III B.

Tech VI Semester (2023-2024)

(A19HS1MG02)

Engineering Economics and

Accountancy
UNIT-IV : Financial Analysis through Ratios

By
Mrs. Ch.V.L.L.Kusuma Kumari
Assistant Professor
H&S Department
Dr GP, H&S Dept,. VNRVJIET
VNR VJIET, Hyderabad
 Introduction of Ratio Analysis
• Ratio analysis refers to the analysis and
interpretation of the figures appearing in the
financial statements (i.e., Profit and Loss
Account, Balance Sheet).
• It is a process of comparison of one figure
against another. It enables the users to get
better understanding of financial statements.
• Accounting ratios are used by the financial
analysts to analyze the accounting ratios to
diagnose the financial health of an enterprise.
• Meaning of financial ratios
– 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.
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
• 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;
• 5. To provide information derived from financial
statements useful for making projections and
estimates for the future.
 Types of ratios
• 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:
• Liquidity Ratios
• Solvency Ratios
• Activity (or Turnover) Ratios
• Profitability Ratios
 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 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
• 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 are given
below: Cash, Bank, Inventory (raw material,
work-in-progress and finished goods),
Marketable securities, Accounts receivables
(Debtors and bills receivables), Prepaid
expenses
• Some examples of current liabilities are given
below: Accounts payable (Bills payable and
creditors), Accrued payable, Bonds payable and
Bank OD etc.
• (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:

Liquid assets = current assets – inventory

• (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.
 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 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) Interest Coverage ratio
– (v) 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.
• 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.
• (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.

• (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.
(iv) Interest Coverage ratio The interest coverage ratio, or times
interest earned (TIE) ratio, is used to determine how well a company
can pay the interest on its debts and is calculated by dividing EBIT
(EBITDA or EBIAT) by a period's interest expense.

(v) 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.
 Activity (or Turnover) 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:
– (i) Inventory turnover ratio
– (ii) Receivables turnover ratio
– (iii) Average collection period
– (iv) Accounts payable turnover ratio
– (v) Working capital turnover ratio
– (vi) 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:
• (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.
 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.
• 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
• (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:
Thank You