Ratio Analysis

Submitted to PRESENTED BY
Shruti Mam ROHIT (76)
RAHUL (68)
Content

 Meaning
 Objectives
 Benefits
 Limitation
 Types
Meaning

Ratio analysis is the comparison of line item

in the financial statement of a business.
Ratio analysis is used to evaluate a number
of issues with an entity, such as its liquidity,
efficiency of operation, and profitability. This
type of analysis is particularly useful to
outside of a business, since their primary
source of information about an organization
is its financial statements.
Objective of Ratio
Analysis
 Measuring of Profitability
 Measuring Efficiency
 Solvency of the Business
 Financial Status of the
Company
 Comparative Analysis
Significance of Ratio
Analysis
 Helpful in FinancialaAnalysis
 For Explaining Financial Robustness
 Useful For Locating Weak Areas
 For Future Forecasting
 Inter-Firm Comparison
 Assessing Operating Efficiency
Limitation of Ratio Analysis

 False Result
 Limited Utility of Particular Ratio
 No Fixed Terminology Ratio
 No Attention to Qualitative
 Overlooks Inflation
 Misleading Results
 Types of
Ratios

Solvency Profitability
Liquidity Ratio Activity Ratio
Ratio Ratio

i.Current Ratio
i. Gross Profit I. Fixed Assets
ii. Quick Ratio i. Debt Equity Ratio
Ratio Turnover
ii. Net Profit Ratio
ii. Equity Ratio Ratio ii. Stock
Iii. Capital iii. Operating Turnover
Gearing Ratio Profit Ratio
iv. Expense iii. Working
Ratio Capital
v. Price Turnover
Earning Ratio Ratio
iv. Total Assets
Turnover
Ratio
Liquidity ratios

These ratios analyze the short-term financial

position of a firm and indicate the ability of the firm to meet its
short-term commitments (current
liabilities) out of its short-term resources (current
assets).
These are also known as ‘solvency ratios’. The
ratios which indicate the liquidity of a firm are:

1. Current ratio
2. Liquidity ratio or Quick ratio or acid test ratio
 Current Ratio
 Current ratio It is calculated by
dividing
current assets by current liabilities.
Current ratio = Current assets
Current liabilities
CURRENT ASSETS

 include –
Inventories of raw material, WIP,
finished goods,
stores and spares,
sundry debtors/receivables,
short term loans deposits and advances,
cash in hand and bank,
prepaid expenses,
incomes receivables and marketable investments and
short term securities.
CURRENT LIABILITIES

include –
Sundry creditors/bills payable,
outstanding expenses,
unclaimed dividend,
advances received,
incomes received in advance,
provision for taxation,
proposed dividend,
instalments of loans payable within 12 months, bank
overdraft and cash credit
Quick Ratio or Acid Test
Ratio
This is a ratio between quick current assets and current
liabilities (alternatively quick liabilities).

It is calculated by dividing quick current assets by

current liabilities (quick current liabilities)

Quick ratio =
quick assets
Current liabilities/(quick liabilities)
QUICK ASSETS & QUICK
LIABILITIES
QUICK ASSETS are current assets (as stated earlier)
less prepaid expenses and inventories.

QUICK LIABILITIES are current liabilities (as stated

earlier)
less bank overdraft and incomes received in
advance.
Capital structure/
leverage ratios
These ratios indicate the long term solvency of a firm
and indicate the ability of the firm to meet its long-
term commitment with respect to
(i) repayment of principal on maturity or in
predetermined instalments at due dates and
(ii) periodic payment of interest during the period of
the loan.
Capital structure/
leverage ratios
 The different ratios are:
 Debt equity ratio
 Proprietary ratio
 Debt to total capital ratio
 Interest coverage ratio
 Debt service coverage ratio
Debt equity ratio

This ratio indicates the relative proportion of debt and equity

in financing the assets of the firm. It is calculated by dividing
long-term debt by shareholder’s funds.
Debt equity ratio = long-term debts where Shareholders funds

Generally, financial institutions favour a ratio of 2:1.

However this standard should be applied having regard

to size and type and nature of business and the degree of
risk involved
LONG-TERM FUNDS are long-term loans whether
secured or unsecured like – debentures, bonds, loans
from financial institutions etc.

SHAREHOLDER’S FUNDS are equity share

capital plus preference share capital plus reserves and
surplus minus fictitious assets (eg. Preliminary expenses,
past accumulated losses, discount on issue of shares
etc.)
Proprietary Ratio

This ratio indicates the general financial strength of

the firm and the long- term solvency of the business.
This ratio is calculated by dividing proprietor’s funds
by total funds.
Proprietary ratio =
proprietor’s funds
Total funds/assets

As a rough guide a 65% to 75% proprietary ratio is

advisable
PROPRIETOR’S FUNDS are same as explained in
shareholder’s funds

TOTAL FUNDS are all fixed assets and all

current assets.
Alternatively it can be calculated as
proprietor’s funds plus long-term funds plus
current liabilities.
Debt to total capital ratio

In this ratio the outside liabilities are related to

the total capitalisation of the firm. It indicates
what proportion of the permanent capital of the
firm is in the form of long-term debt.

Debt to total capital ratio =

long- term debt
Shareholder’s funds + long- term debt

Conventionally a ratio of 2/3 is considered

satisfactory
Interes coverage ratio

This ratio measures the debt servicing capacity of a firm

in so far as the fixed interest on long-term loan is
concerned. It shows how many times the interest
charges are covered by EBIT out of which they will be
paid.
Interest coverage ratio =
EBIT
Interest
A ratio of 6 to 7 times is considered satisfactory.
Higher the ratio greater the ability of the firm to pay
interest out of its profits. But too high a ratio may
imply lesser use of debt and/or very efficient operations
Debt service coverage
ratio
This is a more comprehensive measure to compute the
debt servicing capacity of a firm. It shows how many
times the total debt service obligations consisting of
interest and repayment of principal in instalments are
covered by the total operating funds after payment of
tax.
Debt service coverage ratio =
EAT+ interest + depreciation + other non-cash exp
Interest + principal instalment

EAT is earnings after tax.

Generally financial institutions consider 2:1 as a
satisfactory ratio.
Profitability ratios

These ratios measure the operating efficiency of

the firm and its ability to ensure adequate returns
to its shareholders.
The profitability of a firm can be measured by its
profitability ratios.

Further the profitability ratios can be determined

(i) in relation to sales and
(ii) in relation to investments
Profitability ratios

Profitability ratios in relation to sales:

1. gross profit margin
2. Net profit margin
3. Expenses ratio
Profitability ratios

Profitability ratios in relation to investments

 Return on assets (ROA)
 Return on capital employed (ROCE)
 Return on shareholder’s equity (ROE)
 Earnings per share (EPS)
 Dividend per share (DPS)
 Dividend payout ratio (D/P)
 Price earning ratio (P/E)
Gross profit margin

This ratio is calculated by dividing gross

profit by sales. It is expressed as a percentage.
Gross profit is the result of relationship
between prices, sales volume and costs.

Gross profit margin =

gross profit x 100
Net sales
Gross profit margin

A firm should have a reasonable gross profit

margin to ensure coverage of its operating
expenses and ensure adequate return to the
owners of the business ie. the shareholders.

To judge whether the ratio is satisfactory or

not, it should be compared with the firm’s
past ratios or with the ratio of similar firms in
the same industry or with the industry average.
Net profit margin

This ratio is calculated by dividing net profit by

sales. It is expressed as a percentage.

This ratio is indicative of the firm’s ability to

leave a margin of reasonable compensation to
the owners for providing capital, after meeting
the cost of production, operating charges and the
cost of borrowed funds.

Net profit margin =

net profit after interest and tax x 100
Net sales
Net profit margin

Another variant of net profit margin is operating

profit margin which is calculated as:
Operating profit margin =
net profit before interest and tax x 100
Net sales
Higher the ratio, greater is the capacity of the
firm to withstand adverse economic conditions
and vice versa
Expenses ratio
These ratios are calculated by dividing the various expenses by
sales. The variants of expenses ratios are:

Material consumed ratio =

Material consumed x 100
Net sales
Manufacturing expenses ratio =
manufacturing expenses x 100
Net sales
Administration expenses ratio =
administration expenses x 100
Net sales
Selling expenses ratio =
Selling expenses x 100
Net sales
Operating ratio =
cost of goods sold plus operating expenses x 100
Net sales
Financial expense ratio =
financial expenses x 100
Net sales
Expenses ratio

The expenses ratios should be compared over

a period of time with the industry average as
well as with the ratios of firms of similar type.
A low expenses ratio is favourable.

The implication of a high ratio is that only a

small percentage share of sales is available for meeting
financial liabilities like interest, tax, dividend etc.
Return on assets (ROA)

This ratio measures the profitability of the total funds of

a firm. It measures the relationship between net profits
and total assets. The objective is to find out how
efficiently the total assets have been used by the
management.

Return on assets =
net profit after taxes plus interest x 100
Total assets

Total assets exclude fictitious assets. As the total assets

at the beginning of the year and end of the year may not
be the same, average total assets may be used as the
denominator.
Return on shareholders
equity
This ratio measures the relationship of profits to owner’s
funds. Shareholders fall into two
groups i.e. preference shareholders and equity
shareholders. So the variants of return on shareholders
equity are

Return on total shareholder’s equity =

net profits after taxes x 100
Total shareholders equity
TOTAL SHAREHOLDER'S
EQUITY
includes preference share capital plus equity
share capital plus reserves and surplus less
accumulated losses and fictitious assets. To
have a fair representation of the total
shareholders funds, average total shareholders funds
may be used as the denominator
Return on ordinary shareholders equity =

net profit after taxes – pref. dividend x 100

Ordinary shareholders equity or net
worth

ORDINARY SHAREHOLDERS EQUITY

OR NET WORTH includes equity share capital
plus reserves and surplus minus fictitious assets.
Earning per share (EPS)

This ratio measures the profit available to the

equity shareholders on a per share basis. This ratio is
calculated by dividing net profit available to equity
shareholders by the number of equity shares.
Earnings per share =
net profit after tax – preference dividend
Number of equity shares
Divindend per share (DPS)

This ratio shows the dividend paid to the

shareholder on a per share basis. This is a better
indicator than the EPS as it shows the amount of
dividend received by the ordinary shareholders,
while EPS merely shows theoretically how much
belongs to the ordinary shareholders

Dividend per share =

Dividend paid to ordinary shareholders
Number of equity shares
Dividend payout ratio
(D/P)
This ratio measures the relationship between the
earnings belonging to the ordinary shareholders and the
dividend paid to them.
Dividend pay out ratio =
total dividend paid to ordinary shareholders x 100

Net profit after tax –preference dividend

OR
Dividend pay out ratio =
Dividend per share x 100
Earnings per share
Price Earning ratio(P/E)

This ratio is computed by dividing the market

price of the shares by the earnings per share. It
measures the expectations of the investors and market
appraisal of the performance of the firm.

Price earning ratio =

market price per share
Earnings per share
Activity ratios

These ratios are also called efficiency ratios / asset

utilization ratios or turnover ratios. These ratios
show the relationship between sales and various
assets of a firm. The various ratios under this group
are:
 Inventory/stock turnover ratio
 Debtors turnover ratio and average collection
period
 Asset turnover ratio
 Creditors turnover ratio and average credit period
Inventory/stock turnover
ratios
This ratio indicates the number of times inventory is
replaced during the year. It measures the relationship
between cost of goods sold and the inventory level.
There are two approaches for calculating this ratio,
namely:
Inventory turnover ratio =
cost of goods sold
Average stock
AVERAGE STOCK can be calculated as
Opening stock + closing stock
2
Alternatively
Inventory turnover ratio =
sales
Closing inventory
Inventory/stock turnover
ratio
A firm should have neither too high nor too
low inventory turnover ratio. Too high a ratio
may indicate very low level of inventory and a
danger of being out of stock and incurring high
‘stock out cost’. On the contrary too low a ratio is
indicative of excessive inventory
entailing excessive carrying cost.
Debtor turnover ratio and
average collection period
This ratio is a test of the liquidity of the debtors
of a firm. It shows the relationship between
credit sales and debtors.
Debtors turnover ratio =
Credit sales
Average Debtors and bills receivables

Average collection period =

Months/days in a year
Debtors turnover
Debtor turnover ratio and
average collection period
These ratios are indicative of the efficiency of
the trade credit management. A high turnover
ratio and shorter collection period indicate
prompt payment by the debtor. On the
contrary low turnover ratio and longer
collection period indicates delayed payments
by the debtor.

In general a high debtor turnover

ratio and
short collection period is preferable.
Asset turnover ratio

Depending on the different concepts of assets employed, there

aremany variants of this ratio. These ratios measure the efficiency of a firm in
managing and utilising its assets.
Total asset turnover ratio =
sales/cost of goods sold
Average total assets
Fixed asset turnover ratio =
sales/cost of goods sold
Average fixed assets
Capital turnover ratio =
sales/cost of goods sold
Average capital employed
Working capital turnover ratio =
sales/cost of goods sold
Net working capital
Asset turnover ratio

Higher ratios are indicative of efficient

management and utilisation of resources while low
ratios are indicative of under-utilisation of resources
and presence of idle capacity.
Creditors turnover ratio
and average credit period
This ratio shows the speed with which payments are
made to the suppliers for purchases made from
them. It shows the relationship between credit
purchases and average creditors.
Creditors turnover ratio =
credit purchases
Average creditors & bills payables
Average credit period =
months/days in a year
Creditors turnover ratio
Creditors turnover ratio
and average credit period
Higher creditor turnover ratio and short credit period
signifies that the creditors are being paid prompty
and it enhances the creditworthiness of the firm.