Crack Grade B 1

RATIO ANALYSIS

PYQs asked from this chapter:

Q1. Calculate the Return on Assets (ROA), if Income – is Rs 100 Lakhs and Asset size =
is Rs 500 lakhs.
a) 10
b) 50
c) 20
d) 25
e) 15

Q2. Which of the following does not measure long term solvency:
a. Times Interest Earned Ratio
b. Total Debt ratio
c. Current Ratio and acid test ratio
d. fixed asset to net worth ratio

Q3. Weighted average cost of capital (WACC): Calculate WACC if a firm has 20 million in
long term debt, Rs 4 million preferred stock, Rs 16 million of common equity, all at market
value, the before tax cost for debt, preferred stock and common equity form of capital are 8%,
9% and 15% respectively. Assume 40% tax rate: 9.3%.
WACC = [(D/V x Rd) x (1 – T)] + (E/V x Re) + (P/V x Rp)
(0.5) (8%) (1-.40) + (0.10) (9%) +(0.40) (15%) = 2.4% +0 .9% + 6% = 9.3%.

Answer the Question no. 4 to 7 based on the statement given below:

Statement: According to J. Batty “the term accounting ratio is used to describe
significant relationships between figures shown on a Balance Sheet, in a Profit and Loss
Account, in a Budgetary Control System or in any part of the accounting organisation.” In
simple words, it is an assessment of significance of any figure in relation to another.
The accounting ratios indicate a quantitative relationship which is used for analysis and
decision-making. It provides basis for inter-firm as well as intra-firm comparisons.
Besides, in order to make the ratios effective, they are compared with ratios of base
period or with standards or with the industry average ratios.

Different kinds of ratios are selected for different types of situations:

Balance Sheet Ratios: These ratios are also known as financial ratios. These ratios deal
with relationship between two items or group of items which are both available in Balance
sheet. Examples of these ratios are: Current ratio, Liquid ratio, Debt-Equity ratio, Capital
bearing ratio, Proprietary ratio, etc.

Profit and Loss Account Ratios: These ratios deal with the relationship between two items
or group of items which are usually taken out from the profit and loss account.
Examples of these ratios are: Gross profit ratio, Net profit ratio, Operating ratio,
Operating profit ratio, Interest coverage ratio etc.

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Q4. If 1:1 bonus shares are issued, which of the following will be impacted:
a. Face value reduces
b. Debt equity ratio will reduce
c. No impact on net Tangible net worth (correct)
d. None
e. market value will reduce
Q5. Which of the following is most important driver of market price of a share?
a. Dividend
b. EPS
c. Profit
d. None

Q6. Return on Investment measures which of the following ratio?

a. Profitability ratio
b. Solvency ratio
c. Liquidity ratio
d. None of the above

Q7. The share price and earning per share for 5 different bank as follows, which bank
has the highest P/E ratio:

Name of the bank Share price per Earnings per share

share
AXIS Bank 1020 60
ICICI Bank 1240 52
HDFC Bank 2060 67
CITI Bank 830 44
YES Bank 1450 70

a. YES Bank
b. CITI Bank
c. HDFC Bank
d. ICICI Bank
e. AXIS Bank

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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. 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.

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; and
5. To provide information derived from financial statements useful for making
projections and estimates for the future.

Types of ratios
The most commonly used classification which is as follows:

A. Profitability Ratios
B. Liquidity Ratios
C. Activity (or Turnover) Ratios
D. Solvency Ratios

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. 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

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business to increase the production capacity and strengthen the overall

financial position of the company.

(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.

(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:

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.
(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

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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.

(v) Earnings per share (EPS) ratio It is computed by dividing net income less
preferred dividend by the number of shares of common stock outstanding
during the period. Earnings per share ratio (EPS ratio) is computed by the
following formula:

Earnings per Share (EPS) = Net Profit available to equity shareholders/ No.
of Equity shares outstanding

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.

(vi) Return on Assets (ROA) It measures relationship between net profits and
assets employed to earn that profit.

ROA = Net Profit after Taxes/ Total Assets

(vii) Return on Capital Employed (ROCE)

ROCE = Earnings before interest and taxes (EBIT) / Capital Employed

Here Capital Employed can be calculated in 3 ways:

Capital Employed = Total Assets – Current Liabilities
OR
Capital Employed = Fixed Assets + Working Capital
OR
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Capital Employed = Equity + Long Term Debt

Intangible assets should be included in Capital Employed (Eg

Goodwill, Patents, Trademarks) but no Fictitious

(viii) Return on Equity (ROE) It measures the profitability of equity funds

invested in the firm. This ratio reveals how profitably of the owners funds
have been utilized by the firm.

ROE = (Net Profit after Taxes – Preference Dividend)/Equity

Shareholders fund

(ix) Dividend per Share (DPS) It indicates the amount of profit distributed to
equity shareholders per share.

DPS = Total Dividend paid to equity shareholders/ Number of equity

share outstanding

Example on Profitability Ratios

Following is the Profit and Loss Account of X Ltd., for the year ended 31st
March, 2022.
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 By Gross Profit b/d
Expenses 20,000 2,01,000
To Selling and 89,000 By Interest on 10,000
Distribution Investments
Expenses By Profit on sale of Assets 8,000
To Non-Operating 30,000
Expenses
To Net Profit Transferred to 80,000
Capital

2,19,000 2,19,000

You are required to calculate:

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(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.
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.

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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)
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.

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. An acid test of 1:1 is considered satisfactory.

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(ii) 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.

Note: Net working Capital= Current Assets – Current Liabilities (Excluding

Short Term bank borrowing)

Example on Liquidty Ratios:

The following is the Balance Sheet of X Ltd., for the year ending 31st
March, 2022.

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

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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.
90,000
= 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 =
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
(iv) 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.

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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) It measures how many times a company
has sold and replaced its inventory during a certain period of time.

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.
(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.

(iii) Average collection period It is expressed in days and is an indication of

the quality of receivables.
The formula is given below:

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A short collection period means prompt collection and better management of

receivables.
(iv) Accounts payable turnover ratio (also known as creditors turnover ratio
or creditors’ velocity). 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 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.

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.
(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 during the period.
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

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From Balance Sheet From Income Statement

CURRENT ASSETS REVENUE

Cash Rs 2,550 Sales Rs.112,500

Marketable Rs. 2,000 Cost of Rs. 85,040

securities Goods
Sold(COGS)

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

Receivable
(Net)

Inventories Rs.26,470

Total Rs.47,695
Current
Assets

Opening Inventory = Rs.22,500

Using the above figures, calculate the average collection period ratio, Inventory Turnover
Ratio.

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.

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(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.

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.

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.
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.
(iii) 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. 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:

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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 3,00,000 Fixed Assets 6,00,000
Each Current Assets 2,00,000
2,000 10% Preference shares 2,00,000
of Rs.100 each
1,000 11% Debentures 1,00,000
Rs.100 each 50,000
General
Reserves 50,000
Reserves for contingencies
Current Liabilities 1,00,000
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 =
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Rs.1,00,000/Rs.6,00,000 = 1:6
Shareholders’ funds

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