RATIO ANALYSIS

Meaning & Definition

• Ratio: The term ratio refers to the numerical or
quantitative relationship between two items /
variables.
• According to Wixon, Kell and Bedford, “a
ratio is an expression of the quantitative
relationship between two numbers’
• Ratio Analysis: the process of determining
and interpreting numerical relationship b/w
figures of the financial statements.
 Nature of ratio analysis
• Powerful tool for financial analysis
• Helps analyze financial statements more clearly
• They are not deciding factor , rather help to take
correct decisions.
• Serve as indicators of financial strength,
soundness,weakness & position of a concern
• Figures convey much meaning when studied in
relation to one another
 Inter-Firm & Intra-Firm
comparison
• Inter-firm comparison refers to comparison of
two or more firms organized by a trade
association with the objective of providing
information regarding the competitive position
of participating companies to improve
productivity & profitability.
• Intra-firm comparison refers to the
comparison of the different department or
divisions belonging to a single firm with a view
of ascertaining the strength & weaknesses of
the different departments.
 Conditions for inter-Firm
comparison
• Similarities of firm – nature, size, age,
capital, product…
• Uniformity in accounting procedure –
inventory, depreciation
• Disclosure of information
• Use of accounting ratios for comparison.
• The success depends on cooperation of all
participating firms, confidentiality, full
disclosure by all firms.
 Advantages of Ratio analysis
• Important technique of financial analysis
• Helps in judging financial health of a firm
• Helps in decision-making
• Useful in simplifying accounting figures
• Useful in judging operating efficiency
• Useful in forecasting & planning
• Useful in locating weak areas
• Useful in in comparison of performance
• Useful to all stakeholders
 Limitations of Ratio Analysis

• Limited use of a single ratio - Comparative study required

• Limitations of financial statements
• Only quantitative aspects
• Lack of adequate standards
• Problems of price level changes
• Changes in accounting procedures / polices
• Personal bias
• Ratios devoid of absolute figures may distort facts.
 CLASIFICATIONOF RATIOS

Traditional Functional Significance

Classification Classification Ratios

a. Profitabilit a. Primary
a. Balance
y Ratios Ratios
sheet
Ratios b. Turnover b. Secondary
Ratios Ratios
b. P & L A/C
Ratios c. Liquidity
Ratios
c. Composite
Ratios d. Long-term
solvency /
Leverage
Ratios
 Profitability Ratios
Based on Sales Based on Investments
• Gross Profit ratio • Return on investment
• Operating ratio • Return on capital
• Operating profit ratio employed
• Net profit ratio • Return on shareholder’s
• Expense ratio equity
• Return on Equity
shareholder’s funds
• Return on total Assets
• Earnings per share
• Price-Earning ratio
 Turnover ratios
1. Inventory / Stock turnover ratio
2. Debtors turnover ratio/Debtors velocity
3. Debt collection period
4. Creditors turnover ratio/Creditors velocity
5. Debt payment period
6. Fixed Assets turnover ratio
7. Total Asset turnover ratio
8. Capital turnover ratio
9. Working Capital turnover ratio
 Liquidity Ratios
1. Current Ratio
2. Liquid ratio/ Acid test ratio / quick ratio
3. Absolute liquid or Cash ratio
Leverage Ratios
1. Debt-Equity ratio
2. Debt to Shareholders equity
3. Debt to total funds ratio
4. Proprietary Ratio
5. Capital Gearing ratio
6. Interest Coverage ratio
7. Dividend coverage ratio
 Profitability Ratios
• Gross Profit Ratio: Gross Profit Ratio shows
the relationship between Gross Profit of the
concern and its Net Sales. Gross Profit Ratio can
be calculated in the following manner: -
• Gross Profit Ratio = Gross Profit/Net Sales x
100
• Where Gross Profit = Net Sales – Cost of Goods
Sold
• Cost of Goods Sold = Opening Stock + Net
Purchases + Direct Expenses – Closing Stock
• And Net Sales = Total Sales – Sales Return
 Gross Profit Ratio
• Gross Profit Ratio provides guidelines to the
concern whether it is earning sufficient profit to
cover administration and marketing expenses and
is able to cover its fixed expenses.
• It is desirable that this ratio must be high and
steady because any fall in it would put the
management in difficulty in the realisation of
fixed expenses of the business.
 Net Profit Ratio:
• Net Profit Ratio shows the relationship between
Net Profit of the concern and Its Net Sales. Net
Profit Ratio can be calculated in the following
manner: -
• Net Profit Ratio = Net Profit/Net Sales x 100
• Where Net Profit = Gross Profit – Selling and
Distribution Expenses – Office and
Administration Expenses – Financial Expenses –
Non Operating Expenses + Non Operating
Incomes.
• And Net Sales = Total Sales – Sales Return
 Net Profit Ratio:

• Objective and Significance:

This ratio is helpful to determine the
operational ability of the concern. While
comparing the ratio to previous years’
ratios, the increment shows the efficiency of
the concern.
 Operating Profit Ratio:
• Operating Profit Ratio shows the relationship
between Operating Profit and Net Sales. Operating
Profit Ratio can be calculated in the following
manner: -
• Operating Profit Ratio = Operating Profit/Net
Sales x 100
• Where Operating Profit = Gross Profit – Operating
Expenses
• Or Operating Profit = Net Profit + Non Operating
Expenses – Non Operating Incomes
• And Net Sales = Total Sales – Sales Return
• Objective and Significance: Operating
Profit Ratio indicates the earning capacity
of the concern on the basis of its business
operations and not from earning from the
other sources. It shows whether the business
is able to stand in the market or not.
 Operating Ratio:
• Operating Ratio matches the operating cost to the net
sales of the business. Operating Cost means Cost of
goods sold plus Operating Expenses.
• Operating Ratio = Operating Cost/Net Sales x 100
• Where Operating Cost = Cost of goods sold + Operating
Expenses
• Cost of Goods Sold = Opening Stock + Net Purchases +
Direct Expenses – Closing Stock
• Operating Expenses = Selling and Distribution
Expenses, Office and Administration Expenses, Repair
and Maintenance.
• Objective and Significance: Operating
Ratio is calculated in order to calculate the
operating efficiency of the concern. As this
ratio indicates about the percentage of
operating cost to the net sales, so it is better
for a concern to have this ratio in less
percentage. The less percentage of cost
means higher margin to earn profit.
 Return on Investment or Return
on Capital Employed
a. This ratio shows the relationship between the
profit earned before interest and tax and the
capital employed to earn such profit.
• Return on Capital Employed = Net Profit before Interest,
Tax and Dividend/Capital Employed x 100
• Where Capital Employed = Share Capital (Equity +
Preference) + Reserves and Surplus + Long-term Loans
– Fictitious Assets. OR
• Capital Employed = Fixed Assets + Current Assets –
Current Liabilities
 Objective and Significance
• ROCE measures the profit, which a firm earns on
investing a unit of capital.
• The return on capital expresses all efficiencies and
inefficiencies of a business.
• To shareholders it indicates how much their
capital is earning and to the management as to
how efficiently it has been working.
• This ratio influences the market price of the
shares.
• The higher the ratio, the better it is.
 Return on Equity
a. The ratio establishes relationship between profit
available to equity shareholders with equity
shareholders’ funds.
• Return on Equity = Net Profit after Interest,
Tax and Preference Dividend/Equity
Shareholders’ Funds x 100
• Where Equity Shareholders’ Funds = Equity
Share Capital + Reserves and Surplus –
Fictitious Assets
 Objective and Significance

• Return on Equity judges the profitability

from the point of view of equity
shareholders.
• This ratio has great interest to equity
shareholders.
• The investors favour the company with
higher ROE.
 Earning Per Share

• Earning per share is calculated by dividing

the net profit (after interest, tax and
preference dividend) by the number of
equity shares.
• Earning Per Share = Net Profit after
Interest, Tax and Preference
Dividend/No. Of Equity Shares
 Objective and Significance
• EPS helps in determining the market price of the
equity share of the company.
• It also helps to know whether the company is able
to use its equity share capital effectively when
compared to other companies.
• It also tells about the capacity of the company to
pay dividends to its equity shareholders.
 Price-Earning ratio
• Price-Earning ratio =
Market Price per Share
Earning per Share
• Indicates:

* Price which investors are ready to pay for every

rupee of earning