Ratio Analysis: Meaning,

Classification and Limitation of Ratio

Analysis

Ratio Analysis: Meaning, Classification and Limitation of Ratio Analysis!

Meaning:
Ratio analysis is the process of determining and interpreting numerical
relationships based on financial statements. A ratio is a statistical yardstick
that provides a measure of the relationship between two variables or figures.

This relationship can be expressed as a percent or as a quotient. Ratios are

simple to calculate and easy to understand. The persons interested in the
analysis of financial statements can be grouped under three heads,

i) owners or investors

ii) creditors and

iii) financial executives.

Although all these three groups are interested in the financial conditions and
operating results, of an enterprise, the primary information that each seeks to
obtain from these statements differs materially, reflecting the purpose that the
statement is to serve.
Investors desire primarily a basis for estimating earning capacity. Creditors
are concerned primarily with liquidity and ability to pay interest and redeem
loan within a specified period. Management is interested in evolving analytical
tools that will measure costs, efficiency, liquidity and profitability with a view to
make intelligent decisions.

RATIO ANALYSIS

Important Formulae :
(1) Gross Profit Ratio = Gross Profit X 100

Net Sales

Gross Profit = Net Sales – Cost of Goods Sold

Net Sales = Total Sales – Sales Return

Total Sales = Cash Sales + Credit Sales

Cost of Goods Sold = Opening Stock + Purchases + Direct
Expenses – Purchase Return – Closing Stock

(2) Net Profit Ratio = Net Profit X 100

Net Sales

Net Profit = Gross Profit – Operating Expenses + Non

Operating Incomes – Non Operating Expenses

Operating Expenses = (SODA) Selling Expenses + Office Expenses

+ Distribution Expenses + Administrative Expenses

(3) Operating Profit Ratio = Operating Profit X 100

Net Sales

Operating Profit = Gross Profit – Operating Expenses

OR

Operating Profit = Net Profit + Non Operating Expenses – Non Operating

Income

(4) Operating Ratio = Operating Cost X 100

Net Sales

Operating Cost = Cost of Goods Sold + Operating Expenses

 (5) Operating Ratio + Operating Profit Ratio
=1

(6) Return on Investment (ROI) = Profit before Interest, Tax & Dividend X 100

Capital Employed

Where, Profit before interest, Tax & Dividend = Profit After Tax + Interest + Tax

= Profit after Interest + Interest

Capital Employed = Share Capital (Equity + Preference)

+ Reserves + Surplus/Profit & Loss A/c (Cr.)/Accumulated Profits

+ Debentures + Long term loans – [Preliminary Expenses

– Discount/Commission or Issue of Share / Debenture – Profit

& Loss A/c (Dr. Balance)]

ALTERNATIVELY
Capital Employed = Net Fixed Assets + Long Term Investments +
Working Capital

Net Fixed Assets = Total Fixed Assets – Depreciation

Working Capital = Current Assets – Current Liabilities

(7) (a)
Return on Shareholder's Funds = Profit after Interest & Tax but before Dividend X
100

Equity or Shareholder's Funds

Equity or Shareholders' Fund = Share Capital (Equity + Preference) + Reserve

+ Surplus / Profit & Loss A/c (Cr. Balance) or accumulated profits

– Preliminary Expenses – Discount/Commission on Issue of

Share Debentures – Profit & Loss A/c (Dr. Balance) or
Accumulated Losses
Profit after Interest, Tax but before Preference Dividend
= Profit after Tax – Preference Dividend

= Profit after Interest – Tax – Preference Dividend

= Profit before Interest – Interest – Tax – Preference Dividend

(7) (b) Return on Equity (ROE)

= Profit after interest, Tax & Pref. Dividend X 100

Equity Shareholder's Funds

Equity shareholder's Fund = Equity Share Capital + Reserve + Surplus / Profit & Loss
A/c (Cr. Balance) or accumulated profits – Preliminary Expenses –
Discount / commission on issue of Share Debentures – Profit & Loss
A/c (Dr. Balance) or Accumulated Losses

(8) Interest coverage (Debt Service) Ratio = Profit before Interest, Tax & Dividend

Interest on Debentures & Loans

(9) Current Ratio = Current Assets

Current Liabilities

Current Assets = Cash in Hand + Cash at Bank + Bills Receivable

 + Sundry Debtors + Marketable Securities or Short
term investments + Loans & Advances + Stock / Inventories
+ Prepaid Expenses + Accrued Incomes

Current Liabilities = Sundry Creditors + Bills Payable + Provision for

Bad Debts + Provision for Taxation + Bank Overdraft
+ Outstanding Expenses + Income received in Advance
+ Short term Loans

(10) Liquid Ratio / Quick Ratio / Acid Test Ratio

= Liquid Assets or Quick Assets

Current Liabilities

Liquid Assets = Current Assets – Closing Stock – Prepaid Expenses

(11) Stock Turnover Ratio (STR) = Cost of Goods Sold

Average Stock

Average Stock = ½ (Opening Stock + Closing Stock)

(12) Debtors Turnover Ratio (DTR) = Net Credit Sales in a year

Average Accounts Receivable

Average A/c Receivable = ½ (Opening A/c Receivable + Closing A/c Receivable)

Accounts Receivable = Debtors + B/R

 OR

Account Receivable = Opening Debtor + Opening B/R + Closing Debtors + Closing B/R

(13) Average Debt Collection Period = Days or Months in a year

Debtors Turnover Ratio

Alternatively, Average Debt Collection Period

= Days or Months in a year X Accounts Receivable in a year

Net Credit Sales in a year

(14) Creditors Turnover Ratio (CTR) = Net Credit Purchases

Average Accounts Payable

Average A/c Payable = ½ (Opening A/c Payable + closing A/c Payable)

Accounts Payable = Creditors + B/P

(15) Average Payment Period = Days or Months in a year

Creditors Turnover Ratio

Alternatively, Average Payment Period = Days or Months in a year X Accounts Payable in

a year

Net Credit Purchases in a year

(16) Capital Turnover Ratio = Net Sales

Capital Employed

(17) Fixed Assets Turnover Ratio = Net Sales

Net Fixed Assets

Net Fixed Assets = Gross Fixed Assets - Depreciation

(18) Working Capital Turnover Ratio = Net Sales

Working Capital

Working Capital = current Assets – Current Liabilities

(19) Assets Turnover Ratio = Net Sales

Total Assets

Total Assets = Fixed Assets + Long Term Investment Current Assets

(20) Debt-Equity Ratio = Long term Debt or Loans

Equity or Shareholders' Funds

 Long term Debts = Debentures + Loans or Mortgage

OR Long Term Debts = Total Debts – Current Liabilities

(21) Debt Total Fund Ratio = Long Term Debts

Total Long Term Funds

Total Funds Term Fund = shareholder's Funds + Long Term Debts

(22) Proprietary Ratio = Shareholder's Funds or Proprietor's Fund

Total Assets

Shareholder's Funds = Share Capital (Equity + Preference)

+ Reserves + Surplus/Accumulated Profit or P/L

A/c(Cr) - Preliminary Expenses

– Discount on issue of Shares/Debentures

– P/L A/c (Dr.)

RATIO ANALYSIS
Important Formulae :
(2) Net Profit Ratio = Net Profit X 100

Net Sales

Net Profit = Gross Profit – Operating Expenses + Non

Operating Incomes – Non Operating Expenses

Operating Expenses = (SODA) Selling Expenses + Office Expenses

+ Distribution Expenses + Administrative Expenses

(3) Operating Profit Ratio = Operating Profit X 100

Net Sales

Operating Profit = Gross Profit – Operating Expenses

OR

Operating Profit = Net Profit + Non Operating Expenses – Non Operating

Income

(4) Operating Ratio = Operating Cost X 100

Net Sales

Operating Cost = Cost of Goods Sold + Operating Expenses

 (5) Operating Ratio + Operating Profit Ratio
=1

(6) Return on Investment (ROI) = Profit before Interest, Tax & Dividend X 100

Capital Employed

Where, Profit before interest, Tax & Dividend = Profit After Tax + Interest + Tax

= Profit after Interest + Interest

Capital Employed = Share Capital (Equity + Preference)

+ Reserves + Surplus/Profit & Loss A/c (Cr.)/Accumulated Profits

+ Debentures + Long term loans – [Preliminary Expenses

– Discount/Commission or Issue of Share / Debenture – Profit

& Loss A/c (Dr. Balance)]

ALTERNATIVELY
Capital Employed = Net Fixed Assets + Long Term Investments +
Working Capital

Net Fixed Assets = Total Fixed Assets – Depreciation

Working Capital = Current Assets – Current Liabilities

(7) (a)
Return on Shareholder's Funds = Profit after Interest & Tax but before Dividend X
100

Equity or Shareholder's Funds

Equity or Shareholders' Fund = Share Capital (Equity + Preference) + Reserve

+ Surplus / Profit & Loss A/c (Cr. Balance) or accumulated profits

– Preliminary Expenses – Discount/Commission on Issue of

Share Debentures – Profit & Loss A/c (Dr. Balance) or
Accumulated Losses
Profit after Interest, Tax but before Preference Dividend

= Profit after Tax – Preference Dividend

= Profit after Interest – Tax – Preference Dividend

= Profit before Interest – Interest – Tax – Preference Dividend

(7) (b) Return on Equity (ROE)

=Profit after interest, Tax & Pref. Dividend X 100

Equity Shareholder's Funds

Equity shareholder's Fund = Equity Share Capital + Reserve + Surplus / Profit & Loss
A/c (Cr. Balance) or accumulated profits – Preliminary Expenses –
Discount / commission on issue of Share Debentures – Profit & Loss A/c
(Dr. Balance) or Accumulated Losses

(8) Interest coverage (Debt Service) Ratio = Profit before Interest, Tax & Dividend

Interest on Debentures & Loans

(9) Current Ratio = Current Assets

Current Liabilities

Current Assets = Cash in Hand + Cash at Bank + Bills Receivable

 + Sundry Debtors + Marketable Securities or Short
term investments + Loans & Advances + Stock / Inventories
+ Prepaid Expenses + Accrued Incomes

Current Liabilities = Sundry Creditors + Bills Payable + Provision for

Bad Debts + Provision for Taxation + Bank Overdraft
+ Outstanding Expenses + Income received in Advance
+ Short term Loans
(10) Liquid Ratio / Quick Ratio / Acid Test Ratio

= Liquid Assets or Quick Assets

Current Liabilities

Liquid Assets = Current Assets – Closing Stock – Prepaid Expenses

(11) Stock Turnover Ratio (STR) = Cost of Goods Sold

Average Stock

Average Stock = ½ (Opening Stock + Closing Stock)

(12) Debtors Turnover Ratio (DTR) = Net Credit Sales in a year

Average Accounts Receivable

Average A/c Receivable = ½ (Opening A/c Receivable + Closing A/c Receivable)

Accounts Receivable = Debtors + B/R

OR

Account Receivable =Opening Debtor + Opening B/R + Closing Debtors + Closing B/R

(13) Average Debt Collection Period = Days or Months in a year

Debtors Turnover Ratio

Alternatively, Average Debt Collection Period

=Days or Months in a year X Accounts Receivable in a year

Net Credit Sales in a year

(14) Creditors Turnover Ratio (CTR) = Net Credit Purchases

Average Accounts Payable

Average A/c Payable = ½ (Opening A/c Payable + closing A/c Payable)

Accounts Payable = Creditors + B/P

(15) Average Payment Period = Days or Months in a year

Creditors Turnover Ratio

Alternatively, Average Payment Period = Days or Months in a year X Accounts Payable in a

year

Net Credit Purchases in a year

(16) Capital Turnover Ratio = Net Sales

Capital Employed

(17) Fixed Assets Turnover Ratio = Net Sales

Net Fixed Assets

 Net Fixed Assets = Gross Fixed Assets - Depreciation

(18) Working Capital Turnover Ratio = Net Sales

Working Capital

Working Capital = current Assets – Current Liabilities

(19) Assets Turnover Ratio = Net Sales

 Total Assets

Total Assets = Fixed Assets + Long Term Investment Current Assets

(20) Debt-Equity Ratio = Long term Debt or Loans

Equity or Shareholders' Funds

Long term Debts = Debentures + Loans or Mortgage

OR Long Term Debts = Total Debts – Current Liabilities

(21) Debt Total Fund Ratio = Long Term Debts

Total Long Term Funds

Total Funds Term Fund = shareholder's Funds + Long Term Debts

(22) Proprietary Ratio = Shareholder's Funds or Proprietor's Fund

Total Assets

Shareholder's Funds = Share Capital (Equity + Preference)

+ Reserves + Surplus/Accumulated Profit or P/L

A/c(Cr) - Preliminary Expenses

– Discount on issue of Shares/Debentures

– P/L A/c (Dr.)

 List of Financial Ratios
Here is a list of various financial ratios. Take note that most of the ratios can also be expressed
in percentage by multiplying the decimal number by 100%. Each ratio is briefly described.
Profitability Ratios
1. Gross Profit Rate = Gross Profit / Net Sales
Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales minus
sales returns, discounts, and allowances) minus cost of sales.
1) Gross Profit Ratio = Gross Profit X 100

Net Sales

Gross Profit = Net Sales – Cost of Goods Sold

Net Sales = Total Sales – Sales Return

Total Sales = Cash Sales + Credit Sales

Cost of Goods Sold = Opening Stock + Purchases + Direct

Expenses – Purchase Return – Closing Stock
2. Return on Sales = Net Income / Net Sales
Also known as "net profit margin" or "net profit rate", it measures the percentage of income derived from
dollar sales. Generally, the higher the ROS the better.
3. Return on Assets = Net Income / Average Total Assets
In financial analysis, it is the measure of the return on investment. ROA is used in evaluating
management's efficiency in using assets to generate income.
4. Return on Stockholders' Equity = Net Income / Average Stockholders' Equity
Measures the percentage of income derived for every dollar of owners' equity.
Liquidity Ratios
1. Current Ratio = Current Assets / Current Liabilities
 Evaluates the ability of a company to pay short-term obligations using current assets (cash, marketable
securities, current receivables, inventory, and prepayments).
2. Acid Test Ratio = Quick Assets / Current Liabilities
Also known as "quick ratio", it measures the ability of a company to pay short-term obligations using the
more liquid types of current assets or "quick assets" (cash, marketable securities, and current
receivables).
3. Cash Ratio = ( Cash + Marketable Securities ) / Current Liabilities
Measures the ability of a company to pay its current liabilities using cash and marketable securities.
Marketable securities are short-term debt instruments that are as good as cash.
4. Net Working Capital = Current Assets - Current Liabilities
Determines if a company can meet its current obligations with its current assets; and how much excess or
deficiency there is.
Management Efficiency Ratios
1. Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Measures the efficiency of extending credit and collecting the same. It indicates the average number of
times in a year a company collects its open accounts. A high ratio implies efficient credit and collection
process.
2. Days Sales Outstanding = 360 Days / Receivable Turnover
Also known as "receivable turnover in days", "collection period". It measures the average number of days
it takes a company to collect a receivable. The shorter the DSO, the better. Take note that some use 365
days instead of 360.
3. Inventory Turnover = Cost of Sales / Average Inventory
Represents the number of times inventory is sold and replaced. Take note that some authors use Sales in
lieu of Cost of Sales in the above formula. A high ratio indicates that the company is efficient in managing
its inventories.
4. Days Inventory Outstanding = 360 Days / Inventory Turnover
Also known as "inventory turnover in days". It represents the number of days inventory sits in the
warehouse. In other words, it measures the number of days from purchase of inventory to the sale of the
same. Like DSO, the shorter the DIO the better.
5. Accounts Payable Turnover = Net Credit Purchases / Ave. Accounts Payable
Represents the number of times a company pays its accounts payable during a period. A low ratio is
favored because it is better to delay payments as much as possible so that the money can be used for
more productive purposes.
6. Days Payable Outstanding = 360 Days / Accounts Payable Turnover
Also known as "accounts payable turnover in days", "payment period". It measures the average number
of days spent before paying obligations to suppliers. Unlike DSO and DIO, the longer the DPO the better
(as explained above).
7. Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding
 Measures the number of days a company makes 1 complete operating cycle, i.e. purchase merchandise,
sell them, and collect the amount due. A shorter operating cycle means that the company generates sales
and collects cash faster.
8. Cash Conversion Cycle = Operating Cycle - Days Payable Outstanding
CCC measures how fast a company converts cash into more cash. It represents the number of days a
company pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the
shorter the CCC the better.
9. Total Asset Turnover = Net Sales / Average Total Assets
Measures overall efficiency of a company in generating sales using its assets. The formula is similar to
ROA, except that net sales is used instead of net income.
Leverage Ratios
1. Debt Ratio = Total Liabilities / Total Assets
Measures the portion of company assets that is financed by debt (obligations to third parties). Debt ratio
can also be computed using the formula: 1 minus Equity Ratio.
2. Equity Ratio = Total Equity / Total Assets
Determines the portion of total assets provided by equity (i.e. owners' contributions and the company's
accumulated profits). Equity ratio can also be computed using the formula: 1 minus Debt Ratio.
The reciprocal of equity ratio is known as equity multiplier, which is equal to total assets divided by total
equity.
3. Debt-Equity Ratio = Total Liabilities / Total Equity
Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is a
leveraged firm; less than 1 implies that it is a conservative one.
4. Times Interest Earned = EBIT / Interest Expense
Measures the number of times interest expense is converted to income, and if the company can pay its
interest expense using the profits generated. EBIT is earnings before interest and taxes.
Valuation and Growth Ratios
1. Earnings per Share = ( Net Income - Preferred Dividends ) / Average Common Shares Outstanding
EPS shows the rate of earnings per share of common stock. Preferred dividends is deducted from net
income to get the earnings available to common stockholders.
2. Price-Earnings Ratio = Market Price per Share / Earnings per Share
Used to evaluate if a stock is over- or under-priced. A relatively low P/E ratio could indicate that the
company is under-priced. Conversely, investors expect high growth rate from companies with high P/E
ratio.
3. Dividend Pay-out Ratio = Dividend per Share / Earnings per Share
Determines the portion of net income that is distributed to owners. Not all income is distributed since a
significant portion is retained for the next year's operations.
4. Dividend Yield Ratio = Dividend per Share / Market Price per Share
Measures the percentage of return through dividends when compared to the price paid for the stock. A
high yield is attractive to investors who are after dividends rather than long-term capital appreciation.
5. Book Value per Share = Common SHE / Average Common Shares
Indicates the value of stock based on historical cost. The value of common shareholders' equity in the
books of the company is divided by the average common shares outstanding.
Conclusion
Here's a tip. When computing for a ratio that involves an income statement item and a balance sheet
item, make sure to average the balance sheet item. This is because the income statement item pertains
to a whole period's activity. The balance sheet item should then reflect the whole period as well; that's
why we average.
There are other financial ratios in addition those listed above. The ones listed here are the most common
ratios used in evaluating a business. In interpreting the ratios, it is better to have a basis for comparison,
such as historical ratios and industry standards.