Ratio Analysis

Ratio Analysis is a study of relationship among various financial factors in a business.

Ratio Analysis is a technique of analysing the financial statements by computing Ratios.

A Ratio is an arithmetical expression of relationship between two related or

interdependent items.

Users of Ratio Analysis

1. Shareholders/Owners
2. Managers
3. Creditors/Lenders
4. Potential Investors
5. Analysts

Ratios computed for different users are compared with

1. Past Year(s) Data
2. Nearest Competitor
3. Industry Leader
4. Industry averages

Types of Ratios
1. Return on Investment Ratio
2. Activity/Turnover Ratio
3. Liquidity Ratio
4. Solvency Ratio
5. Capital Market Ratio
6. Profitability Ratio

Caution (What analysts must ensure in calculating, using and interpreting Ratio)
1. Look for any difference in Industry group, Accounting Policies, Size & Nature.
2. Similarity in defining various terms in financial statements and Ratio.
3. Reliance on past to predict future.

Cash Flow Statement Analysis

The Analyst should analyze the Cash Flow Statement also. While doing so, he/she should
carefully look into the cash flows being generated/used from/in Operating activities, cash
flows being generated/used from/in Investing activities, cash flows being generated/used
from/in financing activities. The analyst should also compare the Net Profit and Cash
Flow generated from Operating Activities. This shows the quality of Earning, whether
Business is able to convert its sales into Cash quickly or it has large amount of Trade
Receivables on its Balance Sheet. The analyst should also see whether Business is self
sufficient to fund its Investing Activities through its Cash flows from Operating
Activities or it has to rely on cash flows from financing activities which may attract
heavy Interest charges affecting the profitability of the Business.

The Ratios given in the subsequent pages are majorly for Manufacturing
Sector. For Banking and Service Sector, a separate set of Ratios are required to
be calculated. Also, the ratios shown here Do not constitute the complete list of
Ratios used for Financial Statement Analysis. Also, before applying any ratio,
please define the variables accurately. Ratios computed with the variables not
defined properly are not considered very accurate ones.
 Ratio Computation
1). Return on Investment Ratio

Return on Invested Capital (ROIC) = Profit after Tax __________________

Non Current Liabilities + Shareholders Fund

This ratio is useful for those shareholders, Bankers and Financial Institutions who have
provided the funds to the Organisation for a longer period (more than 5 years).Gives
%age return on total long term funds invested in the Business.

Return on Net Worth (RONW) = Profit after Tax

Net Worth
Net Worth = Shareholders Funds +Share Application Money Pending Allotments

This ratio is useful for present and potential shareholders and also for the management of
the Organisation as an important indicator of Wealth Creation for shareholder. Gives
%age return on Shareholders funds provided by the shareholders.
2). Activity/Turnover Ratio

Total Asset Turnover Ratio = Sales Revenue (Net of returns & Excise)
Total Assets
Total Assets = Non Current Assets + Current Assets
This ratio is useful for managers. Indicates how much sales are being generated on Total
Assets of Business or how effectively total assets have been put to use by the
Organisation.The other variant of this ratio is Fixed Assets Turnover Ratio.

Invested Capital Turnover Ratio = Sales Revenue (Net of returns & Excise)___
Non Current Liabilities + Shareholders Fund

This Ratio is useful for Long Term Fund Providers. Indicates the level of sales generated
by using Long term Funds. Another Variant can be Net worth Turnover Ratio.

Average Collection Period = Trade Receivables*365

Credit Sales
In absence of data on Credit Sales, Net Sales (Sales Sales Return) can also be taken.

This ratio is useful for Managers and Working Capital Funds providers. This ratio
indicates the period, company takes to collect money from its Trade Receivables.

Inventory Turnover Ratio = Cost of Goods Sold

Inventory
Cost of Goods Sold = Material consumed + Change in Stock + Manufacturing Expenses
+Purchase of Tradable goods
Inventory = Closing inventory

This ratio is useful for Managers and Working Capital Funds providers. Indicates the
velocity with which Inventory moves or how quickly a company is able to convert its
inventory into cash or cash equivalents.

Working Capital Turnover Ratio = _Sales (Net of returns &Excise)

Working Capital
Working Capital = Current Assets Current Liabilities

This ratio is useful for Managers and Working Capital Funds providers. Indicates how
much sales company is able to make on working capital.

Average Credit Period = Trade Payables*365

Credit Purchases
In absence of data on Credit Purchases, Net Purchases of Raw Material/Finished
goods/Goods for Trading can also be taken.

This Ratio is useful for managers so that they can compare Average Credit period with
Average Collection Period. Indicates the no of days, within which company pays off to
its creditors for goods.
This Ratio is difficult to compute as it requires the data on Credit purchases which is not
available in P&L Account. Therefore, the ratio is computed with the data available in
P&L Account with certain assumptions.
3). Liquidity Ratio

Current Ratio = Current Assets /Current Liabilities

This Ratio is useful for Managers and working capital fund providers. Measures the
companys liquidity and also the margin of safety ,the company has in order to meet any
emergency arising out of uneven flows of funds through current assets and current
liabilities account.

Acid Test Ratio = Current Assets (Inventory + Prepaid Expenses)/Current Liability

This ratio is useful for Managers and working capital fund providers. It is a better
indicator of immediate liquidity position of the Organisation. Companies having similar
Current Ratio are analyzed on Acid Test Ratio as it gives better picture of liquidity
position of the Organisation.
4). Solvency Ratio

Debt Equity Ratio = Non Current Liability/Shareholders Funds

This ratio is useful for Lenders, Shareholders and potential shareholders. Indicates the
Organizations reliance on own funds or debt funds. Higher debt is cause of concern for
Organisation. If this ratio is very high compared to industry average/Nearest Competitor
and its operating cash flows are very low, this is a cause of concern for company.

Debt to Total Invested Capital = Non Current Liability______________

Non Current Liabilities + Shareholders Fund

This ratio is useful for Lenders, Shareholders and potential shareholders. It indicates the
proportion of debt in total Long Term Funds available with the Organisation.

Interest Coverage Ratio = Earnings before Interest & Tax / Total Interest Charges

This ratio is useful for Lenders and Managers. It indicates the safety net available to the
Organisation for the payment of Interest Charges.
5). Capital Market Ratio

Earnings per Share = _ Profit After Tax________

No of Equity Shares outstanding/issued

This ratio is useful for Shareholders. Indicates the amount of profit available for equity
shareholders after paying off all expenses and if the entire amount of profit is distributed
to all shares, how much each share will be getting.

Cash Realization = Cash Generated by Operations

PAT
This Ratio is useful for Managers and Lenders. It indicates how much %age of PAT is
being realized in cash. Higher the ratio better is the quality of earning.

Dividend Payout Ratio = Total Dividend Paid/Profit after Tax

This ratio is useful for Shareholders. Indicates how much %age of PAT is being paid as
dividend by the Organisation.

Price Earnings Ratio = Market Price/EPS

This ratio is useful for shareholders. It expresses the market price as a certain multiple of
earnings per share. This ratio indicates how much significance Market gives to the
earnings of the company.
6). Profitability Ratio

PBITDA Ratio = Profit before Interest Tax Depreciation & Amortization *100
Sales net of returns & Excise

This ratio is useful for Managers, Shareholders/Owners and Lenders. This is also known
as Operating Cash Profit. Provide information on cushion available for absorbing
Depreciation, Interest and Tax.

Operating Profit Ratio =___Operating Profit*100_____

Sales net of returns & Excise

This ratio is useful for Managers, Shareholders/Owners and Lenders. Indicates the profit
available after deducting Manufacturing and Operating Expenses (including depreciation)
from Total Revenue. Provide information of the cushion available for paying Interest &
Taxes.

Net Profit Ratio = _Profit after Tax*100______

Sales net of returns & Excise

This ratio is useful for Managers, Shareholders/Owners and Lenders. Indicates the
amount of profit available after deducting total expenses from total revenue.