RATIO ANALYSIS

MEANING OF RATIO ANALYSIS

A ratio is a simple arithmetical expression of
the relationship of one number to another.

Accounting ratios present the information of

the financial statements in simplified,
systematized and summarised form.
Financial ratio analysis is a way of appraising the importance
of items appearing in balance sheet.
Liquidity ratio : The ratio of current assets to current
liabilities, for example, gives the analyst an idea of the
extent to which the firm can meet its current obligations.
Financial leverage ratios (such as the debt–asset ratio and
debt as a percentage of total capitalization) are used to
make judgments about the advantages to be gained from
raising funds by the issuance of bonds (debt) rather than
stock.
Activity ratios: relating to the turnover of such asset
categories as inventories, accounts receivable, and fixed
assets, show how intensively a firm is employing its assets.
Profitability Ratio : A firm’s primary operating objective is to
earn a good return on its invested capital, and various profit
ratios (profits as a percentage of sales, of assets, or of net
worth) show how successfully it is meeting this objective.
 CLASSIFICATION OF RATIOS
1. LIQUIDITY RATIOS
(1) Current ratio
(2) Liquid ratio (Acid test or quick ratio)
(3) Absolute liquid ratio

2. ACTIVITY RATIOS OR TURNOVER RATIO

1. Inventory turnover ratio
2. Debtors turnover ratio
3. Creditors turnover ratio
4. Working capital turnover ratio
3. PROFITABILITY RATIOS :
A. In relation to sales
(i) Gross profit ratio
(ii) Net profit ratio
(iii) operating profit ratio
(iv) Operating ratio
(v) Expense ratio

B. In relation to investment
(vi) Return on investment
(vii) Return on capital employed
(viii) Return on equity capital (ROE)
(ix) Earnings per share
(x) Price earning ratio
4. LONG TERM SOLVENCY RATIOS
1. Debt equity ratio
2. Debt to total capital ratio
3. Interest coverage ratio
4. Capital gearing ratio
5. Fixed asset ratio
6. Proprietary ratio
A. LIQUIDITY RATIOS / SHORT TERM SOLVENCY RATIO
Ratio Formula Numerator Denominator

1. Current Ratio Current Assets Inventories Sundry Creditors

Current Liabilities + Debtors + Outstanding
+ Cash & Bank Expenses
+ Receivables + Short Term Loans
+ Short terms Loans &Advances
+ Marketable + Bank Overdraft
Investments + Provision for
taxation
+ Proposed Dividend

2. Quick Ratio or Quick Assets Current Assets Current Liabilities

Acid test ratio Current Liabilities Less : Inventories
Less : Prepaid
Expenses
3. Absolute Cash Ratio (Cash & bank+Marketable Securities)
Current Liabilities

[B] ACTIVITY RATIO/TURNOVER RATIO

1. (A) Inventory Turnover Ratio Cost of Goods Sold

Average Stock

Cost of goods sold = Opening stock + purchases + direct expenses – closing stock
Or
Cost of goods sold = Net sales – gross profit

Average stock = opening stock + closing stock

2

365
(B) Inventory conversion period
inventory turnover ratio
(2) (a) Debtors turnover ratio Net credit sales
Average Debtors
(b) Average collection period 365
Debtors turnover ratio
Average Debtors = opening debtors + closing debtors
2
3 (a) Creditors turnover ratio Net credit purchase
Average trade creditors

(b) Average payment period 365

Creditors turnover ratio
4. Working capital turnover ratio Cost of goods sold
Average working capital
Profitability ratios
I. Gross Profit Ratio Gross Profit x 100 Gross Profit as per Sales net of
Sales Trading returns
Account
2. Operating Profit Operating Profit x 100 Gross Profit – operating Sales net of
ratio Sales expenses (or) returns
Net Profit
Or Add: Non-operating
expenses
100 – Operating Ratio Less : Non-operating
incomes

3. Net Profit Ratio Net Profit x 100 Net Profit Sales net of
Sales returns
4. Operating Ratio Operating Cost x 100 Cost of goods sold + Sales net of
Sales Operating expenses returns

5. Expense Ratio Expense x 100 Every expense Sales net of

Net sales returns
Operating expenses consist of :
(a) Administrative and office expenses like rent, salaries to
staff, insurance etc.
(b) Selling and distribution expenses like advertisement,
salaries to salesmen, bad debts, discount etc.

Non operating income : It includes income from non-trading

operations, such as refund of tax, interest and dividend
received, profit on sale of assets, compensation received etc.

Non-operating expenses : These expenses include all

financial expenses such as interest on debentures, dividend,
depreciation, loss on sale of assets, abnormal loss such as
loss by fire, discount or loss on issue of shares of
debentures, goodwill and preliminary expenses written off,
reserves, dividend and interest paid.
OVERALL PROFITABILITY RATIO

1. Return on investment (ROI)

2. Return on equity (ROE)
3. Earning per share (EPS)
4. Dividend per share (DPS)
Particulars

Estimated EBIT (Operating Profit)

Less : Interest on Debentures
Interest on Bank Loan
Profits Before Tax (PBT)
Less : Corporate Tax
Profit after Tax (PAT)
Less : Dividend on Pref. Shares
Earning available for Equity shares (A)
No. of equity shares (B)
Earning per share (EPS) A / B
P/E Ratio

Market price per share

 Overall Profitability Ratio
1.Return on Profit before interest Profits after taxes +Taxation + Interest
Investment (ROI) or and taxes
Return on Capital Total Capital
Employed (ROCE) Employed
Calculation of Capital Employed :

Assets Route:
Net Fixed Assets +Net working Capital

Or, Total Assets – Current Liabilities

Liability Route :
Equity Share Capital
+ Preference Share Capital
+ Reserves & Undistributed profits
+Debentures and Long Term Loans
Less : Fictitious assets (preliminary expns., discount on issue of shares)

Note : - This ratio indicates how well the management has utilised the funds
supplied by the owners and creditors. The higher the ROI, the more efficient
the management is in using the funds available.
2. Return on Equity Net Profit after Profit After Taxes & Equity +
ROE interest, Taxes & Interest
Dividend Preference +
Shareholder’s fund Reserve funds +
undistributed profit
+ share premium –
Prel. Expenses –
Discount on issue of
debentures

3. Earnings Per [PAT - Preference Profit After Taxes Equity Share Capital
Share Dividend] Less Face Value per share
EPS Number of Equity Preference Dividend
Shares

4. Dividend Per Dividends Profits distributed to Equity Share Capital

Share Number of Equity Equity Face Value per share
DPS Shares Shareholders
 CAPITAL STRUCTURE RATIO
OR
LONG TERM SOLVENCY RATIO

Important solvency ratio :

1. Debt equity ratio
2. Proprietary ratio
3. Fixed Assets to Net worth
ratio
4. Interest coverage ratio
5. Funded debt to total
capitalisation ratio
1. DEBT EQUITY RATIO
Long term debt
Shareholder’s funds
Long term debts = Debentures + long term loans
Shareholder’s fund = Equity Share Capital + Preference Share Capital + Reserves &
Surplus – Accumulated losses
{The debt equity ratio of 1 : 1 is generally acceptable. The lower the ratio the
better it is}

2. PROPRIETARY RATIO
Shareholder’s fund
Total Assets
Total Assets = Total Assets – Deferred Expenses – Depreciation

3. FIXED ASSETS TO NET WORTH RATIO

Fixed Assets (After depreciation)
Shareholder’s funds

{It indicates the extent to which shareholder’s funds are sunk into the fixed asseets.
4. INTEREST COVERAGE RATIO
Net profit before interest and taxes (EBIT)
Fixed Interest charges (i.e. int. on debentures/long term loans)
{The standard for this ratio for an industrial company is that
interest charges should be covered 6 to 7 times.}
5. FUNDED DEBT TO TOTAL CAPITALIZATION RATIO

Funded debt x 100

Total Capitalization
Funded debt = Debentures + Mortgage loans + bonds + other long-
term loans
Total capitalization = Equity share capital + preference share capital
+ reserves and surplus + other undistributed reserves +
debentures + Mortgage loans + bonds + other long-term loans
{The lesser the reliance on outsiders the better it will be. Up to
50% to 55% is tolerable.}
 Q1. The following is the balance sheet of New India Ltd. as on 31/12/2004.

Liabilities Rs. Assets Rs.

9% Preference share capital 5,00,000 Goodwill 1,00,000
Equity share capital 10,00,000 Land & building 6,50,000
8% Debentures 2,00,000 Plant 8,00,000
Long-term loan 1,00,000 Furniture & fixture 1,50,000
Bills payable 60,000 Bills receivable 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 :

(a) Current Ratio
(b) Acid test ratio
(c) Absolute liquid ratio
(4.17 skg)
Q2. The following information is given :
Current ratio 2.5 : 1; Acid test ratio 1.5 : 1; Current liabilities Rs. 50,000
Find out :
(a) Current Assets
(b) Liquid assets
(c) Inventory
(4.20 skg)

Q3. Given :
Current ratio = 2.8
Acid test ratio = 1.5
Working capital = Rs. 1,62,000
Find out :
a) Current Assets
b) Current liabilities
c) Liquid assets
Q4. from the following information calculate stock turnover ratio
Rs. Rs.
Opening stock 28000 Carriage inward 4000
Closing stock 22000 Office expenses 4000
Purchases 46000 Selling and distribution exp. 2000
Sales 90000 Capital employed 200000
Sales return 10000

(899)

Q5. Determine the sales of a firm with the following financial data :
Current ratio 1.5
Acid test ratio 1.2
Current liabilities Rs. 4,00,000
Inventory turnover ratio 5 times
(4.29 skg)
 Q5. The following information is given about M/s S.P. Ltd. For the year ending Dec. 31,
2004

Stock turnover ratio 6 times

Gross profit ratio 20% on sales
Sales for 2004 3,00,000
Closing stock is Rs. 10,000 more than the opening stock
Opening creditors 20,000
Closing creditors 30,000
Trade debtors at the end 60,000
Net working capital 50,000

Find out :
(a) Average stock
(b) Purchases
(c) Creditors turnover ratio
(d) Average payment period
(e) Average collection period

4.38 skg
 Q6. The balance sheet as on 31-12-2002 is as follows.
Liabilities Rs. Assets Rs.
Share capital 2,00,000 Goodwill 1,18,000
Surplus 58,000 Plant & Machinery 1,50,000
Debentures 1,00,000 Stock 80,000
Creditors 40,000 Debtors 45,000
Bills payable 20,000 Cash 17,000
Other assets 8,000
4,18,000 4,18,000

Stock on 1-1-2002 Rs. 1,00,000

Sales for the year (credit) Rs. 4,00,000
Cost of sales Rs. 2,40,000
The year may be taken of 360 days
Calculate :
a. Current ratio
b. Quick ratio
c. Inventory turnover ratio
d. Average collection period
Q7. The comparative statement is given below :
2003 2004
Rs. Rs.
Net sales 1,00,000 1,50,000
Less cost of sales 70,000 1,10,000
Gross profit 30,000 40,000
Less operating expenses 20,000 25,000
Net profit 10,000 15,000
Cash in hand 5,000 8,000
Cash at bank 4,000 2,000
Debtors 40,000 25,000
Stock at cost 15,000 10,000
Fixed assets (net) 56,000 65,000
1,20,000 1,10,000
Creditors 36,000 12,000
Bills payable 2,000 1,000
Mortgage loan 10,000 20,000
Equity share capital 60,000 70,000
Reserve & surplus 12,000 7,000
1,20,000 1,10,000
Calculate :
(a) Current ratio
(b) Acid test ratio
(c) Debtors turnover ratio
(d) Average collection period
(e) Stock turnover ratio (assume 360 days in a year)

(4.40 skg)
 Questions on profitability ratios
Q 8. Following is the profit and loss account for the year 31-12-2004
Rs. 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 profit c/d 2,01,000
6,60,000 6,60,000
To administrative expns 20,000 By gross profit 2,01,000
To selling and dist. Expns 89,000 By interest on investment 10,000
To non-operating expns. 30,000 By profit on sale of
To net profit 80,000 investment. 8,000
2,19,000 2,19,000

Calculate :
1. Gross profit ratio
2. Net profit ratio
3. Operating ratio
4. Operating profit ratio
5. Administrative ratio (4.60)
 Questions on overall profitability ratio
Q 9. Calculate the following ratios from the given balance sheet :
(i) Current ratio
(ii) Fixed assets to net worth ratio
(iii) Debt equity ratio
(iv) Return on capital employed (3.32 mna)
Liabilities Rs. Assets Rs.
600 shares of Rs. 100 each 60,000 Land 40,000
General reserve 35,000 Plant 20,000
Dividend equalisation reserve 5,000 Machines 27,500
Long-term loans 20,000 Investments 25,000
Bills payable 30,000 Inventories 30,000
Provision for tax 5,000 Bills receivable 13,500
Profit & loss A/c Cash and bank 12,000
Balance 1,000 Preliminary expenses 8,000
Current year 20,000 21,000
1,76,000 1,76,000
Q.
Liabilities Rs. Assets Rs.
Equity share capital 3,00,000 Goodwill 90,000
9% Preference share capital 1,50,000 Land & building 1,00,000
Reserve fund 50,000 Plant & Machinery 2,50,000
Profit and loss A/c 20,000 Equipment 60,000
Share premium 10,000 Furniture & fittings 80,000
8% Debentures 2,00,000 Sundry debtors 92,000
6% Mortgage loan 60,000 Less : Provision 2,000 90,000
Sundry creditors 80,000 Bills receivable 1,00,000
Income tax provision 20,000 Stock-in-hand 1,20,000
Depreciation fund 50,000 Cash balance 45,500
Prepaid insurance 1,500
Preliminary Expenses 2,000
Discount on issue of 1,000
debentures

9,40,000 9,40,000
From the above balance sheet, compute :
(a) Equity Ratio (Proprietary Ratio)
(b) Debt-equity ratio
(c) Funded-debt to total capitalization
(d) Fixed assets to net worth ratio
(e) Current assets to proprietor’s fund ratio

Note : Net worth is same as shareholder’s fund

(4.93 skg)
Q. Gross profit ratio 15%
Stock velocity 6 months
Debtors velocity 3 months
Creditors velocity 3 months
Gross profit for the year ending Dec. 31, 2004 amounts to Rs.
60,000. closing stock is equal to opening stock.
Find out :
(a) Sales
(b) Closing stock
(c) Sundry debtors
(d) Sundry creditors

4.97
Q. From the following details, make out the balance sheet with
as many details as possible :
(i) Stock velocity = 6
(ii) Capital turnover ratio = 2
(iii) Fixed assets turnover = 4
(iv) Gross profit turnover = 20%
(v) Debtors collection period = 2 months
(vi) Creditors payment period = 73 days

The gross profit was Rs. 60,000.

Reserve & Surplus amounts to Rs. 20,000.
Closing stock was Rs. 5,000 in excess of opening stock.

(4.100 skg)