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Ratio Analysis

A ratio analysis is a quantitative analysis of information contained in a

financial statement of the company. This analysis helps to evaluate
various aspects of a company such as efficiency, liquidity, profitability
or solvency by studying the Trend over the period of Time..

Types of Ratios

There are actually two ways in which the ratios can be classified, that is on
the basis of accounting statements from where they are obtained & on the
basis of uses of the ratios and the purpose for which they are calculated.

Traditional Classification

✔ Profit and Loss Ratios

✔ Balance Sheet Ratios
✔ Composite Ratios

Profit and Loss Ratios

When both figures are derived from the statement of Profit and Loss A/c
then it is called a Profit and Loss Ratio. For example Gross Profit ratio,
which is the ratio of Gross Profit to Sales & in this ratio both these amounts
will be derived from the Profit and Loss A/c.

Balance Sheet Ratios

If both the components are obtained from the balance sheets then it is
a balance sheet ratio. For example Current ratio in which both are derived
from the balance sheet.

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Composite Ratios

A composite ratio in which both variables from two different parts. One is
taken from the Profit and Loss A/c and the other component from the
Balance Sheet. For example Return on Capital Employed Ratio. The return
can be obtained from the Income Statement and the Capital Employed is in
the Balance Sheet. It is also called as Hybrid or Combined Ratio.

Liquidity Ratios

Liquidity ratios analyze the ability to convert its assets to cash for the
purpose of payment of its obligations without any difficulty .Liquidity
ratios are:

⮚ Current Ratio

It measures the ability of a business to repay current liabilities from its

current assets.

Current assets are assets which can be converted into cash within one
year. like cash and cash equivalents, marketable securities, short-term
investments, Sundry Debtors , , Inventories & Prepaid Expenses.

Current liabilities are short term liabilities which require settlement within
one year like Accounts Payable, Salaries and wages payable, Income
tax payable, etc.

Current Ratio =

⮚ Quick Ratio

Quick ratio (also known as acid test ratio) is a liquidity ratio which
measures the liquid current assets available with respect to current

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Liabilities. Liquid current assets include cash, Marketable securities and

Debtors..

Quick Ratio =

⮚ Profitability ratios

Profitability Ratios measure the efficiency of management in the

generation of Profits for the business.

Net profit (NP) ratio

Net profit ratio (NP ratio) shows the relationship between Net profit after
tax and Net sales.

NP Ratio:- x100

A high ratio indicates the better performance for the company.

Gross profit ratio

Gross profit ratio (GP ratio) shows the relationship between Gross Profit
and total Net sales revenue.

GP Ratio:- x100

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A higher ratio is considered to be better.

Price earnings ratios (P/E ratio)

Price earnings ratios (P/E ratio) measures how many times the Market
Price has been covered by Earning of an ordinary share..

P/E Ratio:-

Operating ratio

This ratio is used to measure the operational efficiency of the business &
shows the relationship of operating cost with respect to sales.

x100

A low operating ratio means high net profit ratio as if expenses are less
the profits will be higher..

Dividend yield ratio

Dividend yield ratio shows the percentage which shareholder has

earned on their investment (Current Market Price) in the form of
Dividend.

x100

Dividend payout ratio

Dividend payout ratio discloses what portion of the earnings the

company has paid to its stockholders in the form of dividend.

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x100

A low dividend payout ratio means the company has retained a

large portion of its earnings for growth in future and a high payout
ratio shows the company is paying a large portion of its earnings
to its common shareholders.

⮚ Return on capital employed ratio

Return on capital employed ratio measures the success of a business in

generating satisfactory profit on capital invested.

= X100

Earnings per share (EPS)

It measures amount earned by shareholder on each share

x100

A continuous improvement in the EPS figure year after year is the

indication of continuous improvement in the earning power.

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Activity ratios or Turnover ratios

Activity ratios (Turnover ratios) measure the efficiency of a firm or

company in generating revenues by converting its production into cash or
sales.

⮚ Inventory turnover ratio

Inventory turnover ratio is a tool to evaluate the liquidity of

inventory. It measures how many times a company has sold and
replaced its inventory during a particular period of time.

If cost of goods sold is not given net sales that is (Sales – Sales
Return) can be used instead of COGS

Average inventory is the Average of Inventory in the begging &

Inventory at the end of the period.

A high ratio indicates fast movement of inventories should be

preferable & if it is low then it may results into the obsolescence
of inventory or over holding of Inventroy.

⮚ Receivables turnover ratio or Debtor Turnover Ratio

Receivables turnover ratio (Debtors turnover ratio) measures how

many times the receivables are collected during a particular period.

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Net Credit Sales means Sales – Sales Return if any. Do not

consider the amount of Cash Sales.

Average Debtor is the Average of Debtor in the beginning & Debtor at

the end of the period.

High ratio indicates that the receivables are more liquid and are being
collected frequently & if the ratio is low it means that the debtors are
not being collected promptly which may increase the chances of Bad
Debts.

⮚ Average collection period

Average collection period shows the average period during which

debtors are being collected.

A lower ratio indicates the prompt collection and better management

of receivables. High ratio is not better for the firm as it may increase
the chances of the bad debts.

Asset turnover ratio

It is an activity ratio that measures the efficiency of Assets to

generate the sales or revenue in the business.

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Fixed assets turnover ratio

Fixed assets turnover ratio is a ratio that measures the efficiency with
which a company uses its fixed assets to generate its sales revenue.

Higher ratio would be preferred as it means that the Assets are

used efficiently in the business.

Solvency ratios:

Solvency ratios measure the ability of a business to survive for a long

period of time & are used to analyze the capital structure of the
company, to determine the ability of the company to pay interest on
long term borrowings etc.

⮚ Debt to equity ratio

Debt to equity ratio indicates the soundness of long-term financial

policies of a company. It shows the portion of assets
financed by creditors and stockholders.

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⮚ Times interest earned (TIE) ratio

Times interest earned (TIE) ratio that measures the ability of a

company to pay its interest charges as they become due.

Times interest earned ratio is also known as debt service ratio, fixed
charges cover ratio and Interest coverage ratio.

A high ratio ensures a periodical interest income for lenders.

⮚ Proprietary ratio

The proprietary ratio or Net worth ratio or Equity ratio is used to

evaluate the soundness of the capital structure of a company.

A high proprietary ratio indicates strong financial position of the

company as it shows the total fund of shareholder which is used in
the total assets of the business.

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