RATIO ANALYSISRATIO ANALYSIS

Ratio analysis is the process of determining and Ratio analysis is the process of determining and interpreting numerical relationship based on interpreting numerical relationship based on financial statements. It is the technique of financial statements. It is the technique of interpretation of financial statements with the help interpretation of financial statements with the help of of accountingaccounting ratiosratios derived from the balance derived from the balance sheet and profit and loss account.sheet and profit and loss account.

Basis Of ComparisionBasis Of ComparisionTrend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance – improvement, deterioration or constancy – over the years.

. Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firm’s performance in relation to its competitors

Comparison with standards or industry average

Classification Of RatiosClassification Of Ratios

Analysis of Short Term Financial Position Analysis of Short Term Financial Position or Test of Liquidity.or Test of Liquidity.

Analysis of Long Term Financial Position Analysis of Long Term Financial Position or Test of Solvency.or Test of Solvency.

Activity Ratios.Activity Ratios.

Profitability Ratios.Profitability Ratios.

I. Test Of LiquidityI. Test Of Liquidity

The liquidity ratios are used to test the short term The liquidity ratios are used to test the short term solvency or liquidity position of the business.solvency or liquidity position of the business.

It enables to know whether short term liabilities can be It enables to know whether short term liabilities can be paid out of short term assets.paid out of short term assets.

It indicates whether a firm has adequate working It indicates whether a firm has adequate working capital to carry out routine business activity.capital to carry out routine business activity.

It is a valuable aid to management in checking the It is a valuable aid to management in checking the efficiency with which working capital is being efficiency with which working capital is being employed.employed.

It is also of importance to shareholders and long term It is also of importance to shareholders and long term creditors in determining to some extent the prospects creditors in determining to some extent the prospects of dividend and interest payment.of dividend and interest payment.

Important Ratios In Test Of Important Ratios In Test Of LiquidityLiquidity

Current ratio.Current ratio.

Quick ratio.Quick ratio.

Absolute liquid ratio.Absolute liquid ratio.

Current RatioCurrent RatioIt is the most widely used of all analytical devices based on the balance sheet. It establishes relationship between total current assets and current liabilities.

Current assets Current assets Current ratio=Current ratio= Current liabilitiesCurrent liabilities

Ideal ratio:Ideal ratio: 2:1 2:1

High ratio indicates under trading and over High ratio indicates under trading and over capitalization.capitalization.

Low ratio indicates over trading and under capitalization.Low ratio indicates over trading and under capitalization.

Quick Ratio or Acid Test RatioQuick Ratio or Acid Test RatioIt establishes relationship between liquid assets and It establishes relationship between liquid assets and liquid liabilities. It is a refinement to current ratio and liquid liabilities. It is a refinement to current ratio and second testing device for working capital.second testing device for working capital.

Quick assetsQuick assetsQuick ratio=Quick ratio= Current liabilitiesCurrent liabilities

Ideal ratioIdeal ratio: 1:1: 1:1

Usually, a high acid test ratio is an indication that the Usually, a high acid test ratio is an indication that the firm is liquid and has ability to meet its current or liquid firm is liquid and has ability to meet its current or liquid liabilities in time and on the other hand a low quick ratio liabilities in time and on the other hand a low quick ratio represents that the firm’s liquidity position is not good.represents that the firm’s liquidity position is not good.

Absolute Liquidity RatioAbsolute Liquidity Ratio

This ratio establishes a relationship between absolute This ratio establishes a relationship between absolute liquid assets to quick liabilities.liquid assets to quick liabilities.

Absolute liquid assetsAbsolute liquid assetsAbsolute liquid ratio=Absolute liquid ratio= Quick liabilitiesQuick liabilities

Ideal ratioIdeal ratio: 1:2: 1:2

It means that if the ratio is 1:2 or more than this the It means that if the ratio is 1:2 or more than this the concern can be taken as liquid. If the ratio is less than concern can be taken as liquid. If the ratio is less than the standard of 1:2, it means the concern is not liquid.the standard of 1:2, it means the concern is not liquid.

II. Test Of SolvencyII. Test Of Solvency

Long term solvency ratios denote the Long term solvency ratios denote the ability of the organisation to repay the loan ability of the organisation to repay the loan and interest.and interest.When an organization's assets are more When an organization's assets are more than its liabilities is known as solvent than its liabilities is known as solvent organisation.organisation.Solvency indicates that position of an Solvency indicates that position of an enterprise where it is capable of meeting enterprise where it is capable of meeting long term obligations.long term obligations.

Important Ratios In Test Of Important Ratios In Test Of SolvencySolvency

Debt-equity ratio.Debt-equity ratio.

Proprietary ratio.Proprietary ratio.

Solvency ratio.Solvency ratio.

Debt Equity RatioDebt Equity RatioIt Is calculated to measure the relative claims of It Is calculated to measure the relative claims of outsiders and the owners against the firm’s assets. This outsiders and the owners against the firm’s assets. This ratio indicates the relationship between the total debt ratio indicates the relationship between the total debt funds and the shareholders’ funds.funds and the shareholders’ funds.

Total debtTotal debtDebt equity ratio=Debt equity ratio= Shareholders EquityShareholders Equity

Ideal ratioIdeal ratio: 2:1; It means for every 2 shares there is 1 : 2:1; It means for every 2 shares there is 1 debt. If the debt is less than 2 times the equity, it means debt. If the debt is less than 2 times the equity, it means the creditors are relatively less and the financial the creditors are relatively less and the financial structure is sound. If the debt is more than 2 times the structure is sound. If the debt is more than 2 times the equity, the state of long term creditors are more and equity, the state of long term creditors are more and indicate weak financial structure.indicate weak financial structure.

Proprietary Ratio or Net Worth Proprietary Ratio or Net Worth RatioRatio

It establishes relationship between the proprietors fund It establishes relationship between the proprietors fund or shareholders funds and the total assetsor shareholders funds and the total assets

Equity Equity Equity to Asset ratio = Equity to Asset ratio = Total assets Total assets

Ideal ratioIdeal ratio: 0.5:1: 0.5:1

Higher the ratio better the long term solvency (financial) Higher the ratio better the long term solvency (financial) position of the company. This ratio indicates the extent position of the company. This ratio indicates the extent to which the assets of the company can be lost without to which the assets of the company can be lost without affecting the interest of the creditors of the companyaffecting the interest of the creditors of the company

Solvency RatioSolvency Ratio

It expresses the relationship between total assets and It expresses the relationship between total assets and total liabilities of a business. This ratio is a small variant total liabilities of a business. This ratio is a small variant of equity ratio and can be simply calculated as of equity ratio and can be simply calculated as

100-equity ratio100-equity ratio Total assetsTotal assetsSolvency ratio=Solvency ratio= Total liabilitiesTotal liabilities

No standard ratio is fixed in this regard. It may be No standard ratio is fixed in this regard. It may be compared with similar, such organizations to evaluate compared with similar, such organizations to evaluate the solvency position. Higher the solvency ratio, the the solvency position. Higher the solvency ratio, the stronger is its financial position and vice-versa.stronger is its financial position and vice-versa.

III. Activity RatioIII. Activity Ratio

Activity ratios indicate the performance of an Activity ratios indicate the performance of an organisation.organisation.

This indicate the effective utilization of the This indicate the effective utilization of the various assets of the organisation.various assets of the organisation.

Most of the ratio falling under this category is Most of the ratio falling under this category is based on turnover and hence these ratios are based on turnover and hence these ratios are called as turnover ratios.called as turnover ratios.

Important Ratios In Activity RatioImportant Ratios In Activity Ratio

Inventory turnover ratio.Inventory turnover ratio.Receivable turnover ratio.Receivable turnover ratio.Payable turnover ratio.Payable turnover ratio.Wording capital turnover ratio.Wording capital turnover ratio.Current assets turnover ratio.Current assets turnover ratio.Total assets turnover ratio.Total assets turnover ratio.

Inventory Turnover RatioInventory Turnover RatioThis ratio establishes the relationship between the cost This ratio establishes the relationship between the cost of goods sold during a given period and the average of goods sold during a given period and the average sock holding during that period. It tells us as to how sock holding during that period. It tells us as to how many times stock has turned over (sold) during the many times stock has turned over (sold) during the period. Indicates operational and marketing efficiency. period. Indicates operational and marketing efficiency. Helps in evaluating inventory policy to avoid over Helps in evaluating inventory policy to avoid over stocking.stocking. Cost of goods soldCost of goods soldInventory turnover ratio=Inventory turnover ratio= Average InventoryAverage InventoryCost of goods sold= sales-gross profitCost of goods sold= sales-gross profit Beg Inventory + purchases – closing stock Beg Inventory + purchases – closing stock Opening stock + Closing stockOpening stock + Closing stockAverage stock= Average stock= 22

Interpretation Of Inventory Interpretation Of Inventory Turnover RatioTurnover Ratio

Ideal ratioIdeal ratio: 8 times; A low inventory turnover may : 8 times; A low inventory turnover may reflect dull business, over investment in inventory, reflect dull business, over investment in inventory, accumulation of stock and excessive quantities of accumulation of stock and excessive quantities of certain inventory items in relation to immediate certain inventory items in relation to immediate requirements.requirements.

A high ratio may not be accompanied by a relatively A high ratio may not be accompanied by a relatively high net income as, profits may be sacrificed in high net income as, profits may be sacrificed in obtaining a large sales volume (unless accompanied obtaining a large sales volume (unless accompanied by a larger total gross profit). It may indicate under by a larger total gross profit). It may indicate under investment in inventories. But generally, a high stock investment in inventories. But generally, a high stock turnover ratio means that the concern is efficient and turnover ratio means that the concern is efficient and hence it sells its goods quickly. hence it sells its goods quickly.

Receivable Turnover RatioReceivable Turnover RatioThis ratio explains the relationship of net credit sales of This ratio explains the relationship of net credit sales of a firm to its book debts indicating the rate at which cash a firm to its book debts indicating the rate at which cash is generated by turnover of receivables or debtors.is generated by turnover of receivables or debtors.

The purpose of this ratio is to measure the liquidity of the The purpose of this ratio is to measure the liquidity of the receivables or to find out the period over which receivables or to find out the period over which receivables remain uncollected.receivables remain uncollected. Net credit salesNet credit salesReceivable turnover =Receivable turnover = Average ReceivableAverage Receivable Opening balance + closing balance Opening balance + closing balance Average Receivable =Average Receivable = 22

Debtors include bills receivables along with book debtsDebtors include bills receivables along with book debts

Average Collection PeriodAverage Collection Period

Number of working day in yearNumber of working day in year

Average collection period=Average collection period=

Debtor turnover ratioDebtor turnover ratio

The average collection period represents the average The average collection period represents the average number of days for which a firm has to wait before its number of days for which a firm has to wait before its receivables are converted into cashreceivables are converted into cash

Interpretation Of Debtor Turnover Interpretation Of Debtor Turnover RatioRatio

Ideal ratioIdeal ratio: 10 to 12 times; debt collection : 10 to 12 times; debt collection period of 30 to 36 days is considered ideal.period of 30 to 36 days is considered ideal.

A high debtor turnover ratio or low collection A high debtor turnover ratio or low collection period is indicative of sound management period is indicative of sound management policy.policy.

The amount of trade debtors at the end of The amount of trade debtors at the end of period should not exceed a reasonable period should not exceed a reasonable proportion of net sales. Larger the trade debtors proportion of net sales. Larger the trade debtors greater the expenses of collection.greater the expenses of collection.

Payable Turnover RatioPayable Turnover RatioThis ratio indicates the number of times the creditors are This ratio indicates the number of times the creditors are paid in a year. It is useful for creditors in finding out how paid in a year. It is useful for creditors in finding out how much time the firm is likely to take in repaying its trade much time the firm is likely to take in repaying its trade creditors.creditors. Net credit purchases Net credit purchases Payable turnover ratio=Payable turnover ratio= Average creditorsAverage creditors

Opening balance + closing balanceOpening balance + closing balanceAverage creditors=Average creditors= 22

Number of working daysNumber of working daysAverage payment period=Average payment period= Payable turnover ratio Payable turnover ratio

Interpretation Of Creditor Turnover Interpretation Of Creditor Turnover RatioRatio

Ideal ratioIdeal ratio: 12 times; debt payment period of : 12 times; debt payment period of 30 days is considered ideal.30 days is considered ideal.

Very less creditors turnover ratio, or a high debt Very less creditors turnover ratio, or a high debt payment period may indicate the firms inability payment period may indicate the firms inability in meeting its obligation in time.in meeting its obligation in time.

Working Capital Turnover RatioWorking Capital Turnover RatioThis ratio indicates the number of times the working This ratio indicates the number of times the working capital is turned over in the course of the year. capital is turned over in the course of the year. Measures efficiency in working capital usage. It Measures efficiency in working capital usage. It establishes relationship between cost of sales and establishes relationship between cost of sales and working capital working capital

Cost of salesCost of salesWorking capital turnover ratio=Working capital turnover ratio= Average working capitalAverage working capital

Opening + closing workingOpening + closing working capitalcapitalAverage working capital=Average working capital= 22

Interpretation of Working Capital Interpretation of Working Capital Turnover RatioTurnover Ratio

A higher ratio indicates efficient utilization A higher ratio indicates efficient utilization of working capital and a low ratio indicates of working capital and a low ratio indicates inefficient utilization of working capital.inefficient utilization of working capital.

But a very high ratio is not a good situation But a very high ratio is not a good situation for any firm and hence care must be taken for any firm and hence care must be taken while interpreting the ratio. while interpreting the ratio.

Total Asset Turnover RatioTotal Asset Turnover RatioThis ratio establishes a relationship between total assets This ratio establishes a relationship between total assets and sales. This ratio enables to know the efficient and sales. This ratio enables to know the efficient utilisation of total assets of a business.utilisation of total assets of a business.

Net salesNet salesTotal assets turnover ratio=Total assets turnover ratio= Total assetsTotal assets

Ideal ratioIdeal ratio: 2 times: 2 times

High ratio indicates efficient utilization and ratio less than High ratio indicates efficient utilization and ratio less than 2 indicates under utilization.2 indicates under utilization.

IV. Profitability RatioIV. Profitability Ratio

Profitability ratios indicate the profit earning Profitability ratios indicate the profit earning capacity of a business.capacity of a business.

Profitability ratios are calculated either in Profitability ratios are calculated either in relation to sales or in relation to investments.relation to sales or in relation to investments.

Profitability ratios can be classified into two Profitability ratios can be classified into two categories. categories.

a) General Profitability Ratios.a) General Profitability Ratios.

b) Overall Profitability Ratios. b) Overall Profitability Ratios.

General Profitability RatiosGeneral Profitability Ratios

Gross profit ratio.Gross profit ratio.

Net profit ratio.Net profit ratio.

Operating ratio.Operating ratio.

Operating profit ratio.Operating profit ratio.

Gross Profit RatioGross Profit Ratio

It expresses the relationship of gross profit to net sales It expresses the relationship of gross profit to net sales and is expressed in terms of percentage. This ratio is a and is expressed in terms of percentage. This ratio is a tool that indicates the degree to which selling price of tool that indicates the degree to which selling price of goods per unit may decline without resulting in losses.goods per unit may decline without resulting in losses.

Gross profitGross profitGross profit ratio= X 100Gross profit ratio= X 100 Net salesNet sales

A low gross profit ratio may indicate unfavorable A low gross profit ratio may indicate unfavorable purchasing, the instability of management to develop purchasing, the instability of management to develop sales volume thereby making it impossible to buy goods sales volume thereby making it impossible to buy goods in large volume.in large volume.

Higher the gross profit ratio better the results. Higher the gross profit ratio better the results.

Net Profit RatioNet Profit Ratio

It expresses the relationship between net profit after It expresses the relationship between net profit after taxes to sales. Measure of overall profitability useful to taxes to sales. Measure of overall profitability useful to proprietors, as it gibes an idea of the efficiency as well proprietors, as it gibes an idea of the efficiency as well as profitability of the business to a limited extent.as profitability of the business to a limited extent.

Net profit after taxesNet profit after taxesNet profit ratio= X 100Net profit ratio= X 100 Net sales Net sales

Higher the ratio better is the profitabilityHigher the ratio better is the profitability

Operating RatioOperating RatioThis ratio establishes a relationship between cost of This ratio establishes a relationship between cost of goods sold plus other operating expenses and net sales. goods sold plus other operating expenses and net sales. This ratio is calculated mainly to ascertain the This ratio is calculated mainly to ascertain the operational efficiency of the management in their operational efficiency of the management in their business operations.business operations. Cost of goods sold + operating expensesCost of goods sold + operating expensesOperating ratio=Operating ratio= Net salesNet sales

Higher the ratio the less favorable it is because it would Higher the ratio the less favorable it is because it would leave a smaller margin to meet interest, dividend and leave a smaller margin to meet interest, dividend and other corporate needs. For a manufacturing concern it is other corporate needs. For a manufacturing concern it is expected to touch a percentage of 75% to 85%. This expected to touch a percentage of 75% to 85%. This ratio is partial index of over all profitability.ratio is partial index of over all profitability.

Operating Profit RatioOperating Profit Ratio

This ratio establishes the relationship between This ratio establishes the relationship between operation profit and net sales.operation profit and net sales.

Operating profitOperating profitOperating profit ratio= X 100Operating profit ratio= X 100 Net salesNet sales

Operating profit ratio= 100-operating ratioOperating profit ratio= 100-operating ratio

Operating profit= Net sales – ( cost of goods sold + Operating profit= Net sales – ( cost of goods sold + Administrative and office expenses + selling and Administrative and office expenses + selling and distributive expenses.distributive expenses.

Test Of Overall ProfitabilityTest Of Overall Profitability

Return on shareholders investment or Net Return on shareholders investment or Net worth ratio.worth ratio.Return on equity capital.Return on equity capital.Return on capital employed.Return on capital employed.Return on total resources.Return on total resources.Dividend yield ratio.Dividend yield ratio.Dividend pay out ratio.Dividend pay out ratio.Earning per share. Earning per share.

Return On Shareholders Return On Shareholders InvestmentInvestment

Shareholders investment also called return on Shareholders investment also called return on proprietor’s funds is the ratio of net profit to proprietor’s proprietor’s funds is the ratio of net profit to proprietor’s funds. It is calculated by the prospective investor in the funds. It is calculated by the prospective investor in the business to find out whether the investment would be business to find out whether the investment would be worth-making in terms of return as compared to the risk worth-making in terms of return as compared to the risk involved in the business.involved in the business. Net profit (After tax and int)Net profit (After tax and int)Return on shareholders investment=Return on shareholders investment= Proprietors fundsProprietors funds

Return On Shareholders Return On Shareholders InvestmentInvestment

This ratio is of great importance to the present and This ratio is of great importance to the present and prospective shareholders as well as the management of prospective shareholders as well as the management of the company. As this ratio reveals how well the the company. As this ratio reveals how well the resources of a firm are being used, higher the ratio, resources of a firm are being used, higher the ratio, better are the results. The return on shareholders better are the results. The return on shareholders investment should be compared with the return of other investment should be compared with the return of other similar firms in the same industry. The inter firm similar firms in the same industry. The inter firm comparision of this ratio determines whether their comparision of this ratio determines whether their investments in the firm are attractive or not as the investments in the firm are attractive or not as the investors would like to invest only where their return is investors would like to invest only where their return is higher. Similarly, trend ratios can also be calculated for higher. Similarly, trend ratios can also be calculated for a number of years to get5 an idea of the prosperity, a number of years to get5 an idea of the prosperity, growth of deterioration in the company’s profitability and growth of deterioration in the company’s profitability and efficiency.efficiency.

Return On Equity CapitalReturn On Equity Capital

This ratio establishes the relationship between net profit This ratio establishes the relationship between net profit available to equity shareholders ad the amount of capital available to equity shareholders ad the amount of capital invested by them. It is used to compare the performance invested by them. It is used to compare the performance of company's equity capital with those of other of company's equity capital with those of other companies, and thus help the investor in choosing a companies, and thus help the investor in choosing a company with higher return on equity capital.company with higher return on equity capital.

Net profit – preference dividend Net profit – preference dividend Return on equity capital=Return on equity capital= Equity share capital (paid up) Equity share capital (paid up)

Return On Capital EmployedReturn On Capital EmployedThis ratio is the most appropriate indicator of the earning This ratio is the most appropriate indicator of the earning power of the capital employed in the business. It also power of the capital employed in the business. It also acts as a pointer to the management showing the acts as a pointer to the management showing the progress or deterioration in the earning capacity and progress or deterioration in the earning capacity and efficiency of the business.efficiency of the business.

Net profit before taxes andNet profit before taxes and interest on long – term loans and debentures interest on long – term loans and debentures Return on capital employed=Return on capital employed= Capital employedCapital employed

Ideal ratioIdeal ratio: 15% : 15%

If the actual ratio is equal ratio is equal to or above 15% If the actual ratio is equal ratio is equal to or above 15% It indicates higher productivity of the capital employed It indicates higher productivity of the capital employed and vice versaand vice versa

Return of total resourcesReturn of total resources

This ratio acts as an yardstick to assess the efficiency of This ratio acts as an yardstick to assess the efficiency of the efficiency of the operations of the business as it the efficiency of the operations of the business as it indicates the extent to which assets employed in the indicates the extent to which assets employed in the business are utilised to results in net profit business are utilised to results in net profit

Net profit Net profit Return on total recourses = X 100Return on total recourses = X 100 Total assets Total assets

Dividend Yield RatioDividend Yield Ratio

It refers to the percentage or ratio of dividend paid per It refers to the percentage or ratio of dividend paid per share to the market price per share. This ratio throws share to the market price per share. This ratio throws light on the effective rate of return on investment, which light on the effective rate of return on investment, which potential investors may hope to earn.potential investors may hope to earn.

Dividend paid per equity shareDividend paid per equity shareDividend yield ratio = Dividend yield ratio = Market price per equity shareMarket price per equity share

Price Earning RatioPrice Earning Ratio

It shows how many times the annual earnings the It shows how many times the annual earnings the present shareholders are willing to pay to get a share. present shareholders are willing to pay to get a share. This ratio helps investors to know the effect of earnings This ratio helps investors to know the effect of earnings per share on the market price of the share. This ratio per share on the market price of the share. This ratio when calculated for several years can be used as term when calculated for several years can be used as term analysis for predicting future price earning ratios and analysis for predicting future price earning ratios and therefore, future stock prices.therefore, future stock prices.

Average market price per shareAverage market price per sharePrice earning ratio=Price earning ratio= Earning per shareEarning per share

Dividend Pay Out RatioDividend Pay Out RatioThis ratio indicates the proportion of earnings available This ratio indicates the proportion of earnings available which equity share holders actually receive in the form of which equity share holders actually receive in the form of dividend.dividend.

Dividend paid per shareDividend paid per sharePay out ratio = Pay out ratio = Earning per shareEarning per share

An investor primarily interested should invest in equity An investor primarily interested should invest in equity share of a company with high pay out ratio. A company share of a company with high pay out ratio. A company having low pay out ratio need not necessarily be a bad having low pay out ratio need not necessarily be a bad company. A company having income may like to finance company. A company having income may like to finance expansion out of the income, thus low pay out ratio. expansion out of the income, thus low pay out ratio. investor interested in stock price appreciation may well investor interested in stock price appreciation may well invest in such a company though the pay out ratio is low. invest in such a company though the pay out ratio is low.

Earning Per ShareEarning Per Share

This ratio indicates the earning per equity share. It This ratio indicates the earning per equity share. It establishes the relationship between net profit available establishes the relationship between net profit available for equity shareholders and the number of equity shares.for equity shareholders and the number of equity shares.

Net profit available for equity share holdersNet profit available for equity share holdersEarning per share = Earning per share = Number of equity sharesNumber of equity shares