Ratio Analysis – An Introduction

 A ratio can be defined as an indicator of the relationship

between two variables having either cause and effect
relationship or connected with each other in some or the
other manner.
 An accounting ratio is the mathematical relationship
between two interrelated accounting figures.
 The figures have to be inter-related because no useful
purpose will be served if ratio is calculated between two
figures, which are not at all related to each other.

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Different Accounting Ratios

Different ratios are grouped into four categories

 Liquidity Ratios
 Activity (or)Turnover Ratios
 Profitability Ratios
 Solvency Ratios

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Classification of Items for Ratio
Analysis –1

Current Assets Stock, Sundry Debtors, Bills Receivable,

Marketable Securities (short term
investment), Cash & Bank Balance, Pre-paid
expenses, Accrued income, others
Current Liabilities Sundry creditors, Bills payables, tax payable,
Outstanding expenses, Unearned income,
Short bank loan, Bank overdraft, Provision
for doubtful debts, others
Fixed Assets (long Land & Building, Plant & Machinery,
term assets) Equipments, Long term investment, Furniture
& Fixtures, Freehold Property, others
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Classification of Items for Ratio
Analysis –2

Intangible and Fictitious Goodwill, Patents, Copyrights, Trade

Assets Mark & Logo, Preliminary Expenses,
Discount/Expenses on Issue of
Shares/Debentures, Deferred Revenue
Expenses
Long Term Liabilities Debentures, Secured Loan, Long Term
Loan
Shareholders Net Worth Equity Share Capital + Preference Share
( Tangible Net Worth) Capital + Reserve & Surplus –
Intangible & Fictitious Assets

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Classification of Items for Ratio
Analysis –3

Net Capital Employed Shareholders Net Worth + Long

term Liabilities Alternatively Fixed
Assets including Investment +
Total Current Assets – Current
Liabilities
Gross Capital Shareholders Net Worth + Long
Employed term Liabilities Alternatively Fixed
Assets including Investment +
Total Current Assets

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Accounting Policies

The accounting policies adopted by the finance officer

in preparing books of accounting and presenting
annual accounts must help in achieving
 uniformity,
 consistency and
 comparability
 of financial results.

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Quality of Earning

Quality of earning implies having consistent pattern

of reporting earning across the years.
The consistency is must to have a comparative
analysis of the financial performance.
However interpretation of quality of earning is
different for different stakeholders.

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Stakeholders Quality
of Earning
 For finance officer projection of earning as per the accounting standards
is the measurement of good quality of earning.
 For shareholders of the company increasing level of earning represents
good quality of earning.
 For tax authorities presentation of profits as per tax laws implies good
quality of earning.
 For employees of the business firm earning likely to bring reward for
them is the measurement of good quality of earning.
 For prospective investors estimation and reporting of future profitability
indicates good quality.
 For money lenders earning capable of providing sufficient coverage for
default risk indicates good quality of earning.

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Black Holes – Red Flags –1

In view of the limitation of ratio analysis the financial analysts

should detect following black holes before carrying out
interpretation with the help of financial ratios
 Changes in accounting policies and their effect on financial
results
 Unexplained changes in accounting policies and their impact
of reported profits
 Report of CFO
 Directors’ reports

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Black Holes – Red Flags –2
 Corporate governance practices
 Comment of audit committee
 Auditors’ report
 Unusual increase or decrease in certain expenses or
losses
 Unusual increase or decrease in certain revenue or
profits
 Disclosure to annual accounts

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Assessing The Liquidity
of The Firm – Liquidity Ratios

 Liquidity ratio are also termed as " working

capital" or short term solvency ratio.
 Following are the prominent liquidity ratios
which help in assessing liquidity position of
business
– Current Ratio
– Quick Ratio
– Absolute Liquidity Ratio

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Current Ratio
 This ratio is an indicator of the firm's commitment to meet its
short term liabilities.
 Current assets are either used up or converted into cash
within a years’ time or normal operating circle of the business.
 Current liabilities are payable with in a year or operating
cycle, out of the existing current assets or by creation of
current liabilities.
 Current ratio = Current Assets/Current Liabilities

(standard 2:1)

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Quick or Acid test Ratio
 All the current assets are not equally current or liquid.
 But inventory is the most illiquid assets as it cannot be
sold till there are buyer available.
 Quick or Acid test Ratio = Quick Assets /Current
Liabilities
(Note : Quick Assets = Current Assets- Inventory &
prepaid expenses)
(Standard 1:1)

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Absolute Liquidity Ratio
 Cash & Bank Balance + Marketable Securities including
short term investment are super liquid assets.
 This ratio measures the ability in making the payment of
current liability if an immediate payment at a short notice is
to be made.
 Absolute Liquidity Ratio = (Cash & Bank Balance +
Marketable Securities including short term investment )/
Current Liabilities
(Standard 0.5:1)

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ASSESSING SOLVENCY –
SOLVENCY/ LEVERAGE RATIOS

 These ratios help in ascertaining the long term

solvency of a firm which depends basically on three
factors –
 Whether the firm has adequate resources to meet its
long term funds requirements.
 Whether the firm has used appropriate debt-equity
mix to raise long term funds.
 Whether the firm earns enough to pay interest &
instalment of long term loan in time.
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Prominent Solvency
Ratios –1
 Debt Equity Ratio (standard 2:1)
= Long Term Liabilities/Shareholders Net Worth
 Solvency/ or Total Indebtedness Ratio

= (Total outside liabilities)/Tangible net worth

 Fixed Assets Ratio

= Net fixed Assets/Net Capital Employed

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Prominent Solvency
Ratios –2
 Proprietary Ratio
= Shareholder’s Net Worth/Total Tangible Assets
 Debt Ratio

= Total Debt ( Long term debt & Current liabilities)/ Total

Tangible Assets
 Interest Coverage Ratio

= EBIT/Interest

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Different Sales Based
Profitability Ratios-1

 Gross Profit Ratio

= (Gross Profit / Net Sales)x100
 Operating Profit Ratio

= (Operating profit/ Net sales)x100

 Net Profit Ratio

= (Net profit/ Net sales)x100

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Measuring Overall Performance
In Relation To Investment –
Investment Based Profitability Ratios

 Profitability of a business enterprises can be measured in

terms of investment in different assets as well as in terms of
capital employed .
 Capital employed includes total long term funds used by a
business enterprises in financing its assets.
 To assess whether a firm has generated sufficient return on
the total funds employed in the firm specially long term
funds – debt funds and owners’ funds.

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Different Investment Based
Profitability Ratios
 Return on Investment (ROI)
= (EBIT/ Total Assets) * 100
 Return on Capital Employed (ROCE)

= (EBIT/Net Capital employed) * 100

 Return on Shareholders’ Net Worth (RONW)

= (EAT/ Shareholders’ Net Worth ) * 100

 Return on Equity Shareholders’ Net Worth

= {(EAT- Preference Dividend)/ Shareholders’ Net

Worth } * 100

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Capital Market Related Ratio

 These ratios are used with the aim the assess

financial performance from the angle of
investment or generally used by the investors
while making investment decision.
 Earning per share

= (EAT - preference dividend)/Number of equity

shares

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…..contd.

 Price Earning Ratio (P/E Ratio)

= Market Price per equity share/Earning per share
 Pay out Ratio

= (Dividend per equity share / Earning per equity

share)x100
 Dividend Yield Ratio

= (Dividend per share/ Market price per share)x100

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Efficiency in Using Resources –
Turnover Ratio
 Those ratio which indicate the efficiency of the
enterprise in the utilization of available funds,
particularly of a short term nature,
 Following ratios fall under this category
 Inventory Turnover Ratio

= Cost of goods sold/Average inventory

(instead of cost of goods sold sales can be used,
similarly instead of average inventory closing inventory
can be used)

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……contd.
 Average Inventory Holding Period
= 365/Inventory Turnover Ratio
 Average Debt Collection Period

= {(Bill receivable + Sundry Debtors)/ Annual Credit

Sales} * 365
 Average Payables Period

= {(Bills payable +Sundry Creditors)/Annual Credit

Purchases} x365

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….contd.

 FixedAssets Turnover Ratio

= Net Sales/ Fixed Assets

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Common Size Statement - Intra Firm
Comparison

 Common size statement is the presentation of income statement as well

as balance sheet as a proportion of certain common base value.
 While preparing common size statement each item of a particular
statement is presented as a percentage of the total value of the same
statement.
 In case of income statement each element of income statement is
represented as a percentage of sales value.
 Similarly in case of balance sheet each item of balance sheet is
represented as a percentage of total of balance sheet.
 The purpose of preparing common size statement is to identify each item
either as progressing or regressing with reference to the base figure.

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Trend Analysis – Vertical Financial
Performance Evaluation

 Trend analysis implies making an analysis of pattern of

ratios across different financial years of a business firm.
 Under this result of a particular ratio for the base (first) year
is taken equal to 100.
 Then ratio value for each of the subsequent financial year for
the same ratio is represented as a percentage to base year’s
value for the same ratio.
 By doing so increasing or decreasing trend in a particular
ratio can be identified.

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Precaution While Using Financial Ratios –
Limitation of Ratio Analysis

Apart from the accounting standards and accounting

policies one needs to observe general precaution while
using these statements these are as follows :
 Effect of window dressing
 Effect of changes in accounting practices
 Impact of historical cost concept
 Impact of fully depreciated assets
 Non-projection of Human Assets

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Stakeholders and
Ratio Analysis-1

Creditors and Suppliers View Point - Interpretation About

Liquidity Ratio
 Liquidity of a business organization translates into short-
term solvency.
 A firm is considered to be solvent in short-term if it has
sufficient liquid resources.
 Current ratio, Analysis of gap between current ratio and
liquid ratio are the prominent ratio used by creditors

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Stakeholders and
Ratio Analysis-2
Debenture holders’ View Point - Interpretation about
Solvency Ratios
 Solvency in general implies long term solvency, which
translates into the capacity of a business organization in
making the repayment of long term external liabilities –
repayment of long term loan and debentures.
 A firm is considered to be solvent if it has sufficient coverage
for the repayment of long term loan/debentures.
 Interpretation about Fixed to proprietary fund ratio,
Interpretation about Proprietary Ratio, Debt Equity Ratio,
Interest Coverage Ratio are used by debenture holders.

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Stakeholders and
Ratio Analysis-3

Investors and Shareholders’ View Point -

Interpretation about Profitability Ratios
 Profitability is analysed by all the stakeholders, may
it be shareholders, debenture holders, employees or
creditors.
 Comparison of Gross Profit and Operating Profit,
Comparison of Operating Profit Ratio and Net
Profit Ratio, Comparison of ROI and ROE are main
ratios used by shareholders

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Sources:

1. Dhanesh K Khatri, Financial Accounting, Tata

Mc –Graw Hill, 2011.
2. Paresh Shah, Financial Accounting for
Management 2e, Oxford Press, 2015.
3. S. N. Maheshwari, Sunil K Maheshwari,
Sharad K Maheshwari, Financial Accounting,
5e, Vikas Publications, 2013.

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