Ratio Analysis

• This is one of the most important methods

of financial analysis
• It is the technique of analyzing and
interpreting financial statements with the
help of accounting of ratios
• A ratio may be expressed in three
methods. They are:
– Simple or pure ratios
– Percentage
– Rate
 Ratio Analysis
• Significance of Ratio Analysis
1. Simplifying financial information
2. Converting absolute figures
3. Helps in control of the firm’
4. Helps to make trend analysis
5. Helps in decision making
6. Helps in inter-firm comparison
 Ratio Analysis
• Types of Ratios
1. Profitability ratios
2. Liquidity ratios
3. Activity ratios
4. Solvency ratios
5. Leverage/Capital Structure Ratios
 Ratio Analysis
1. Profitability Ratios
 Profitability is an indication of the efficiency
with which the operations of the concern are
carried on.
 Profitability of a concern can be known through
the analysis of general and overall profitability
 Thus profitability ratios are brought into two
groups. They are:
 General Profitability Ratios
 Overall Profitability Ratios
 Ratio Analysis
a. General Profitability Ratios
 The important general profitability ratios are:
1. Gross profit ratio
2. Net profit ratio
3. Operating ratio
4. Operating profit ratio
5. Expense ratio
 Ratio Analysis
1. Gross Profit Ratios
 Gross profit ratios measure the relationship
of gross profit to net sales. It is usually
represented as percentage and hence it is
calculated by dividing the gross profit by
sales
GP Ratio = Gross Profit/Net sales x100
or
GP Ratio = Net sales- COGS/Net sales x100
 Ratio Analysis
• Significance of GP Ratios
 The GP ratio indicates the degree to which
the selling price of goods per unit may decline
without resulting in losses on operations of a
firm. It reflects the efficiency with which a firm
produces it products
 A low gross profit ratio is an indication of the
high cost of goods sold due to unfavorable
purchasing policies, lesser sales etc
 Ratio Analysis
2. Net Profit Ratio
 Net profit ratio establishes the relationship
between net profit and sales. It indicates
the efficiency of the management in
manufacturing, selling, administrative and
other activities of the concern.
 It is calculated as:
 Net operating profit/Net Sales x100
 Ratio Analysis
• Significance
 This ratio shows the number of dollars that
remains out of every 100 dollar of sales
 An increase in the ratio over the previous
period is an indication of improvement in the
operational efficiency of the concern, provided
the gross profit is constant
 Hence net profit is described as an index of
operational efficiency
 The higher the ratio, the more successful the
business is
 Ratio Analysis
3. Operating Ratio
 Operating ratio measures the cost of
operation per dollar of sales
 It is generally represented as a percentage
 The two elements of this ratio are operating
cost and net sales
 Operating cost is the sum of operating
expenses ( admn exp, office expense, selling
and distribution exp etc) and the cost of goods
 Ratio Analysis
• The formula for calculation of operating
ratio is

Operating cost/ Net sales x 100

Or
COGS + Operating Expenses
X 100
Net Sales
 Ratio Analysis
• Significance
– This ratio is the yardstick of operational
efficiency
– The higher the ratio, the less favorable it is as
it should have a small operating profit to cover
interest , income tax, dividend and reserves
 Ratio Analysis
4. Operating Profit Ratio
Operating profit ratio is net sales minus
operating cost. In other words, operating
profit is net sales minus (cost of goods
sold + administrative and office expenses
+ selling and distribution expenses). This
is always calculated as a percentage
 Ratio Analysis
5. Expense Ratio
 It is the relationship of various expenses to net
sales.
 It is calculated by dividing each item of expense
or groups of expenses with the net sales to
analyze the cause of variation of the operating
ratio
 The smaller the ratio, higher is the profitability
and greater the ratio, the lower is the profitability
 Ratio Analysis
The various expense ratios are:

1. Cost of Goods Sold Ratio

Cost of goods sold
= X 100
sales
 Ratio Analysis
2.Administrative & Office Expense Ratio

= Admv & Office Expense

X 100
Sales
 Ratio Analysis
3. Selling and Distribution Expense
4.Non-operating expense ratio