Ratio Analysis

Ratio means arithmetical relationship between two figures. Ratio analysis is a widely used tool of financial analysis. The technique of ratio analysis as a technique for interpretation of financial statements deals with computation of various ratios from the information appearing on financial statements with the intention of drawing fruitful conclusions there from.

Interpretation of Ratios
Use of ratios as tools of financial analysis involves their comparison as single ratios like absolute figures are not of much use. Three types of comparisons are generally involved: 1. Trend analysis/Time series Analysis 2. Inter firm comparison 3. Comparison with standard or industry average.
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Classification of Ratios
Ratios can be broadly classified into following four groups: 1.Liquidity Group 2.Solvency or Capital structure or Leverage. Group 3.Profitability Group 4.Turnover Group 5.Miscellaneous Group
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Liquidity Ratios
Liquidity ratio measures the ability of the firm to meet its short term obligations and reflects its short term financial strength. Commercial banks and short term creditors may basically be interested in these ratios Imp Liquidity ratios are 1.Current Ratio 2.Quick or acid test ratio. 3. Absolute Cash Ratio
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Current Ratio
It is the ratio of current assets to current liabilities. Current Assets/ current liabilities Interpretations: It indicates rupees of current assets available for each rupee of current liability. As such Higher the current ratio, better will be the situation. A higher current ratio may also indicate unnecessarily higher investments in current assets in form of inventory or receivables. Current Ratio of 2:1 is supposed to be standard and ideal In this components of CA are not differentiated
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Liquid ratio or Quick ratio

It is 1. Liquid assets Liquid liabilities 2. Liquid assets Current liabilities Liquid assets includes all current assets except inventories and prepaid expenses. Liquid liabilities includes all current liabilities except bank overdraft or cash credit. Interpretations: IT indicates rupees of quick assets available for each rupee of current liability. A liquid ratio of 1:1is supposed to be standard and ideal.
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Absolute Cash Ratio

Absolute Cash Ratio is :

Cash and Marketable Securities Current Liabilities Objective: the objective of this ratio is to measure the ability of enterprise to meet its short term obligations as and when due without relying upon realization of stocks and debtors. Interpretation: It indicates cash and

marketable securities available for each rupee of current liability.

Solvency or Capital Structure or leverage Ratios

This ratio indicates the long term solvency of the firm. This is indicated in its ability to assure the long term creditors with regards to periodic payment of interest and repayment of loan on maturity or in pre-determined instalment on due date. They are two types of such ratio: 1.Debts Equity: Assets based 2.Coverage Ratio: income based.
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Debt Equity OR Asset Based Ratios or Balance Sheet Ratios

Debt Equity Ratio Proprietary Ratio Capital Gearing Ratio

Coverage Ratios
1.Interest Coverage Ratios 2. Preference Dividend Coverage Ratio 3. Debt Service Coverage Ratio

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1. Debt equity Ratio

It may be calculated in two ways: 1. Total External liabilities Shareholders funds

2.Long term Liabilities Shareholders funds Shareholders s funds means equity. .

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Indications: Debt equity ratio indicates the stake of shareholders or owners in the organization with respect to that of creditors. A high debt equity ratio indicates that financial stake of creditors is more than that of owners. A very high debt equity ratio makes the proposition of investment in the organization a risky one. A low debt equity ratio indicates that borrowing capacity of the organization is underutilized.
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2. Proprietary Ratio
This ratio indicates the relationship between the owners funds( equity) and total assets. Proprietary ratio= proprietors funds *100 total assets Interpretation: This ratio indicates the extent to which the assets of the enterprise have been financed out of Proprietors funds. Traditionally a proprietary ratio of 1:4 is considered satisfactory .

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3. Capital Gearing Ratio

It is calculated as : Funds bearing fixed financial payments Equity Shareholder Funds Fixed income bearing securities consists of preference share capital, debentures, long term loans.

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Indications: A high capital gearing ratio indicates that in capital structure, fixed income bearing securities are more in comparison to equity share capital. It also indicates the extent of risk to which company is subject and also the opportunity for trading on equity. It indicates the margin of safety available to the supplier of funds bearing fixed financial payments.
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Coverage Ratios: Income based

1. Interest Coverage Ratios:

EBIT (Earning before interest and taxes) Interest In this denominator considers the interest charges which is in the form of interest on long term borrowing and not the interest on working capital facilities.

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Indications: This ratio indicates the protection available to lenders of long term capital in the form of funds available to pay interest charges.

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2. Preference Dividend Coverage Ratio : Net profit after interest and taxes Preference Dividend Objective of this ratio is to measure the preference share servicing capacity of a firm so far as fixed dividend on preference shares is concerned.

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3. Debt Service Coverage Ratio. (DSCR) This is one of the most imp ratios calculated by bankers giving long term finances to the organization. net profit after taxes+ depreciation+ interest Interest on long term loans+ installment on long term loan

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Indications: This ratio is calculated to ascertain the capabilities of organization to repay the dues arising as a result of long term borrowing. Too low a DSCR indicates the insufficient earnings capacity of the organization to meet the obligations of long term borrowings.

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3. Profitability Ratios.
Profitability of a firm is measured on the basis of this ratio. Such ratios can be computed either on sales or investments. Some Profitability ratios based on sales are: 1.Gross profit ratios 2 Operating Profit Ratio 3. Net profit ratio

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Profitability ratio based on investments are: 1.Return on capital Employed 2.Return on equity or return on share holders funds 3.Return on equity share holders funds

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Gross profit ratio

Gross profit ratio = Gross profit*100 Sales Gross profit is the difference between net sales and cost of goods sold. Objective: the main objective is to determine the efficiency with which production/ purchase and sales operations are carried on.

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Interpretations: This ratio indicates: 1. Average gross margin earned on the sale of Rs 100 2. What portion of sales is left to cover operating and non operating expenses.

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Operating profit ratio

It is Operating profit*100 Sales Operating Profit is the excess of Gross Profit over other operating expenses. Objective: is to determine the operational efficiency of the management.

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Interpretation:1. It indicates the operational margin earned on a sale of Rs 100 2. It also indicates the portion of sales is available to cover non operating expenses.

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Net Profit Ratio

Net Profit ratio= Net profit*100 sales This ratio shows the earning left for shareholders as a percentage of net sales. It measures the overall efficiency of all the functions of a business firm like production, administration, selling, financing, pricing etc. this ratio reveals the overall profitability of the concern. Higher the ratio better it is.
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Operating Ratio
Cost of goods sold +operating expenses*100 Net sales This ratio is reciprocal to operating profit to sales ratio. Non operating expenses and non operating incomes are excluded from this ratio. The higher this ratio, the lower is the margin for operating profit. This ratio can be further analyzed to find out the percentage of each types of expenses to sales.
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Return on capital employed.

This is profit before interest & tax *100 Capital Employed Capital employed = Equity capital + preference capital +reserve and surplus+ long term debtfictitious assets This ratio is very important because it reflects the overall efficiency with which the capital is used. This ratio should be compared with the ratio of other business in the same industry to find out exact position of that business.
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Return on Equity
This is Net profit after interest and Taxes *100 shareholders funds This ratio indicates the firms ability to generate profit per rupee of share holders funds. Higher the ratio the more efficient the management and utilization of share holders funds.

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Return on Equity share holder funds

This is Net Profit available for *100 Equity shareholders Equity shareholders funds Numerator is Net profit after interest , tax and preference dividend . This ratio indicates the productivity of owners capital employed in the firm. In inflationary period, in judging the profitability of the firm, the ratio may show an upward trend as numerator represents current value and denominator shows historical values.
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Turn Over Ratios

These ratios are also known as activity ratios or asset management ratios. This ratios helps to find out how well the facilities at disposal are being used. Higher turnover ratios indicates better utilization of resources. 1.Working capital turnover ratio 2. Fixed assets turnover ratios 3. Capital turn over ratio 4. Debtors Turnover ratios 5.Creditors turnover ratios 6.Inventory turnover ratios
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Working capital Turnover Ratios

It is Net Sales Net Working capital It indicates the ability of firm to generate sales per rupee of working capital. Higher ratio indicates the capabilities of the organization to achieve maximum sales with minimum investment in working capital. As such higher the ratio better will be the situation.

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Fixed asset turnover Ratio

Sales (Net) Net Fixed Assets This ratio indicates firms ability to generate sales per Rupee of fixed assets. A high fixed assets ratio indicates the capabilities of the organization to achieve maximum sales with minimum investment in fixed assets It is the indication of efficiency of using fixed assets in the business. Higher this ratio better will be the situation. .
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It is

Capital Turnover Ratio

This ratio indicates the firms ability to generate sales per rupee of capital It is Sales(Net) Capital Employed Denominator includes Shareholders Fund+ Long term liabilities. Higher the ratio more efficiently is the capital used.

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Debtor Turnover Ratio

This Ratio indicates the credit policy followed by the firm. This ratio is Credit Sales(net) average debtors . This ratio indicates number of times debtors have made payments. Higher the ratio, lower is the collection period. An average collection period which is shorter than the credit period allowed by the firm needs to be analyzed carefully. It may mean efficient credit management or excessive conservatism in credit granting.
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Creditors turnover Ratio

This ratio indicates credit period allowed to the creditors. It is Credit Purchase Average accounts payable A high turnover ratio indicates that payment to creditors is quite prompt but it also implies that full advantage of credit allowed by creditors is not taken . A low ratio indicates that payment to creditors is not quite prompt and it needs to be improved/
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Inventory/ Stock turnover ratio

It is Cost of Goods sold Average Stock during that period. The ratio determines the efficiency with which inventory is converted into sales. Higher the ratio, better it is as it shows rapid turnover of stock. A low turnover ratio is indicative of slow moving stock.

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Miscellaneous Group
Earning Per share Price Earning Ratio Dividend Payout Ratio

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Earning Per Share

It is calculated as Net Profit after taxes-Preference Dividend Number of Equity shares outstanding indications: It is widely used ratio to measure the profit available to the equity share holders.However it does not indicates how much of the earning are paid to owners by way of dividend and how much is retained in business.
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Price Earning Ratio

It is calculated as: Market Price Per share*100 Earning Per share Indications: This ratio indicates the price currently being paid in the market for each rupee of EPS. It measures the expectations of Investors. This is important ratio from the point of view of investors. The investors will be reluctant to invest in shares with low P/E ratio.
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Dividend Payout Ratio

It is calculated as Dividend Per Share *100 Earning Per share Indications: It measures the relationship between earnings belonging to equity shareholders and amount finally paid to them as dividend. It indicates the policy of management to pay cash dividend.
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Importance of Ratio Analysis

Ratio Analysis is helpful is assessing the performance of the firm in respect of the following aspects: 1. Liquidity Position 2. Long term Solvency 3. Operating Efficiency 4. Overall profitability 5. Inter and Intra Firm Comparison 6. Trend Analysis

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Limitations Of Ratio analysis

1. 2. 3.

4.
5. 6. 7. 8.

Only quantitative analysis and not qualitative analysis Historical Analysis Impact of Inflation Subjectivity Inadequate Only symptoms and not cure Accuracy of accounts to be considered Difference in Accounting policies
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