RATIO ANALYSIS

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What Is Ratio Analysis?

■ Ratio analysis is a quantitative method of gaining insight into a company's

liquidity, operational efficiency, and profitability by comparing information

contained in its financial statements. Ratio analysis involves evaluating the

performance and financial health of a company by using data from the

current and historical financial statements. In simple words it is a process

of computing the financial statements and analyzing them.

Interpretation of Ratios
1. Trend Analysis

Under this method ratios are interpreted by making comparison over time where a company

can select base year and compare ratios for number of years.

2. Comparison with Industry Standards

Industries have pre-defined standards from which the firms can be compared with. Ratios of

any one company may be compared with the other company which belongs to same industry.
TYPES OF RATIO
 A. LIQUIDITY RATIO

It is calculated to measure the sort term solvency of the business that is the firm’s ability to

meets its current obligation.

Further with, there are three different types of ratios included under it.

 CURRENT RATIO

 QUICK RATIO

 ABSOLUTE RATIO
 1. CURRENT RATIO
The proportion of the current assets to current liabilities is known as current ratio.

Normally, it is safe to have a ratio within the parameters of 2:1.

Formula:

Current ratio = Current Assets / Current liabilities

 2. QUICK RATIO
Commonly also known as acid test, or liquid ratio. It is the ratio between liquid or

quick asset to current liabilities. Quick assets are defined as those assets which are

quickly convertible into cash. This ratio is considered to be better than current ratio

as a measure of liquidity position of the business. Normally, it is safe to have a

ratio of 1:1.

Formula: Quick Ratio = Quick Assets / Current Liabilities

 3. ABSOLUTE LIQUID RATIO
This is the ratio between cash and cash equivalents with current liabilities. Cash and cash

equivalents are cash in hand, cash at bank, and marketable instruments which have

maturity within three months. Higher the ratio, it is considered to be better as it is taken

that there are sufficient cash resources available in the business to meet its current

obligation.

Formula: Absolute Cash Ratio = Cash and Cash Equivalents / Current Liabilities
 B. SOLVENCY RATIO
Also known as leverage and capital structure ratio. They are calculated to determine the ability of
the business to service its debts in the long run.  The solvency ratio indicates whether a company’s
cash flow is sufficient to meet its short-and long-term liabilities. The lower a company's solvency
ratio, the greater the probability that it will default on its debt obligation.

Following are the ratios which helps in evaluation of long term solvency of the given business:

 DEBT EQUITY RATIO

 DEBT TO TOTAL CAPITAL

 DEBT TO CAPITAL EMPLOYED

 PROPRIETORY RATIO

 FIXED ASSET TO NET WORTH

 INTEREST COVERAGE RATIO

1. DEBT EQUITY
2. DEBT TO TOTAL CAPITAL

Debt to Total Capital = Long-term Debt / Total assets

3. PROPRIETORY RATIO
4. FIXED ASSETS TO NET WORTH
5. INTEREST COVERAGE RATIO
 C.Turnover ratios
This ratios indicates the speed at which the
activity of the business are being performed.
It rep3the amount of assets or liabilities that a
company replaces in relation to its sales. This
is useful for determining the efficiency with
which a business utilizes its assets.
There are 6 turnover ratios:
■ Inventory turnover ratio
■ Trade receivables turnover ratio
■ Trade payables turnover ratio
■ Investment /net asset turnover ratio
■ Fixed asset turnover ratio
■ Working capital turnover ratio
Inventory turnover ratio
■ Inventory turnover ratio is an efficient ratio that shows how
efficiently inventory is managed by comparing costs of goods sold
with average inventory for a period
■ It is calculated by:
■ Inventory turnover ratio = cost of revenue from operations / average
inventory
■ CORO= opening inventory + purchase + direct expenses-closing
inventory
■ Average inventory = opening inventory + closing inventory / 2
■ Average holding period = number of days/months / avg inventory
Trade Receivables turnover

■ It is an efficient ratio that measures how many times a business

can turn its trade receivables into cash during a period of time
■ It can be calculated by-
Trade receivables turnover ratio = net credit revenue from
operations / average receivables
Average trade receivables = (opening debtors + bills receivables) +
(closing debtors + bills receivables) / 2
Avg. collection period = no. of days/months / trade receivables
turnover
Trade payables turnover
■ It is a liquidity ratio that shows a company's ability to pay off
its accounts payable by comparing its net credits purchases
■ It can be calculated by-
Trade payables turnover ratio = net credit purchase / average
trade payables
Average trade payables = (opening creditors + bills payables) +
(closing creditors + bills payables) / 2
Avg. payment period= no of days/months / trade payable
turnover
Net asset turnover ratio

■ It is an efficiency ratio that measures a

company's ability to generate sales from its
assets by comparing its net sales
■ It is calculated by-
Net asset turnover = revenue from operations /
capital employed
Capital employed = total assets - current liabilities
Fixed asset turnover
■ It is an efficiency ratio that measures
companies return on their investment in
properties, plants etc. by comparing with its
net sales
■ It can be calculated by-
Fixed asset turnover ratio = net revenue from
operations / net fixed assets
Working capital turnover
■ It indicates a company's effectiveness in using its
working capital
■ It can be calculated by
■ Working capital turnover ratio = net revenue from
operations / working capital
■ Working capital = current assets - current liabilities
 D. Profitability ratios
■ Profitability ratios are financial metrics used by analysts and
investors to measure and evaluate the ability of a company to
generate income (profit) relative to revenue, balance sheet assets,
operating costs, and shareholders’ equity during a specific period of
time. They show how well a company utilizes its assets to produce
profit and value to shareholders.
■ A higher ratio or value is commonly sought-after by most
companies, as this usually means the business is performing well by
generating revenues, profits, and cash flow. The ratios are most
useful when they are analyzed in comparison to similar companies
or compared to previous periods.
Significance of profitability ratios
■ Profitability ratios are tools to measure or gauge a company’s overall efficiency
and business performance.
■ Externally, creditors and investors are given a clear picture of the business
through significant and fathomable ratios.
■ Internally, owners, operators, and managers are enabled to make business related
concerns such as diversification, expansion, or shake-up that would lead to better
profitability.
■ In truth, no investor would bet their hard-earned money on a non-earning
proposition. Profitability ratios are referred to as the ‘classic’ financial metrics to
judge a company’s ability to make profits and be considered a worthy
investment. 
Types of Profitability ratios
■ Gross profit ratio
■ Net profit ratio
■ Operating profit ratio
■ Operating ratio
■ Return on investment/capital employed ratio
■ Return on net worth ratio
■ Earning per share ratio
■ Book value per share ratio
■ Dividend payout ratio
■ Price earning ratio
■ Retention ratio
GROSS PROFIT RATIO

■ GP RATIO = GP X 100
REVENUE FROM OPERATION (RO)

NOTE:
■ IF GP IS 20% ON RO, THEN IT IS 25% ON COST OF REVENUE
FROM OPERATION (CORO)
■ IF GP IS 25% ON SALES, THEN IT IS 1/3RD ON CORO
NET PROFIT RATIO
■ NP RATIO = NP X 100
REVENUE FROM OPERATION

■ OPERATING PROFIT RATIO = OPERATING PROFIT ( EBIT) X

100
REVENUE FROM OPERATION
 OPERATING RATIO

■ OPERATING RATIO = CORO + OPERATING EXPENSES X 100

REVENUE FROM OPERATION

OPERATING EXPENSES = ADMINISTRATION EXP. + SELLING AND

DISTRIBUTION EXP.
RETURN ON INVESTMENT/CAPITAL EMPLOYED RATIO

ROI RATIO = EBIT X 100

CAPITAL EMPLOYED

CAPITAL EMPLOYED = SHAREHOLDER’S FUND + LONG TERM DEBTS

■ RETURN ON NET WORTH RATIO = EARNING AFTER TAX (EAT)

X 100
SHAREHOLDER’S FUND
EARNING PER SHARE RATIO

EPS RATIO = EAT or EARNINGS AVAILABLE FOR EQ.

SHAREHOLDERS
NO. OF EQUITY SHARES

■ BOOK VALUE PER SHARE RATIO = EQ. SHAREHOLDER’S

FUND
NO. OF EQ. SHARES
DIVIDEND PAYOUT RATIO
DIVIDEND PAYOUT RATIO = DIVIDEND PER SHARE X
100
EPS

■ PRICE EARNING RATIO = MARKET PRICE PER SHARE

EPS

■ RETENTION RATIO = 100 - DIVIDEND PAYOUT RATIO

QUES. Following is the summarised Balance Sheet of a concern as at
31st December: