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Introduction
Ratio analysis refers to the analysis and interpretation of the figures appearing in the
financial statements (i.e., Profit and Loss Account, Balance Sheet and Fund Flow
statement etc.).
It is a process of comparison of one figure against another. It enables the users like
shareholders, investors, creditors, Government, and analysts etc. to get better
understanding of financial statements.
Ratio analysis is a very powerful analytical tool useful for measuring performance of an
organisation. Accounting ratios may just be used as symptom like blood pressure, pulse
rate, body temperature etc. The physician analyses these information to know the causes
of illness. Similarly, the financial analyst should also analyse the accounting ratios to
diagnose the financial health of an enterprise.

Meaning of financial ratios

As stated earlier, accounting ratios are an important tool of financial statements analysis.
A ratio is a mathematical number calculated as a reference to relationship of two or more
numbers and can be expressed as a fraction, proportion, percentage and a number of times.
When the number is calculated by referring to two accounting numbers derived from the
financial statements, it is termed as accounting ratio.
It needs to be observed that accounting ratios exhibit relationship, if any, between
accounting numbers extracted from financial statements. Ratios are essentially derived
numbers and their efficacy depends a great deal upon the basic numbers from which they
are calculated. Hence, if the financial statements contain some errors, the derived numbers
in terms of ratio analysis would also present an erroneous scenario. Further, a ratio must
be calculated using numbers which are meaningfully correlated. A ratio calculated by
using two unrelated numbers would hardly serve any purpose. For example, the furniture
of the business is Rs. 1,00,000 and Purchases are Rs. 3,00,000. The ratio of purchases to
furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance. The reason is that there
is no relationship between these two aspects.
Metcalf and Tigard have defined financial statement analysis and interpretations as a
process of evaluating the relationship between component parts of a financial statement to
obtain a better understanding of a firm's position and performance.

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Khan and Jain define the term ratio analysis as “the systematic use of ratios to interpret the
financial statements so that the strengths and weaknesses of a firm as well as its historical
performance and current financial conditions can be determined.”

Procedure for computation of ratios Generally, ratio analysis involves four steps:
(i) Collection of relevant accounting data from financial statements.
(ii) Constructing ratios of related accounting figures.
(iii) Comparing the ratios thus constructed with the standard ratios which may be the
corresponding past ratios of the firm or industry average ratios of the firm or ratios of
competitors.
(iv) Interpretation of ratios to arrive at valid conclusions.

Objectives of ratio analysis

Ratio analysis is indispensable part of interpretation of results revealed by the financial
statements. It provides users with crucial financial information and points out the areas
which require investigation. Ratio analysis is a technique which involves regrouping of
data by application of arithmetical relationships, though its interpretation is a complex
matter. It requires a fine understanding of the way and the rules used for preparing
financial statements. Once done effectively, it provides a lot of information which helps
the analyst:
1. To know the areas of the business which need more attention;
2. To know about the potential areas which can be improved with the effort in the desired
direction;
3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency
levels in the business;
4. To provide information for making cross-sectional analysis by comparing the
performance with the best industry standards; and
5. To provide information derived from financial statements useful for making
projections and estimates for the future.
USERS OF FINANCIAL STATEMENTS
Preparation of Financial Statements is the beginning of ratio analysis. It doesn’t usually
provide detailed answers to the management’s questions but it does identify the areas in
which further data should be generated.
Shareholders Financial Statements act as an important source for the shareholders of the
company. They can help in examining efficiency and effectiveness of the management and
position, progress and prospects of the company.
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Investors: A purchaser of business would like to ascertain the value of shares on the basis of
the earnings of the company as revealed in the Financial Statements. A small investor may
like to know the dividends paid by the company in the past as shown in the Financial
Statements to ascertain the value of shares. A company wishing to take over or absorb
another company may want to study the Financial Statements of the absorbed company to
ascertain its financial position and the price to be paid for the acquisition. Thus, potential
investors have to study the Financial Statements before deciding upon whether to buy or not
a business or shares Lenders Short-term as well as long-term solvency information is needed
by the lenders of the company to accurately assess the position of the business.
Trade creditors are interested in short-term solvency, whereas debenture holders, long-term
loan provider are interested in long-term solvency. Management Financial statements help
the management in acquiring accurate information regarding the progress, position and
prospects of business. They help the management in finding out the relationship between the
working and progress of the business; and therefore, help the management in analyzing the
trends in the present and future prospectus of the enterprise.
Public Various groups such as financial analysts, lawyers, trade associations, researchers,
financial press, labour unions are interested in the trend analysis, working and growth of a
business. With the help of published financial information or statement of the enterprise,
these interested groups are able to analyze and interpret, and therefore judge the working and
growth of an enterprise. Government The growth of the economy is associated with the
growth of the companies registered in the country. Any fraudulent activity or unscrupulous
act affects the industry which percolates the growth of the economy. This can retard the
economic growth of the country which would have an adverse effect on our national
economy.
Types of ratios
There is a two way classification of ratios:
(1) traditional classification, and
(2) functional classification. The traditional classification has been on the basis of
financial statements to which the determinants of ratios belong. On this basis the ratios are
classified as follows:
(i) ‘Statement of Profit and Loss Ratios: A ratio of two variables from the
statement of profit and loss is known as statement of profit and loss ratio. For example,
ratio of gross profit to revenue from operations is known as gross profit ratio. It is
calculated using both figures from the statement of profit and loss.
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(ii) Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified
as balance sheet ratios. For example, ratio of current assets to current liabilities known as
current ratio. It is calculated using both figures from balance sheet.
(iii) Composite Ratios: If a ratio is computed with one variable from the statement of
profit and loss and another variable from the balance sheet, it is called composite ratio.
For example, ratio of credit revenue from operations to trade receivables (known as trade
receivables turnover ratio) is calculated using one figure from the statement of profit and
loss (credit revenue from operations) and another figure (trade receivables) from the
balance sheet.

Although accounting ratios are calculated by taking data from financial statements but
classification of ratios on the basis of financial statements is rarely used in practice. It
must be recalled that basic purpose of accounting is to throw light on the financial
performance (profitability) and financial position (its capacity to raise money and invest
them wisely) as well as changes occurring in financial position (possible explanation of
changes in the activity level). As such, the alternative classification (functional
classification) based on the purpose for which a ratio is computed, is the most commonly
used classification which is as follows:

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Profitability ratios
Profit is the primary objective of all businesses. All businesses need a consistent
improvement in profit to survive and prosper. A business that continually suffers losses
cannot survive for a long period.
Profitability ratios measure the efficiency of management in the employment of business
resources to earn profits. These ratios indicate the success or failure of a business
enterprise for a particular period of time. Profitability ratios are used by almost all the
parties connected with the business. A strong profitability position ensures common
stockholders a higher dividend income and appreciation in the value of the common stock
in future. Creditors, financial institutions and preferred stockholders expect a prompt
payment of interest and fixed dividend income if the business has good profitability
position.
Management needs higher profits to pay dividends and reinvest a portion in the business
to increase the production capacity and strengthen the overall financial position of the
company.

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Some important profitability ratios are given below:

(i) Net profit (NP) ratio
(ii) Gross profit (GP) ratio
(iii) Price earnings ratio (P/E ratio)
(iv) Operating ratio
(v) Expense ratio
(vi) Dividend yield ratio
(vii) Dividend payout ratio
(viii) Return on capital employed ratio
(ix) Earnings per share (EPS) ratio
(x) Return on shareholder’s investment/Return on equity
(xi) Return on common stockholders’ equity ratio
(i) Net profit ratio (NP ratio) is a popular profitability ratio that shows relationship
between net profit after tax and net sales. It is computed by dividing the net profit (after
tax) by net sales.

For the purpose of this ratio, net profit is equal to gross profit minus operating expenses
and income tax. All non-operating revenues and expenses are not taken into account
because the purpose of this ratio is to evaluate the profitability of the business from its
primary operations.
Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A
high ratio indicates the efficient management of the affairs of business.
(ii) Gross profit ratio (GP ratio) is a profitability ratio that shows the relationship between
gross profit and total net sales revenue. It is a popular tool to evaluate the operational
performance of the business . The ratio is computed by dividing the gross profit figure by
net sales.
The following formula/equation is used to compute gross profit ratio:

When gross profit ratio is expressed in percentage form, it is known as gross profit
margin or gross profit percentage. The formula of gross profit margin or percentage is
given below:

The basic components of the formula of gross profit ratio (GP ratio) are gross profit and

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net sales. Gross profit is equal to net sales minus cost of goods sold. Net sales are equal to
total gross sales less returns inwards and discount allowed. The information about gross
profit and net sales is normally available from income statement of the company.
(iii) Price earnings ratios (P/E ratio) measures how many times the earnings per share
(EPS) has been covered by current market price of an ordinary share. It is computed by
dividing the current market price of an ordinary share by earnings per share.
The formula of price earnings ratio is given below:

A higher P/E ratio is the indication of strong position of the company in the market and a
fall in ratio should be investigated.
(iv) Operating ratio is computed by dividing operating expenses by net sales. It is
expressed in percentage.
Operating ratio is computed as follows:

The basic components of the formula are operating cost and net sales. Operating cost is
equal to cost of goods sold plus operating expenses. Non-operating expenses such as
interest charges, taxes etc., are excluded from the computations. This ratio is used to
measure the operational efficiency of the management. It shows whether the cost
component in the sales figure is within normal range. A low operating ratio means high
net profit ratio i.e., more operating profit.
The ratio should be compared: (1) with the company’s past years ratio, (2) with the
ratio of other companies in the same industry. An increase in the ratio should be
investigated and brought to attention of management. The operating ratio varies from
industry to industry.
(v) Expense ratio (expense to sales ratio) is computed to show the relationship between an
individual expense or group of expenses and sales. It is computed by dividing a particular
expense or group of expenses by net sales. Expense ratio is expressed in percentage.

The numerator may be an individual expense or a group of expenses such as

administrative expenses, sales expenses or cost of goods sold.
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Expense ratio shows what percentage of sales is an individual expense or a group of

expenses. A lower ratio means more profitability and a higher ratio means less
profitability.
(vi) Return on shareholders’ investment ratio is a measure of overall profitability of the
business and is computed by dividing the net income after interest and tax by average
stockholders’ equity. It is also known as return on equity (ROE) ratio and return on net
worth ratio. The ratio is usually expressed in percentage.

The numerator consists of net income after interest and tax because it is the amount of
income available for common and preference stockholders. The denominator is the
average of stockholders’ equity (preference and common stock). The information about
net income after interest and tax is normally available from income statement and the
information about preference and common stock is available from balance sheet.
Return on equity (ROE) is widely used to measure the overall profitability of the company
from preference and common stockholders’ view point. The ratio also indicates the
efficiency of the management in using the resources of the business.
(vii) Return on common stockholders’ equity ratio measures the success of a company in
generating income for the benefit of common stockholders. It is computed by dividing the
net income available for common stockholders by common stockholders’ equity. The ratio
is usually expressed in percentage.

The numerator in the above formula consists of net income available for common
stockholders which are equal to net income less dividend on preferred stock. The
denominator consists of average common stockholders’ equity which is equal to average
total stockholders’ equity less average preferred stockholders equity. If preferred stock is
not present, the net income is simply divided by the average common stockholders’ equity
to compute the common stock equity ratio. Like return on equity (ROE) ratio, a higher
common stock equity ratio indicates high profitability and strong financial position of the

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company and can convert potential investors into actual common stockholders.
(viii) Earnings per share (EPS) ratio measures how many dollars of net income have
been earned by each share of common stock. It is computed by dividing net income less
preferred dividend by the number of shares of common stock outstanding during the
period. It is a popular measure of overall profitability of the company and is usually
expressed in dollars. Earnings per share ratio (EPS ratio) is computed by the following
formula:

The numerator is the net income available for common stockholders’ (net income less
preferred dividend) and the denominator is the average number of shares of common stock
outstanding during the year.

The formula of EPS ratio is similar to the formula of return on common stockholders’
equity ratio except the denominator of EPS ratio formula is the number of average shares
of common stock outstanding rather than the average common stockholders’ equity. The
higher the EPS figure, the better it is. A higher EPS is the sign of higher earnings, strong
financial position and, therefore, a reliable company to invest money.
(ix) Return on capital employed ratio is computed by dividing the net income before
interest and tax by capital employed. It measures the success of a business in generating
satisfactory profit on capital invested. The ratio is expressed in percentage.
Formula:

The basic components of the formula of return on capital employed ratio are net income
before interest and tax and capital employed.
Net income before the deduction of interest and tax expenses is frequently referred to as
operating income. Here, interest means interest on long term loans. If company pays
interest expenses on short-term borrowings, that is deducted to arrive at operating income.
Return on capital employed ratio measures the efficiency with which the investment made
by shareholders and creditors is used in the business. Managers use this ratio for various
financial decisions. It is a ratio of overall profitability and a higher ratio is, therefore,
better.

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(x) Dividend yield ratio shows what percentage of the market price of a share a company
annually pays to its stockholders in the form of dividends. It is calculated by dividing the
annual dividend per share by market value per share. The ratio is generally expressed in
percentage form and is sometimes called dividend yield percentage.
Since dividend yield ratio is used to measure the relationship between the annual amount
of dividend per share and the current market price of a share, it is mostly used by investors
looking for dividend income on continuous basis.
Formula:
The following formula is used to calculated dividend yield ratio:

(xi) Dividend payout ratio discloses what portion of the current earnings the company is
paying to its stockholders in the form of dividend and what portion the company is
ploughing back in the business for growth in future. It is computed by dividing the

dividend per share by the earnings per share (EPS) for a specific period. The formula of
dividend payout ratio is given below:
The numerator in the above formula is the dividend per share paid to common
stockholders only. It does not include any dividend paid to preferred stockholders.
Example on Profitability Ratios
Following is the Profit and Loss Account of Samir Auto Ltd., for the year ended 31st
March, 2016.
Dr. Cr.

Particulars Amount Particulars Amount

in Rs. in Rs.
To Opening Stock 1,00,000 By Sales 5,60,000
To Purchases 3,50,000 By Closing Stock 1,00,000
To Wages 9,000
To Gross Profitc/d 2,01,000
6,60,000 6,60,000
To Administrative Expenses By Gross Profit b/d 2,01,000
To Selling and 20,000 By Interest on Investments
Distribution
Expenses By Profit on sale of Assets 10,000
To Non-Operating Expenses 89,000
To Net Profit Transferred 8,000
to
Capital 30,000

80,000

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2,19,000 2,19,000

You are required to calculate:

(i) Gross Profit Ratio
(ii) Net Profit Ratio
(iii) Operating Ratio
(iv) Operating Profit Ratio
(v) Administrative Expenses Ratio
Solution:
(i) Gross Profit Ratio= Gross Profit X 100
Net Sales
= 2,01,000 X 100 = 35.9%
5,60,000
(ii) Net Profit Ratio= Net Profit After Tax X 100
Net Sales
= 80,000 X 100 = 14.3%
5,60,000
(iii) Operating Ratio = Cost of Goods Sold + Operating Exp.
Net Sales
Cost of Goods Sold= Op.Stock + Purchases + Wages – Closing Stock
= 1,00,000 + 3,50,000 + 9,000- 1,00,000= Rs.3,59,000
Operating Expenses= Administrative Exp. + Selling and Distribution Exp. = Rs.20,000 +
Rs.89,000 = Rs.1,09,000
Operating Ratio = 3,59,000 + 1,09,000 X 100 =83.6%
5,60,000
(iv) Operating Profit Ratio= 100- Operating Ratio= 16.4%
(v) Administrative Expense Ratio= Administrative Exp X 100
Net Sales
= 20,000 X 100 = 3.6%
5,60,000

Liquidity ratios
Liquidity ratios measure the adequacy of current and liquid assets and help evaluate the
ability of the business to pay its short-term debts. The ability of a business to pay its short-
term debts is frequently referred to as short-term solvency position or liquidity position
of the business.
Generally a business with sufficient current and liquid assets to pay its current liabilities
as and when they become due is considered to have a strong liquidity position and a
businesses with insufficient current and liquid assets is considered to have weak liquidity
position. Short-term creditors like suppliers of goods and commercial banks use liquidity
ratios to know whether the business has adequate current and liquid assets to meet its

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current obligations. Financial institutions hesitate to offer short-term loans to businesses

with weak short-term solvency position.
Three commonly used liquidity ratios are given below:
(i) Current ratio or working capital ratio
(ii) Quick ratio or acid test ratio
(iii) Absolute liquid ratio

(i)Current ratio (also known as working capital ratio) is a popular tool to evaluate
short-term solvency position of a business. Short-term solvency refers to the ability of a
business to pay its short-term obligations when they become due. Short term obligations
(also known as current liabilities) are the liabilities payable within a short period of time,
usually one year.
Current ratio is computed by dividing total current assets by total current liabilities of the
business. This relationship can be expressed in the form of following formula or equation:
Above formula comprises of two components i.e., current assets and current liabilities.

Both the components are available from the balance sheet of the company. Some
examples of current assets and current liabilities are given below:
Current assets Current liabilities
Accounts payable /
Cash creditors
Marketable securities Accrued payable Accounts receivables /
debtors Bonds payable

Inventori
es / stock
Prepaid
expenses

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(ii) Quick ratio (also known as “acid test ratio” and “liquid ratio”) is used to test the
ability of a business to pay its short-term debts. It measures the relationship between liquid
assets and current liabilities. Liquid assets are equal to total current assets minus
inventories and prepaid expenses.

The formula for the calculation of quick ratio is given below:

Quick ratio is considered a more reliable test of short-term solvency than current ratio
because it shows the ability of the business to pay short term debts immediately.
Inventories and prepaid expenses are excluded from current assets for the purpose of
computing quick ratio because inventories may take long period of time to be converted
into cash and prepaid expenses cannot be used to pay current liabilities.

(iii) Absolute Liquid ratio-some analysts also compute absolute liquid ratio to test the
liquidity of the business. Absolute liquid ratio is computed by dividing the absolute liquid
assets by current liabilities.

The formula to compute this ratio is given below:

Absolute liquid assets are equal to liquid assets minus accounts receivables (including
bills receivables). Some examples of absolute liquid assets are cash, bank balance and
marketable securities etc.
Example on Liquidty Ratios:
The following is the Balance Sheet of Samir Auto. Ltd., for the year ending 31 st March,
2016.

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Liabilities Amount Assets Amount

in Rs. in Rs.

10% preference Share Goodwill 1,00,000

capital 5,00,000 Land and Building 6,50,000
Equity Share Capital 10,00,000 Plant 8,00,000
9% Debentures 2,00,000 Furniture and
Long-term Loan 1,00,000 Fixtures 1,50,000
Bills Payable 60,000 Bills Receivables 70,000
Sundry Creditors 70,000 Sundry Debtors 90,000
Bank Overdraft 30,000 Bank Balance 45,000
Outstanding Expenses 5,000 Short-term
Investments 25,000
Prepaid Expenses 5,000
Stock 30,000

19,65,000 19,65,000
From the balance sheet calculate:
(i) Current ratio
(ii) Acid test ratio
(iii) Absolute liquid ratio
(iv) Comment on these ratios
Solution
(i) Current Ratio= Current Assets
Current Liabilities
Current Assets= Rs.70,000 + Rs.45,000 + Rs.25,000 + Rs.5,000 + Rs.30,000
= Rs.2,65,000
Current Liabilities= Rs.60,000 + Rs.70,000 + Rs.30,000 + Rs.5,000 = Rs.1,65,000
Current Ratio= Current Assets = Rs.2,65,000 = 1.61 Current Liabilities
Rs.1,65,000
(ii) Acid test ratio = Liquid Assets
Current Liabilities
Liquid Assets= Current Assets- (Stock + Prepaid Expenses)= Rs.2,30,000 Acid
test ratio = Liquid Assets = Rs.2, 30,000 = 1.39
Current Liabilities Rs. 1,65,000
(iii) Absolute liquid ratio= Absolute Liquid Assets
Current Liabilities
Absolute Liquid Assets= Rs.45,000 + Rs.25,000 =Rs.70,000 Absolute liquid ratio=
Absolute Liquid Assets = 70,000 = 0.42
Current Liabilities 1,65,000

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Comments: Current ratio of the company is not satisfactory because the ratio (1.61) is
below the generally accepted standard of 2:1. Acid- Test ratio, on the other hand, is more
than normal standard of 1:1. Liquid assets are quite sufficient to provide a cover to the
current liabilities. The absolute liquid ratio is 0.42 which is slightly less than the accepted
standard of 0.5.
Activity ratios
Activity ratios (also known as turnover ratios) measure the efficiency of a firm or
company in generating revenues by converting its production into cash or sales. Generally
a fast conversion increases revenues and profits.
Activity ratios show how frequently the assets are converted into cash or sales and,
therefore, are frequently used in conjunction with liquidity ratios for a deep analysis of
liquidity.
Some important activity ratios are:
(iv) Inventory turnover ratio
(v) Receivables turnover ratio
(vi) Average collection period
(vii) Accounts payable turnover ratio
(viii) Average payment period
(ix) Asset turnover ratio
(x) Working capital turnover ratio
(xi) Fixed assets turnover ratio
(i) Inventory turnover ratio (ITR) is an activity ratio is a tool to evaluate the liquidity of
inventory. It measures how many times a company has sold and replaced its inventory
during a certain period of time.
Inventory turnover ratio is computed by dividing the cost of goods sold by average
inventory at cost. The formula/equation is given below:

Two components of the formula of inventory turnover ratio are cost of goods sold and
average inventory at cost. Cost of goods sold is equal to cost of goods manufactured
(purchases for trading company) plus opening inventory less closing inventory. Average
inventory is equal to opening balance of inventory plus closing balance of inventory
divided by two. Inventory turnover ratio varies significantly among industries. A high
ratio indicates fast moving inventories and a low ratio, on the other hand, indicates
slow moving or obsolete inventories in stock. A low ratio may also be the result of
maintaining excessive inventories needlessly.

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Maintaining excessive inventories unnecessarily indicates poor inventory management

because it involves tiding up funds that could have been used in other business operations.
(ii) Receivables turnover ratio (also known as debtors turnover ratio) is computed
by dividing the net credit sales during a period by average receivables. Accounts
receivable turnover ratio simply measures how many times the receivables are
collected during a particular period. It is a helpful tool to evaluate the liquidity of
receivables.

Two components of the formula are “net credit sales” and “average trade accounts
receivable”. It is clearly mentioned in the formula that the numerator should include only
credit sales. But in examination questions, this information may not be given. In that case,
the total sales should be used as numerator assuming all the sales are made on credit.
Average receivables are equal to opening receivables (including notes receivables) plus
closing receivables (including notes receivables) divided by two. But sometimes opening
receivables may not be given in the examination questions. In that case closing balance of
receivables should be used as denominator.
(iii) Average collection period is computed by dividing the number of working days for a
given period (usually an accounting year) by receivables turnover ratio. It is expressed in
days and is an indication of the quality of receivables.
The formula is given below:

A short collection period means prompt collection and better management of receivables.
A longer collection period may negatively effect the short-term debt paying ability of the
business in the eyes of analysts.
(iv) Accounts payable turnover ratio (also known as creditors turnover ratio or creditors’
velocity) is computed by dividing the net credit purchases by average accounts payable. It
measures the number of times, on average, the accounts payable are paid during a period.
Like receivables turnover ratio, it is expressed in times.
In above formula, numerator includes only credit purchases. But if credit purchases are

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not known, the total net purchases should be used.

Average accounts payable are computed by adding opening and closing balances of
accounts payable (including notes payable) and dividing by two. If opening balance of
accounts payable is not given, the closing balance (including notes payable) should be
used.

Accounts payable turnover ratio indicates the creditworthiness of the company. A high
ratio means prompt payment to suppliers for the goods purchased on credit and a low ratio
may be a sign of delayed payment. Accounts payable turnover ratio also depends on the
credit terms allowed by suppliers. Companies who enjoy longer credit periods allowed by
creditors usually have low ratio as compared to others.
(v) Average payment period means the average period taken by the company in making
payments to its creditors. It is computed by dividing the number of working days in a year
by creditors turnover ratio. Some other formulas for its computation are given below:
Formula:
This ratio may be computed in a number of ways:

Any of the above formulas may be used to compute average payment period. If credit
purchases are unknown, the total purchases may be used. A shorter payment period
indicates prompt payments to creditors. Like accounts payable turnover ratio, average
payment period also indicates the creditworthiness of the company. But a very short
payment period may be an indication that the company is not taking full advantage of the
credit terms allowed by suppliers.
(vii) Working capital turnover ratio is computed by dividing the cost of goods sold by net
working capital. It represents how many times the working capital has been turned over

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during the period.

The formula consists of two components – cost of goods sold and net working capital. If the cost of
goods sold figure is not available or cannot be computed from the available information, the total
net sales can be used as numerator. Net working capital is equal to current assets minus current
liabilities. This information is available from the balance sheet.

Generally, a high working capital turnover ratio is better. A low ratio indicates inefficient
utilization of working capital. The ratio should be carefully interpreted because a very
high ratio may also be a sign of insufficient working capital.
(viii) Fixed assets turnover ratio (also known as sales to fixed assets ratio) is a commonly
used activity ratio that measures the efficiency with which a company uses its fixed
assets to generate its sales revenue. It is computed by dividing net sales by average
fixed assets.

Generally, a high fixed assets turnover ratio indicates better utilization of fixed assets and
a low ratio means inefficient or under-utilization of fixed assets. The usefulness of this
ratio can be increased by comparing it with the ratio of other companies, industry
standards and past years.

Example of Activity Ratios

From Balance Sheet From Income Statement

CURRENT ASSETS REVENUE

Cash Rs 2,550 Sales Rs.112,500

Marketabl e securities Rs. 2,000 Cost of Goods Rs. 85,040

Sold(COGS)

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Account Receivable Rs.16,675 Gross Margin Rs. 27,460

(Net)

Inventorie s Rs.26,470

Total Current Assets Rs.47,695

Opening Inventory = Rs.22,500

Using the above figures, we can calculate the average collection period ratio.

Average Collection Period = Accounts Receivable X 360 days

Sales

= Rs. 360
16,675 X
Rs.112,500

= 53.36 or 54 days (rounded up to the

nearest day)

Inventory Turnover Cost of Goods Sold = Rs.85,040 (Rs.22,500

Average Inventory + Rs.26,470)
* / (2)

= 3.5 times

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Solvency ratios
Solvency ratios (also known as long-term solvency ratios) measure the ability of a
business to survive for a long period of time. These ratios are very important for
stockholders and creditors.
Solvency ratios are normally used to:
 Analyze the capital structure of the company
 Evaluate the ability of the company to pay interest on long term borrowings
 Evaluate the ability of the the company to repay principal amount of the
long term loans (debentures, bonds, medium and long term loans etc.).
 Evaluate whether the internal equities (stockholders’ funds) and external
equities (creditors’ funds) are in right proportion.
Some frequently used long-term solvency ratios are given below:
(i) Debt to equity ratio
(ii) Proprietary ratio
(iii)Fixed assets to equity ratio (iv)Capital gearing ratio

(i) Debt to equity ratio is a long term solvency ratio that indicates the soundness of long-
term financial policies of a company. It shows the relation between the portion of assets
financed by creditors and the portion of assets financed by stockholders. As the debt to
equity ratio expresses the relationship between external equity (liabilities) and internal
equity (stockholder’s equity), it is also known as “external-internal equity ratio”.
Debt to equity ratio is calculated by dividing total liabilities by stockholder’s equity.
The numerator consists of the total of current and long term liabilities and the denominator

consists of the total stockholders’ equity including preferred stock. Both the elements of
the formula are obtained from company’s balance sheet.

A ratio of 1 (or 1: 1) means that creditors and stockholders equally contribute to the assets
of the business. A less than 1 ratio indicates that the portion of assets provided by
stockholders is greater than the portion of assets provided by creditors and a greater than
1 ratio indicates that the portion of assets provided by creditors is greater than the portion
of assets provided by stockholders.
Creditors usually like a low debt to equity ratio because a low ratio (less than 1) is the
indication of greater protection to their money. But stockholders like to get benefit from
the funds provided by the creditors therefore they would like a high debt to equity ratio.

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(ii) The proprietary ratio (also known as net worth ratio or equity ratio) is used to evaluate
the soundness of the capital structure of a company. It is computed by dividing the
stockholders’ equity by total assets.

Formula:

The proprietary ratio shows the contribution of stockholders’ in total capital of the
company. A high proprietary ratio, therefore, indicates a strong financial position of the
company and greater security for creditors. A low ratio indicates that the company is
already heavily depending on debts for its operations. A large portion of debts in the total
capital may reduce creditors interest, increase interest expenses and also the risk of
bankruptcy.

(iii) Fixed assets to equity ratio measures the contribution of stockholders and the
contribution of debt sources in the fixed assets of the company. It is computed by dividing
the fixed assets by the stockholders’ equity.
Other names of this ratio are fixed assets to net worth ratio and fixed assets to
proprietors fund ratio.
Formula:

The numerator in the above formula is the book value of fixed assets (fixed assets less
depreciation) and the denominator is the stockholders’ equity that consists of common
stock, preferred stock, paid in capital and retained earnings. Information about fixed assets
and stockholders’ equity is available from balance sheet.
(iv) Capital gearing ratio is a useful tool to analyze the capital structure of a company
and is computed by dividing the common stockholders’ equity by fixed interest or
dividend bearing funds.

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Analyzing capital structure means measuring the relationship between the funds provided
by common stockholders and the funds provided by those who receive a periodic interest
or dividend at a fixed rate.

A company is said to be low geared if the larger portion of the capital is composed of
common stockholders’ equity. On the other hand, the company is said to be highly geared
if the larger portion of the capital is composed of fixed interest/dividend bearing funds.

Formula:

In the above formula, the numerator consists of common stockholders’ equity that is equal
to total stockholders’ equity less preferred stock and the denominator consists of fixed
interest or dividend bearing funds that usually include long term loans, bonds, debentures
and preferred stock etc. All the information required to compute capital gearing ratio is
available from the balance sheet.
Example on Solvency Ratios
From the following Balance Sheet Calculate Debt-Equity Ratio.

Liabilities Amount Assets Amount

in Rs. in Rs.

3,000 Equity shares of Rs.100 Fixed Assets 6,00,000

each 3,00,000 Current Assets 2,00,000
2,000 10% Preference shares
of Rs.100 each 2,00,000
1,000 11% Debentures of
Rs.100 each General Reserves 1,00,000
Reserves for contingencies 50,000

Current Liabilities
50,000
1,00,000

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8,00,000
8,00,000

Solution:
(i) Debt-Equity Ratio= Outsiders’ Funds
Shareholders’ fund
= 1,00,000 (Debentures) + 1,00,000 (Current Liabilities) 3,00,000 + 2,00,000 +
50,000 + 50,000
= Rs.2,00,000/ Rs.6,00,000 = 1:3
(ii) Debt-Equity Ratio (excluding current liabilities)
= Long-term Debt = Rs.1,00,000/Rs.6,00,000 = 1:6 Shareholders’ funds

Advantages of Ratio analysis

Ratio analysis is widely used as a powerful tool of financial statement analysis. It
establishes the numerical or quantitative relationship between two figures of a financial
statement to ascertain strengths and weaknesses of a firm as well as its current financial
position and historical performance. It helps various interested parties to make an
evaluation of certain aspect of a firm’s performance.
The following are the principal advantages of ratio analysis:
Forecasting and Planning:
The trend in costs, sales, profits and other facts can be known by computing ratios of
relevant accounting figures of last few years. This trend analysis with the help of ratios
may be useful for forecasting and planning future business activities.
Budgeting:
Budget is an estimate of future activities on the basis of past experience. Accounting ratios
help to estimate budgeted figures. For example, sales budget may be prepared with the
help of analysis of past sales.
Measurement of Operating Efficiency:
Ratio analysis indicates the degree of efficiency in the management and utilisation of its
assets. Different activity ratios indicate the operational efficiency. In fact, solvency of a
firm depends upon the sales revenues generated by utilizing its assets.
Communication:
Ratios are effective means of communication and play a vital role in informing the
position of and progress made by the business concern to the owners or other parties.
Control of Performance and Cost:
Ratios may also be used for control of performances of the different divisions or
departments of an undertaking as well as control of costs.
Inter-firm Comparison:
Comparison of performance of two or more firms reveals efficient and inefficient firms,

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thereby enabling the inefficient firms to adopt suitable measures for improving their
efficiency. The best way of inter-firm comparison is to compare the relevant ratios of the
organisation with the average ratios of the industry.

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Indication of Liquidity Position:

Ratio analysis helps to assess the liquidity position i.e., short-term debt paying ability of a
firm. Liquidity ratios indicate the ability of the firm to pay and help in credit analysis by
banks, creditors and other suppliers of short-term loans.
Indication of Long-term Solvency Position:
Ratio analysis is also used to assess the long-term debt-paying capacity of a firm. Long-
term solvency position of a borrower is a prime concern to the long-term creditors,
security analysts and the present and potential owners of a business. It is measured by the
leverage/capital structure and profitability ratios which indicate the earning power and
operating efficiency. Ratio analysis shows the strength and weakness of a firm in this
respect.
Indication of Overall Profitability:
The management is always concerned with the overall profitability of the firm. They want
to know whether the firm has the ability to meet its short-term as well as long-term
obligations to its creditors, to ensure a reasonable return to its owners and secure optimum
utilisation of the assets of the firm. This is possible if all the ratios are considered together.
Signal of Corporate Sickness:
A company is sick when it fails to generate profit on a continuous basis and suffers a
severe liquidity crisis. Proper ratio analysis can give signal of corporate sickness in
advance so that timely measures can be taken to prevent the occurrence of such sickness.
Aid to Decision-making:
Ratio analysis helps to take decisions like whether to supply goods on credit to a firm,
whether bank loans will be made available etc.
Simplification of Financial Statements:
Ratio analysis makes it easy to grasp the relationship between various items and helps in
understanding the financial statements.
Limitations of Ratio analysis
The technique of ratio analysis is a very useful device for making a study of the financial
health of a firm. But it has some limitations which must not be lost sight of before
undertaking such analysis.
Some of these limitations are:
i. Limitations of Financial Statements:
Ratios are calculated from the information recorded in the financial statements. But
financial statements suffer from a number of limitations and may, therefore, affect the quality
of ratio analysis.

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ii. Historical Information:

Financial statements provide historical information. They do not reflect current conditions.
Hence, it is not useful in predicting the future.
iii. Different Accounting Policies:
Different accounting policies regarding valuation of inventories, charging depreciation
etc. make the accounting data and accounting ratios of two firms non-comparable.
iv. Lack of Standard of Comparison:
No fixed standards can be laid down for ideal ratios. For example, current ratio is said to
be ideal if current assets are twice the current liabilities. But this conclusion may not be
justifiable in case of those concerns which have adequate arrangements with their bankers
for providing funds when they require, it may be perfectly ideal if current assets are equal
to or slightly more than current liabilities.
v. Quantitative Analysis:
Ratios are tools of quantitative analysis only and qualitative factors are ignored while
computing the ratios. For example, a high current ratio may not necessarily mean sound
liquid position when current assets include a large inventory consisting of mostly obsolete
items.
vi. Window-Dressing:
The term ‘window-dressing’ means presenting the financial statements in such a way to
show a better position than what it actually is. If, for instance, low rate of depreciation is
charged, an item of revenue expense is treated as capital expenditure etc. the position of
the concern may be made to appear in the balance sheet much better than what it is. Ratios
computed from such balance sheet cannot be used for scanning the financial position of
the business.
vii. Changes in Price Level:
Fixed assets show the position statement at cost only. Hence, it does not reflect the changes in price
level. Thus, it makes comparison difficult.
viii. Causal Relationship Must:
Proper care should be taken to study only such figures as have a cause-and-effect relationship; otherwise
ratios will only be misleading.
ix. Ratios Account for one Variable:
Since ratios account for only one variable, they cannot always give correct picture since several other
variables such Government policy, economic conditions, availability of resources etc. should be kept in
mind while interpreting ratios.
x. Seasonal Factors Affect Financial Data:
Proper care must be taken when interpreting accounting ratios calculated for seasonal business. For example, an umbrella
company maintains high inventory during rainy season and for the rest of year its inventory level becomes 25% of the
seasonal inventory level. Hence, liquidity ratios and inventory turnover ratio will give biased picture.

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