RATIO ANALYSIS

Ratio analysis is the process of determining and interpreting numerical

relationships based on financial statements.
 INTRODUCTION
 Ratio analysis is an important tool of financial statements analysis.
 Financial statements prepared by a business enterprise in the corporate sector are published and
are available to the decision-makers.
 These statements provide financial data which require analysis, comparison and interpretation for
taking decision by the external as well as internal users of accounting information. This act is termed
as financial statement analysis.
 Ratios for analyzes the information contained in financial statements for assessing the solvency,
efficiency and profitability of the enterprises.
 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.
The Parties Interested:
The persons interested in the analysis of financial statements can be grouped under three heads:
(i) Owners or investors :- Investors desire a primary basis for estimating earning capacity.
(ii) Creditors :- Creditors (trade and financial) are concerned primarily with liquidity and ability to pay
interest and redeem loan within a specific period.
(iii) Financial executives :- Management is interested in evolving analytical tools that will measure costs,
efficiency, liquidity and profitability with a view to making intelligent decisions.

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.
Advantages of Ratio Analysis
1. Helps to understand efficacy of decisions: The ratio analysis helps you to understand whether the
business firm has taken the right kind of operating, investing and financing decisions. It indicates how far
they have helped in improving the performance.
2. Simplify complex figures and establish relationships: Ratios help in simplifying the complex accounting
figures and bring out their relationships. They help summarise the financial information effectively and
assess the managerial efficiency, firm’s credit worthiness, earning capacity, etc.
3. Helpful in comparative analysis: The ratios are not be calculated for one year only. When many year
figures are kept side by side, they help a great deal in exploring the trends visible in the business. The
knowledge of trend helps in making projections about the business which is a very useful feature.
4. Identification of problem areas: Ratios help business in identifying the problem areas as well as the
bright areas of the business. Problem areas would need more attention and bright areas will need
polishing to have still better results.
5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring in the business. The
information of change helps the management a great deal in understanding the current threats and
opportunities and allows business to do its own SWOT (Strength Weakness-Opportunity-Threat) analysis.
6.Various comparisons: Ratios help comparisons with certain bench marks to assess as to whether firm’s
performance is better or otherwise. For this purpose, the profitability, liquidity, solvency, etc., of a business,
may be compared:
(i) over a number of accounting periods with itself (Intra-firm Comparison/Time Series Analysis),
(ii) with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis) and
(iii) with standards set for that firm/industry (comparison with standard (or industry expectations).
 Limitations of Ratio Analysis
1. Limitations of Accounting Data: Accounting data give an unwarranted impression of precision and
finality. In fact, accounting data “reflect a combination of recorded facts, accounting conventions
and personal judgements which affect them materially. It is merely an opinion of the accountant
based on application of accounting policies. The soundness of the judgement necessarily
depends on the competence and integrity of those who make them and on their adherence to
Generally Accepted Accounting Principles and Conventions”. Thus, the financial statements may
not reveal the true state of affairs of the enterprises and so the ratios will also not give the true
picture.
2. Ignores Price-level Changes: The financial accounting is based on stable money measurement
principle. It implicitly assumes that price level changes are either non-existent or minimal. But the
truth is otherwise. We are normally living in inflationary economies where the power of money
declines constantly. A change in the price-level makes analysis of financial statement of different
accounting years meaningless because accounting records ignore changes in value of money.
3. Ignore Qualitative or Non-monetary Aspects: Accounting provides information about quantitative (or
monetary) aspects of business. Hence, the ratios also reflect only the monetary aspects, ignoring
completely the non-monetary (qualitative) factors.
4. Variations in Accounting Practices: There are differing accounting policies for valuation of inventory,
calculation of depreciation, treatment of intangibles Assets definition of certain financial variables etc.,
available for various aspects of business transactions. These variations leave a big question mark on the
cross-sectional analysis. As there are variations in accounting practices followed by different business
enterprises, a valid comparison of their financial statements is not possible.
5. Forecasting: Forecasting of future trends based only on historical analysis is not feasible. Proper
forecasting requires consideration of non-financial factors as well.
❖ DIFFERENT FORMS IN WHICH RATIO CAN BE EXPRESSED

There are three different forms in which an accounting ratio can be expressed:

a) Pure ratio :- A pure ratio is a simple division of one number by another. It will be expressed as 2:1.

b) Percentage :- Certain accounting ratios become more meaningful if expressed as a percentage. For

example, if sales are Rs. 4,00,000 and Gross Profit is Rs. 2,00,000 then it is expressed as gross profit being

50% of sales.

c) Rate :- Sometimes ratios are expressed as rates i.e. 'number of times' over a certain period. If stock

turnover rate is said to be '8' times in a year, it means that the stock is converted into sales 8 times in 12

months.
Types of Ratios
There is a two way classification of ratios:

(1)traditional classification:- The traditional classification has been on the basis of financial
statements to which the determinants of ratios belong.
1. Statement of Profit and Loss Ratios
2. Balance Sheet Ratios
3. Composite Ratios

(2) functional classification :- the alternative classification (functional classification) based on the
purpose for which a ratio is computed,
1. Liquidity Ratios
2. Solvency Ratios
3. Activity (or Turnover) Ratios
4. Profitability Ratios
Traditional Classification
1. 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.
Statement Balance 2. Balance Sheet Ratios: In case both variables are from the
of Profit Sheet balance sheet, it is classified as balance sheet ratios. For
and Loss Ratios example, ratio of current assets to current liabilities known
Ratios as current ratio. It is calculated using both figures from
balance sheet.
3. Composite Ratios: If a ratio is computed with one variable
from the statement of profit and loss and another variable
Composite from the balance sheet, it is called composite ratio. For
Ratios 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.
Traditional Classification Ratios.

Statement of Profit and Balance Sheet Ratios Composite Ratios

Loss Ratios
• Gross Profit Ratio • Current Ratio • trade receivables
• Operating Ratio • Liquid Ratio turnover ratio
• Expenses Ratio • Proprietary Ratio • Trade Payable Turnover
• Net Operating Profit • Stock Working capital Ratio
Ratio Ratio
• Net Profit Ratio • Capital Gearing Ratio
• Debt Equity Ratio
Functional Classification
 Profitability Ratios :- It refers to the analysis of profits in relation
to revenue from operations or funds (or assets) employed in the
business and the ratios calculated to meet this objective are
known as ‘Profitability Ratios’.

Profitability Solvency  Solvency Ratios :- Solvency of business is determined by its

ability to meet its contractual obligations towards stakeholders,
Ratios Ratios particularly towards external stakeholders, and the ratios
calculated to measure solvency position are known as ‘Solvency
Ratios’. These are essentially long-term in nature.

 Liquidity Ratios :- To meet its commitments, business needs

liquid funds. The ability of the business to pay the amount due to

Liquidity Activity or stakeholders as and when it is due is known as liquidity, and the
(turnover) ratios calculated to measure it are known as ‘Liquidity Ratios’.
Ratios ratio These are essentially short-term in nature.

 Activity or (turnover) ratio :- This refers to the ratios that are

calculated for measuring the efficiency of operations of business
based on effective utilization of resources. Hence, these are also
known as ‘Efficiency Ratios’.
 Functional Classification Ratios.
Profitability Ratios Activity or (turnover) Liquidity Ratios Solvency Ratios
ratio

• Gross Profit Ratio • Inventory Turnover • Current Ratio • Debt Equity Ratio
• Operating Ratio Ratio • Liquidity Ratio • Proprietary Ratio
• Operating Profit Ratio • Debtors Turnover • Fixed Assets Ratio
• Net Profit Ratio Ratio • Capital Gearing
• Return on Investment • Creditors Turnover
• Return on Equity Ratio
Shareholders Fund • Fixed Assets Turnover
Ratio
• Working Capital
Turnover Ratio
• Capital Turnover Ratio
 Balance Sheet Ratios:
1.Current Ratio = Current Assets
Current Liabilities

2. Liquid Ratio = Quick (Liquid) Assets

Quick (Liquid) Liabilities
• Liquid assets are those which are readily converted into cash and will include cash/ bank balances, bills
receivable, sundry debtors and short term investments. Inventories and Prepaid Expenses are not included in
liquid assets.
• Liquid Liabilities includes all items of current liabilities except Bank Overdraft.

3. Proprietary Ratio = Proprietors funds

Total Assets
• Proprietor fund = Share capital(Equity & Pref.) + Retained earnings (less loss if any) -Fictitious assets
• Total Assets = Fixed Assets + Current Assets-Fictitious assets
4. Stock Working capital Ratio = Closing Stock
Working Capital
• Working Capital = Current assets – Current liabilities

5. Capital Gearing Ratio = Fixed Interest & Dividend Bearing Funds

Equity Share holders fund

• Equity Share holders fund= Equity Sh. Capital + Retained earnings (less loss if any) -Fictitious assets

6. Debt Equity Ratio = Long Term Debt

Proprietors Fund
 INCOME STATEMENT RATIOS
1. Gross Profit Ratio = Gross Profit X100
Net Sales
Purpose: Indicates the efficiency of production and trading operations

2. Operating Ratio = Cost of Goods Sold + Operating Expenses X100

Net Sales
Purpose: index of managerial ability to control operating expenses.

3. Expenses Ratio = Operating Expenses X100

Net Sales
(Expenditure may be cost of production or Cost of sales, administrative or Selling or distribution expenses or
any other Element of Group)
Purpose: Indicates the direction in which economies ought to be effected.
4. Net Operating Profit Ratio = Operating Profit X100
Net Sales
Purpose: Index of Operating Efficiency.

5. Net Profit Ratio = Net Profit After Tax X100

Net Sales
Purpose: Indicates Net Margin on sales.
Prob 1:

Calculate Following Ratios from the above balance sheet:

1. Current Ratio
2. Liquid Ratio
3. Proprietary Ratio
4. Stock Working capital Ratio
5. Capital Gearing Ratio
6. Debt Equity Ratio
Solution:
1. Current ratio = Current assets/current liabilities
= 6,50,000/1,00,000
= 6.5:1
Current assets = inventory (3,00,000)+ s.debtors(3,00,000) + cash balance(50,000) = 6,50,000
Current liabilities = S.Creditors = 1,00,000

2. Liquid ratio = liquid assets/liquid liabilities

= 3,50,000/1,00,000
= 3.5:1
liquid assets = s.debtors(3,00,000) + cash balance(50,000) = 3,50,000
liquid liabilities = S.Creditors = 1,00,000

3. Proprietary Ratio = Proprietors fund / total assets

= 800,000/12,00,000
= 0.66 : 1
Proprietor fund = Share capital(Equity & Pref.) + Retained earnings(GR) (less loss if any) -Fictitious assets
= 5,00,000 + 2,00,000 + 100,000
= 8,00,000
Total Assets = Fixed Assets + Current Assets-Fictitious assets
= 12,00,000
4. Stock Working capital Ratio = closing stock(inventory) / working capital
= 300,000 / 5,50,000
= 0.55:1
Working capital (CA-CL= 6,50,000 – 1,00,000 = 5,50,000)

5. Capital Gearing Ratio = Fixed Interest & Dividend Bearing Funds / Equity Share holders fund
= 500,000 / 600,000
= 0.83 : 1
Fixed Interest & Dividend Bearing Funds = pref sh. (2,00,000) + secured loan (3,00,000) = 500,000
Equity Share holders fund = Eq. Shares (5,00,000) + GR (100,000) = 600,000

6. Debt Equity Ratio = Long Term Debt / Proprietors Fund

= 3,00,000/8,00,000
= 0.38 : 1
Long term debt = secured loan (300,000)
Prob 2:

Calculate Following Ratios from the above balance sheet:

1. Current Ratio
2. Liquid Ratio
3. Proprietary Ratio
4. Capital Gearing Ratio
5. Debt Equity Ratio
Solution:

1. Current ratio = Current assets/current liabilities

= 4,16,000/3,20,000
= 1.3:1

Current assets = stock (2,02,000)+ BR (40,000)+ s.debtors(98000) + cash balance(76,000)

= 4,16,000
Current liabilities = trade payable (2,44,000) + Bank o/d(40,000) + provision for income tax (36,000)
= 320,000

2. Liquid ratio = liquid assets/liquid liabilities

= 2,14,000/2,80,000
= 0.76:1

liquid assets = BR (40,000)+ s.debtors(98000) + cash balance(76,000)

= 2,14,000
liquid liabilities = trade payable (2,44,000) provision for income tax (36,000)
= 2,80,000

3. Proprietary Ratio = Proprietors fund / total assets

= 6,72,000/12,32,000
= 0.55 : 1
Proprietor fund = Share capital(Equity & Pref.) + Retained earnings (less loss (p&L)if any) -Fictitious assets
= 2,00,000 + 3,60,000 + 140,000-28,000
= 6,72,000
Total Assets = Fixed Assets + Current Assets-Fictitious assets
= 12,60,000 – 28,000
= 12,32,000

4. Capital Gearing Ratio = Fixed Interest & Dividend Bearing Funds / Equity Share holders fund
= 600,000 / 3,12,000
= 1.92 : 1

Fixed Interest & Dividend Bearing Funds = pref sh. (3,60,000) + debentures (2,40,000)
= 6,00,000
Equity Share holders fund = Eq. Shares (2,00,000) + GR (1,40,000) – profit & loss (28000)
= 3,12,000

5. Debt Equity Ratio = Long Term Debt / Proprietors Fund

= 2,40,000/6,70,000
= 0.36 : 1

Long term debt = debentures (2,40,000)

Prob 3:
The following is the balance sheet of New India Ltd., for the year ending 31st Dec. 2023.
From the balance sheet calculate
•Current Ratio
•Liquid Ratio
Rs. Rs.
9% Preference Share Capital 500000 Goodwill 100000
Equity Share Capital 1000000 Land and Building 650000
8%Debentures 200000 Plant 800000
Long-term Loan 100000 Furniture & Fixture 150000
Bills Payable 60000 Bills Receivables 70000
Sundry Creditors 70000 Sundry Debtors 90000
Bank Overdraft 30000 Bank Balance 45000
Outstanding Expenses 5000 Short-term Investments 25000
Prepaid expenses 5000
Stock 30000
1965000 1965000
1.Current Ratio = Current Assets / Current Liabilities
= 265000 / 165000
= 1.61
Current Assets = Rs. 70000 + Rs. 90000 + Rs. 45000 + Rs. 25000 + Rs.5000+ Rs. 30000

= Rs. 265000

Current Liabilities = Rs. 60000 + Rs. 70000 + Rs. 30000 + Rs. 5000

= Rs. 165000

2.Quick Ratio = Liquid Assets / Current liabilities

=Rs. 230000 / Rs. 135000

=1.7

Liquid Assets = Rs. 70000 + Rs. 90000 + Rs. 45000 + Rs. 25000

= Rs. 230000

Liquid Liabilities = Rs. 60000 + Rs. 70000 + Rs. 5000

=135000
 Prob 4: Calculate current ratio from the following
information :
stock 60,000 Sundry Creditors 20,000
Sundry Debtors 70,000 Bills Payable 15,000
Cash Balances 20,000 Tax Payable 18,000
Bills Receivables 30,000 Outstanding Expenses 7,000
Prepaid Expenses 10,000 Bank Overdraft 25,000
Land and Building 1,00,000 Debentures 75,000
Goodwill 50,000
Solution:
Current Ratio = Current Assets / Current Liabilities

= 1,90,000 / 85,000

= 2.24:1

Current Assets = Rs. 60,000 + 70,000 + 20,000 + 30,000 + 10,000

= Rs. 1,90,000

Current Liabilities = Rs. 20,000 + 15,000 + 18,000 + 7,000 + 25,000

= Rs. 85,000
Prob 5:
Ans.

Current Ratio = Current Assets

Current Liabilities

Current Ratio
= Rs.1,34,000 = 1.29:1
Rs.1,04,000

Current Assets
= Inventories + Trade receivables + Advance tax +
Cash and cash equivalents
= Rs. 50,000 + Rs. 50,000 + Rs. 4,000 + Rs. 30,000
= Rs. 1,34,000

Current Liabilities
= Trade payables + Short-term borrowings
= Rs. 1,00,000 + Rs. 4,000
= Rs. 1,04,000
Prob. 1:
Following is the Income Statement of Urja Auto. Ltd. For the year ended 31st Dec 2024. You are required to
calculate:
1) Gross Profit Ratio;
2) Operating Ratio;
3) Net operating Profit Ratio and
4) Net Profit Ratio.
Solution: (Hint: only needs to replace available figures with respective formula to arrive at answer)

1. Gross Profit Ratio = Gross Profit X100 / Net Sales

= 800000/20,00,000 x 100
= 40%

2. Operating ratio = Cost of Goods Sold + Operating Expenses X100 / Net Sales
= 12,00,000 + 4,80,000 X100
20,00,000
= 84%

3. Net operating profit Ratio = Operating Profit X100 / Net Sales

= 3,20,000/20,00,000 x 100
= 16%

4. Net profit ratio = Net Profit After Tax X100 / Net Sales
= 2,46,400/20,00,000 x 100
= 12.3%
Prob. 2:
The following Trading and Profit and Loss Account of Tiptop Ltd. for the year 31‐3‐2024 is given below:
Calculate: Gross profit ratio, Expense ratio, operating ratio, net operating profit ratio & net profit ratio.
Solution:

1. Gross Profit Ratio = Gross Profit X100 / Net Sales

= 2,00,000/500,000 x 100
= 40%

2. Expense ratio = operating exp x 100. / net sales

=1,13,000+5,00,000 x 100
= 22.60%

3. Operating ratio = cost of goods sold +operating Exp x100 / net sales
= 3,00,000 + 1,13,000 x100
5,00,000
= 82.6%
(Cost of Goods sold = Op. stock + purchases + carriage inward + wages – Closing Stock)

4. Operating profit ratio = operating profit x100 / net sales

= 87,000 x 100 /5,00,000
= 17.40%
(Operating profit = sales – (cost of goods sold + operating exp.)

5. Net profit ratio = Net profit x 100 /net sales

= 84,000 x 100 / 5,00,000
= 16.8%
Practice problems:

Q1. Calculate Following Ratios from the above balance sheet:

1. Current Ratio.
2. Liquid Ratio.
3. Proprietary Ratio.
4. Capital Gearing Ratio.
5. Debt Equity Ratio
Q2. From the following information for the year ended 31st Dec 2024, You are required to
calculate: 1) Gross Profit Ratio; 2) Operating Ratio; 3) Net operating Profit Ratio and 4) Net Profit
Ratio.

Total Sales- Rs. 5,00,000/-

Sales Return- Rs. 50,000/-
Gross Profit – 40% of Net Sales.
Cost of goods sold – Rs. ??
Operating Expenses – Rs.60,000/-
Non-operating Income – Rs. 21,000/-
Tax Rate is 50%

Hint: first prepare income statement and then calculate ratios.