Ratio analysis

INTRODUCTION

Dr.M.Velavan
Faculty Member, School of Management
SASTRA Deemed University, Thanjavur – 613
401
[email protected]
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 INTRODUCTION
Meaning of Ratio
It is a comparison of two or more numbers
that indicates their sizes in relation to each
other.
It is a mathematical relationship between two
items expressed in a quantitative form.
Arithmetically, a ratio is a comparison of the
numerator with the denominator.

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Ratio is the quantitative relationship between
two amounts depicting the number of times
one value contains within the other.
Ratio is the relationships expressed in
quantitative terms between figures which
have cause and effect relationships or which
are connected with each other in some
manner or the other.

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An accounting ratio is a quantitative
relationship between two or more items of
the financial statements connected with each
other.
Financial statements contain historical and
static information in absolute terms and does
not provide the relationship between two or
more items in the statements.

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The basic aim of ratio is to help the users of
financial information to analyse, interpret and
express the implications of relationships
between two or more items.
Analysis involves a scientific way of
examining the facts to know about what it
tries to convey.
Interpretation is the act of explaining,
reframing and inferring from the analysis
made. It is the inference made and based on
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 Modes of expression
In Proportion: Amounts of two items are
expressed in a common dominator (2:1)
In Rate or Times or Coefficient: A quotient
obtained by dividing one item by another is
taken as unit of expression. ( 2 times)
In Percentage: A quotient obtained by
dividing one itemn by another is multiplied by
one hundred to show the relationship in terms
of percentage. (25%)
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 Steps in ratio analysis
Selection of relevant information: Select
relevant information from financial
statements and calculate appropriate ratios
required to take decision.
Comparison of calculated ratios: To
assess the relative meaning, calculated ratios
are compared with past ratios industry ratios.
Interpretation and reporting: Draw
inferences to write a report. The report should
recommend a specific action for
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 Advantages of ratio
analysis
Forecasting: Ratios reveal the trends in
costs, sales, profits and other inter-related
facts, which will be helpful in forecasting
future events.
Managerial control: Ratios can be used
as instrument of control regarding sales,
costs and profit.
Facilitates communication: Ratios
facilitate the communication function of
management as ratios convey the
information relating to the present and
future quickly, forcefully and clearly. 8
Measuring efficiency: Ratios help to
know operational efficiency by
comparison of present ratios with those
of the past working and also with those
of other firms in the industry.
Facilitating investment decisions:
Ratios are helpful in computing return
on investment. This helps the
management in exercising effective
decisions regarding profitable avenues
of investment.
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Useful in measuring financial solvency:
Ratios indicate the liquidity position and
proportion of borrowed funds to total
resources which reveal the short term and
long term solvency position of a firm.
Inter firm comparisons: It helps the
management to compare its performance
with an external benchmark or standard.

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 Limitations of ratio analysis
Practical knowledge: The analyst should
have through knowledge and experience
about the firm and industry.
Ratios are means: Ratios are not an end in
themselves but they are means to achieve a
particular end.
Inter-relationship: Ratios are inter-related
and therefore a single ratio cannot convey
any meaning. It has to be interpreted with
reference to other related ratios to draw
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Non-availability of standards or norms:
Ratios will be meaningful if they can be
compared with standards or norms.
Accuracy of financial information: The
accuracy of ratio depends on the accuracy of
information derived from financial statements.
Consistency in preparation of financial
statements: Inter-firm comparisons with the
help of ratio analysis will be useful only if the
firms use uniform accounting procedures
consistently.
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Detachment from financial statements: Ratios
are not substitutes to financial statements. They can
be meaningful only if they are read along with
information with which they are prepared. It they are
detached, ratios themselves cannot convey useful
message.
Time lag: Ratio analysis will be useful only if the
conclusions are conveyed quickly to the
management. If there is any delay, the utility of the
data is diminished and the purpose itself may be
defeated.
Change in price level: Ratio analysis becomes
redundant during periods of heavy price13
 Ratio analysis
CLASSIFICATION

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Classification by statements
Balance Sheet Profit & Loss A/c B/s & P&LA/c Ratios
Ratios Ratios
Liquid Ratio Gross Profit Ratio Return on Investment
Current Ratio Operating Ratio Return on Shareholders'
funds
Proprietary Ratio Operating Profit Return on Total Assets
Ratio
Debt Equity Ratio Expense Ratios Stock Turnover Ratio
Fixed Assets Ratio Net Profit Ratio Debtors Turnover Ratio
Capital Gearing Ratio Creditors Turnover Ratio
Fixed Assets Turnover
Ratio
Working capital Turnover
Ratio
Earning Per Share
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 Classification by users
Management Creditors Shareholders
Operating Ratio Current Ratio Return on Shareholders'’
funds
Return on Investment Solvency Ratio Payout Ratio
Stock Turnover Debt Equity Ratio Capital Gearing
Debtors Turnover Credtors Turnover Dividends Cover
Debt Equity Fixed Assets Ratio Dividend Yield
Fixed Assets Turnover Assets Cover
Creditors Turnover Interest Cover
Gross Profit Ratio
Short- Term Liquidity
Long-Term Liquidity
Working Capital
Turnover
Net Profit Ratio
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Classification by Purpose/Function

Profitability Turnover Solvency

Short-Term Long-Term
Return on Stock Turnover Current Ratio Proprietary Ratio
Investment
Net Profit Ratio Creditors Turnover Liquidity Ratio Debt-Equity
Ratio
Gross Profit Ratio Debtors Turnover Cash position Fixed Assets
Ratio Ratio
Expense Ratios Working Capital Capital Gearing
Turnover
Operating Profit Fixed Assets Turnover
Ratios

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 Profitability Ratios
Return on Investment (Overall profitability Ratio)
ROI= [Operating Profit/Capital employed]x100
Operating Profit= Profit before Interest and Tax
Capital employed:
(i) Total assets
(ii) Total fixed assets
(iii) Net working capital + Fixed Assets
(iv) Total long-term funds employed in the business
[Share capital + Reserves and surplus + Long-term
loans]- [Non business assets+ Fictitious Assets]
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 Significance of ROI
ROI is used to measure the operational
and managerial efficiency. Higher the
ratio, the more efficient is the use of the
capital employed.,
A comparison of ROI with that of similar
firms, with that of industry and with past
ratio will be helpful in determining how
efficiently the long-term funds of owners
and creditors being put into use.

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 Return on shareholders’ funds
ROSH=
[Net profit after interest and Tax/
Shareholders’ funds]
This ratio determines the profitability from the
shareholders’ point of view. The term
shareholders’ funds includes equity share
capital, preference share capital and all
reserves and profits belonging to
shareholders. The net profit means profit
after payment of interest and tax and
includes net non-operating income also. 20
 Return on equity shareholders’
funds
Return on Equity or net worth= [Net profit
after interest, tax and preference
dividend/Equity shareholders’ funds]
Net worth refers to Equity share capital =
[Reserves + Profits – Accumulated Losses]
This ratio signifies the return on equity
shareholders’ funds. The profit considered
for computing is taken after the payment of
preference dividend.
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 Return on Total Assets
ROTA= [Net profit after tax/Total assets]
OR [(Net profit after tax + Interest)/Total
assets excluding fictitious assets]x100
This ratio is calculated to measure the
productivity of total assets.
The term fictitious assets refers to
preliminary expenses, debit balances of
P&LA/c and similar losses on Balance Sheet
asset side.
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 Ratio analysis
CLASSIFICATION

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 Gross Profit Ratio

Gross margin or Trading margin ratio

indicates the difference between sales and
direct costs. It explains the relationship
between gross profit and sales.
GP Ratio: [Gross profit/Net Sales]x100
A higher ratio is preferable, indicating
higher profitability.

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A higher GP ratio may be due to:
(i) Increase in selling price without change in
COGS
(ii) Decrease in COGS, with selling price remaining
constant
(iii) Increase in selling price and decrease in COGS
(iv) Increase in sales mix with high gross margin
products.
A lower GP ratio may be due to:
(v) Increase in COGS
(vi) Decrease in selling price
(vii)Increase in cost and decrease in selling price 25
 Operating Ratio
This ratio indicates the relationship between total
operating expenses and sales.
Operating Ratio
= [Cost of sales + Operating Expenses/Net
Sales]x100
Operating expenses include COGS and
administration, selling and distribution expenses.
Finance expenses are excluded.
It indicates the operational efficiency of the
concern. Lower the ratio, more is the efficiency.
Lower ratio indicates a fair return to the
shareholders. 26
 Operating profit Ratio
It indicates the operational efficiency of the
firm and the efficiency of the management
in carrying on the regular operations of the
firm.
Operating profit Ratio
= [Operating profit/Net Sales]x100
Operating profit= [ Net profit + Non
operating expenses-Non-operating incomes]
(or) Gross profit-Operating expenses
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 Expenses Ratio
It indicates the efficiency of the firm in
managing costs.
Administrative expenses Ratio:
[Administrative expenses/ Net Sales]x100
Selling and Distribution expenses Ratio:
[Selling and Distribution / Net Sales]x100
Financial expenses Ratio:
[Financial expenses/ Net Sales]x100
Similar ratios can be calculated for direct
material cost, direct labour cost and other 28
 Net Profit Ratio

It indicates the return on shareholders’

investments. Higher the ratio, better is the
operational efficiency of the firm.
Net Profit Ratio= [Net profit after tax/Net
Sales]x100
Net profit= [Net profit + non-operating
incomes –Provision for tax]

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 Earnings per share

It indicates the capacity of the concern to pay

dividend to its equity shareholders. This ratio is
useful in determining the market value of the
shares.
Earning per share= [Net profit after tax and
preference dividend/ No. of equity shares]

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 Price Earnings Ratio
This ratio indicates earnings per share
reflected by market price.
Price Earnings Ratio= [Market price per
equity share/ Earnings per equity share]
This ratio is useful to potential investors to
decide whether to invest in the equity
shares of a company at a particular market
price or not.

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 Pay out Ratio
It reflects the financial policy of the
management in ploughing back of profits.
Pay out Ratio= [Dividend per equity
share/Earnings per equity share]x100
(or) [Equity dividend/Net profit after tax
and preference dividend]

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 Retained Earnings Ratio
This ratio indicates the proportion of profits
retained in the firm out of current year’s
profits. The total of pay out ratio and
retained earnings ratio should be equal to
100.
Retained Earnings Ratio= [Retained
Earnings/ Net profit after tax and
preference dividend]x100
(or) [Retained earnings per equity share/
Earnings per equity share]x100.
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 Interest cover or Fixed charges
cover
It highlights the ability of the concern to
meet fixed interest obligations and its
ability to raise additional funds in future.
Interest cover= [Profit before interest and
tax/ Fixed interest charges]
Higher the ratio, better is the position of
long-term creditors and the company’s risk
is less.

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 Dividend Yield Ratio
This ratio explains the relationship
between dividend and market value of the
shares.
Dividend Yield
= [Dividend per share/Market price per
share]x100
This ratio is useful to the potential
investors to take investment decisions
based on dividend income.
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