effective utilization of assets

↓RATIO → ineffective utilization of assets

5. FIXED ASSETS TURNOVER RATIO

COST OF GOODS SOLD

¿ ASSETS ( AFTER DEP . )

Investment in fixed assets is made for the ultimate purpose of efficient sale , the ratio is used to
measure the fulfillment of the objective.

Investment will not be included in fixed assets.

6. CURRENT ASSETS TURNOVER RATIO

COST OF GOODS SOLD

CURRENT ASSETS

 It reflects the efficiency and capacity of working capital

 Useful for non-factoring unit or those manufacturing units require lesser working capital.
7. WORKING CAPITAL TURNOVER RATIO

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COST OF GOODS SOLD
NET WORKING CAPITAL

↑RATIO →LOW INVESTMENT→MORE PROFIT OR OVER TRADING → EFFICIENT MANAGEMENT

↓RATIO →HIGH INVESTMENT→LOW PROFIT OR UNDER TRADING

8. CAPITAL TURNOVER RATIO

COST OF GOODS SOLD

C APITAL EMPLOYEED

↑RATIO→HIGH PROFIT

↓RATIO→LOWER PROFIT

PROFITABILITY RATIO
Each firm wants to earn maximum profit not only in absolute term but also in relative term.

The firm’s ability to earn maximum profit by the best utilization of its resources is called
profitability

1. GROSS PROFIT RATIO OR MARGIN RATIO

GROSS PROFIT
∗100
NET SALES

↑RATIO → high margin

Due to

 Higher selling price

 Lower cost of goods sold
 Excess combination of selling price and cost where margin is more
 Increase in item of excess margin
2. OPERATING RATIO

OPERATING COST
∗100
NET SALES

Operating cost = operating expenses + cost of goods sold

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OPERATING EXENSES→ office and administration exp as salary, rent, depreciation, director fees,

Electricity, insurance and selling &distribution exp.

NON OPERATING EXPENSES→ interest, discount provision for doubtful debts, provision for tax,

Abnormal exp. preliminary expenses donation, share or debenture

Issue expenses.

↓ RATIO → HIGH OPERATING PROFIT

3. OPERATING PROFIT RATIO

OPERATING PROFIT
∗100
NET SALES

OR

100- OPERATING RATIO

This ratio indicates the net profitability of the main business i.e. operating efficiency of a firm

↑ RATIO→ firm is able to increase sale and can cut down its operating cost.

4. NET PROFIT RATIO

FOR MANAGERIAL EFFICIENCY

NET PROFIT ( AT )
∗100
NET SALES

FOR OWNER’S PURPOSE

NET PROFIT (BT )

∗100
N ET SALES

5. RETURN ON PROPRIETOR’S FUND OR EQUITY

EAIT
∗100
SHARE HOLDER FUND

Share holder fund = net assets = net worth

6. RETURN ON EQUITY SHARE HOLDER’S FUND

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NET PROFIT AFTER TAX −PREFERENCE DIVIDEND
EQUITY SHARE HOLDER FUND

RETURN ON EQUITYU CAPITAL

NET PROFIT AFTER TAX −PREFERENCE DIVIDEND−RESERVE

∗100
EQUITY SHARE CAPITAL ( PAID UP )

7. RETURN ON TOTAL ASSETS

NET PROFIT AFTER TAX

∗100
TOTAL ASSETS

Non trade investment will not be included

↑RATIO→BETTER POSITION

 This ratio is not sound if assets are financed by funds provided by owner’s and creditors
 Basic objective is to measure the effectiveness of the use of funds
 But income earned by use of fund is not true because amount of interest is charged against
profit
RETURN ON TOTAL ASSETS

NET PROFIT AFTER TAX + INTEREST

∗100
TOTAL ASSETS

8. RETURN ON CAPITAL EMPLOYEED

Or
RETURN ON INVESTMENT
Compare profitability of firm with capital employed

Managerial efficiency→

NET PROFIT BEFORE INTEREST ∧TAX

∗100
AVERAGE CAPITAL EMPLOYEED

Net profit before interest on long term funds and tax & and excluding non trading income and abnormal
loss

Owner’s purpose→

NET PROFIT AFTER INTEREST ∧TAX

∗100
AVERAGE CAPITAL EMPLOYEED

Gross capital employed →Total assets

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Net capital employed → total assets – current liabilities

Capital employed → Debt + share holder fund

Capital employed →Fixed Assets +working capital

Return on capital employed → assets turnover ratio* profit margin

While calculating capital employed these items should be excluded

A. Non trading investment

B. Idle assets
C. Intangible assets like G/W, patent, whose realizable value is nil
D. Factious assets
E. Abnormal debtors
F. Cash and bank balance more than requirement

This ratio provides profitability related to long term funds

IMPORTANCE

 Measurement of overall profitability

 Basis of inter firm comparison
 Aid in decision making
 Aid in budgetary control

DU-PONT ANALYSIS CHART

Company with high return on equity with little or no debt can grow easily.

If two companies have same ROE than it is possible that one is sounder.

For the reason a finance executive of E.I.Du.Pont Nemours and Co. of Wilmington Delaware created the
Du-Pont system in 1919

Composition of return on equity

1) Net profit margin

2) Assets turnover
3) Equity multiplier→ net assets /share holder equity

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ROE is affected by many factors

If cost of goods sold↑ than net profit ↓ so ROI ↓

If working capital↑ than capital employed↑ so ROI will ↓

QUESTION
Calculate ROE from following data
Revenue = 29261
Net income = 4212
Assets = 27987
Share holder’s equity = 13572
SOLUTION
ROE=net profit ratio*assets turnover ratio ratio*equity multiplier
4212
∗29261
29261
∗27987
27987
13572
.1439*1.0455*2.0621

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 =31.02%

INVESTMENT ANALYSIS RATIO

1. EARNING PER SHARE (EPS)

NET PROFIT AFTER TAX −PREFERENCE SHARE DIVIDEND

NO OF EQUITY SHARE
No of equity share→ as per AS 20 no. of equity share means weighted average no. of equity share
outstanding during the period
↑ Ratio → high price of share
Helps to company in raising additional capital

2. PRICE EARNING RATIO (P/E RATIO) → establish relationship between the market price of share and
earning per share.
MARKET PRICE OF SHARE
EPS
A high P/E ratio as the indication of over valuation of shares and vice-versa
This ratio is use in determining the future market price of share and rate of capitalization.
This ratio measure the growth potential of investment, risk characteristics, shareholders orientation,
corporate image and degree of liquidity.
3. DIVIDEND PER SHARE
The EPS ratio represent to what extent the profit belong to the owner of
a firm but it is customary in all companies to retain a portion of profit in the
business.

DIVIDEND PAID ¿ EQUITY SHARE ¿

NO OF EQUITY SHARE OUTSTANDING
This ratio represent to what extent the profit have been received by the owners as dividend
Investor would like to invest in high dividend paying company.
 Dividend per share is not measure of profitability because retain earning might have been
utilized for payment of dividend.

4. DIVIDEND YIELD RATIO

EPS and DPS are determined on the basis of book value of share
DIVIDEND PER SHARE
MARKET PRICE PER SHARE

5. DIVIDEND PAY OUT RATIO(D/P RATIO)

This ratio shows that what % of NPAT is distributed to owners.
This is a relationship between EPS and DPS

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DIVIDEND PER SHARE
EARNING PER SHARE
OR

EQUITY DIVIDEND
PROFIT AFTER TAX −PREFERENCE SHARE DIVIDEND
TRANSFER TO RESERVE = 100- D/P RATIO

6. RESERVE TO CAPITAL RATIO

EQUITY DIVIDEND
EQUITY SHARE CAPITAL
This ratio explain the profit allocation policy of a company
High ratio→ sound financial position and company can absorb losses in future
This ratio shows the progress or development made by a company , when it follows conservative policy
in dividend distribution then it will be high.

INTERPRETATION OF RATIOS
I. Interpretation by single absolute ratio
II. Interpretation by group of ratio
III. Interpretation by historical comparison
IV. Interpretation by inter firm comparison

QUESTION
From the following information prepare a B/S on 31 march 2009
Working capital 2,40,000
Bank overdraft 40,000
Fixed assets to proprietary ratio 0.75
Reserve 1, 60,000
Current ratio 2.5 times
Liquid ratio 1.5 times
ANSWER
CA-CL = 2, 40,000
CA/CL = 2.5 CA = 2.5 CL
2.5 CL-CL = 2, 40,000 CL = 1, 60,000
CA = 4, 00,000
LIQUID RATIO
LA/LL = LA/1, 60,000-40,000 = 1.5
LA = 1, 80,000
STOCK = 2, 20,000
Proprietary fund = cap. + Reserve –loss = X
Total of B/S = X + current liabilities

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 = X – 2, 40,000
Fixed assets = total of B/S – CA
= X+1, 60,000-4, 00,000
= X-2, 40,000
FA to proprietary fund ratio

X−2,40,000
=0.75
X

X −2,40,000=.75 X
X= 9, 60,000

CAPITAL 8,00,000 CURRENT ASSETS 1,80,000

RESERVE 1,60,000 STOCK 2,20,000
BANK O/D 40,000 FIXED ASSETS 7,20,000
OTHER C/L 1,20,000
11,20,000 11,20,000

OTHER WORKING NOTES

PROPERITORY FUND – FA = WORKING CAPITAL
ANOTHER WAY
FA/PROPRITORY FUND = 0.75 SO
WC/PROPRITORY FUND = 0.25
2,40,000/PROPRETORY FUND = 0.25
PROPRIETORY FUND = 9,60,000

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