Ratio Analysis 1

RATIO ANALYSIS
It refers to the systematic use of ratios to interpret the fnancial statements in terms
of the operating performance and fnancial position of a frm. It involves comparison
for a meaningful interpretation of the fnancial statements.
Quantitative analysis of information contained in a companys fnancial statements.
Ratio analysis is based on line items in fnancial statements like the balance sheet,
income statement and cash fow statement the ratios of one item ! or a combination
of items " to another item or combination are then calculated. Ratio analysis is used to
evaluate various aspects of a companys operating and fnancial performance such as
its e#ciency, li$uidity, proftability and solvency. %he trend of these ratios over time is
studied to check whether they are improving or deteriorating. Ratios are also
compared across di&erent companies in the same sector to see how they stack up,
and to get an idea of comparative valuations. Ratio analysis is a cornerstone of
fundamental analysis.
'hile there are numerous fnancial ratios, most investors are familiar with a few key
ratios, particularly the ones that are relatively easy to calculate. (ome of these ratios
include the current ratio, return on e$uity, the debt"e$uity ratio, the dividend payout
ratio and the price)earnings *+),- ratio.
.s well, ratios are usually only comparable across companies in the same sector,
since an acceptable ratio in one industry may be regarded as too high in another. /or
e0ample, companies in sectors such as utilities typically have a high debt"e$uity ratio,
but a similar ratio for a technology company may be regarded as unsustainably high.
Ratio analysis can provide an early warning of a potential improvement or
deterioration in a companys fnancial situation or performance. .nalysts engage in
e0tensive number"crunching of the fnancial data in a companys $uarterly fnancial
reports for any such hints.
In view of the needs of various uses of ratios the ratios, which can be calculated from
the accounting data are classifed into the following broad categories
.. 1i$uidity Ratio
2. %urnover Ratio
3. (olvency or 1everage ratios
4. +roftability ratios
A. LIQUIDITY RATIO
It measures the ability of the frm to meet its short"term obligations, that is capacity
of the frm to pay its current liabilities as and when they fall due. %hus these ratios
refect the short"term fnancial solvency of a frm. . frm should ensure that it does
not su&er from lack of li$uidity. %he failure to meet obligations on due time may
result in bad credit image, loss of creditors confdence, and even in legal proceedings
against the frm on the other hand very high degree of li$uidity is also not desirable
Dr.Rakesh Chouhan
Ratio Analysis 2
since it would imply that funds are idle and earn nothing. (o therefore it is necessary
to strike a proper balance between li$uidity and lack of li$uidity.
%he various ratios that e0plains about the li$uidity of the frm are
5. 3urrent Ratio
6. .cid %est Ratio ) $uick ratio
7. .bsolute li$uid ration ) cash ratio
1. CURRENT RATIO
%he current ratio measures the short"term solvency of the frm. It establishes the
relationship between current assets and current liabilities. It is calculated by dividing
current assets by current liabilities.
3urrent Ratio 8 3urrent .sset
3urrent 1iabilities
Current assets include cash and bank balances, marketable securities, inventory, and
debtors, excluding provisions for bad debts and doubtful debtors, bills receivables
and prepaid expenses. Current liabilities includes sundry creditors, bills payable,
short- term loans, income-tax liability, accrued expenses and dividends payable.
2. ACID TEST RATIO / QUICK RATIO
It has been an important indicator of the frms li$uidity position and is used as a
complementary ratio to the current ratio. It establishes the relationship between
$uick assets and current liabilities. It is calculated by dividing $uick assets by the
current liabilities.
.cid %est Ratio 8 Quick .ssets
3urrent liabilities
Quick assets are those current assets, which can be converted into cash immediately
or within reasonable short time without a loss of value. These include cash and bank
balances, sundry debtors, bills receivables and short-term marketable securities.
3. ABSOLUTE LIQUID RATION / CASH RATIO
It shows the relationship between absolute li$uid or super $uick current assets and
liabilities. .bsolute li$uid assets include cash, bank balances, and marketable
securities.
.bsolute li$uid ratio 8 .bsolute li$uid assets
3urrent liabilities
B. TURNOVER RATIO
%urnover ratios are also known as activity ratios or e#ciency ratios with which a frm
manages its current assets. %he following turnover ratios can be calculated to 9udge
the e&ectiveness of asset use.
5. Inventory %urnover Ratio
6. 4ebtor %urnover Ratio
7. 3reditor %urnover Ratio
:. .ssets %urnover Ratio
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Ratio Analysis 3
1. INVENTORY TURNOVER RATIO
%his ratio indicates the number of times the inventory has been converted into sales
during the period. %hus it evaluates the e#ciency of the frm in managing its
inventory. It is calculated by dividing the cost of goods sold by average inventory.
Inventory %urnover Ratio 8 3ost of goods sold
.verage Inventory
The average inventory is simple average of the opening and closing balances of
inventory. !pening " Closing balances # $%. &n certain circumstances opening
balance of the inventory may not be known then closing balance of inventory may be
considered as average inventory
2. DEBTOR TURNOVER RATIO
%his indicates the number of times average debtors have been converted into cash
during a year. It is determined by dividing the net credit sales by average debtors.
4ebtor %urnover Ratio 8 ;et 3redit (ales
.verage %rade 4ebtors
'et credit sales consist of gross credit sales minus sales return. Trade debtor
includes sundry debtors and bills receivables. (verage trade debtors !pening "
Closing balances # $%
'hen the information about credit sales, opening and closing balances of trade
debtors is not available then the ratio can be calculated by dividing total sales by
closing balances of trade debtor
4ebtor %urnover Ratio 8 %otal (ales
%rade 4ebtors
3. CREDITOR TURNOVER RATIO
It indicates the number of times sundry creditors have been paid during a year. It is
calculated to 9udge the re$uirements of cash for paying sundry creditors. It is
calculated by dividing the net credit purchases by average creditors.
3reditor %urnover Ratio 8 ;et 3redit +urchases
.verage %rade 3reditor
'et credit purchases consist of gross credit purchases minus purchase return
'hen the information about credit purchases, opening and closing balances of trade
creditors is not available then the ratio is calculated by dividing total purchases by the
closing balance of trade creditors.
3reditor %urnover Ratio 8 %otal purchases
%otal %rade 3reditors
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Ratio Analysis 4
4. ASSETS TURNOVER RATIO
%he relationship between assets and sales is known as assets turnover ratio. (everal
assets turnover ratios can be calculated depending upon the groups of assets, which
are related to sales.
a- %otal asset turnover.
b- ;et asset turnover
c- /i0ed asset turnover
d- 3urrent asset turnover
e- ;et working capital turnover ratio
a. TOTAL ASSET TURNOVER
%his ratio shows the frms ability to generate sales from all fnancial resources
committed to total assets. It is calculated by dividing sales by total assets.
%otal asset turnover 8 %otal (ales
%otal .ssets
b. NET ASSET TURNOVER
%his is calculated by dividing sales by net assets.
;et asset turnover 8 %otal (ales
;et .ssets
;et assets represent total assets minus current liabilities. Intangible and fctitious
assets like goodwill, patents, accumulated losses, deferred e0penditure may be
e0cluded for calculating the net asset turnover.
c. FIXED ASSET TURNOVER
%his ratio is calculated by dividing sales by net f0ed assets.
/i0ed asset turnover 8 %otal (ales
;et /i0ed .ssets
'et )xed assets represent the cost of )xed assets minus depreciation.
d. CURRENT ASSET TURNOVER
It is divided by calculating sales by current assets
3urrent asset turnover 8 %otal (ales
3urrent .ssets
. NET !ORKIN" CA#ITAL TURNOVER RATIO
. higher ratio is an indicator of better utili<ation of current assets and working capital
and vice"versa *a lower ratio is an indicator of poor utili<ation of current assets and
working capital-. It is calculated by dividing sales by working capital.
;et working capital turnover ratio 8 %otal (ales
'orking 3apital
*orking capital is represented by the di+erence between current assets and current
liabilities.
Dr.Rakesh Chouhan
Ratio Analysis 5
C. SOLVENCY OR LEVERA"E RATIOS
%he solvency or leverage ratios throws light on the long term solvency of a frm
refecting its ability to assure the long term creditors with regard to periodic payment
of interest during the period and loan repayment of principal on maturity or in
predetermined instalments at due dates. %here are thus two aspects of the long"term
solvency of a frm.
a. .bility to repay the principal amount when due
b. Regular payment of the interest.
%he ratio is based on the relationship between borrowed funds and owners capital it
is computed from the balance sheet, the second type are calculated from the proft
and loss a)c. %he various solvency ratios are
5. 4ebt e$uity ratio
6. 4ebt to total capital ratio
7. +roprietary *,$uity- ratio
:. /i0ed assets to net worth ratio
=. /i0ed assets to long term funds ratio
>. 4ebt service *Interest coverage- ratio
1. DEBT EQUITY RATIO
4ebt e$uity ratio shows the relative claims of creditors *?utsiders- and owners
*Interest- against the assets of the frm. %hus this ratio indicates the relative
proportions of debt and e$uity in fnancing the frms assets. It can be calculated by
dividing outsider funds *4ebt- by shareholder funds *,$uity-
4ebt e$uity ratio 8 ?utsider /unds *%otal 4ebts-
(hareholder /unds or ,$uity
The outsider fund includes long-term debts as well as current liabilities. The
shareholder funds include e,uity share capital, preference share capital, reserves and
surplus including accumulated pro)ts. -owever )ctitious assets like accumulated
deferred expenses etc should be deducted from the total of these items to
shareholder funds. The shareholder funds so calculated are known as net worth of
the business.
2. DEBT TO TOTAL CA#ITAL RATIO
4ebt to total capital ratio 8 %otal 4ebts
%otal .ssets
3. #RO#RIETARY $EQUITY% RATIO
%his ratio indicates the proportion of total assets fnanced by owners. It is calculated
by dividing proprietor *(hareholder- funds by total assets.
+roprietary *e$uity- ratio 8 (hareholder funds
%otal assets
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Ratio Analysis 6
4. FIXED ASSETS TO NET !ORTH RATIO
%his ratio establishes the relationship between f0ed assets and shareholder funds. It
is calculated by dividing f0ed assets by shareholder funds.
/i0ed assets to net worth ratio 8 /i0ed .ssets @ 5AA
;et 'orth
The shareholder funds include e,uity share capital, preference share capital, reserves
and surplus including accumulated pro)ts. -owever )ctitious assets like
accumulated deferred expenses etc should be deducted from the total of these items
to shareholder funds. The shareholder funds so calculated are known as net worth of
the business.
&. FIXED ASSETS TO LON" TER' FUNDS RATIO
/i0ed assets to long term funds ratio establishes the relationship between f0ed assets
and long"term funds and is calculated by dividing f0ed assets by long term funds.
/i0ed assets to long term funds ratio 8 /i0ed .ssets @ 5AA
1ong"term /unds
(. DEBT SERVICE $INTEREST COVERA"E% RATIO
%his shows the number of times the earnings of the frms are able to cover the f0ed
interest liability of the frm. %his ratio therefore is also known as Interest coverage or
time interest earned ratio. It is calculated by dividing the earnings before interest and
ta0 *,2I%- by interest charges on loans.
4ebt (ervice Ratio 8 ,arnings before interest and ta0 *,2I%-
Interest 3harges
#ROFITABILITY RATIOS
%he proftability ratio of the frm can be measured by calculating various proftability
ratios. Beneral two groups of proftability ratios are calculated.
a. +roftability in relation to sales.
b. +roftability in relation to investments.

#)*+,ab-.-,/ -0 ).a,-*0 ,* 1a.1
5. Bross proft margin or ratio
6. ;et proft margin or ratio
7. ?perating proft margin or ratio
:. ?perating Ratio
=. ,0penses Ratio
1. "ROSS #ROFIT 'AR"IN OR RATIO
It measures the relationship between gross proft and sales. It is calculated by
dividing gross proft by sales.
Bross proft margin or ratio 8 Bross proft @ 5AA
;et sales
.ross pro)t is the di+erence between sales and cost of goods sold.
2. NET #ROFIT 'AR"IN OR RATIO
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Ratio Analysis 7
It measures the relationship between net proft and sales of a frm. It indicates
managements e#ciency in manufacturing, administrating, and selling the products.
It is calculated by dividing net proft after ta0 by sales.
;et proft margin or ratio 8 ,arning after ta0 @ 5AA
;et (ales
3. O#ERATIN" #ROFIT 'AR"IN OR RATIO
It establishes the relationship between total operating e0penses and net sales. It is
calculated by dividing operating e0penses by the net sales.
?perating proft margin or ratio 8 ?perating e0penses @ 5AA
;et sales
?perating e0penses includes cost of goods produced)sold, general and administrative
e0penses, selling and distributive e0penses.
4. EX#ENSES RATIO
'hile some of the e0penses may be increasing and other may be declining to know
the behavior of specifc items of e0penses the ratio of each individual operating
e0penses to net sales should be calculated. %he various variants of e0penses are
3ost of goods sold 8 3ost of goods sold @ 5AA
;et (ales
.dministrative ,0penses Ratio 8 .dministrative ,0penses @ 5AA
;et sales
(elling and distribution e0penses ratio 8 (elling and distribution e0penses @ 5AA
;et sales
&. O#ERATIN" #ROFIT 'AR"IN OR RATIO
?perating proft margin or ratio establishes the relationship between operating proft
and net sales. It is calculated by dividing operating proft by sales.
?perating proft margin or ratio 8 ?perating +roft @ 5AA
;et sales
!perating pro)t is the di+erence between net sales and total operating expenses.
!perating pro)t / 'et sales 0 cost of goods sold 0 administrative expenses 0 selling
and distribution expenses.%
#ROFITABILITY IN RELATION TO INVEST'ENTS
5. Return on gross investment or gross capital employed
6. Return on net investment or net capital employed
7. Return on shareholders investment or shareholders capital employed.
:. Return on e$uity shareholder investment or e$uity shareholder capital employed.
1. RETURN ON "ROSS CA#ITAL E'#LOYED
%his ratio establishes the relationship between net proft and the gross capital
employed. %he term gross capital employed refers to the total investment made in
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Ratio Analysis 8
business. %he conventional approach is to divide ,arnings .fter %a0 *,.%- by gross
capital employed.
Return on gross capital employed 8 ,arnings .fter %a0 *,.%- @ 5AA
Bross capital employed
2. RETURN ON NET CA#ITAL E'#LOYED
It is calculated by dividing ,arnings 2efore Interest C %a0 *,2I%- by the net capital
employed. %he term net capital employed in the gross capital in the business minus
current liabilities. %hus it represents the long"term funds supplied by creditors and
owners of the frm.
Return on net capital employed 8 ,arnings 2efore Interest C %a0 *,2I%- @ 5AA
;et capital employed
3. RETURN ON SHARE CA#ITAL E'#LOYED
%his ratio establishes the relationship between earnings after ta0es and the
shareholder investment in the business. %his ratio reveals how proftability the
owners funds have been utili<ed by the frm. It is calculated by dividing ,arnings
after ta0 *,.%- by shareholder capital employed.
Return on share capital employed 8 ,arnings after ta0 *,.%- @ 5AA
(hareholder capital employed
4. RETURN ON EQUITY SHARE CA#ITAL E'#LOYED
,$uity shareholders are entitled to all the profts remaining after the all outside claims
including dividends on preference share capital are paid in full. %he earnings may be
distributed to them or retained in the business. Return on e$uity share capital
investments or capital employed establishes the relationship between earnings after
ta0 and preference dividend and e$uity shareholder investment or capital employed
or net worth. It is calculated by dividing earnings after ta0 and preference dividend
by e$uity shareholders capital employed.
Return on e$uity share capital employed 8 ,arnings after ta0 *,.%-, preference dividends @ 5AA
,$uity share capital employed
EARNIN"S #ER SHARE
I% measure the proft available to the e$uity shareholders on a per share basis. It is
computed by dividing earnings available to the e$uity shareholders by the total
number of e$uity share outstanding
,arnings per share 8 ,arnings after ta0 ! +referred dividends *if any-
,$uity shares outstanding
DIVIDEND #ER SHARE
%he dividends paid to the shareholders on a per share basis in dividend per share.
%hus dividend per share is the earnings distributed to the ordinary shareholders
divided by the number of ordinary shares outstanding.
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Ratio Analysis 9
4ividend per share 8 ,arnings paid to the ordinary shareholders
;umber of ordinary shares outstanding
DIVIDENDS #AY OUT RATIO $#AY OUT RATIO%
It measures the relationship between the earnings belonging to the e$uity
shareholders and the dividends paid to them. It shows what percentage shares of the
earnings are available for the ordinary shareholders are paid out as dividend to the
ordinary shareholders. It can be calculated by dividing the total dividend paid to the
e$uity shareholders by the total earnings available to them or alternatively by
dividing dividend per share by earnings per share.
4ividend pay our ratio *+ay our ratio- 8 %otal dividend paid to e$uity share holders
%otal earnings available to e$uity share holders
?r
4ividend per share
,arnings per share
DIVIDEND AND EARNIN"S YIELD
'hile the earnings per share and dividend per share are based on the book value per
share, the yield is e0pressed in terms of market value per share. %he dividend yield
may be defned as the relation of dividend per share to the market value per ordinary
share and the earning ratio as the ratio of earnings per share to the market value of
ordinary share.
4ividend Dield 8 4ividend +er share
Earket value of ordinary share
,arnings yield 8 ,arnings per share
Earket value of ordinary share
#RICE EARNIN" RATIO
%he reciprocal of the earnings yield is called price earnings ratio. It is calculated by
dividing the market price of the share by the earnings per share.
+rice earnings *+),- ratio 8 Earket price of share
,arnings per share
Dr.Rakesh Chouhan