WELCOME

Arun Jaitley National Institute of

Financial Management
On the topic

Ratio Analysis

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 Current Last Sales
Sales during
Equity year year during
Debenture current year
Co. Capital Profit Profit last
(crore) (crore)
(crore) (crore) (crore) (crore)
Year

A 1000 500 150 160 2500 2400

B 1000 700 180 170 3000 2900

C 1000 1000 220 200 3100 3200

 Ratio Analysis
A single accounting figure by itself may not
communicate any meaningful information
but when expressed as a relative to some
other figure, it may definitely provide some
significant information. Hence ratio
analysis proves very beneficial.

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 Ratio Analysis
Ratio analysis is not just comparing different
numbers from financial statements. It
involves comparing the ratio against
previous years, against peers, and with the
industry average for the purpose of financial
analysis.

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 Categories of Ratios
Liquidity Ratios
Indicate a company’s short-term debt-paying ability
Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity
financing in a company
Profitability Tests
Relate income to other variables
Market Tests
Help assess relative merits of stocks in the
marketplace

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 OBJECTIVES OF RATIO ANALYSIS
 To show the firm’s relative strengths and weaknesses.
 To help analyse the past performance of the firm and to make
future projections.
 To allow interested parties like shareholders, investors, creditors
and the government to analyse and make evaluation of certain
aspects of firm’s performance.
 To concentrate on inter-relationship among the figures appearing in
the financial statements.
 To provide an easy way to compare present performance with the
past.
 To depict the areas in which the business is competitively
advantageous and disadvantageous.
 To determine the financial condition and performance of the firm.
 To help to make suitable corrective measures when the financial
conditions and financial performance are unfavourable to the firm.
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 Ratio Analysis - Advantages
Ratios help stakeholders (like owners, managers,
investors, lenders, employees) to draw conclusion
about the
 Performance (past, present and future)
 Strengths & weakness
 And take decision in relation to the firm

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Advantages/Importance/Significance
- Ratio Analysis
• Analytical Tool For Measuring Performance.
• Ratios Makes Comparison Easy.
• Inter Firm Comparison Possible.
• Ascertainment Of Short Term Liquidity & Long
Term Solvency Position Possible.
• Analysis About The Strengths & Weaknesses Of
The Firm’s Operations.
• Analyze Past Performance & Make Further
Projections.

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 Types of Ratio
The ratios can be classified into following
four broad categories:
1. Liquidity Ratios
2. Capital Structure/Leverage ratios
3. Activity Ratios
4. Profitability Ratios
5. Return Ratios

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FINANCIAL RATIOS ACTIVITY RATIOS PROFITABILITY MARKET TEST
SOLVENCY RATIOS TURNOVER RATIOS RATIOS RATIOS

• Short Term • Stock Turnover • Gross Profit • Earnings Per

Solvency Ratio Ratio Share
Ratios • Debtors • Net Profit • Price Earnings
• Current Ratio Turnover Ratio Ratio Ratio
• Liquidity Ratio • Creditors • Cash Profit • Dividend
• Cash Ratio Turnover Ratio Ratio Payout
• Long Term • Fixed Assets • Return on • Dividend Yield
Solvency Turnover Ratio Investment Ratio
Ratios • Total Assets • Return on Net
• Debt Equity Turnover Ratio Worth
Ratio • Working • Debt service
• Capital Gearing Capital Coverage
Ratio Turnover • Operating
• Fixed Asset • Sales to Capital Ratio
Ratio Employed
• Proprietary
Ratio
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 IMPORTANT TERMS
Shareholders’ Funds, Preference Share Capital + Equity Share
Owners Funds, Capital +
Reserves and Surplus – Fictitious Assets
Proprietors Funds, Net Worth

Equity Share Capital + Reserves and Surplus

Equity Shareholders Funds –Fictitious Assets

Shareholders’ Funds + Loan Funds

Capital Employed Fixed Assets + Investments + Working
Capital
Current Assets – Current Liabilities
Working Capital

COGS Sales – Gross Profit

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 Ratios
Liquidity Ratios
Current Ratio = Current Asset
Current Liabilities
where,
Current Asset (CA)= Inventories + Sundry Debtors + Cash &
Bank balances + Receivables / Accruals + Loans & Advances
+ Disposable Investments
Current Liabilities (CL)= Creditors + Short term Loans +
Bank Overdraft + Cash Credit +Outstanding Expenses +
Provision for Taxation + Proposed Dividend + Unclaimed
Dividend

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 Liquidity Ratios
Current Ratio
● The main question this ratio address is: Does
business have enough current assets to meet
its current debts.
● A generally acceptable current ratio is 2:1.
● But whether or not a specific ratio is
satisfactory depends on the nature of business
and characteristics of its CA and CL.

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 Liquidity Ratios
Quick Ratio/Acid Test Ratio
Quick Asset
Quick Liabilities
Quick Asset = CAs – Inventories-Prepaid expenses
Quick Liabilities = CLs - Bank Overdraft

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 Liquidity Ratios
Quick Ratio/Acid Test Ratio
● The quick ratio is a much more conservative
measure than current ratio.
● This ratio measure the immediate solvency of
the company.
● The ideal liquid ratio is 1:1. This is irrespective
of nature of business.

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 Ratios
Capital Structure/Leverage Ratios
These ratios indicate the mix of funds provided by
owners and lenders. Leverage ratios are of two types:
● Capital Structure ratios
● Coverage ratios

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Capital Structure/Leverage Ratios
These ratios provide an insight into the financing
techniques used by a business and focus, as a
consequence, on the long term solvency
position.

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Capital Structure/Leverage Ratios
Equity ratio:
This ratio indicates proportion of owners fund to
total fund invested in the business.
Equity Ratio = Shareholder’s Equity
Total Capital Employed

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Capital Structure/Leverage Ratios
Debt ratio:
Total debt includes short and long term
borrowing from financial institution, debentures/
bonds deferred payment arrangements
Debt Ratio = Total Debt
Capital Employed

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Capital Structure/Leverage Ratios
Debt equity ratio:
This ratio indicates the proportion of debt fund in
relation to equity. Lenders are very keen to know this
ratio since it shows relative weight of debt and equity.
Debt equity Ratio=
Debt+ Preference Share Capital
Shareholders Equity
A high ratio here means less protection for creditors.
A low ratio, on the other hand, indicates a wider safety
cushion.

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 Capital Structure/Leverage Ratios
Coverage Ratios
The coverage ratios measure the firm’s ability to
service the fixed liabilities. These ratios establish the
relationship between fixed claims and what is
normally available out of which these claims are to
be paid.
The fixed claims of:
I. Interest on loans
II. Preference Dividends
III. Repayment instalment of loans
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Capital Structure/Leverage Ratios
Debt Service Coverage ratios
Earnings available for debt service
Interest + Installments
Earnings for debt service= Net Profit + Non
cash operating expenses like depreciation and
other amortisation + non-operating
adjustments like loss on sale of fixed assets +
Interest on debt funds

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Capital Structure/Leverage Ratios
Debt Service Coverage ratios
Lenders are interested in debt service coverage
to judge the firms ability to pay off current
interest and instalments.

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Capital Structure/Leverage Ratios
Interest Coverage Ratio
EBIT
Interest
This ratio indicates the extent to which earnings
may fall without causing any embarrassment to
the company regarding the payment of interest
charges.

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Capital Structure/Leverage Ratios
Interest Coverage Ratio
A high ratio means that an enterprise can easily
meet its interest obligation even if EBIT suffers a
considerable decline.
A lower ratio indicates excessive use of debt or
inefficient operations.

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 Capital Structure/Leverage Ratios
Preference Dividend Coverage Ratio
EAT
Preference dividend liability
This ratio measures the ability of a firm to pay
dividend on preference shares which carry a
stated rate of return.

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Capital Structure/Leverage Ratios
Capital Gearing Ratio

Preference Share Capital + Debenture + Long Term Loan

Equity Share Capital + Reserves & Surplus - Losses

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 Ratios
Activity Ratios
● Activity ratios are also called as Turnover
ratios or Performance ratios. These ratios are
used to evaluate efficiency with which the
company manages and utilizes its assets.
● These ratios are usually calculated with
reference to sale/cost of goods sold and are
expressed in terms of rate or times.

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 Activity Ratios
Capital Turnover Ratio
Sales
Capital Employed
This ratio indicates the firm’s ability of
generating sales per rupee of long term
investments.

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 Activity Ratios
Fixed Asset Turnover Ratio
Sales
Capital Asset
This ratio indicates the firm’s ability to efficient
utilisation of fixed asset in generating sales.

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 Activity Ratios
Working Capital Turnover Ratio
Sales
Working Capital

Working Capital Turnover is further segregated

into Inventory turnover, Debtors Turnover,
Creditors turnover.

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 Activity Ratios
Inventory Turnover Ratio
Cost of Sales or Sales
Average or Closing Inventory

Average Inventory =
Opening Stock + Closing Stock
2

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 Activity Ratios
Inventory turnover ratio indicates average
stock holding period. However it can be
directly calculated as

Stock holding Period

Average Inventory X 365
Sales or Cost of sales

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 Activity Ratios
Stock holding Period
This ratio indicates that how fast inventory is
sold. It establishes the relationship between
cost of goods sold during the year and average
inventory held during the year.

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 Activity Ratios
Debtors Turnover Ratio
Credit Sales
Average Accounts Receivables

This ratio throw light on the collection

and credit policies of the firm.

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 Activity Ratios
Debtors Turnover Ratio
Debtors turnover ratio indicates average
collection period. However it can be
directly calculated as
Debtors velocity
Average Debtors X 365
Credit Sales

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 Activity Ratios
Creditors Turnover Ratio
Credit Purchase
Average Accounts Payables

This ratio shows the velocity of the debt payment

by the firm. This ratios reflect the credit terms
granted by creditors.

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 Activity Ratios
Creditors Turnover Ratio
Average payment period can be calculated
as:
Creditors Velocity
Average Creditors X 365
Credit Purchases

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 Ratios
Profitability Ratios
Profitability ratios measure the
profitability as a percentage of sales.
Net Profit Ratio
Net Profit After Tax * 100
Sales

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 Profitability Ratios
Gross Profit Ratio
Gross Profit * 100
Sales

Operating Profit Ratio

Operating Profit * 100
Sales

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 Profitability Ratios
Return Ratios
Return ratios measure the profitability in
relation to capital used. These ratios reflect
the final results of the business.

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 Profitability Ratios
Return on Equity (ROE)
Profit after Taxes * 100
Net worth
Return on equity measures the profitability
of equity funds invested in the firm.

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 Profitability Ratios
Return on capital employed (ROCE) /
Return on Investment (ROI)
Return
Capital Employed

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 Profitability Ratios
Return on capital employed (ROCE) /
Return on Investment (ROI)
where ,
Return = Net Profit before Taxes +Interest
+/- Non trading adjustment
Capital Employed = Equity + Preference +
Reserves & Surplus + Debentures & Other
Long Term Loan – Misc. Expenditure &
Losses – Non trade investments
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 Profitability Ratios
Return on Investment (ROI)
ROI can be improved either by improving
operating profit ratio or capital turnover or
by both.
Profitability Ratio X Capital Turnover Ratio

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 Profitability Ratios
Return on Asset
Net Profit After Tax
Average Fixed Assets
This ratio measures the profitability of the
firm in terms of assets employed in the
firm.

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 Profitability Ratios
Earnings per Share (EPS)

Net Profit available to Equity shareholders

Number of Equity Shares

The profitability per share from the point

of view equity share-holders

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 Profitability Ratios
Price Earning Ratio (PE)
Market Price Per share
Earning Per Share
The PE ratio indicates the expectation of
equity investors about the earnings of the
company.

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 Profitability Ratios
Dividend per Share (DPS)

Dividend distributed to Equity shareholders

Number of Equity Shares

Dividend per share ratio indicates the

amount of profit distributed per equity
share.

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 Ratios
Various ratios are good measure of:
● Growth potential of investment
● Risk characteristics
● Profitability
● Degree of liquidity
● Corporate image

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 IMPORTANT ITEMS TO REMEMBER
Particulars Heads

Carriage Inwards COGS

Custom Duty and Excise Duty COGS
Legal Expenses Office and AdmnExp
General Expenses Office and AdmnExp
Carriage outwards Selling and DistrnExp
Trade Fair Expenses Selling and DistrnExp
Normal Bad Debts Selling and DistrnExp
Discount allowed Selling and DistrnExp
Abnormal Bad Debts Finance Charges
Interest paid Interest
Interest received Non Operating Income
Dividend received and Discount received Non Operating Income
Bad Debts recovery Non Operating Income
Preliminary Expenses w/off Non Operating Expenses

Dividend paid Appropriations

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 Utility of Ratio Analysis
● Assessment of the firm’s financial conditions
and capabilities.
● Diagnosis of the firm’s problems, weaknesses
and strengths.
● Credit analysis
● Security analysis
● Comparative analysis
● Time series analysis

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Cautions in Using Ratio Analysis
● Standards of comparisons
● Company differences
● Price level
● Different definition
● Changing situations
● Past data

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 Ratios
Ratios can be expressed in three different ways:
1. Ratio (e.g., current ratio of 2:1)
2. Percentage (e.g., profit margin of 2%)
3. Decimal (e.g., EPS of 2.25)

CAUTION!!!
“Using ratios and percentages without
considering the underlying causes may
lead to incorrect conclusions.”

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Thank you

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