RATIO ANALYSIS

By Shilpa Arora
Assistant Professor
IITM

RATIO ANALYSIS
Ratio analysis is the process of determining and
interpreting numerical relationship based on
financial statements. It is the technique of
interpretation of financial statements with the help
of accounting ratios derived from the balance
sheet and profit and loss account.

Basis Of Comparision
Trend Analysis involves comparison of a firm over a
period of time, that is, present ratios are compared with
past ratios for the same firm. It indicates the direction of
change in the performance improvement, deterioration
or constancy over the years.
Interfirm Comparison involves comparing the ratios of a
firm with those of others in the same lines of business or
for the industry as a whole. It reflects the firms
performance in relation to its competitors.
Comparison with standards or industry average

Classification Of Ratios
Analysis of Short Term Financial Position
or Test of Liquidity. (LIQUIDITY RATIOS)
Analysis of Long Term Financial Position
or Test of Solvency.
Activity Ratios.
Profitability Ratios.

1.
2.

3.

4.
5.

Liquidity the ability of the firm to pay its way

Investment/shareholders information to enable
decisions to be made on the extent of the risk and the
earning potential of a business investment
Gearing information on the relationship between the
exposure of the business to loans as opposed to share
capital
Profitability how effective the firm is at generating
profits given sales and or its capital assets
Financial the rate at which the company sells its
stock and the efficiency with which it uses its assets

LIQUIDITY

I. Test Of Liquidity
The liquidity ratios are used to test the short term
solvency or liquidity position of the business.
It enables to know whether short term liabilities can be
paid out of short term assets.
It indicates whether a firm has adequate working
capital to carry out routine business activity.
It is a valuable aid to management in checking the
efficiency with which working capital is being
employed.
It is also of importance to shareholders and long term
creditors in determining to some extent the prospects
of dividend and interest payment.

Important Ratios In Test Of Liquidity

Current ratio.
Quick ratio.

Current Ratio
It is the most widely used of all analytical devices based
on the balance sheet. It establishes relationship between
total current assets and current liabilities.
Current ratio=

Current assets
Current liabilities

Ideal ratio: 2:1

High ratio indicates under trading and over
capitalization.
Low ratio indicates over trading and under capitalization.

Quick Ratio or Acid Test Ratio

It establishes relationship between liquid assets and
liquid liabilities. It is a refinement to current ratio and
second testing device for working capital.

Quick ratio=

Quick assets
Current liabilities

Ideal ratio: 1:1

Usually, a high acid test ratio is an indication that the
firm is liquid and has ability to meet its current or liquid
liabilities in time and on the other hand a low quick ratio
represents that the firms liquidity position is not good.

II. Test Of Solvency

Long term solvency ratios denote the
ability of the organisation to repay the
loan and interest.
When an organization's assets are more
than its liabilities is known as solvent
organisation.
Solvency indicates that position of an
enterprise where it is capable of meeting
long term obligations.

Important Ratios In Test Of

Solvency
Debt-equity ratio.
Proprietary ratio.
Solvency ratio.
Fixed assets to net worth ratio.
Current assets to net worth ratio.
Current liabilities to net worth ratio.
Capital gearing ratio.
Fixed assets ratio
Debt servicing ratio.
Dividend coverage ratio.

Debt Equity Ratio

It Is calculated to measure the relative claims of
outsiders and the owners against the firms assets. This
ratio indicates the relationship between the outsiders
funds and the shareholders funds.
Debt equity ratio=

Outsiders funds OR Long term debt

Shareholders funds

Ideal ratio: 2:1; It means for every 2 shares there is 1

debt. If the debt is less than 2 times the equity, it means
the creditors are relatively less and the financial
structure is sound. If the debt is more than 2 times the
equity, the state of long term creditors are more and
indicate weak financial structure.

Proprietary Ratio or Net Worth

Ratio
It establishes relationship between the proprietors fund
or shareholders funds and the total assets
Proprietary ratio=

Proprietary funds
Total assets

or

Capital employed
Total liabilities

Ideal ratio: 0.5:1

Higher the ratio better the long term solvency (financial)
position of the company. This ratio indicates the extent to
which the assets of the company can be lost without
affecting the interest of the creditors of the company

Solvency Ratio
It expresses the relationship between total assets and
total liabilities of a business. This ratio is a small variant
of equity ratio and can be simply calculated as
100-equity ratio
Solvency ratio=

Total assets
Total liabilities

No standard ratio is fixed in this regard. It may be

compared with similar, such organisations to evaluate
the solvency position. Higher the solvency ratio, the
stronger is its financial position and vice-versa.

Fixed Assets To Net Worth

It is obtained by dividing the depreciated book value of
fixed assets by the amount of proprietors funds.
Fixed assets to net worth ratio=

Net fixed assets

Net worth

Ideal ratio: 0.75:1

A higher ratio, say, 100% means that there are no
outside liabilities and all the funds employed are those of
shareholders. In such a case the return to shareholders
would be lower rate of dividend and this is also a sign of
over capitalization.

Fixed Assets To Net Worth

This ratio shows the extent to which ownership
funds are sunk into assets with relatively low
turnover. When the amount of proprietor's funds
exceed the value of fixed assets, apart of the
net working capital is provided by the
shareholders, provided there are no other noncurrent assets, and when proprietors funds are
less than the fixed assets, creditors obligation
have been used to finance a part of fixed
assets. The Yardstick for this measure is 65%
for industrial undertakings.

Current Assets To Net Worth Ratio

It is obtained by dividing the value of current assets by
the amount of proprietors funds. The purpose of this
ratio is to show the percentage of proprietors fund
investment in current assets.
Current assets to net worth ratio=

Current assets
Proprietors fund

A higher proportion of current assets to proprietors fund,

as compared with the proportion of fixed assets to
proprietors funds is advocated, as it is an indicator of
the financial strength of the business, depending on the
nature of the business there may be different ratios for
different firms. This ratio must be read along with the
results of fixed assets to proprietors funds ratio.

Current Liabilities To Net Worth

It is expressed as a proportion and is obtained by
dividing current liabilities by proprietor's fund.

Current liabilities to net worth ratio=

Current liabilities
Net worth

Ideal ratio:1:3
This ratio indicates the relative contribution of short term
creditors and owners to the capital of an enterprise. If
the ratio is high, it means it is difficult to obtain long term
funds by the business.

Capital Gearing Ratio

It expresses the relationship between equity capital and
fixed interest bearing securities and fixed dividend
bearing shares.
shares
CGR=

Fixed interest bearing securities + fixed dividend

bearing

Equity shareholders funds

Components of fixed
Components of equity
interest bearing securities shareholders funds
Debentures
Equity share capital
Long-term loans
Accumulated reserves &
Long-term fixed deposits profits
Less losses and fictitious
assets

Interpretation Of Capital Gearing

Ratio
When fixed interest bearing securities and fixed
dividend bearing shares are higher than equity
shareholders funds, the company is said to be highly
geared.
Where the fixed interest hearing securities and fixed
dividend bearing shares share equal to equity share
capital it is said to be evenly geared.
When the fixed interest bearing securities and fixed
dividend bearing shares are lower than equity share
capital it is said to be low geared.
If capital gearing is high, further raising of long term
loans may be difficult and issue of equity shares may
be attractive and vice-versa

Fixed Assets Ratio

It establishes the relationship between fixed assets and
capital employed

Fixed assets ratio=

Fixed assets
Capital employed

Ideal ratio: 0.67:1

This ratio enables to know how fixed assets are financed
i.e. by use of short term funds or by long term funds.
This ratio should not be more than 1.

Fixed Charges cover or Debt

Service Ratio
This ratio is determined by dividing net profit by fixed
interest charges.
Net profit before deduction of interest
and income tax
Debt service ratio=
Fixed interest charges
Ideal ratio: 6 or 7 times; if the ratio is high it means
there is higher margin of safety for the long term lenders
and as such it is not difficult for the business to obtain
further long term funds and vice-versa.
This ratio indicates the financial ability of the enterprise
to meet interest payment out of current earnings

Dividend Cover Ratio

It is the ratio between disposable profit and dividend.
Disposable profit refers to profit left over after paying
interest on long term borrowing and income tax.
Dividend cover ratio=

Net profit after interest and tax

Dividend declared

This ratio indicates the ability of the business to maintain

the dividend on shares in future. If this ratio is higher is
indicates that there is sufficient amount of retained profit.
Even if there is slight decrease in profit in the future it
will not affect payment of dividend in future

III. Activity Ratio

Activity ratios indicate the performance of an
organisation.
This indicate the effective utilization of the
various assets of the organisation.
Most of the ratio falling under this category is
based on turnover and hence these ratios are
called as turnover ratios.

Important Ratios In Activity Ratio

Stock turnover ratio.
Debtors turnover ratio.
Creditors turnover ratio.
Wording capital turnover ratio.
Fixed assets turnover ratio.
Current assets turnover ratio.
Total assets turnover ratio.
Sales to networth ratio.

Stock Turnover Ratio

This ratio establishes the relationship between the cost
of goods sold during a given period and the average
sock holding during that period. It tells us as to how
many times stock has turned over (sold) during the
period. Indicates operational and marketing efficiency.
Helps in evaluating inventory policy to avoid over
stocking.
Inventory turnover ratio=

Cost of goods sold

Average stock
Cost of goods sold= sales-gross profit
= opening stock + purchases
closing
stock
Opening stock + Closing stock
Average stock=

Interpretation Of Stock Turnover

Ratio
Ideal ratio: 8 times; A low inventory turnover may
reflect dull business, over investment in inventory,
accumulation of stock and excessive quantities of
certain inventory items in relation to immediate
requirements.
A high ratio may not be accompanied by a relatively
high net income as, profits may be sacrificed in
obtaining a large sales volume (unless accompanied
by a larger total gross profit). It may indicate under
investment in inventories. But generally, a high stock
turnover ratio means that the concern is efficient and
hence it sells its goods quickly.

Debtor Turnover Ratio

This ratio explains the relationship of net credit sales of
a firm to its book debts indicating the rate at which cash
is generated by turnover of receivables or debtors.
The purpose of this ratio is to measure the liquidity of the
receivables or to find out the period over which
receivables remain uncollected.
Debtor turnover ratio=
Average debtors=

Net credit sales

Average Debtors
Opening balance + closing balance
2

Debtors include bills receivables along with book debts

Average Collection Period

The average collection period represents the average
number of days for which a firm has to wait before its
receivables are converted into cash
Number of working day in year
Average collection period=
Debtor turnover ratio

Interpretation Of Debtor Turnover

Ratio
Ideal ratio: 10 to 12 times; debt collection
period of 30 to 36 days is considered ideal.
A high debtor turnover ratio or low collection
period is indicative of sound management
policy.
The amount of trade debtors at the end of
period should not exceed a reasonable
proportion of net sales. Larger the trade
debtors greater the expenses of collection.

Creditors Turnover Ratio

This ratio indicates the number of times the creditors are
paid in a year. It is useful for creditors in finding out how
much time the firm is likely to take in repaying its trade
creditors.
Creditors turnover ratio=
Average creditors=

Net credit purchases

Average creditors

Opening balance + closing balance

Average payment period=

2
Number of working days
Creditors turnover ratio

Interpretation Of Creditor Turnover

Ratio
Ideal ratio: 12 times; debt payment period of
30 days is considered ideal.
Very less creditors turnover ratio, or a high debt
payment period may indicate the firms inability
in meeting its obligation in time.

Working Capital Turnover Ratio

This ratio indicates the number of times the working
capital is turned over in the course of the year. Measures
efficiency in working capital usage. It establishes
relationship between cost of sales and working capital

Working capital turnover ratio=

Average working capital=

Cost of sales
Average working capital

Opening + closing working

capital
2

Interpretation of Working Capital

Turnover Ratio
A higher ratio indicates efficient utilization
of working capital and a low ratio indicates
inefficient utilization of working capital.
But a very high ratio is not a good situation
for any firm and hence care must be taken
while interpreting the ratio.

Fixed Assets Turnover Ratio

This ratio establishes a relationship between fixed
assets and sales.

Fixed assets turnover ratio=

Net sales
Fixed assets

Ideal ratio: 5 times

A high ratio indicates better utilisation of fixed assets.
A low ratio indicates under utilisation of fixed assets.

Total Asset Turnover Ratio

This ratio establishes a relationship between total assets
and sales. This ratio enables to know the efficient
utilisation of total assets of a business.
Total assets turnover ratio=

Net sales
Total assets

Ideal ratio: 2 times

High ratio indicates efficient utilization and ratio less than
2 indicates under utilization.

IV. Profitability Ratio

Profitability ratios indicate the profit earning
capacity of a business.
Profitability ratios are calculated either in
relation to sales or in relation to investments.
Profitability ratios can be classified into two
categories.
a) General Profitability Ratios.
b) Overall Profitability Ratios.

General Profitability Ratios

Gross profit ratio.
Net profit ratio.
Operating ratio.
Operating profit ratio.
Expense ratio.

Gross Profit Ratio

It expresses the relationship of gross profit to net sales
and is expressed in terms of percentage. This ratio is a
tool that indicates the degree to which selling price of
goods per unit may decline without resulting in losses.
Gross profit ratio=

Gross profit
Net sales

X 100

A low gross profit ratio may indicate unfavorable

purchasing, the instability of management to develop
sales volume thereby making it impossible to buy goods
in large volume.
Higher the gross profit ratio better the results.

Net Profit Ratio

It expresses the relationship between net profit after
taxes to sales. Measure of overall profitability useful to
proprietors, as it gibes an idea of the efficiency as well
as profitability of the business to a limited extent.
Net profit ratio=

Net profit after taxes

Net sales

X 100

Higher the ratio better is the profitability

Operating Ratio
This ratio establishes a relationship between cost of
goods sold plus other operating expenses and net sales.
This ratio is calculated mainly to ascertain the
operational efficiency of the management in their
business operations.
Cost of goods sold + operating expenses
Operating ratio=
Net sales
Higher the ratio the less favorable it is because it would
leave a smaller margin to meet interest, dividend and
other corporate needs. For a manufacturing concern it is
expected to touch a percentage of 75% to 85%. This
ratio is partial index of over all profitability.

Operating Profit Ratio

This ratio establishes the relationship between
operation profit and net sales.
Operating profit ratio=

Operating profit
Net sales

X 100

Operating profit ratio= 100-operating ratio

Operating profit= Net sales ( cost of goods sold +
Administrative and office expenses + selling and
distributive expenses.

Expenses Ratio
It establishes relationship between individual operation
expenses and net sales revenue.

1. Cost of goods sold ratio=

Cost of goods sold

X 100

Net sales
Office and admin exp
2. Admin. and office exp ratio=
X100
Net sales
Selling and dist. exp
3. Selling and distribution ratio=
X 100
Net sales
Non operating expense
4. Non-operating expense ratio=
X 100
Net sales

Test Of Overall Profitability

Return on shareholders investment or Net worth
ratio.
Return on equity capital.
Return on capital employed.
Return on total resources.
Dividend yield ratio.
Preference dividend cover ratio.
Equity dividend cover ratio.
Price covering ratio.
Dividend pay out ratio.
Earning per share.

Return On Shareholders
Investment
Shareholders investment also called return on
proprietors funds is the ratio of net profit to proprietors
funds. It is calculated by the prospective investor in the
business to find out whether the investment would be
worth-making in terms of return as compared to the risk
involved in the business.
Net profit (After tax and int)
Return on shareholders investment=
Proprietors funds

Return On Shareholders
Investment
This ratio is of great importance to the present and
prospective shareholders as well as the management of
the company. As this ratio reveals how well the
resources of a firm are being used, higher the ratio,
better are the results. The return on shareholders
investment should be compared with the return of other
similar firms in the same industry. The inter firm
comparision of this ratio determines whether their
investments in the firm are attractive or not as the
investors would like to invest only where their return is
higher. Similarly, trend ratios can also be calculated for a
number of years to get5 an idea of the prosperity, growth
of deterioration in the companys profitability and
efficiency.

Return On Equity Capital

This ratio establishes the relationship between net profit
available to equity shareholders ad the amount of capital
invested by them. It is used to compare the performance
of company's equity capital with those of other
companies, and thus help the investor in choosing a
company with higher return on equity capital.

Net profit preference dividend

Return on equity capital=

Equity share capital (paid up)

Return On Capital Employed

This ratio is the most appropriate indicator of the earning
power of the capital employed in the business. It also
acts as a pointer to the management showing the
progress or deterioration in the earning capacity and
efficiency of the business.
Net profit before taxes and
interest on long term loans and debentures
Return on capital employed=
Capital employed
Ideal ratio: 15%
If the actual ratio is equal ratio is equal to or above 15%
It indicates higher productivity of the capital employed
and vice versa

Return of total resources

This ratio acts as an yardstick to assess the efficiency of
the efficiency of the operations of the business as it
indicates the extent to which assets employed in the
business are utilised to results in net profit

Return on total recourses =

Net profit
Total assets

X 100

Dividend Yield Ratio

It refers to the percentage or ratio of dividend paid per
share to the market price per share. This ratio throws
light on the effective rate of return on investment, which
potential investors may hope to earn.

Dividend yield ratio =

Dividend paid per equity share

Market price per equity share

Preference Dividend Cover

It indicates how many times the preference dividend is
covered by profits after tax. This ratio measures the
margin o safety for preference shareholders. Such
investors normally expect their dividend to be covered
about 3 times by profits available for dividend purpose.

Preference dividend cover =

Profit after tax

Annual programme dividend

Equity Dividend Cover

This ratio indicates the number of times the dividend is
covered by the amount of profit available for equity
shareholders.
Equity dividend cover =
=

Net profit after tax - pref dividend

Dividend paid on equity capital
Earning per equity share
Dividend per equity share

Ideal ratio: 2 times; i.e. for every Rs. 100 profits

available for dividend, Rs. 50 is retained in the business
and Rs. 50 is distributed. Higher the ratio higher is
extent of retained earnings and higher is the degree of
certainty that dividend will be repeated in future

Price Earning Ratio

It shows how many times the annual earnings the
present shareholders are willing to pay to get a share.
This ratio helps investors to know the effect of earnings
per share on the market price of the share. This ratio
when calculated for several years can be used as term
analysis for predicting future price earning ratios and
therefore, future stock prices.

Price earning ratio=

Average market price per share

Earning per share

Dividend Pay Out Ratio

This ratio indicates the proportion of earnings available
which equity share holders actually receive in the form of
dividend.
Pay out ratio =

Dividend paid per share

Earning per share

An investor primarily interested should invest in equity

share of a company with high pay out ratio. A company
having low pay out ratio need not necessarily be a bad
company. A company having income may like to finance
expansion out of the income, thus low pay out ratio.
investor interested in stock price appreciation may well
invest in such a company though the pay out ratio is low.

Earning Per Share

This ratio indicates the earning per equity share. It
establishes the relationship between net profit available
for equity shareholders and the number of equity shares.

Net profit available for equity share holders

Earning per share =
Number of equity shares

EXERCISE 1
LIABILITES
Capital
Reserves

ASSETS
180 Net Fixed Assets
20 Inventories

Term Loan

300 Cash

Bank C/C

200 Receivables

Trade Creditors

50 Goodwill

Provisions

50
800

a.
b.
c.
d.
e.
f.

400
150
50
150
50
800

What is the Net Worth : Capital + Reserve = 200

Tangible Net Worth is : Net Worth - Goodwill = 150
Total Liabilities : TL + CC + Creditors + Provisions = 600
Net Working Capital : C A - C L = 350 - 250 = 50
Current Ratio : C A / C L
= 350 / 300 = 1.17 : 1
Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2
LIABILITIES

2005-06 2006-07

ASSETS

Capital

300

350 Net Fixed Assets

Reserves

140

160 Security
Electricity

Bank Term Loan

320

Bank CC (Hyp)

200506

200607

730

750

30

30

280 Investments

110

110

490

580 Raw Materials

150

170

Unsec. Long T L

150

170 S I P

20

30

Creditors (RM)

120

140

170

30

20

310

240

30

190

50

50

1600

1760

70 Finished Goods

Bills Payable

40

80 Cash

Expenses Payable

20

30 Receivables

Provisions

20

40 Loans/Advances
Goodwill

Total

1600

1760

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70)
820 /800 = 1.02
3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21