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Chapter 18 : Ratio Analysis

Meaning: Ratio Analysis is the process of determining and interpreting the numerical relationship
between figures of financial statements. The objectives of using ratios are to test the profitability,
financial position (liquidity and solvency) and the operating efficiency of a concern. Ratio analysis
is one of the techniques of financial analysis to evaluate the financial condition and performance of
a business concern.

Advantages: The advantages of accounting ratios are as follows:

1. To workout the profitability & solvency: Accounting ratio help to measure the profitability
of the business by calculating the various profitability ratios. With the help of solvency ratios,
solvency of the company can be measured.
2. Helpful in analysis of financial statement: Ratio analysis help the outsiders just like
creditors, shareholders, debenture-holders, bankers to know about the profitability and ability
of the company to pay them interest and dividend etc.
3. Helpful in comparative analysis of the performance: Ratio analysis facilitates inter firm and
intra firm comparative analysis of the performance.

Limitations: It suffers from the following limitations.

1. Limited Comparability: Different firms apply different accounting policies. Therefore the
ratio of one firm can not always be compared with the ratio of other firm.
2. Effect of Price Level Changes: Price level changes often make the comparison of figures
difficult over a period of time. A change in price affects the cost of production, sales and also
the value of assets.
3. Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and
thus, ignores qualitative factors, which may be important in decision making. For example,
average collection period may be equal to standard credit period, but some debtors may be in
the list of doubtful debts, which is not disclosed by ratio analysis.
Write answer of these questions in your copy:
1. What is meant by current Assets & Current Liabilities?
2. Explain the term:
a. Capital Gearing Ratio
b. Interest Coverage Ratio
c. Return on Equity Shareholders’ Fund. [ISC 2007]
3. What is Quick ratio? State its significance. [ISC 2005]
4. When calculating the Acid Test Ratio, name two items that are excluded from current assets.
[ISC 2008]

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Classification of Ratios

Liquidity Solvency Profitability Activity (Turnover)

Measure firms’ ability Solvency refers to the Efficiency of a Activity ratios indicate
to pay off current firms ability to meet business is measured the performance of the
dues. They are its long term by profitability. business. The
otherwise called as indebtedness. Profitability ratio performance of a
Short Term Solvency Solvency ratio studies measures the profit business is judged
Ratios the firms ability to earning capacity of the with its sales or cost of
meet its long term business concern. goods sold. These
obligations. ratios are thus referred
to as turnover ratios.
1. Current Ratio 1. Debt-Equity Ratio 1. Gross Profit Ratio 1. Working Capital
2. Liquid Ratio 2. Proprietary Ratio 2. Net Profit Ratio Turnover Ratio
3.Total Asset to Debt 3. Operating Profit 2. Fixed Asset
Ratio Ratio Turnover Ratio
4. Capital Gearing 4. Operating Ratio 3. Debtors Turnover
Ratio Ratio 4.Creditors
Turnover Ratio

Which Ratio? How to Calculate? What is the Objective?

Balance Sheet Ratios
It refers to those Ratios which are calculated from the information and data from the Balance Sheet.
This ratio shows the relationship between
Proprietary Shareholders’ Fund
1 proprietors or shareholders funds and total
Ratio Total Asset
assets.
ƒ Shareholders’ Fund = Equity Share Capital + Preference Share Capital + Reserves & Surplus –
Fictitious Assets (Preliminary Expenses, etc.)
This ratio is used to assess the firm’s ability to
Current Assets meet its current liabilities. The relationship of
2 Current Ratio
Current Liabilities current assets to current liabilities is known as
current ratio.
ƒ Current Assets = Cash + Bank + Marketable Securities + Short term Investments + Debtors + Bills
Receivable + Accrued Income + Prepaid Expenses + Stock in Trade.
ƒ Current Liabilities = Creditors + Bills Payable + Liability for Taxes + Outstanding Expenses + Income
received in Advance + Provision for taxation + Proposed Dividend + Bank Overdraft.
This ratio is used to assess the firm’s short term
liquidity. The relationship of liquid assets to
Quick Assets
3 Quick Ratio quick liabilities is known as liquid ratio. It is
Quick Liabilities
otherwise called as Quick ratio or Acid Test
ratio.
ƒ Quick Assets = Current Assets – Stock – Prepaid Expenses.
ƒ Quick Liabilities = Current Liabilities – Bank Overdraft.
This ratio helps to ascertain the soundness of the
long term financial position of the concern. It
Debt Equity Long Term Debt indicates the proportion between total long-term
4
Ratio Shareholders’ Fund debt and shareholders funds. This also indicates
the extent to which the firm depends upon
outsiders for its existence.
ƒ Long Term Debt = Debentures + Bonds + Loan from Financial Institutions
This ratio measures the safety margin available
Total Asset to Total Assets
5 to the suppliers of long term debts. It measures
Debt Ratio Long Term Debt
the extent to which debt is covered by assets.

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Revenue Statement Ratios
It refers to those Ratios which are calculated from the information and data from the Revenue Statement
(Trading, Profit and Loss Account).
This ratio indicates the efficiency of trading
Gross Profit Gross Profit X 100
1 activities. The relationship of Gross profit to
Ratio Net Sales .
Sales is known as gross profit ratio.
This ratio determines the overall efficiency of
Net Profit Net Profit X 100
2 the business. The relationship of Net profit to
Ratio Net Sales .
Sales is known as net profit ratio.
This ratio is an indicator of the operational
Operating Operating Profit X 100
3a efficiency of the management. It establishes the
Profit Ratio Net Sales .
relationship between Operating profit and Sales.
ƒ Operating Profit = Gross profit – Operating expenses = Net profit + Non-operating expenses(for e.g.
interest on loan and loss on sale of assets) - Non-operating income (for e.g. dividend, interest received
and profit on sale of asset}
This ratio determines the operating efficiency of
the business concern. Operating ratio measures
(Cost of Goods Sold + .
Operating the amount of expenditure incurred in
3b Operating Expenses) X 100
Ratio production, sales and distribution of output. The
Net Sales .
relationship between Operating cost to Sales is
known as Operating Ratio
ƒ Cost of Goods Sold = Sales – Gross profit = Op Stock + Purchases + Wages, etc – Cl Stock.
ƒ Operating Expenses = Administrative Expenses + Selling & Distribution Expenses (Financial Expenses
& Non-operating Expenses are to be ignored.)
This ratio is otherwise called as inventory
turnover ratio. It indicates whether stock has
Stock Cost of Goods Sold been efficiently used or not. It establishes a
4a
Turnover Ratio Average Stock relationship between the cost of goods sold
during a particular period and the average
amount of stock in the concern.
ƒ Average = (Opening + Closing)/2
This measures the average age of stock i.e. the
Stock Holding 365 Days OR 12 Months
4b expected time between purchase of stocks and
Period Stock Turnover Ratio
sales of those stocks.

Balance Sheet & Revenue Statement Ratios

It refers to those Ratios which are calculated from the combined information and data from the Balance
Sheet and the Revenue Statement (Trading, Profit and Loss Account).
This establishes the relationship between credit
sales and average accounts receivable. Debtors
Debtors Net Credit Sales
1a turnover ratio indicates the efficiency of the
Turnover Ratio Avg Drs + Avg B/R
business concern towards the collection of
amount due from debtors.
Average Debt 365 Days OR 12 Months It provides a rough approximation of the average
1b
Collection Pd. Debtors Turnover Ratio time taken to collect from the debtors.
This establishes the relationship between credit
Creditors’ Net Credit Purchases purchases and average accounts payable.
2a
Turnover Ratio Avg Crs + Avg B/P Creditors turnover ratio indicates the period in
which the payments are made to creditors.
Average Debt 365 Days OR 12 Months It provides a rough approximation of the average
2b
Payment Pd. Creditors Turnover Ratio time taken to pay back the creditors.
Working Working Capital Turnover Ratio determines the
Net Sales
3 Capital efficiency with which the working capital is
Working Capital
Turnover Ratio utilized.
ƒ Working Capital = Current Assets - Current Liabilities

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