RATIO ANALYSIS

Introduction

A ratio is defined as “the indicated quotient of two mathematical expressions and as the relationship
between two or more things.” Here ratio means financial ratio or accounting ratio which is a
mathematical expression of the relationship between accounting figures.

The term financial ratio can be explained by defining how it is calculated and what the objective of this
calculation is

1. Calculation Basis (Basis of Calculation)

 A relationship expressed in mathematical terms;
 Between two individual figures or group of figures;
 Connected with each other in some logical manner; and
 Selected from financial statements of the concern
2. Objective for financial ratios is that all stakeholders (owners, investors, lenders, employees etc.)
can draw conclusions about the
 Performance (past, present and future);
 Strengths & weaknesses of a firm; and
 Can take decisions in relation to the firm.

Ratio analysis is based on the fact that a single accounting figure by itself may not communicate any
meaningful information but when expressed relative to some other figure, it may definitely provide some
significant information.

Ratio analysis is not just comparing different numbers from the balance sheet, income statement, and cash
flow statement. It is comparing the number against previous years, other companies, the industry, or even
the economy in general for the purpose of financial analysis.

Liquidity Ratios

The terms ‘liquidity’ and ‘short-term solvency’ are used synonymously. Liquidity or short-term solvency
means ability of the business to pay its short- term liabilities.

Inability to pay-off short-term liabilities affects its credibility as well as its credit rating. Continuous
default on the part of the business leads to commercial bankruptcy.

Various Liquidity Ratios are:

 Current Ratio
 Quick Ratio or Acid test Ratio
 Cash Ratio or Absolute Liquidity Ratio
 Basic Defense Interval or Interval Measure Ratios
 Net Working Capital Ratio

Long-term Solvency Ratios /Leverage Ratios

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:
  Periodic payment of interest during the period of the loan and
 Repayment of principal amount on maturity.

Leverage ratios are of two types:

1. Capital Structure Ratios

 Equity Ratio
 Debt Ratio
 Debt to Equity Ratio
 Debt to Total Assets Ratio
 Capital Gearing Ratio
 Proprietary Ratio
2. Coverage Ratios
 Debt-Service Coverage Ratio (DSCR)
 Interest Coverage Ratio
 Preference Dividend Coverage Ratio
 Fixed Charges Coverage Ratio

Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios

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.

Activity Ratios/ Efficiency Ratios/ Performance Ratios/ Turnover Ratios:

 Total Assets Turnover Ratio

 Fixed Assets Turnover Ratio
 Capital Turnover Ratio
 Current Assets Turnover Ratio
 Working Capital Turnover Ratio
 Inventory/ Stock Turnover Ratio
 Receivables (Debtors) Turnover Ratio
 Payables (Creditors) Turnover Ratio.

These ratios are usually calculated with reference to sales/cost of goods sold and are expressed in terms
of rate or times.

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

Profitability Ratios are as follows:

1. Profitability Ratios based on Sales

 Gross Profit Ratio
 Net Profit Ratio
 Operating Profit
 Expenses Ratio
2. Profitability Ratios related to Overall Return on Assets/ Investments
 Return on Investments (ROI)
 Return on Assets (ROA)
 Return of Capital Employed (ROCE)
 Return on Equity (ROE)
3. Profitability Ratios required for Analysis from Owner’s Point of View
 Earnings per Share (EPS)
 Dividend per Share (DPS)
 Dividend Payout Ratio (DP)
4. Profitability Ratios related to Market/ Valuation/ Investors
 Price Earnings (P/E) Ratio
 Dividend and Earning Yield
 Market Value/ Book Value per Share (MVBV)
 Q Ratio

We will discuss the following ratios in this chapter.

1. Current Ratio
2. Quick Ratio or Acid test Ratio
3. Absolute quick ratio
4. Debt to Equity Ratio
5. Interest Coverage Ratio
6. Gross Profit Ratio
7. Net Profit Ratio
8. Operating Profit
9. Return on Investments (ROI)
10. Return on Assets (ROA)
11. Return of Capital Employed (ROCE)
12. Return on Equity (ROE)
 Notes on Gross profit, Net profit, Operating profit and Interest coverage ratios from the
recommended text book

Profitability Ratios related to Sales:

These ratios are based on the premise that a firm should earn sufficient profit on each rupee of sales.
These ratios consist of (1) Profit margin and (2) Expenses ratios.

Profit Margin measures the relationship between profit and sales. As the profits may be gross or net,
there are two types of profit margins or ratios: Gross profit margin and Net profit margin.

Gross profit margin is also known as gross margin. It is calculated as

Gross profit margin= [Gross profit/sales]*100

Gross profit is the result of the relationship between prices, sales volume and costs. A change in the
gross margin can be brought about by change in any of these factors. The gross margin represents the
limit beyond which fall in sales prices are outside the tolerance limit.

A high ratio of gross profit to sales is a sign of good management as it implies that the cost of production
of the firm is relatively low. It may also be indicative of a higher sales price without a corresponding
increase in the cost of goods sold. However, a relatively low gross margin in definitely a danger signal,
warranting a careful and detailed analysis of the factors responsible for it.

A firm should have a reasonable gross margin to ensure adequate coverage for operating expenses of
the firm and sufficient return to the owners of the business, which is reflected in the net profit margin.

Net profit margin or net profit ratio or net margin measures the relationship between net profits and
sales of a firm. Depending on the concept of net profit employed, this ratio can be computed in three
ways:

1. Operating profit ratio= Earnings before interest and taxes (EBIT)/Net sales
2. Pre-tax profit ratio= Earnings before taxes (EBT)/Net sales
3. Net profit ratio= Earnings after interest and taxes (EAT)/Net sales

The net profit margin is indicative of management’s ability to operate the business with sufficient
success not only to recover from revenues of the period, but also to leave a margin of reasonable
compensation to the owners for providing their capital at risk.

A high net profit margin would ensure adequate return to the owners as well as enable a firm to
withstand adverse economic conditions when selling price is declining, cost of production is rising and
demand for the product is falling.

A low net profit margin has the opposite implications. However, a firm with a low profit margin, can
earn a high rate of return on investments if it has a higher inventory turnover.
EX 4.6 (pg. no. 4.19)

From the following information of a firm, determine (1) gross profit margin and (2) net profit margin.

1. Sales Rs. 2,00,000

2. Cost of goods sold Rs. 1,00,000
3. Other operating expenses Rs. 50,000

Sol:

1. Gross profit margin=[100,000/200,000]*100 =50 per cent

2. Net profit margin= [50,000/200,000]*100 = 25 per cent

Interest coverage ratio or time-interest –earned ratio measures the firm’s ability to make contractual
interest payments. It measures the debt servicing capacity of a firm insofar as fixed interest on long-
term loan is concerned. It is determined by dividing the operating profits or earnings before interest
and taxes (EBIT) by the fixed interest charges on loans. Thus,

Interest coverage= EBIT/Interest

It should be noted that this ratio uses the concept of net profits before taxes because interest is tax-
deductible so that tax is calculated after paying interest on long-term loan. This ratio indicates the
extent to which a fall in EBIT is tolerable in that the ability of the firm to service its interest payments
would not be adversely affected. The larger the coverage, the greater is the ability of the firm to handle
fixed-charge liabilities and the more assured is the payment of interest to the lenders.

However, too high a ratio may imply unused debt capacity. In contrast, a low ratio is a danger signal
that the firm is using excessive debt and does not have the ability to offer assured payment of interest
to the lenders.
Return on Total Assets(ROA)

The return on total assets expresses the relationship between net income and total assets. It is the net
income as a percentage of average total assets. Managers often measure the performance of a firm by the
ratio of net income to total assets. However, because net income measures profits net of interest expense,
this practice makes the apparent profitability of the firm a function of its capital structure. It is better to
use net income plus interest because we are measuring the return on all the firm’s assets, not just the
equity investment.

“The rate of return on assets measures the profitability of a firm before any payments to the suppliers of
capital. Various portions of the return on assets are allocated to the various providers of capital. The
share allocated to creditors equals any contractual interest net of tax savings. The share allocated to
preferred shareholders equals the stated dividend amounts on the preferred stock. The common
shareholders have a residual claim on all earnings after creditors and preferred shareholders have received
amounts contractually owed them.” – Cengage Learning

Given the following financial data: Net income/Sales = 5 percent; Sales/Total assets = 2.5 times; calculate
Return on assets.

Net Income Sales

a) Return on assets  
Sales Total assets

5*2.5 = 12.5%

Return on Capital Employed (ROCE)

The profitability of the firm can also be analyzed from the point of view of the total funds employed by
the firm. The term funds employed or capital employed refers to the total long-term sources of funds. It
means that the capital employed comprises of shareholders’ funds and long-term debts. It can also be
treated as Return n Investment (ROI)

The rate of return on common shareholders' equity (ROCE) or Return on Capital Employed or Return on
Investment measures a firm's performance in using and financing assets to generate earnings and is of
primary interest to common shareholders. The ratio is computed as follows:

Net Income - Dividends on Preferred Stock.

Average Common Shareholders' Equity

 or

Return on capital employed = PBIT/capital employed x 100

This measure of profitability assesses a firm's performance in using assets to generate earnings and
explicitly considers the financing of those assets. The rate of return on common shareholders' equity will
exceed the rate of return on assets if the rate of return on assets exceeds the after-tax cost of debt and any
dividends required for preferred shareholders.

Example: If a firm’s equity share capital is Rs. 30000, Retained earnings are Rs. 12800, Its debt is Rs.
24000, Current Liabilities are Rs. 12000, Profit before interest and tax is Rs. 10000. Calculate Return on
capital employed.

Return on capital employed = PBIT/capital employed x 100

=(10000/(30000+12800+24000))*100

= 14.97%

Practice Problem:

From the following balance sheet and income statement of XYZ ltd. Calculate ROA and ROCE

2019 2018
ASSETS Rs.000 Rs.000
Non-current assets
Property, plant and equipment 15,244 7,400

Current assets
Inventories 1,369 888
Trade receivables 3,552 2,220
Cash and cash equivalents 0 925
4,921 4,033

Total assets 20,165 11,433

EQUITY AND LIABILITIES

Equity attributable to equity holders
Share capital 1,850 370
Share premium 740 0
Revaluation reserve 0 2,590
Retained earnings 11,100 6,290
Total equity 13,690 9,250

Non-current liabilities
Long-term borrowings 1,850 0
Total non-current liabilities 1,850 0

Current liabilities
Trade payables 3,811 2,183
Bank overdraft 814 0
Total current liabilities 4,625 2,183

Total equity and liabilities 20,165 11,433

Income statement for the year 2019

Sale 60000
Less: COGS 420000
Interest 2400 44400

Net Profit 1560

Less: Tax@25% 390
Profit after tax 1170
CURRENT RATIO
The current ratio indicates the extent to which the claims of short-term creditors are covered by
assets that are expected to be converted to cash in a period roughly corresponding to the maturity
of the liabilities. Here's how the current ratio is calculated.
Current Ratio = Current Assets
Current Liabilities
As mentioned under the balance sheet section, a current liability represents money a company
owes and is due in the near future- less than one year. A current asset, on the other hand, is cash
or others short-term assets that can be converted into cash in the near future (IE less than a
year). Inventory, for example, is a current asset that is purchased and sold by a company to
obtain cash.
By dividing the current assets by the current liabilities, we can determine whether or not a
company has the ability to pay off its short-term debt (current liabilities). Below shows the
current assets and current liabilities for The Widget Manufacturing Company.
ASSETS: LIABILITIES:

Current Assets: Current Liabilities:

Cash $ 2,550 Accounts Payable $ 9,500

Marketable securities $ 2,000 Short-term Bank Loan $11,375

Account Receivable (Net) $16,675 Total Current Liabilities $20,875

Inventories $ 26,470

Total Current Assets $47,695

Using the values shown in the total current assets account and total current liabilities account we
can calculate the company's current ratio as follows:
Current Ratio = Current Assets = $47,695
Current Liabilities $20,875

= 2.28

As you can see, The Widget Manufacturing Company has a current ratio of 2.28. That is, for
every $1.00 the company owes in current liabilities, it has $2.28 worth of current assets.
Therefore, if the Widget Manufacturing Company's short-term debt was due tomorrow, they
would NOT have any difficulty in paying their creditors. Moreover, they would simply use the
cash in their bank account , redeem their marketable securities, collect cash from customers who
owe them (Accounts Receivable) and sell more products to customers.
Banks like to see a current ratio of at least 2 to 1 ; that is, for every $1.00 a company owes in
short-term debt, it has $2.00 in current assets. Note: the higher the current ratio, the stronger the
company is thought to be.

QUICK RATIO
Some conservative minded investors don't like to use the current ratio as a indicator of whether
or not a company has the ability to pay its short term obligations (debt). Instead, the quick
ratio is used. The quick ratio is similar to the current ratio with one exception; that is, the quick
ratio measures a company's ability to pay its short-term debt, without relying on the sale of its
inventory. Therefore, in calculating a quick ratio, business owners must subtract the inventory
from the current assets. The formula used to calculate the quick ratio is as follows;

Quick Ratio = Current Assets - Inventories

Current Liabilities

The three items required in calculating the quick ratio can be obtained from a company's balance
sheet. Below shows the values of Widget Manufacturing Company's current assets and current
liabilities on December 31, 200Y.
ASSETS: LIABILITIES:

Current Assets: Current Liabilities:

Cash $ 2,550 Accounts Payable $ 9,500

Marketable securities $ 2,000 Short-term Bank Loan $11,375

Account Receivable (Net) $16,675 Total Current Liabilities $20,875

Inventories $26,470

Total Current Assets $47,695

As you can see, as of December 31, 200Y, the company's total current assets are valued at
$47,695, inventory valued at $26,470, and current liabilities are valued at $20,875. Using these
amounts, the Widget Manufacturing Company would calculate its quick ratio as follows:
Quick Ratio = Current Assets - Inventories = $47,695 - $26,470
Current Liabilities $20,875

= 1.02
As shown above, the Widget Manufacturing Company has a quick ratio of 1.02. This means; for
every $1.00 owed by the company in short-term debt, it has $1.02 of current assets (excluding
inventory). In theory, if the Widget Manufacturing Company did not sell any more products,
then it would have the ability to pay all of its short-term debt using its current assets; other than
inventory. Note: the higher the quick ratio, the stronger the company is perceived to
be. For further detail, please refer to our detailed article on the Quick Ratio.

In summary, the liquidity ratios consist of the Current Ratio and the Quick Ratio. The current
ratio is calculated by dividing the current assets by the current liabilities. The quick ratio is
calculated by dividing the current assets (excluding inventory) by the current liabilities.

ABSOLUTE QUICK RATIO / ABSOLUTE LIQUID RATIO

Absolute liquid ratio is computed by dividing the absolute liquid assets by current liabilities.
Formula:

Absolute liquid assets are equal to liquid assets minus accounts receivable and bills receivable.
These assets usually include cash, cash equivalents, bank balances and marketable securities etc.

Example
Following are the current assets and current liabilities of a trading company:

Current assets:
 Cash and Bank: $5,000
 Marketable securities: $18,000
 Accounts receivables, net: $8,000
 Inventories: $10,000
 Prepaid expenses: $500

Current liabilities:
 Accounts payable: $15,000
 Accrued payable: $5,000
 Notes payable: $8,000

Required: Compute current ratio, quick ratio and absolute liquid ratio from the above data.
Solution

(1). Current ratio:

Current assets/Current liabilities
= $41,500 / $28,000
= 1.48
or
1.48 : 1

(2). Liquid ratio:

(Current assets – Inventories) Liquid Assets / Current liabilities
= $31,000* / $28,000
= 1.1
or
=1.1 : 1
(3). Absolute liquid ratio:
Absolute liquid assets / Current liabilities
= $23,000** / $28,000
= 0.82
or
0.82 : 1

*Liquid assets: $5,000 + $18,000 + $8,000 = $31,000

**Absolute liquid assets: $5,000 + $18,000 = $23,000

The reason of computing absolute liquid ratio is to eliminate accounts receivables from the list of
liquid assets because there may be some doubt about their quick collection. This ratio is useful
only when used in conjunction with current ratio and quick ratio. An absolute liquid ratio of
0.5:1 is considered ideal for most of the companies.

DEBT TO EQUITY RATIO

The Debt to Equity ratio (also called the “debt-equity ratio”, “risk ratio”, or “gearing”), is a
leverage ratio that calculates the weight of total debt and financial liabilities against total
shareholders’ equity. Unlike the debt-assets ratio which uses total assets as a denominator, the
D/E Ratio uses total equity. This ratio highlights how a company’s capital structure is tilted
either toward debt or equity financing.

Debt to Equity Ratio Formula

Short formula:
Debt to Equity Ratio = Total Debt / Shareholders’ Equity

Long formula:
Debt to Equity Ratio = (short term debt + long term debt + fixed payment obligations) /
Shareholders’ Equity

Debt to Equity Ratio in Practice

If, as per the balance sheet, the total debt of a business is worth $50 million and the total equity is
worth $120 million, then debt-to-equity is 0.42. This means that for every dollar in equity, the
firm has 42 cents in leverage. A ratio of 1 would imply that creditors and investors are on equal
footing in the company’s assets.

A higher debt-equity ratio indicates a levered firm, which is quite preferable for a company that
is stable with significant cash flow generation, but not preferable when a company is in decline.
Conversely, a lower ratio indicates a firm less levered and closer to being fully equity financed.
The appropriate debt to equity ratio varies by industry.