Chapter

Ratio Analysis – different types of ratios; Advantages and Limitation of ratio analysis.

Types of Ratios: Ratios are classified based on following aspects:

I. Liquidity (short-term solvency): These are the ratios which show the ability of the enterprise to meet its short-
term financial obligations. A generally acceptable current ratio is 2 to 1. But whether or not a specific ratio is
satisfactory depends on the nature of the business and the characteristics of its current assets and liabilities. It
includes

a) Current Ratio: It is a ratio which calculates the relationship between the current assets and current
liabilities. It is a liquidity ratio that measures the ability of the enterprise to pay its short-term financial
obligations i.e., current liabilities

Current Assets
Current Ratio =
Current Liabilities
Where,
Current Assets = Inventories + Sundry Debtors + Cash and Bank Balances
+ Receivables/ Accruals + Loans and Advances +
Disposable Investments + Any other current assets.

Current Liabilities = Creditors for goods and services + Short-term Loans + Bank
Overdraft + Cash Credit + Outstanding Expenses +Provision
for Taxation + Proposed Dividend + Unclaimed Dividend +
Any other current liabilities.

Prepared by: Raman Luthra

Chartered Accountant
 b) Quick or Acid Test Ratio: It is a liquidity ratio which measures the ability of the enterprise to meet its
short-term financial obligations, i.e., Current Liabilities. It is a relationship of liquid assets with current
liabilities.

Quick/Liquid Assets
Acid Test Ratio =
Current Liabilities
Where,
Quick Assets = Current Assets – Inventories – Prepaid Expense

Creditors for goods and services + Short-term Loans + Bank

Current Liabilities = Overdraft + Cash Credit + Outstanding Expenses +Provision
for Taxation + Proposed Dividend + Unclaimed Dividend +
Any other current liabilities.

Note: Inventories and Prepaid expenses are not included in Liquid assets because inventories take time to
convert in cash and cash equivalents and prepaid expenses are something that has already been paid in
advance and cannot be converted into cash.

c) Cash Ratio/ Absolute Liquidity Ratio: The cash ratio measures the absolute liquidity of the business.
This ratio considers only the absolute liquidity available with the firm. This ratio is calculated as:

Cash and Bank balances +Marketable Securities

Cash Ratio =
Current Liabilities

Multiple Choice Questions

1. [Question] Two basic measures of liquidity are:

a) Inventory turnover and Current ratio
b) Current ratio and Quick ratio
c) Gross Profit ratio and Operating ratio
d) Current ratio and Average Collection period
e) Current ratio and Debt-Equity ratio

Answer: b.

2. [Question] Trade receivables 40,000; Trade Payables ₹60,000; Prepaid Expenses ₹10,000; Inventory ₹1,00,000 and
Goodwill is ₹15,000. Current Ratio will be

a) 2.75:1
b) 2.5:1
c) 2.33:1
d) 0.92:1
e) 0.67:1

Answer: b.

Prepared by: Raman Luthra

Chartered Accountant
3. [Question] Cash Balance ₹5,000; Trade Payables ₹40,000; Inventory ₹50,000; Trade Receivables ₹65,000 and
Prepaid Expenses are ₹10,000. Liquid Ratio will be-

a) 3.5:1
b) 2:1
c) 1.875:1
d) 1.75:1
e) 0.125:1

Answer: d.

4. [Question] As at 01.04.2021, a company has total current assets = 1,00,000 and current ratio is 2:1. On 02.04.2021
the company paid 25,000 to a creditor. The new current Ratio after the payment will be:

a) 4:1
b) 3:1
c) 2.5:1
d) 1.5:1
e) No Change in current ratio.

Answer: b.

5. [Question] A Company’s Current Ratio is 3:1; Current Liabilities are ₹2,50,000; Trade receivable are 50,000,
Inventory is ₹60,000 and Prepaid Expenses are ₹5,000. Its Liquid Assets will be:

a) 7,50,000
b) 7,00,000
c) 6,85,000
d) 6,40,000
e) 6,35,000

Answer: c.

Prepared by: Raman Luthra

Chartered Accountant
II. Long-term Solvency Ratio /Leverage Ratio
The leverage ratios may be defined as those financial ratios which measure the long-term stability and structure
of the firm. These ratios indicate the mix of funds provided by owners and lenders and assure the lenders of the
long-term funds with regard to:
(i) Periodic payment of interest during the period of the loan and
(ii) Repayment of principal amount on maturity.

Leverage Ratio

Capital
Coverage Ratios
Structure Ratios

1. Capital Structure Ratios: These ratios provide an insight into the financing techniques used by a business and
focus, as a consequence, on the long-term solvency position.
From the balance sheet one can get only the absolute fund employed and its sources, but only capital structure
ratios show the relative weight of different sources.

a) Debt-to Equity Ratio: It is a relationship between long-term external equities, i.e., external debts (includes
long-term borrowings and long-term provisions) and internal equities (Shareholders’ Funds) of the
enterprise. It measures the proportion of external funds and shareholders invested in the company.

Debt- Equity = Debt

Ratio Equity (Shareholder's Funds)

Debt means long term debt (includes long-term borrowings and long-term provisions)

Long term Borrowings and long-term provisions

➢ It is shown as long-term borrowings under Non-current Liabilities if they are payable after 12
months from the date of Balance Sheet or after the operating cycle period.

➢ Debt = Long-term Borrowings + Long-term Provisions

Or
= Total Debt – Current Liabilities
Or
= Capital Employed – Equity*

➢ Equity = Share Capital + Reserves & Surplus + Money received against share warrants
Or
= Non-Current Assets + Working Capital – Non-Current Liabilities (Long-term Borr. +
Long-term Prov.)
Or
= Total Assets – Total Debt

Prepared by: Raman Luthra

Chartered Accountant
 Notes:
i. Capital Employed = Debt + Equity or Non-Current Assets + Working Capital – Fictitious
Assets
ii. Non-Current Assets = Tangible Assets + Intangible Assets + Non-Current Trade
Investments + Long-term Loans and Advances.
iii. Working Capital = Current Assets – Current Liabilities
iv. Negative Balance in Statement of Profit & Loss (Deficit, i.e. Debit Balance) is deducted to
compute Shareholders’ Funds.
v. Share Capital = Equity share capital + Preference share capital

b) Capital Gearing Ratio: In addition to debt-equity ratio, sometimes capital gearing ratio is also calculated
to show the proportion of fixed interest (dividend) bearing capital to funds belonging to equity
shareholders i.e. equity funds or net worth.

Capital Gearing = (Preference Share Capital+ Debentures + Other interest-bearing

Ratio borrowed funds)

Equity Shareholder funds

c) Total Assets to Debt Ratio: It is a relationship between total assets and long-term debts of the enterprise.
It measures the extent to which debt (Long-term) is covered by the assets. It measures the ‘Safety Margin’
available to the lenders of the long-term debts. A higher ratio means higher safety for lenders and a lower
ratio means lower safety for lenders.

Total Assets to = Total Assets

Debt Ratio Debt (Long-term Debts)

d) Proprietary Ratio: It is a relationship between proprietor’s fund and total assets. It shows the financial
strength of the entity. It is used to measure the proportion of totals assets financed by Proprietors’ Funds.

Proprietary = Proprietor's Funds or Shareholders' Funds or Equity

Ratio Total Assets

Notes:
i. Proprietors’ Funds: This can be computed using either of the 2 approaches available as follows
• Liabilities Approach: In this approach,
Proprietors’ funds = Share Capital (Equity + Preference) + Reserves and Surplus.
• Assets Approach: In this approach,
• Proprietors’ funds = Non-current Assets + Working Capital (i.e. Current Assets – Current
Liabilities) – Non-current Liabilities.
ii. Total Assets: This includes:
• Non-Current Assets: This will include:
o Fixed assets (tangible and intangible assets),
o Non-Current Investments,
o Long term Loans and Advances.

Prepared by: Raman Luthra

Chartered Accountant
 • Current Assets: This will include:
o Current Investments,
o Inventories (including spare parts and loose tools),
o Trade Receivables,
o Cash and Cash Equivalents,
o Short-term Loans and Advances,
o Other Current Assets

2. Coverage Ratios: The coverage ratios measure the firm’s ability to service the fixed liabilities. These ratios
establish the relationship between fixed claims and what is normally available out of which these claims are to be
paid. The fixed claims consist of:
i. Interest on loans
ii. Preference dividend
iii. Amortisation of principal or repayment of the instalment of loans or redemption of preference
capital on maturity.

a) Debt Service Coverage Ratio (DSCR): Lenders are interested in debt service coverage to judge the firm’s
ability to pay off current interest and instalments.

Debt Service = Earnings available for debt services

Coverage Ratio Interest + Instalments

Earning for debt service: Net profit (Earning after taxes) + non-cash operating expenses like depreciation
and other amortizations + Interest +other adjustments like loss on sale of Fixed Asset etc.

b) Interest Coverage Ratio: This ratio also known as “times interest earned ratio” indicates the firm’s ability
to meet interest (and other fixed-charges) obligations. This ratio is computed as:

Interest = Earnings before interest and taxes (EBIT)

Coverage Ratio Interest

c) Preference Dividend Coverage Ratio: This ratio measures the ability of a firm to pay dividend on
preference shares which carry a stated rate of return. This ratio is computed as:

Preference Dividend = Net Profit/Earning after taxes (EAT)

Coverage Ratio Preference dividend liability

Multiple Choice Questions

1. [Question] Equity Share Capital ₹20,00,000; Reserve 5,00,000; Debentures ₹10,00,000; Current Liabilities
₹8,00,000. Debt-equity ratio will be:
a) 0.32:1
b) 0.40:1
c) 0.50:1
d) 0.72:1
e) 0.90:1
Answer: b.

Prepared by: Raman Luthra

Chartered Accountant
2. [Question] Debt equity ratio of a company is 1:2. Which of the following transactions will increase it:

a) Issue of new shares for cash

b) Redemption of Debentures
c) Issue of Debentures for cash
d) Goods purchased on credit
e) Cash realized from trade receivable

Answer: c.

3. [Question]

Balance sheet as on 31st March, 2021 Rs.

Equity and Liabilities:
Equity share capital 30,00,000
10% Preference share capital 10,00,000
Retained earnings 14,00,000
12% secured debentures 18,00,000
Sundry creditors 9,50,000
Bills payable 5,00,000
Income tax provision 3,50,000
90,00,000
Assets:
Fixed assets 62,00,000
Inventory 10,60,000
Sundry debtors 8,50,000
Bills receivable 6,50,000
Cash 2,40,000
90,00,000
Additional information
Profit before interest and depreciation 25,00,000
Depreciation 8,00,000
Interest 2,16,000
Calculate capital gearing ratio?

a) 1.04 Times
b) 0.97 Times
c) 0.93 Tomes
d) 0.67 Times
e) 0.64 Times

Answer: e.

Prepared by: Raman Luthra

Chartered Accountant
4. [Question] On the basis of following data, a Company’s Total Assets-Debt Ratio will be: Working Capital
₹2,70,000; Current Liabilities ₹30,000; Fixed Assets ₹7,00,000; Debentures ₹2,00,000; Long Term Bank Loan
₹50,000.

a) 4.00 Times
b) 3.88 Times
c) 3.76 Times
d) 5.00 Times
e) 3.50 Times

Answer: a.

5. [Question] Fixed Assets ₹5,00,000; Current Assets ₹7,00,000; Equity Share Capital ₹4,00,000; Reserve ₹2,00,000;
Long-term Debts ₹4,00,000. Proprietary Ratio will be:

a) 33%
b) 50%
c) 80%
d) 125%
e) 133%

Answer: b.

6. [Question]

Balance sheet as on 31st March, 2021 Rs.

Equity and Liabilities:
Equity share capital 30,00,000
10% Preference share capital 10,00,000
Retained earnings 14,00,000
11.11% secured debentures 18,00,000
Sundry creditors 9,50,000
Bills payable 5,00,000
Income tax provision 3,50,000
90,00,000
Assets:
Fixed assets 62,00,000
Inventory 10,60,000
Sundry debtors 8,50,000
Bills receivable 6,50,000
Cash 2,40,000
90,00,000
Additional information

Prepared by: Raman Luthra

Chartered Accountant
 Profit before interest and depreciation 25,00,000
Depreciation 8,00,000
Interest 2,00,000

Note: Tax rate 50%. Loan installment payable during the year Rs. 3, 00,000. Equity dividend declared during the
year @ 18% you are required to calculate long-term solvency ratios.

Calculate Interest Coverage ratio, Preference Dividend Coverage ratio and Debt Service Coverage Ratio?

Answer:

Prepared by: Raman Luthra

Chartered Accountant
III. Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio
These ratios are employed to evaluate the efficiency with which the firm manages and utilises its assets. For this
reason, they are often called ‘Asset management ratios’. These ratios usually indicate the frequency of sales with
respect to its assets. These assets may be capital assets or working capital or average inventory.

Asset Turnover Ratios: Based on different concepts of assets employed, it can be expressed as follows:

a) Total Asset Turnover Ratio: This ratio measures the efficiency with which the firm uses its total assets.
This ratio is computed as:

Total Asset = Sales/ Cost of Goods Sold

Turnover Ratio Average Total Assets

b) Fixed Assets Turnover Ratio: It measures the efficiency with which the firm uses its fixed assets.

Fixed Asset = Sales/ Cost of Goods Sold

Turnover Ratio Average Fixed Assets

c) Capital Turnover Ratio/ Net Asset Turnover Ratio: This ratio indicates the firm’s ability of generating
sales/ Cost of Goods Sold per rupee of long-term investment

Capital = Sales/ Cost of Goods Sold

Turnover Ratio Average Net Assets

d) Current Assets Turnover Ratio: It measures the efficiency using the current assts by the firm.

Current Assets = Sales/ Cost of Goods Sold

Turnover Ratio Average Current Assets

e) Working Capital Turnover Ratio:

Working Capital = Sales/ Cost of Goods Sold

Turnover Ratio Average Working Capital

Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover, and Creditors
Turnover

i. Inventory/ Stock Turnover Ratio: This ratio also known as stock turnover ratio establishes the relationship
between the cost of goods sold during the year and average inventory held during the year. It measures
the efficiency with which a firm utilizes or manages its inventory. It is calculated as follows:

Inventory = Sales/ Cost of Goods Sold

Turnover Ratio Average Inventory*

Average = Opening Stock + Closing Stock

Inventory* 2

Prepared by: Raman Luthra

Chartered Accountant
 ii. Receivables (Debtors) Turnover Ratio: In case firm sells goods on credit, the realization of sales revenue
is delayed and the receivables are created. The cash is realised from these receivables later on. High ratio
indicates that customers are paying on time and your company is good at collecting debts.

Receivable (Debtor) = Credit Sales

Turnover Ratio Average Accounts Receivable

iii. Payables Turnover Ratio: This ratio is calculated on the same lines as receivable turnover ratio is
calculated. This ratio shows the velocity of payables payment by the firm. A low creditor’s turnover ratio
reflects liberal credit terms granted by supplies. While a high ratio shows that accounts are settled rapidly.
It is calculated as follows:

Payables Turnover = Annual Net Credit Purchases

Ratio Average Accounts Payables

Multiple Choice Questions

1. [Question] Calculate stock turnover ratio from the following information:

Opening stock Rs 45000, Closing stock Rs 55000 and Purchases Rs 160000.

a) 3.20 Times
b) 3.00 Times
c) 2.90 Times
d) 2.72 Times
e) 1.50 Times

Answer: b.

2. [Question] Find out debtors’ turnover ratio from the following information for one year ended 31st March 2021:

Particulars 31St Mar-21

Total Annual sales 10,00,000
Cash sales 1,00,000
Debtors in the beginning 80,000
Debtors at the end 1,00,000
Debt to be taken for the year 360 days

a) 12.22 Times
b) 72 Days
c) 11.00 Times
d) 10.00 Times
e) 36 Days

Answer: d.

Prepared by: Raman Luthra

Chartered Accountant
3. [Question] Calculate average age of payables/ debt payment period from the following information for one
year ended 31st March 2021:

Particulars 31St Mar-21

Credit purchases during the year 15,00,000
Cash purchases during the year 5,00,000
Creditors in the beginning 100,000
Creditors at the end 2,00,000
No. of days in a year 360 days

a) 20.00 Times
b) 18 Days
c) 10.00 Times
d) 7.50 Times
e) 36 Days

Answer: e.

4. [Question] Find out working capital turnover ratio for the year 2021.

Cash 10,000
Bills receivable 5,000
Sundry debtors 25,000
Stock 20,000
Sundry creditors 30,000
Cost of sales 1,50,000

a) 10.00 Times
b) 5 Times
c) 2.5 Times
d) 1.66 Times
e) Date incomplete

Answer: b.

Prepared by: Raman Luthra

Chartered Accountant
IV. Profitability Ratios
The profitability ratios measure the profitability or the operational efficiency of the firm. These ratios reflect the
final results of business operations. They are some of the most closely watched and widely quoted ratios.
Management attempts to maximize these ratios to maximize firm value. The results of the firm can be evaluated
in terms of its earnings with reference to a given level of assets or sales or owner’s interest etc. Therefore, the
profitability ratios are broadly classified in four categories:
i. Profitability Ratios related to Sales
ii. Profitability Ratios related to overall Return on Investment
iii. Profitability Ratios required for Analysis from Owner’s Point of View
iv. Profitability Ratios related to Market/ Valuation/ Investors

i. Profitability Ratios related to Sales

a) Gross Profit (G.P) Ratio/ Gross Profit Margin: Gross profit ratio (GP ratio) is a financial ratio that
measures the performance and efficiency of a business by dividing its gross profit figure by the total net
sales. Gross margin is the difference between revenue and cost of goods sold, divided by revenue.

Gross Profit Ratio = Gross profit X 100

Sales

b) Net Profit Ratio/ Net Profit Margin: It measures the relationship between net profit and sales of the
business. Depending on the concept of net profit it can be calculated as

Net Profit Ratio = Net profit X 100

Sales

c) Operating Profit Ratio: Operating profit ratio measures the percentage of each sale in rupees that remains
after the payment of all costs and expenses except for interest and taxes.

Operating Profit = Earnings before interest and taxes (EBIT) X 100

Ratio Sales

ii. Profitability Ratios related to overall Return on Investment

a) Return on Investment (ROI): ROI is the most important ratio of all. It is the percentage of return on funds
invested in the business by its owners.

Return on = Return/Profit/Earnings X 100

Investment Investment

Prepared by: Raman Luthra

Chartered Accountant
 The concept of investment varies and accordingly there are three broad categories of ROI i.e.

i. Return on Assets (ROA): The profitability ratio is measured in terms of relationship between net
profits and assets employed to earn that profit.

Return on Assets = EBIT (1- t) X 100

Average Total Assets/ Average Tangible
Assets/ Average Fixed Assets

ii. Return on Capital Employed (ROCE): It is another variation of ROI. The ROCE is calculated as
follows:

Return on Capital = EBIT (1- t) X 100

Employed Capital Employed

iii. Return on Equity (ROE): Return on Equity measures the profitability of equity funds invested
in the firm. This ratio is computed as:

Return on Capital = Net Profit after taxes-Preference dividend X 100

Equity Equity shareholders' fund

iii. Profitability Ratios required for Analysis from Owner’s Point of View

a) Earnings per Share (EPS): The profitability of a firm from the point of view of ordinary shareholders can
be measured in terms of number of equity shares. This is known as Earnings per share. It is calculated as
follows:

Earnings per Share = Net profit available to equity shareholders

(EPS) Number of equity shares outstanding

b) Dividend per Share (DPS): Earnings per share as stated above reflects the profitability of a firm per share;
it does not reflect how much profit is paid as dividend and how much is retained by the business. Dividend
per share ratio indicates the amount of profit distributed to equity shareholders per share. It is calculated
as:

Dividend per Share = Total Dividend paid to equity shareholders

(DPS) Number of equity shares outstanding

c) Dividend Payout Ratio (DP): This ratio measures the dividend paid in relation to net earnings. It is
determined to see to how much extent earnings per share have been retained by the management for the
business. It is computed as:

Dividend per Share = Dividend per equity share (DPS)

(DPS) Earnings per Share (EPS)

Prepared by: Raman Luthra

Chartered Accountant
 iv. Profitability Ratios related to Market/ Valuation/ Investors

a) Price- Earnings Ratio (P/E Ratio): The price earnings ratio indicates the expectation of equity investors
about the earnings of the firm. It relates earnings to market price and is generally taken as a summary
measure of growth potential of an investment, risk characteristics, shareholders orientation, corporate
image and degree of liquidity. It is calculated as

Price-Earnings per = Market Price per Share (MPS)

Share (P/E Ratio) Earnings per Share (EPS)

b) Dividend and Earning Yield:

Dividend Yield = Dividend per Share (DPS) X 100

Market Price per Share (MPS)

Earning Yield = Earnings per Share (EPS) X 100

Market Price per Share (MPS)

ADVANTAGES OF RATIO ANALYSIS

Advantages of ratio analysis for shareholders and prospective investors;

1. Helps to understand efficacy of decisions: The ratio analysis helps you to understand whether the business
firm has taken the right kind of operating, investing and financing decisions. It indicates how far they have
helped in improving the performance.

2. Simplify complex figures and establish relationships: Ratios help in simplifying the complex accounting
figures and bring out their relationships. They help summarise the financial information effectively and assess
the managerial efficiency, firm’s credit worthiness, earning capacity, etc.

3. Helpful in comparative analysis: The ratios are not be calculated for one year only. When many year figures are
kept side by side, they help a great deal in exploring the trends visible in the business. The knowledge of trend
helps in making projections about the business which is a very useful feature.

4. Identification of problem areas: Ratios help business in identifying the problem areas as well as the bright
areas of the business. Problem areas would need more attention and bright areas will need polishing to have
still better results.

5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring in the business. The
information of change helps the management a great deal in understanding the current threats and
opportunities and allows business to do its own SWOT (Strength- Weakness-Opportunity-Threat) analysis.

6. Various comparisons: Ratios help comparisons with certain bench marks to assess as to whether firm’s
performance is better or otherwise. For this purpose, the profitability, liquidity, solvency, etc. of a business, may
be compared:
i) over a number of accounting periods with itself (Intra-firm Comparison/Time Series Analysis),

Prepared by: Raman Luthra

Chartered Accountant
 ii) with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis) and
iii) with standards set for that firm/industry (comparison with standard (or industry expectations).

LIMITATIONS OF RATIO ANALYSIS

1. Limitations of Accounting Data: Accounting data give an unwarranted impression of precision and finality. In
fact, accounting data “reflect a combination of recorded facts, accounting conventions and personal judgements
which affect them materially. For example, profit of the business is not a precise and final figure. It is merely an
opinion of the accountant based on application of accounting policies. The soundness of the judgement necessarily
depends on the competence and integrity of those who make them and, on their adherence, to Generally Accepted
Accounting Principles and Conventions”. Thus, the financial statements may not reveal the true state of affairs of
the enterprises and so the ratios will also not give the true picture.

2. Ignores Price-level Changes: The financial accounting is based on stable money measurement principle. It
implicitly assumes that price level changes are either non-existent or minimal. But the truth is otherwise. We are
normally living in inflationary economies where the power of money declines constantly. A change in the price-
level makes analysis of financial statement of different accounting years meaningless because accounting records
ignore changes in value of money.

3. Ignore Qualitative or Non-monetary Aspects: Accounting provides information about quantitative (or
monetary) aspects of business. Hence, the ratios also reflect only the monetary aspects, ignoring completely the
non-monetary (qualitative) factors.

4. Variations in Accounting Practices: There are differing accounting policies for valuation of inventory, calculation
of depreciation, treatment of intangibles assets definition of certain financial variables etc., available for various
aspects of business transactions. These variations leave a big question mark on the cross-sectional analysis. As
there are variations in accounting practices followed by different business enterprises, a valid comparison of their
financial statements is not possible.

5. Forecasting: Forecasting of future trends based only on historical analysis is not feasible. Proper forecasting
requires consideration of non-financial factors as well.

Prepared by: Raman Luthra

Chartered Accountant