Lesson - 10

RATIO ANALYSIS

Ratio analysis is a tool used in financial statements. It is used to identify the

means of process in computing and determining relationship between the various items
in the financial statements. Ratio analysis interprets and asses the performance of assets
in the business. It is a quantitative investment technique used to compare company on a
relative basis with the market share. It is used as a yard stick to evaluate the financial
condition and performance of an organization.
Relationship between two items over the other is expressed in mathematical term
called as ratios. Ratio is not only expressed to show the relationship between two
numbers it also shows the strengths or weakness of the concern.
It measures the past and future trends of the organization.

Objectives of Ratio Analysis.

1. It helps the management in taking a valuable decision
2. It helps to gauge profitability and efficiency of an enterprise.
3. Ascertain the rate and direction of future potentiality.

Ratios of a concern have been divided into four categories such as

1. Liquidity ratio
2. Turnover ratio
3. Profitability ratio
4. Leverage ratio

Types of Ratio
I Liquidity ratio
It measures the ability to meet its short-term obligations of the organization. Easy
conversion of assets into cash is called liquidity. When a firm is in a sound liquidity
position, it will be useful to the management to have a strong and sound financial
position. Liquidity of the concern mainly depends on the firms current assets. If a firm
is not in a liquid position, it will be easily insolvent.
Liquidity ratios may be
1. Current ratio.
2. Acid test ratio.
3. Cash to current assets ratio.
4. Cash to working capital ratio.

1. Current ratio
It is the most widely used ratio in the business concern. Current ratio is calculated as

Current ratio = Current assets

Current liabilities
It is measured to meet the company’s short term obligations.
Current assets
They are the assets of the organization that are expected to convert into cash
easily as and when needed. Current assets do include cash, inventory, accounts
receivable, cash in hand, cash at bank, debtors and prepaid expenses.
Current liabilities
They are the amount due by the organization in a short span of period. They do
include.
1. Accounts payable
2. Accrued expenses
3. Sundry creditors
4. Short term debts
5. Dividends
6. Outstanding expenses
 The ideal ratio for current assets and liabilities is 2:1. If the ratio is more than 2
then there is no difficulty in the business operations to make payments in order to meet
its current liabilities. If the current ratio is less than 2 then the firm faces difficulty in
conducting the business.
Therefore high current ratio is essential for a business organization in order
to meet its short term funds and also to run a successful business.

2. Quick or acid test ratio

It is more or less same as the current ratio. It excludes inventory as they are
very slow to get converted into cash and also more uncertain to conversion price.

Quick or acid test ratio = Current assets – Inventory

Current liabilities
As the name indicates, it refers to the current assets that can be easily converted
in to cash within a short period. Current assets can be easily converted into cash and
also it is much useful for the creditors who lend money to the organization. More the
current assets of the organization easy for them to get loan form the creditors. In case of
any bankruptcy money can be easily got by converting these current assets into cash.
The ideal ratio for the acid test is 1:1. Organization is wise if they keep the
current equal to the liabilities of the concern. Low acid test ratio brings in more
problem to the concern as there are chances of insolvency if they are not able to meet
the short term obligations. It is much useful for a solvent firm.

3. Cash to current assets ratio

It has a direct proportion of the cash maintained to that of the current assets.
It maintains the level of cash in a concern. Lower ratio indicates greater profitability to
a concern. If the ratio is high it reveals a stock control over cash available. Cash given
in respect of the current assets can be had from the past experience.
Cash to current assets ratio = (Cash / Current Assets) * 100

4. Cash to Working Capital Ratio

Working Capital is the difference between current assets and current liabilities.
Cash inflow and outflow is a major concern over the business operations. If the
working capital is high then it indicates that the company is in sound financial position
and able to pay its short term obligations at times when needed.
Cash to Working Capital = Cash
Working Capital
Cash is an essential concern for the business. Cash is necessary to meet the day
to day expenses of the organization. Proportion of the cash is apportioned to the total
working capital to calculate the necessary cash balances available to the concern. If the
cash is low then it will not be useful for the concern to meet its current needs. Higher
cash to working capital ratio leads to shrinkage of profits.

II Turnover ratio
They are also called as activity ratio and useful for efficiency in the
management. Greater the turnover higher is the efficiency of the management. It
defines the relationship between the sales and the assets of a firm. Turnover ratios are.
1. Current assets turnover ratio.
2. Fixed assets turnover ratio.
3. Debtor’s turnover ratio.
4. Creditor’s turnover ratio.
5. Inventory ratio.

1. Current assets turnover ratio

They rely on the utilization of current assets to ascertain a reasonable turnover.
If the ratio is high it indicator that the current assets are circulated more and of higher
liquidity lower current ratio indicates stagnation of current assets.
Current assets turnover ratio = Sales
Current Assets

2. Fixed asset turnover ratio

It measures the efficiency of the organization with effect of utilization of funds
by the management in fixed assets such as land, building and machinery. If the fixed
assets turnover ratio is high, it indicates higher utilization of funds by the management
there by creating greater efficiency. Lower ratio indicates inefficiency of management
thereby leading to idle utilization of funds.

Fixed assets turnover ratio = Sales

Net fixed assets

3. Debtor’s turnover ratio

It measures the time needed to convert the debtors into cash. It is the test for the
liquidity of the firm.
Debtor’s turnover ratio is measured by
Net credit sales
Average debtors
The debtor’s turnover ratio uses the sales available only on credit. Credit sales
are the sales of the firm minus the return of sale available if any. Debtors are the total
numbers of debtor available to the concern within a year.
Debtor’s turnover ratio helps to measures the financial strength of the
concern, which is must useful for the investors. It shows the average amount of
payment available to the debtors. While calculating the debtor’s turnover ratio it will be
much useful for the organization to easily point out the customers who are facing any
financial issues.
Average collection period
The average collection period with respect to the Debtor’s Turn over ratio is
calculated as
Average collection period = Days in a year
Debtor’s turnover ratio
The days in a year are the 365 days available for the organization. It indicates
the number of days available to collect the receivables from the debtors. It helps to
evaluate the company’s credit and collection receivables.
Higher the debtor’s turnover ratio and lower the collection period indicates
effective credit management. Lower the debtor’s turnover ratio and higher the average
collection period indicates ineffective cash credit management and delay in repayment
of debtors. Therefore for an organization shorter the collection period is better for an
effective management in respect of average debtor’s receivables.

4. Creditors Turnover Ratio

Creditors Turnover Ratio are related with the average purchase made to the
creditors
Creditors turnover ratio = Net credit purchases
Average accounts payable
Accounts payable is trade creditors and bills payable. This ratio is done to
calculate the credit terms offered by the suppliers of the organization.
Higher creditor’s turnover ratio indicates that payments are not made to the
creditors where a lower creditor’s turnover ratio indicates the creditors are not taking
full advantage over the credit period.
Creditor’s turnover ratios do also calculate the average collection period required
for the payment of the purchase to the creditors.
Average collection period
It is measured to calculate the average payment period for the credit purchase to
the creditors. It is calculated as
Average collection period = Days in a year
Creditor’s turnover ratio
If the creditor turnover ratio is high and the average collection period for the
purchase is low it indicates that the creditors are being paid promptly and there is no
delayed payment in paying their credit purchases. Lower the creditor turnover ratio and
higher the average collection period indicates that the creditor’s payment is not paid in
time.
An organization should calculate both debtors and creditors turnover ratio to know
about the prompt payment both for credit purchase and credit sales.

5. Inventory turnover ratio

It measures how fast the inventory can be easily convertible into cash. Because
chances are more for inventory, to convert into receivables easily. Inventory establishes
the relationship between the cost of goods sold and inventory.

Inventory turnover ratio = Cost of goods sold

Average inventory
The average inventory is calculated by
Opening inventory + closing inventory
2
If the inventory turnover ratio is high it indicates a greater operating efficiency and
impels a higher inventory management. The inventory ratio being high indicates that
the firm incurs high stock out costs. If the inventory ratio is low it is really dangerous.
Lower inventory ratio is the result of lower inferior quality and obsolete goods.

III. Profitability ratio

It indicates the efficiency and the effectiveness of an investment for
organization profitability is the most important concern. It is a measure for the liquidity
and solvency for a firm. Profitability indicates the growth and the rate of return on the
investment made.
Profitability ratios are:
1. Gross profit ratio.
2. Net profit ratio.
3. Operating profit ratio.
4. Operating ratio.
5. Return on owner’s equity.
6. Earnings per share.
7. Return on capital employed.
8. Return on assets.

1. Gross Profit Ratio

It is the relationship between the gross profit and sales. Gross profit is arrived
after considering the sales and cost of goods sold. Net sales are the sales minus the
return of goods. Gross Profit is calculated after deducting sales from the cost of goods
sold. Gross profit is the profit earned before considering office and other administrative
expenses.
Gross profit ratio = (Gross Profit / Sales) * 100
If the gross profit ratio is high, it indicates much sales and an efficient cash
management. Lower gross profit ratio indicates that the organization is not able to have
more sales leading to an inefficient management

2. Net Profit Ratio

Net profit is assigned considering all the incomes and expenses. Gross profit,
which considers the cost of goods sold and sales, is also considered in Net Profit. Net
profit considers office, administrative, selling and factory expenses and also the
commission and dividend received.
Net profit Ratio = (Net Profit / Sales) * 100
 Net profit ratio indicates the overall profitability of a business concern. If the
Net Profit ratio is high it indicates that the firm is in a better high position. It is much
useful for the proprietors to know about the level of profitability

3. Operating Profit Ratio

Operating Profit Ratio = (Net Operating Profit / Sales) * 100
It measures the efficiency of the management with which the organization is
managed. Operating profit mainly measures the operating efficiency of the management
considering the gross profit ratio. Operating profit is calculated excluding the sale of
the fixed assets and other non operating expenses.

4. Operating Ratio
Operating expenses are the expenses included in operating a product a service.
The operating ratio establishes the relationship between operating expenses and sales.
Operating ratio is calculated as
(Cost of Goods Sold + Operating Expenses) / Sales * 100
If the operating ratio is high it indicates that the operating expenses are high
there by the profit margin is low therefore lower operating ratio is much essential for a
business.

5. Return on Owner’s Equity

The owner’s equity or shareholders fund is the amount invested by the share
holders in the organization. Shareholders have to be repaid from the investments made
in by them. Return on investments in respect of profits is known to the shareholders.
Profitability of the organization is judged using the return on shareholders equity.
Return on shareholders equity is calculated as:
Net Profit after interest and tax / Shareholder’s or Owner’s Equity * 100
All shareholders who invested in the concern will be much keen on knowing the
return on their investment made. This ratio helps to calculate it.
 This ratio helps to measure whether the firm has made a reasonable profit in
order to repay their return on investment. If the shareholders equity ratio is high it
indicates that the company is efficient in management and having more profit for the
better utilization of the shareholders funds and the organization productivity. Even the
shareholders are much satisfied because they are assured of a favorable dividend.
Lower shareholders equity ratio indicates poor profitability, productivity, and
inefficiency in management.

6. Earnings per share

It is the profit earned form the shareholders point of view. It is the profit earned
by the shareholders in each and every share held by the shareholders after deducting tax
and preference dividend from the net profit.
Earnings per share = Net profit after tax – Preference dividend
Number of equity share.
It indicates the wealth of each and every shareholder on the basis of the shares
held by them. Earnings per share have a direct indication over the performance and
prospects of the firm. If the earnings per share is high it indicates higher profit to the
concern thereby enabling the firm to issue more bonus shares to the shareholders. It
also affects the market price of the firm.

7. Return on capital employed

It is the maximum return expected on the capital invested. It is also known as
the return on investments. The firm’s total profitability is indicated through this ratio.
Return on capital employed = (Operating Profit / Capital Employed) * 100
Capital employed is calculated as (Share capital + Reserves + Long-term loans) - (Non-
business and Fictitious assets).
Operating profit is the profit before calculating interest and tax.
If the return on capital employed ratio is high it indicates that the funds are
properly invested and thereby the overall operating efficiency of the concern improves.
8. Return on Assets
Return on Assets is calculated = (Net Earnings/Total Assets) * 100
It is one of the most widely used ratios in the business concern. Since this ratio
determines how the assets are widely used in an organization it is used to analyze the
profitability of the concern.
The earning power of the assets is also calculated using this ratio thereby
measuring the overall efficiency of the firm. The overall financial position of the
concern is incomplete without assessing the profitability of the concern. If the
profitability of the concern is measured then the overall efficiency of the concern is also
determined.

III Leverage Ratios

Company/organization strength is determined mainly on the financial strength and
soundness of the organization. They are invested to determine the financial strength of
the organization. They are.
1. Debt equity ratio.
2. Debt to net worth
3. Capital gearing ratio.
4. Proprietary ratio.
5. Interest coverage ratio.
6. Financial leverage.

1.Debt equity ratio

Debt is a loan by the organization to third parties. Equity is the amount that
the organization own through its shareholders. The amount the company owes and
owns is compared to estimate this ratio. It measures the financial concern of the
organization. This ratio is quite satisfactory if the shareholders funds are equal to the
borrowed funds by the concern.
Debt Equity ratio is calculated as
Debt
Equity
Equity includes share capital and reserves where as the debt include both short and
long term funds.
Shareholders usually prefer a higher debt equity ratio because it would give
them a higher return of investment on each and every share held by them.
Lower debt equity ratio is preferred by the creditors as they are much worried
about the security of their investments. Companies with high debt equity ratio are
riskier to invest due to the fluctuation in the interest rates. If it is high they have to pay
more interest for the debt to be paid. Lower the debt equity ratio indicates a layer claim
for the equity of funds.

2.Debt to Net Worth

It is calculated as
(Debt / Total Funds) * 100
It calculates the percentage of the total funds. Higher ratio is safe for the concern.

3. Capital Gearing Ratio

It measures the relationship between the interest bearing securities and the
shareholders fund. It is calculated as
Capital Gearing Ratio = Fixed Interest Bearing Securities
Shareholder’s Funds
Interest – bearing securities are securities, which have a fixed rate of dividend and
include debentures and preference dividend. The ratio is interpreted as follows. Capital
gearing ratio more than one indicates that the firm is in a very good position and having
a strong share capital. If it is less than one, it indicates that the firm is in a low gearing
with respect to securities and funds. If it is equal to one, it indicates that the ratio is
even to all levels of the funds and securities. This ratio affects the firm’s capacity to
maintain a uniform dividend policy.

4.Proprietary ratio
The proportion of the assets towards the shareholders funds is identified
through this ratio. It is much useful to the creditors for whom it will be easy to find out
the proportion of the shareholders wealth on each asset. It is calculated as
Proprietary ratio = Net worth
Total assets
If the ratio is high it indicates the organization is financially sound to meet its
obligations and do not depend on the outside source funds.
Lower ratio indicates a smaller amount of owner’s funds over the capital and they
entirely depend on the outside organization for want of funds.

5. Interest coverage ratio

The interest coverage ratio is determined by
Interest coverage = EBIT
Interest
EBIT – Earnings before interest and taxes.
It determines the interest on the long term loan as concerned. As the interest is tax
deductible it uses the operating profit. The EBIT is determined to find out the ability to
service the debts which is not easily affected.
If the interest coverage is more it indicates the ability to manage the liabilities and
the payment of interest is made and assured by the organization.
If the interest coverage ratio is too low it indicates that the firm is using too much
of debt capacity to run its business and the payment of interest towards the creditors is
not assured.
 6. Financial leverage ratio
It determines the financial charges that are fixed in the finance stream. They are
not varied in respect of EBIT and operating profits. Irrespective of the earnings before
interest and taxes, these financial charges should be met to manage the effect of
financial changes on the earnings per share available to the shareholders.
Financial leverage is calculated as EBIT
EBT
Even if the financial leverage is high or low it indicates that the firm is in a very
sound position.
Leverage maintains relationship between the debt and equity financing. The funds
of the shareholders are invested in assets and these assets may be used as collateral to
obtain debt from outside source.

Other types of ratios

Fixed assets ratio

Fixed assets are used in the operations of a business. Fixed assets do include
Land and Building, Plant and machinery, Furniture etc .Investments in the fixed assets
are done by shareholders and are of permanent in nature. The types of fixed assets
ratios are:
1. Fixed assets to net worth.
2. Fixed assets to long-term funds.

1. Fixed assets to net worth

It establishes the relationship between the shareholders funds and the fixed assets of
the concern.
Fixed assets to net worth = Net fixed assets
Net worth.
 If the fixed assets ratio is high it indicates that creditors would have a lesser
protection towards them. Lesser the ratio indicates that the shareholders funds are
mostly financed by them.

Fixed assets to long term funds

This ratio establishes the relationship between fixed assets and long-term funds. It is
calculated as.
Fixed assets to long term funds = Fixed assets
Long-term funds
A lower ratio is preferable because it indicates the working capital is funded
through long-term funds. If it is high it is a dangerous position. Liability is more in such
assets therefore, it is not reliable. Fixed assets do include Investments, Land and
Building, Plant and Machinery. Long-term funds do include share capital reserves and
other borrowings.

DU PONT Model
The profitability of the company is analyzed with the elements of the income
statement.
DU PONT formula =
Return on assets = Net profit margin * Total assets turnover

Net profit margin = Net operating profit after tax

Sales
Total assets turnover = Sales
Average Net Sales

The DUPONT
1. Measures the assets to produce revenues.
2. Measure the assets for any ongoing operations in the business.
Uses of DUPONT model
1. Comparison with different business is made.
2. Impact over the company’s results can be easily studied.
3. The return on assets is examined and demonstrated.

Advantages of DUPONT model

1. Compensation schemes can be linked.
2. Management is convinced for sales functions.
3. It is very simple in comparing the results.

Disadvantages of DUPONT model

1. Cost of capital is excluded in the DUPONT model.
2. Only accounting numbers are done therefore it is not reliable.
All the incomes from the statements are integrated to calculate it. In the DUPONT
model, the numbers are collected and calculated based on the return on assets and
concluded based on the profitability of the concern.

Limitations of ratio analysis

1. Informational figures available through ratio analysis is outdated and do not
relate to the current or relevant date.
2. Ratio analysis is used to interpret the financial statements. They determine the
financial position of the concern but do not decide upon the performance as
whether it is good or bad.
3. Creative accounting is applied in ratio analysis to show its better performance
than financial accounting.
4. It is not useful for decision making because they are based on historical cost
form of accounting.
 5. Any changes in the accounting policy affect the compassion of results with the
precious years.
6. Changes in the accounting standards affects the enterprise in reporting and the
compassion of it over years.
7. Ratios cannot be used to compare accounting information between two
companies as the information may be misleading.
8. Comparison of the results over years with the help of ratios is not possible when
there is a high level of government influence on the organization.
9. Certain companies make their financial results look good for the purpose of
showing a great and high level of performance. Ratio prepared on the basis of
the above decent and irrelevant figures is unreliable.
10. Ratios are prepared on the basis of summarized accounting information.
Summarized information leave out certain mayor relevant information which is
not a true reflection of the company’s performance and results.
Ratio analysis is a useful tool but the above limitations be carefully looked upon.
Considering the above limitations if it is prepared wisely and intelligently it can
provide a better and efficient results.

Market value vs. book value

Market value
Market price is the price available in the market. It is the price at which the
shareholders are willing to buy the shares of the organization. Price earning ratio and
dividend yield is related to the market shares as the investors are much concerned about
the risk and return associated with the amount of money they invest. The market value
ratios are.
1. Dividend Cover
2. Dividend Yield
3. Earnings per share ratio
4. Price Earnings ratio
 1.Dividend Cover
It is the amount of profit available by the company that is to be paid to its
shareholders. Companies earned profit pay some portion as dividend and retain the
remaining part for the company for future purposes. Providing dividend to the
shareholders make them to have more and more investment in the organization. Even
some companies do not earn profit has to pay certain amount of dividend in order to
satisfy the shareholders.

2.Dividend Yield
It is the percentage of dividend per share on the current share price. It is an
important tool for the measurement of shares. If the dividend yield is high then it
indicates that the company is risky leaving that it is distributing a huge portion of profit
to the shareholders

3. Earnings per share ratio

It is the profit earned on each and every shareholder. It is considered after deducting
the dividend and tax based on the numbers of equity shares held.
Earnings per share = Net profit after tax – Preference dividend
Number of equity share.
If the EPS is more it attracts investors with the hope that the organization is more
profitable and pay dividends to the shareholders. Not all profits are paid as dividends to
the share holders certain amount is retained for future purpose.

4. Price Earnings Ratio

The price earnings ratio compares the values of the earnings of company with that
of the earnings of different companies mainly based on the overall market share.
Market value is determined based on the above ratios. Market price alone is not
essential there are other investments to be considered in determining the price value.
Book value
It is the total equity of a business. It distinguishes between the accounting value
and the market price. Book value is calculated by dividing the equity fund by the
number of shares. It can also be calculated by dividing the total assets by the total
number of shares.
Book value can be measured
1. As ‘Per Share’ value
2. Diluted per Share value.
1. Per Share Value → Equity value in the balance sheet is divided by the total
number of shares.
2. Diluted per share value → Equity shares is added with the exercise price or
warrants and then divided by the number of shares.
Price to book value
It is calculated as Market price of share
Book value per share
If the ratio is less than once it measures the stock at discount value. It means that
the market value is less than the total value of assets.
Uses of book value
1. It can be used to measure the earnings generated.
2. Book value is the only price indicators that are used when a business is
liquidated. For capital intensive industries the book value ratio is low because
they generate lower earnings. For human capital business the book value ratio is
high because they generate higher earnings. Sale of a share increase the book
value at the same time purchase of any additional shares decreases the book
value. Any dividend paid will decrease the book value and the book share.
Earnings/losses will increase/decrease the book value/share.

International issue
Common size ratio
Common size ratio is used to compare the financial statements of the
previous years. Standard financial statements are created thereby revealing trends of
how different company’s statements are compared. Common size statements are
prepared considering the incomes, revenues and expenses in the income statements and
the balance sheet which is expressed as total assets. The comparison in the common
size statements reveals the trends in the value obtained. Historical comparisons are
made with the common size statements. They compare business with other business
Common size ratio = Item of interest
Reference item.
Common size financial statements can be used to compare the financial records of
various companies at the same time. Companies of different sizes are compared.
Comparison of company’s is done by preparing the ratio analysis. Ratios are
calculated for each company’s and interpreted based on the results obtained from the
Liquidity, Turnover, Profitability and the Leverage ratios. The interpreted result is
given in one column and the respective average for each industry is calculated in
another column. Based on the items and interpretation in the financial statement the
comparison is made.

Limitations of common size financial statements

1. Accounting policies may be different to different industries.
2. Accounting calendars and periods to differ according to various business.

Effects of changes over price and inflation

Inflation
It is a negative impact on the economy. It may occur due to resource misallocation
transaction cost, shoeleather and menu cost. These costs affect the overall economy.
Inflation of the country if it is changing continuously it has a greater block on the
investment and consumption. This automatically turns business to become reluctant to
invest in new machinery. Consumers in turn are hesitant to spend as a result of
inflation.
Inflation causes changes in price level more frequently. These changes in costs
have a potential impact on the growth of the business and the profits to be earned.
Inflation therefore tends people to misinterpret the price and misallocate the resources
that are to be provided.
Inflation cost the economy an increase in the transaction cost. There are two types
of transaction cost. Such as shoeleather and menu costs.

Shoeleather Costs
It involves greater level of financial transactions. It represents the decline in the
value of money due to inflation. When the value of money is low people automatically
personalize their personal spending. Individual go for mutual funds shares which bring
in more money. Spend more time in series of financial transactions. It consumes more
time and effort and also money.

Menu costs
It is the change in the price of the business goods. Businesses consciously change
the price with new price stickers and tags. Inflation leads to changes in the price and
this automatically costs more.
They have an effect on the distribution of income and wealth. Relationship
between income and inflation, in terms of high inflation the worth of the fixed incomes
are less.