Significance of Ratio Analysis:

Ratio analysis is the process of determining and presenting the relationship of items or

group of items in the financial statements. Given below are the various points which
highlights the significance of ratio analysis :

1. Simplifies accounting figures – Ratios simplify, summaries accounting figures which

in turn can be easily understood by those who do not know the language of accounting.

2. Measures liquidity position – Liquidity position of a firm is said to be satisfactory if

it is able to meet its current obligations as and when they mature. Hence liquidity ratios
are used by banks and other short term lenders for looking into the liquidity position of
the company.

3. For comparison– They are useful tools in the hands of management to evaluate the
firm’s performance over a period of time by comparing the present ratios with the past
ratios and comparing with other companies also so as to see where the company stands in
the industry.

4. Profitability – Profit and loss account reveals the profit earned or loss incurred during
a period but fails to convey the capacity of the company to earn in terms of per dollar
invested or per dollar of sales, this is where ratio analysis comes into play and hence very
significant in terms of measuring the profitability.

5. Trend analysis – Trend analysis of ratios reveals whether financial position of the
company is improving or deteriorating over years because it enables a company to take
the time dimension into account. With the help of such analysis, one can ascertain
whether the trend is favorable or not.

6. Long term solvency – Ratio analysis also evaluates long term solvency of the firm
through capital structure or leverage ratios. It is used by creditors, security analysts and
present and prospective investors because these ratios reveal whether or not company is
financially sound.

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Limitations of Ratio Analysis:

The ratio analysis is one of the most powerful tools of financial management. Though
ratios are simple to calculate and easy to understand, they suffer from serious limitation:

1. Limited Use of a Single Ratio. A single ratio does not convey of a sense. To make a
better interpretation a number of ratios have to be calculated which is likely to confuse
than help him in making any meaningful conclusion.

2. Lack of Adequate Standards. There are no well accepted standard or rules of thumb
for all ratios which can be accepted as norms .It renders interpretation of the ratios
difficult.

3. Inherent Limitation of Accounting. Like financial statement, ratios also suffer from
the inherent weakness of a accounting records such as their historical nature. Ratios of
the past are not necessarily true indicators of the future.

4. Change of Accounting Procedure. Change in accounting procedure by a firm often

makes ratio analysis misleading.
5. Window Dressing. Financial Statement can easily be window dressed to present
better picture of its financial and profitability position to outsiders. Hence, one has to be
very careful in making a decision from the ratio calculated from such financial statement.
However, it may be very difficult for a outsider to know about the window dressed made
by a firm.

6. Personal Bias. Ratios are only means of financial analysis and not an end in itself.
Ratios have to be interpreted and difficult people may interpret the same ratio in different
ways.

7. Incomparable. Not only industries differ in their nature but also the firms of the
similar business widely differ in their size and accounting procedure etc. It makes
comparison of ratios difficult and misleading. Moreover, comparisons are made difficult
due to difference in definitions of various financial terms used in the ratios analysis.

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8. Absolute Figures Distortive. Ratios devoid of absolute figures may prove distortive
as ratios analysis is primarily a quantitative analysis and not a qualitative analysis.

9. Price Level Changes. While making ratios analysis, no consideration is made to the
changes in price levels and this makes interpretation of ratios invalid.

10. Ratios No Substitutes. Ratio analysis is merely a tool of financial statements. Hence,
ratios become useless if separated from the statement from which they are computed.

Liquidity Ratio:

The term liquidity means the propensity and extent of quick cover liability of assets into
money. It is of paramount importance on the part of a business to be steady with adequate
liquid resources to meet current obligations as and when they become due for payment.
That is to say, the resources of a business should be so close to money or easily
convertible into money that they may be used easily to pay off all current or short-term
liabilities as soon as they require to be liquidated. If these short-term or current liabilities
are left unpaid on their maturity, the technical insolvency will surface which threatens the
very survival of the business itself. Therefore, the state of all business is a pre-requisite
for its survival.

Liquidity ratios measure the ability of your company to meet current liabilities
such as trade accounts payable, short-term loan payments, payrolls, and so on. Investor
look at liquidity ratios to determine the ability of a business to pay off its short term
obligations from cash or near cash assets to evaluate the risk associated if were to invest
in this company. Failure to pay off short term obligation may result in financial difficulty
or bankruptcy in near future.
Liquidity ratios help investors to minimize the risk in stock market investment to
screen out financial sound companies on stock pick to build up their "buy and hold"
portfolio.

Some of the liquidity ratio’s are:

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 i. Current Ratio: the current ratio id the ratio that subsists between the total current
assets and the total current liabilities. It is a measure of general liquidity and is most
widely used to make the analysis for short term financial position or liquidity of a
firm. It is calculated by dividing the total of the current assets by total of the current
liabilities.

Current ratio may be defined as the relationship between current assets and

current liabilities. This ratio is also known as "working capital ratio". It is a measure
of general liquidity and is most widely used to make the analysis for short
term financial position or liquidity of a firm. It is calculated by dividing the total of
the current assets by total of the current liabilities.

Formula:

Current Ratio=Current A ssets /Current Li bilities

The ideal ratio is 2:1

Significances: The current ratio is an index of the concern’s financial stability

since it shows the extent of the working capital which is the amount by which the
current assets exceed the current liabilities. As stated earlier a higher current ratio
would indicate inadequate employment of fund while a poor current ratio is a
danger signal to the management. It shows that business is trading beyond its
resources.

ii. Liquid or Acid Test or Quick Ratio : The Acid-test or quick ratio or liquid

ratio measures the ability of a company to use its near cash or quick assets to
immediately extinguish or retire its current liabilities. Quick assets include
those current assets that presumably can be quickly converted to cash at close to
their book values.

It is the ratio of liquid assets to current liabilities. The true liquidity refers to the
ability of a firm to pay its short term obligations as and when they become due.

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 Formula:
Liquid Assets
Acid Test = .
Current Liabilities

The ideal ratio is 1:1.

The Quick Ratio is a much more exacting measure than the Current Ratio.
The ratio is also indicator of short term solvency of the company. By excluding
inventories, it concentrates on the really liquid assets, with value that is fairly
certain. It helps answer the question: "If all sales revenues should disappear, could
my business meet its current obligations with the readily convertible `quick' funds
on hand?"

iii. Inventory to Current Assets: Inventory to current Assets shows the portion of assets
tied up in inventory. Generally, a lower ratio is considered better.

Formula:
Closing Stock
Inventory ¿Current Assets=
Current Assets .

iv. Inventory to working capital: Inventory to working capital ratio shows that what
portion of a company’s inventories is financed from its available cash. In general, the
lower the ratio, the higher the liquidity of a company is. However, the value of
inventory to working capital ratio varies from industry and company. The better
benchmark is to compare with the industry average.

Formula:
Closing Stock
Inventory ¿Current Assets=
Current Assets

Significances: Inventory to working capital ratio is an important indicator of a

company’s operation efficiency. A low value 1or less of inventory to working
capital ratio means that a company has high liquidity of current asset. While it
may also mean insufficient inventory. A high value of inventory to working
capital ratio means that a company is carrying too much inventory in stock. It is

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 not favorable for management because excessive inventories can place a heavy
burden on the cash resources of a company.

v. Cash Ratio / Cash Position Ratio: Thus, the ratio is relationship between absolute
liquidity assets and quick liabilities or current liabilities. Marketable securities are the
short term inventory near money instruments which can be corrected into cash
quickly.

(ca sh+ Marketable securities)

Formula: Cash Ratio=
quick liabilities

The ideal ratio is 0.5:1

Significances: Cash ratio measure the ability of a business to meet short term
obligations. It measures to the extent which current obligations can be paid
from cash or near cash assets. A measure of the amount of cash available to offset
current debt (Cash / Total Current Liabilities). A ratio below .5 may mean you are
having cash flow problems, possibly because of a significant backlog in accounts
receivable.

Turnover Ratio/Active Ratio:

There are also known as activity ratio or performance ratios. They indicate the
effectiveness with which the firm employs its resources. They are used to measure the
speed with which inventories, debtors, fixed assets etc. are converted into sales or cash.

Both the current ratio and quick ratio will mislead if they are not subjected to
qualitative tests. The major components of current assets namely, stock and debtor must
be assessed to determine their quality if debtors and stock are too high because of slow
collection and slow turnover (sales) respectively, these ratios will be misleading. These
ratios ignore the movement of current assets. Therefore, turnover ratios are necessary for
analysis of policy for debt collection and turnover stock.

The better the management of asset, the large the amount of sales. Activity ratios
are employed to evaluate the efficiency with which the firm managers and utilizes its

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assets. These ratios are also called turnover ratios because they indicate the speed with
which assets are being covered or turned over into sales. Activity ratio, thus involve as
relationship between sales and assets. A proper balance between sales and assets
generally reflects that assets are managed well. Several activity ratios can be calculated to
judge the effectiveness of assets utilization.

Some of the Turnover ratios are:

i. Inventory Turnover Ratio: this ratio indicates whether investment in

inventory is efficiently used or not and also indicates the efficiency of the firm in
producing and selling its products. It is calculated by dividing cost of goods sold
by the average inventory.
The average inventory is the average of opening and
closing balance of inventory. In a manufacturing, company inventory of finished
goods is used to calculate inventory turnover.

Formula:

Cost of goods sold

Inven tory Turnover Ratio=
Average inventory

Significances: Inventory Turnover Ratio is figured as "turnover times". Average

inventory should be used for inventory level to minimize the effect of seasonality.
A low inventory turnover ratio is a signal of inefficiency, since inventory usually
has a rate of return of zero. It also implies either poor sales or excess inventory. A
high inventory turnover ratio implies either strong sales or ineffective buying
(the company buys too often in small quantities; therefore the buying price is
higher).

ii. Working Capital turnover ratio: Working capital turnover ratio indicates the
velocity of the utilization of net working capital. This ratio indicates the number
of times the working capital is turned over in the course of a year. This ratio
measures the efficient utilization.
Formula:

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 Cost of sales
Working Capital Turnover Ratio=
net working capital

Significances: The working capital turnover ratio measures the efficiency with
which the working capital is being used by a firm. A high ratio indicates efficient
utilization of working capital and a low ratio indicates otherwise. But a very high
working capital turnover ratio may also mean lack of sufficient working capital
which is not a good situation.

iii. Fixed assets turnover ratio: This is also known as sales to fixed assets ratio.
This ratio measures the company's effectiveness in generating sales from its
investments in plant, property, and equipment. It is especially important for a
manufacturing firm that uses a lot of plant and equipment in its operations to
calculate its fixed asset turnover ratio.

Formula:
Cost ofSales
¿ AssetsTurnoverRatio= Assets ¿
Net ¿
Significances: If the fixed asset turnover ratio is low as compared to the industry
or past years of data for the firm, it means that sales are low or the investment in
plant and equipment is too much. This may not be a serious problem if the
company has just made an investment in fixed asset to modernize.

Profitability Ratio:

A Company should earn profits to survive and grow over a long period. Profits are
essential, but it would be wrong to assume that every action initiated by management of a
company should be aimed at maximizing profits, irrespective of social consequences.
Profit is the difference between revenues and expenses over a period of time
(usually a year). Profit is the ultimate output of a company and it will have no future if it
fails to make sufficient profits. Therefore the financial manager should continuously

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evaluate to the efficiency of the measure the operating efficiency of the company.
Besides management of the company, creditors want to get interest and repayment of
principle regularly. Owners want to get a required rate of return on their investment. This
is possible only when the company earns enough profits.

Some of the profitability ratio:

i. Gross profit Ratio: Gross profit margin reflects the efficiency with which the
management products each unit product. This ratio indicates the average spread
between the cost of goods sold and the sales revenue. When we subtract the gross
profit margin from 100% we obtain the ratio of cost of goods to sales. Both this
shows profits relative to sales after the dedication of production costs, and
indicates the relation between production costs and selling price.

Formula:

Gross Profit Ratio=¿ ¿

A high gross profit margin ratio is a sign of good management. A gross
margin ratio may increase due to any of the following factors. Higher sales prices,
cost of goods sold remaining constant, lower cost of goods sold, sales prices
remaining constant. A low gross profit margin may reflect higher cost goods sold
due to the firm’s inability to purchase raw materials at favorable terms, inefficient
utilization of plant and machinery, resulting in higher cost of production.

ii. Net Profit Ratio: Net profit is obtained when operation expenses, interest and
taxes are subtract from the gross profit. If the non-operating income figure is
substantial, it may be excluded from PAT to see profitability arising directly from
sales. This ratio is the overall measure of the firm’s ability to turn each rupee sales
into net profit. If the net margin is inadequate, the firm will fail to achieve
satisfactory return on shareholder’s funds.

Formula:

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 Net Profit Ratio=¿ ¿

A firm with a high net margin ratio would be in an advantageous position

to survive in the face of falling selling prices, rising costs of production or
declining demands for the product. It would really be difficult for a low net
margin firm to withstand these adversities. Similarly, a firm higher net profit
margin can make better use of favorable conditions such as rising selling prices;
falling in costs of production or increasing demand for the product. Such a firm
will be able to accelerate its profits at a faster rate than a firm with a low net profit
margin will.

iii. Operating Ratio: it is the ratio of cost of goods sold plus operating expenses to
net sales. It is generally expressed in percentage. Operating ratio measures the
cost of operations per dollar of sales. This is closely related to the ratio of
operating profit to net sales.

Formula:
(cost of goods sold+ other operating exps )
Operating Ratio= ∗100
sales
Operating ratio shows the operational efficiency of the business. Lower
operating ratio shows higher operating profit and vice versa. An operating ratio
ranging between 75% and 80% is generally considered as standard for
manufacturing concerns. This ratio is considered to be a yardstick of operating
efficiency but it should be used cautiously because it may be affected by a number
of uncontrollable factors beyond the control of the firm. Moreover, in some firms,
non-operating expenses from a substantial part of the total expenses and in such
cases, operating ratio may give misleading results.

iv. Operating Profit Ratio: This ratio establishes the relationship between the total
cost incurred and sales. Operating profit is the net profit after depreciation but
before interests and taxes. The purpose of computing this ratio is to find out the
overall operational efficiency of the business concern. It measures the constant
this ratio is expressed as operating profit to sales.

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 Formula:

Operating Profit Ratio=¿ ¿

The operating profit shows how much cash is thrown off after most of the
expenses are met. A high operating profit margin means that the company has
good cost control and/or that sales are increasing faster than costs, which is the
optimal situation for the company. Operating profit will be a lot lower than the
gross profit since selling, administrative, and other expenses are included along
with cost of goods sold.

v. Return on Investment (LT) Ratio: Return on long term investment is for a long
period of time such as 10 to 20 years. Where investing in the equity share, bonds,
debenture, Bank borrowings and financial institutional borrowings. It is ratio
earnings before interest and tax to long term capital employed
Formula:

EBIT
Return on ( ¿ ) Investment= ∗100
Long Term Capital Employed

For the better performance of the company, long-term return on investment

should be lower where it is acceptable by the investor. If the ratio is high that is
not the better indication for company.

vi. Return on Investment (total): This ratio establish a relationship between total
capital and net profit of the business. It indicates the percentage of return on
capital employed and it can be used to show efficiency as whole. This ratio tells
the owner whether all the effort put into the business has been worthwhile.

Formula:
EBIT
Return on total investment = ∗100
Capital employed

Return on investment of 15% is generally considered necessary to fund

future growth from the business, this means that a business will not depend on the
financial its growth with long term debt but will be able to generate the income

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 from its own operation. Low ratio indicates inefficient management performance
or it could reflect highly capitalized. If the ratio is more than or equal to 15%
where management is efficient or the firm is undercapitalized.

vii. Return on Equity Share holder’s equity: the profitability from the point of
view of equity share holders will be judged after taking into account the amount
of dividend payable to the preference share holders. The Return on equity share
holders’ fund will be computed on the following basis.

Returnon Equity Share Holders equity

PAT −Preference share
¿ ∗100
Equity Share Holders Equity
Equity Share Holders’ Equity includes equity share capital of the company
and all reserves and surplus. This ratio is more meaningful to the equity
shareholders who are interested to know profits earned by the company and those
profits which can be made available to pay dividends to them. Interpretation of
the ratio is similar to the interpretation of return on shareholder's investments and
higher the ratio better is.  

viii. Sales to Net worth: This ratio indicates how many sales rupees are generated
with each rupee of investment (net worth).
Formula:
Sales
Sales¿ Networth=
Networth

A high ratio of sales to net worth, after all, can result either from booming
sales or from meager net worth. If high sales are the cause, chances are that the
business is in good shape and its credit is strong. Nevertheless, if the cause is low
net worth, the company is probably a poor credit risk.
Long Term Solvency Ratio:

Long-term financial solvency ratio should be maintained to protect a firm from

bankruptcy. It is judged on the basis of the long term financial strength of the firm. It is

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examined by using long term solvency ratios. They are also called capital structure ratios,
leverage ratios or solvency ratios.
Long-term financial solvency of a firm is measured in terms of its ability (1) to pay
the interest regularly during the period of the long-term loan and (2) repay the principal
on maturity. There are two aspects of the long-term solvency, namely, (a) ability to repay
the principal on due date, and (b) ability to pay the interest regularly.
Accordingly, there are two different, but mutually dependence types of long-term
solvency ratio, namely (1) Ratios based on the relationship between borrowed fund and
owner’s capital. (2) Coverage ratio.

i. Total debt-Equity ratio: The total debt is the generally, refers to long term and
short term (current) liabilities. Debt equity ratio is an important indicator of the
solvency of a firm. This ratio indicates the relationship between the external
equities or the outsider’s funds and the internal equities or the shareholder’s
funds.
Formula:
GrossTotal Debt
Total Debt −Equity Ratio=
Share Holders Equity
A ratio of 1:1 is usually considered to be satisfactory ratio although there cannot
be rule of thumb or standard norm for all types of businesses. A high debt-to-
equity ratio, which indicates very aggressive financing or a history of large losses,
results in very volatile earnings. A low debt-to-equity ratio, which indicates
conservative financing and low risk, results in fewer possibilities of large losses
or large gains in earnings.

ii. Leverage ratio: Capitalization ratios need to be evaluated over time, and
compared with other data and standards. Care should be taken when comparing
companies in different industries or sectors. The same figures that appear to be
low in one industry can be very high in another. This show how a company's
operations are financed. Too much equity in a firm often means the management
is not taking advantage of the leverage available with long-term debt. On the other

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 hand, outside financing will become more expensive as the debt-to-equity ratio
increases.
Formula:
Long Term debt
Lever age Ratio=
(Long Term Debr +Share Holders Fund)
They compare a firm's debt with either its total capital (debt plus equity)
or its equity capital. They readily indicate how reliant a firm is on debt financing.
Thus, the leverage of an organization has to be considered with respect both to its
profitability and the volatility of the industry.

iii. The long-term debt to equity ratio: This ratio tells how much debt a company is
using to finance its operations. If this number is too high it may signify future
liquidity problems. If this number is too low it can signify inefficient use of the
financing alternatives available to a company. This ratio establish a relationship
between the borrower funds and the owners funds it is determined to ascertain the
soundness of the long term financial position of the company. It is calculated from
the following formula.
Formula:
Long Term Debt
Long Term Debit Equity Ratio=
Share Holders Equity
Standard debit equity ratio is 2:1.this ratio is the measure contribution of
owners fund to the long term fund of the concern as compared to the contribution
of long term lenders. It indicates the relative claim of owners and the long term
lenders if the total assets of the firm and help to measure the risk of the long term
against the owners.

iv. Fixed Assets to Proprietor's Fund Ratio: Fixed assets to proprietor’s fund ratio
establish the relationship between fixed assets and shareholders’ funds. The
purpose of this ratio is to indicate the percentage of the owner's funds invested in
fixed assets.
Formula:
Proprietory Ratio=Net ¿ Assets ¿
Share Holders Equity

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 The fixed assets are considered at their book value and the proprietor's
funds consist of the same items as internal equities in the case of debt equity ratio.

Market Test Ratio:

Market Test Ratio relates the firm’s stock price to its earnings and book value per share.
These ratios indicate what investor think of the company’s past performance and the
future prospect. The market price of the share is influenced by these ratios. These ratios
are calculated in the case companies whose shares are listed in stock exchange the
important Market Test Ratio are:

i. Earning per Share: This is one of the most widely reported and understood
ratios. It represents the net earnings of the company (less commitments to
preferred shareholders) in relation to the total number of common shares issued
and outstanding. This figure is often referred to by the acronym EPS, for
“earnings per share”, and is a stepping-stone to the Price- Earnings Ratio.
The Earnings per Share figure suggests the possibility of dividends that
may be paid on common shares. However, this is a corporate policy decision and
there is no rule of thumb regarding the frequency or size of dividend payments.
Formula:
(PAT −Preference dividend)
Earning per Share=
No. of equity shares

The earnings per share growth rate indicate the amount of growth for investors.
This ratio helps determine the multiplier used in calculating the company's market
value. A higher ratio yields a higher multiplier. The trend in this ratio indicates
whether growth is steady, sporadic, accelerating or declining.

ii. Dividend per Share: The the sum of declared dividends for every ordinary share
issued. Dividend per share (DPS) is the total dividends paid out over an entire
year (including interim dividends but not including special dividends) divided by

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 the number of outstanding ordinary shares issued.
Formula:

Equity Divided
Dividend per Share=
No . of Share Outstanding
The dividend per share is a measure of a company's performance, simply because
it indicates how profitable a company is over a quarter or year. Companies often
compare the performance in each quarter to what it did in the same quarter the last
year. This may also include a comparison of the dividend per share from the
previous year.

iii. Price Earnings Ratio: This ratio is the most widely reported and regarded ratio in
financial analysis. The ratio is calculated to make an estimate of appreciation in
the value of a share of a company and is widely used by investors to decide
whether or not to buy shares in a particular company. This ratio value has the
most relevance for an actively traded stock in a highly liquid market – like a public
stock market.
Formula:

Adjusted Closing Price

Price Earning Ratio=
Earning Per Sha ℜ
The Price-Earnings Ratio illustrates the optimism investors have with regards to
the future earnings performance of the company. In many instances, the higher the
ratio the more speculative the optimism for short-term increase in value or the
more confident the investor is in the longer-term realization of earnings.

iv. Dividend Yield Ratio: This ratio reflects the percentage yield that an investor’s
receives on this investment at current market price this measure is useful for
investors who are interested in yield per share than capital appreciation. Dividend
yield ratio is the relationship between dividends per share and the market value of
the shares.
Formula:

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 Dividend Per Share
Dividend yield= ∗100
Adjusted Closing Price

Shareholders are real owners of a company and they are interested in real
sense in the earnings distributed and paid to them as dividend.

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