Unit 5 Ratio Analysis

Concept and Introduction to Ratios;

Ratio is simply one number expressed in terms of another. It is a means of highlighting in arithmetical terms
the relationship between figures drawn from various financial statements. Therefore, it refers to the
numerical or quantitative relationship between two variables or items. A ratio expresses simply in one
number the result of comparison between two figures.

Ratio analysis is therefore a technique of analysis and interpreting various ratios for helping in making
certain decisions. It involves the methods of calculating and interpreting financial ratios to assess the firm’s
performance and status.

Ratio can be expressed in the following three forms;

 As proportion
 As percentage
 As turnover or rate

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Unit 5 Ratio Analysis

Concept and Introduction to Ratios;

The ratio analysis is one of the most powerful tools of financial analysis. The firm is answerable to the
owners, the creditors and employees. The firm can reach a number of parties. On the other hand, parties
interested in the business can compute ratios based on the financial statements of the firm. The analysis is
not restricted to any one aspect but takes into account all aspects such as earning capacity of the firm,
financial obligation, liquidity and solvency aspects, liquidity and profitability concepts.

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Unit 5 Ratio Analysis

Classification of Ratios; Types of Ratios;

There is a two-way classification of ratios:

(1) Traditional classification, and

(2) Functional classification.

The traditional classification has been on the basis of financial statements to which the determinants of
ratios belong. On this basis the ratios are classified as follows:

 Statement of Profit and Loss Ratios:

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.

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Unit 5 Ratio Analysis

Classification of Ratios;

 Balance Sheet Ratios:

In case both variables are from the balance sheet, it is classified as balance sheet ratios. For example, ratio
of current assets to current liabilities known as current ratio. It is calculated using both figures from balance
sheet.

 Composite Ratios:

If a ratio is computed with one variable from the statement of profit and loss and another variable from the
balance sheet, it is called composite ratio. For 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.

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Unit 5 Ratio Analysis

Classification of Ratios;

Although accounting ratios are calculated by taking data from financial statements but classification of
ratios on the basis of financial statements is rarely used in practice. It must be recalled that basic purpose of
accounting is to throw light on the financial performance (profitability) and financial position (its capacity to
raise money and invest them wisely) as well as changes occurring in financial position (possible explanation
of changes in the activity level).

As such, the alternative classification (functional classification) based on the purpose for which a ratio is
computed, is the most commonly used classification which is as follows:;

 Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the business to pay
the amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to
measure it are known as ‘Liquidity Ratios’. These are essentially short-term in nature.

 Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations
towards stakeholders, particularly towards external stakeholders, and the ratios calculated to measure
solvency position are known as ‘Solvency Ratios’. These are essentially long-term in nature.
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Unit 5 Ratio Analysis

Classification of Ratios;

 Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the efficiency of
operations of business based on effective utilisation of resources. Hence, these are also known as
‘Efficiency Ratios’.

 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’.

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Unit 5 Ratio Analysis

Objectives of Ratio Analysis;

Interpreting the financial statements and other financial data is essential for all stakeholders of an entity.
Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Following are
some objectives;

 Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing
past and current financial statements.

 Comparative data can demonstrate how a company is performing over time and can be used to
telegraph likely future performance.

 This data can also compare a company's financial standing with industry averages while measuring how
a company stacks up against others within the same sector.

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Unit 5 Ratio Analysis

Objectives of Ratio Analysis;

 To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business;

 To provide information for making cross-sectional analysis by comparing the performance with the best
industry standards; and

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

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Unit 5 Ratio Analysis

Key Ratios;

 Solvency Ratios;

The ratios are analyzed on the basis of long-term financial position of a firm. It is also known as test of
solvency or analyzing the debt. Many financial analysts are interested in the relative use of debt and equity
in the firm. Debt refers to outside borrowings by the firm. The debt position of a firm indicates the amount
of other people’s money being used in attempting to generate profits. The long-term debts are of much
importance to the firm since a firm is expected to commit the payment of periodic interest over the long
run. In addition, repayment of loan after the expiry of maturity date has to be planned.

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Unit 5 Ratio Analysis
Ratio Name Formula Interpretation

Example Calculation:
Total Debt = ₹5,00,000
Total Equity = ₹10,00,000
Debt to Equity Measures financial Debt to Equity Ratio=5,00,000 / 10,00,000=0.5
Total Debt / Total Equity
Ratio leverage and risk level
Interpretation:
Lower than 1 → Business is financially stable.
Higher than 2 → Business relies too much on debt (high risk).

Example Calculation:
Total Debt = ₹5,00,000
Total Assets = ₹12,00,000
Debt to Assets Shows the percentage of
Total Debt / Total Assets Debt to Assets Ratio: 5,00,000/ 12,00,000= 0.42
Ratio assets financed by debt
Interpretation:
Lower than 50% → Business is less risky (more assets than debt).
Higher than 50% → High financial risk, as debt funds most assets.

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Unit 5 Ratio Analysis
Ratio Name Formula Interpretation

Example Calculation:
Shareholder’s Equity = ₹7,00,000
Total Assets = ₹12,00,000
Shareholder’s Equity / Indicates the proportion of
Equity Ratio Equity Ratio= 7,00,000/ 12,00,000= 0.58
Total Assets assets funded by owners
Interpretation:
Higher ratio (>50%) → Business is financed mainly by equity (good stability).
Lower ratio (<50%) → Business depends on debt for financing.

Example Calculation:
EBIT = ₹3,00,000
Interest Expense = ₹50,000
Interest Coverage Shows how easily a Interest Coverage Ratio = 3,00,000 / 50,000=6
EBIT / Interest Expense
Ratio company can pay interest
Interpretation:
Ratio > 3 → Business easily covers interest payments (low risk).
Ratio < 1.5 → Businesses may struggle to pay interest (high risk).

Example Calculation:
EBIT = ₹3,00,000
Lease Payments = ₹50,000
(EBIT + Lease Interest = ₹50,000
Fixed Charge Measures the ability to
Payments) / (Interest + Fixed Charge Coverage Ratio = 3,00,000+50,000 / 50,000 + 50,000 = 3.5
Coverage Ratio cover fixed expenses
Lease Payments)
Interpretation:
Higher than 2.5 → The Company can easily cover fixed charges.
Lower than 1.5 → Business may struggle to meet obligations.

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Unit 5 Ratio Analysis

 Liquidity Ratios;

Liquidity ratios are calculated to measure the short-term solvency of the business, i.e. the firm’s ability to
meet its current obligations. These are analysed by looking at the amounts of current assets and current
liabilities in the balance sheet.

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Unit 5 Ratio Analysis
Ratio
Formula Interpretation
Name

Example Calculation:
The Current Current Assets = ₹8,00,000
Ratio measures a Current Liabilities = ₹5,00,000 Current Ratio is 1: 6
Current Assets/Current company’s ability to pay
Current Ratio
Liabilities off its short-term Interpretation
liabilities using its short- Current Ratio > 1.5 to 2 → Good Liquidity (Company has enough assets to pay off
term assets. short-term debts).
Current Ratio < 1 → Liquidity Crisis (Company may struggle to pay liabilities).
Current Ratio > 3 → Excess Liquidity (Company is not using its assets efficiently).

Quick Ratio
Example Calculation:
Quick Assets = CA – Stock –
The Quick Ratio, also
Prepaid Expenses Current Assets = ₹8,00,000
known as the Acid-Test Inventory = ₹2,00,000
Quick Liabilities = CL –
Quick Ratio Ratio, measures a Current Liabilities = ₹5,00,000 Quick Ratio is 1.2
Bank Overdraft
(Acid-Test company’s ability to pay
Ratio) short-term liabilities Interpretation
Quick Ratio is also known Quick Ratio > 1 → The company has enough liquid assets to cover short-term
without relying on
as Liquid Ratio and Acid obligations.
inventory.
Test Ratio Quick Ratio < 1 → The company may struggle to pay liabilities without selling
Quick Assets/ Quick inventory.
Liabilities

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Unit 5 Ratio Analysis
Ratio
Formula Interpretation
Name

The Cash Ratio measures

a company’s ability to Example Calculation:
pay its short-term Cash and Cash Equivalents = ₹3,00,000
liabilities using only cash Current Liabilities = ₹5,00,000 Cash Ratio is 0.6
Cash + Bank + Short term and cash equivalents.
Cash Ratio
Invs / Current Liability This is the most Interpretation
conservative liquidity Cash Ratio > 1 → The company has more than enough cash to pay short-term debts
ratio because it does not immediately.
Cash Ratio < 1 → The company does not have enough cash and may need to rely on
consider receivables or receivables or inventory.
inventory.

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Unit 5 Ratio Analysis

 Profitability Ratios;

Profitability Ratios measure a company’s ability to generate profit relative to its revenue, assets, or
shareholders’ equity. These ratios help businesses, investors, and financial analysts evaluate how efficiently
a company is converting sales into profits and how well it is utilizing its resources to maximize earnings.

Profitability ratios are critical in assessing business performance, growth potential, and financial stability. A
higher profitability ratio indicates a more efficient and financially healthy company.

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Unit 5 Ratio Analysis
Ratio
Formula Interpretation
Name

Example Calculation:

Revenue = ₹10,00,000 Cost of Goods Sold (COGS) = ₹6,00,000

Gross Profit = ₹10,00,000 – ₹6,00,000 = ₹4,00,000 Gross Profit Margin 40%
Measures the percentage of
Gross Profit
(Gross Profit / Revenue) × 100 revenue that exceeds the cost of
Margin Interpretation:
goods sold (COGS)
Higher margin (>40%) → Company efficiently controls production costs.
Lower margin (<20%) → Business may need to reduce COGS or increase selling
prices.

Example Calculation:

Net Profit = ₹1,50,000 Revenue = ₹10,00,000

Shows the percentage of Net Profit Margin 15%
Net Profit
(Net Profit / Revenue) × 100 revenue left as profit after all
Margin
expenses Interpretation:

Higher margin (>15%) → Strong profitability after all expenses.

Lower margin (<5%) → Indicates high operating costs or low pricing.

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Unit 5 Ratio Analysis
Ratio
Formula Interpretation
Name

Example Calculation:

Net Profit = ₹1,50,000

Measures how effectively Shareholder’s Equity = ₹7,00,000 ROE 21.4%
Return on Equity (Net Profit / Shareholder’s
shareholders’ funds generate
(ROE) Equity) × 100
profit Interpretation:

Higher ratio (>15%) → Strong returns to shareholders.

Lower ratio (<10%) → Weak profitability.

Example Calculation:

EBIT (Earnings Before Interest & Tax) = ₹2,00,000

Return on
Indicates profitability in Capital Employed (Equity + Debt) = ₹8,00,000 ROCE 25%
Capital
(EBIT / Capital Employed) × 100 relation to total capital
Employed
invested Interpretation:
(ROCE)
Higher ratio (>20%) → Company is effectively using its capital.
Lower ratio (<10%) → Inefficient capital usage.

Example Calculation:

Operating Profit = ₹2,00,000

Evaluates the percentage of Revenue = ₹10,00,000 Operating Profit Margin 20%
Operating Profit (Operating Profit / Revenue) ×
revenue that remains after
Margin 100
operating expenses Interpretation:

Higher ratio (>20%) → Strong control over operating expenses.

Lower ratio (<10%) → High operational costs affecting profitability.

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Unit 5 Ratio Analysis
Ratio
Formula Interpretation
Name
Example Calculation:

Assesses how efficiently a Net Profit = ₹1,50,000

Return on
(Net Profit / Total Assets) × 100 company uses its assets to Total Assets = ₹12,00,000 ROA 12.5%
Assets (ROA)
generate profit
ROA of over 5% is generally considered good. Over 20% is excellent. ROAs should
always be compared among firms in the same sector

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Unit 5 Ratio Analysis

 Efficiency Ratios;

Efficiency ratios also called activity ratios measure how well companies utilize their assets to generate
income. Efficiency ratios often look at the time it takes companies to collect cash from customer or the time
it takes companies to convert inventory into cash—in other words, make sales. These ratios are used by
management to help improve the company as well as outside investors and creditors looking at the
operations of profitability of the company.

 Turnover ratio will always be expressed in “Times”.

 Whenever turnover ratios are asked, there will be Average in Denominator.

 Whenever calculation of Average is not Possible, take closing in denominator.

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Unit 5 Ratio Analysis
Ratio
Formula Interpretation
Name

Opening stock Rs. 45000

Closing stock Rs. 55000
Purchases Rs. 160000
It is both an activity and
Solution : Average stock = Opening stock +Closing stock Rs. 50000
COGS/ Average Stock efficiency ratio. This ratio
Stock 2
helps to determine stock-
Turnover/invent Cost of goods sold = Opening stock + Purchases – Closing stock
Average Stock X 365/52/12 related issues such as
ory ratio = Rs 45000 + 160000 – 55000 = Rs 150000
COGS overstocking and
Stock Turnover Ratio 3 Times
overvaluation.
“Good" stock turnover ratio generally indicates efficient inventory management,
but the ideal range varies by industry. For most industries, a good ratio is between
4 and 10, meaning inventory is sold and restocked roughly every 1-2 months.

Company has net credit sales of ₹6,00,000 for the year. The average accounts
receivable for the same period is ₹1,50,000.
Debtors
The debtors turnover ratio To calculate the Debtors Turnover Ratio, divide the net credit sales by the average
Turnover Ratio
Credit Sales / Average Debtors represents the total number accounts receivable:
of times the average debtor’s
Average Debtors X 365/52/12 outstanding balance is Debtors Turnover Ratio = 6,00,000 / 1,50,000 = 4
Debtors
Credit Sales collected as cash during the
Collection Period
fiscal year. Higher ratio is preferred, indicating better credit management and faster
collections, but excessively high ratios might suggest overly strict credit policies. A
ratio of 0.4 or less might be preferred, while 0.6 or higher could indicate higher risk.

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Unit 5 Ratio Analysis
Ratio
Formula Interpretation
Name

Calculate creditor’s turnover ratio from the information provided below;

Total Purchases – 5,00,000
Cash Purchases – 2,00,000
Creditors (Beginning of period) – 50,000 & Creditors (End of period) – 1,00,000

Soln;
Creditor’s turnover ratio or Accounts payable turnover ratio = (Net Credit
Sales/Average Trade Receivables)
It is an activity ratio that finds Net Credit Purchases = Total Purchases – Cash Purchases
out the relationship between = 5,00,000 – 2,00,000
net credit purchases and Net Credit Purchases = 3,00,000
average trade payables of a Average Trade Payables = (Opening Trade Payables + Closing Trade Payables)/2
business. It finds out how
Credit Purchases / Average
Creditors efficiently the assets are = (50,000 + 1,00,000)/2
Creditors
Turnover Ratio employed by a firm and
indicates the average speed = 75,000
Average Creditors X 365/52/12
with which the payments are
Credit Purchases
made to the trade creditors. Ratio = (3,00,000/75,000) => 4/1 or 4:1

An ideal creditors turnover A high ratio may indicate

ratio, generally falls between
6 and 10. • Low credit period available to the business or early payments made by the
business.
• The company may operate majorly on the cash basis.
• The company is not availing full credit period.

A low ratio may indicate

• Creditors are not paid in time.

• Increased credit period is allowed to the business.

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Unit 5 Ratio Analysis- Ratio Analysis significance and its Limitations;

Ratio analysis is critical for analyzing a company’s financial condition, liquidity, profitability, risk, efficiency,
operational effectiveness, and wise use of cash. It also illustrates the tendency or comparison of economic
conditions, which is useful for corporate shareholders’ investment decisions. Different types of accounting
ratios provide different information and serve different purposes.

The benefits of ratio analysis include a quick and easy approach to analyzing a business’s financial results,
the ability to compare firms, and the ability to spot patterns and shifts over the years. Here are some of the
advantages of Ratio Analysis:

 Planning: Through doing trend analysis, it aids in predicting and planning.

 Estimation: By analyzing prior trends, it is possible to estimate the firm’s budget.
 Informative: It gives users accounting information and important information about the business’s
performance.
 Solvency: It aids in determining the firm’s liquidity as well as its long-term solvency.
 Comparison: It helps in the comparison of different firms on various scales as well as inter-firm analysis.

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Unit 5 Ratio Analysis- Ratio Analysis significance and its Limitations;

Limitations of Ratio Analysis;

 Historical Information: Information used in the analysis is based on past results that the company
releases. Therefore, ratio analysis metrics do not necessarily represent future company performance.

 Inflationary effects: Financial statements are provided on a regular basis, thus there are time gaps
between each publication. If there has been inflation between periods, actual prices are not represented
in the financial accounts.

 Changes in accounting policies: If the company’s accounting standards and practices have changed, this
may have a substantial impact on financial reporting.

 Operational changes: A company’s operational structure can alter dramatically, from its supply chain
strategy to the product it sells. When large operational changes occur, comparing financial indicators
before and after the change may lead to inaccurate inferences about the company’s accomplishments
and various reports.

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Unit 5 Ratio Analysis- Ratio Analysis significance and its Limitations;

Limitations of Ratio Analysis;

 Limited use of a single ratio.

 Window-dressing can affect ratios.

 Lack of proper standards for comparison.

 Ratios alone are not adequate for proper conclusions.

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QUESTIONS PLEASE………….!!

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