Ratio analysis

Theory and
problems
Importance
 Most of us are interested in the bottom line of the
company. Or in other words analysing the
profitability of a company.
 While the profit figure is important, it however, does
not give the complete picture of the performance of
the company.
 So one should not use the bottom line figure alone as
a barometer for some sort of an indicator. That would
have severe repercussions.
Example
 Two companies A and B is the same industry. A has earned a profit
of Rs. 100 Crores and B has earned Rs. 1000 Crs. for the financial
year 2003.
 Now one would on the face of it say that Company B is better than
company A. However, if it should be wise enough to compare the
profit earned with the level of investment made to earn the profit.
 For instance, company A had spent about 500 Crs to earn Rs 100
Cr. Profit and Company B had spent about Rs. 10000 Cr. to earn
Rs. 1000 Cr. profit. So its clear that profitability of company A is
higher than company B. In that the profit earned to the investment
ratio is higher for company A (100/500 = 20%) compared to
company B (1000/10000 = 10%).
 Hence one should look at profitability and not just profit figures. So
the key point is that one has to look into appropriate ratios not just
absolute figures for comparison. Hence ratio analysis would help
understand the financial results better.
Financial or accounting ratio
 A financial ratio (or accounting ratio) is a relative
magnitude of two selected numerical values taken from an
enterprise's financial statements.
 Often used in accounting, there are many standard ratios used
to try to evaluate the overall financial condition of a
corporation or other organization.
 Financial ratios may be used by managers within a firm, by
current and potential shareholders (owners) of a firm, and by a
firm's creditors. 
 A ratio can be expressed in various ways, including as a
percentage, a fraction, a “times” figure, a number of days, a
rate or as a simple number.
Objectives of Ratio Analysis 
1. To know the areas of the business which need more
attention;
2. To know about the potential areas which can be
improved with the effort in the desired  direction;
3. To provide a deeper analysis of the profitability,
liquidity, solvency and efficiency levels in the business;
4. To provide information for making cross sectional
analysis by comparing the performance with the best
industry standards;
5. To provide information derived from financial
statements useful for making projections and estimates
for the future.
Questions asked by stake holders..
 Shareholders???
 Suppliers???
 Customers, dealers and distributors???
 Competitors???
 Lenders???
 Employees???
 Government regulatory bodies and society???
Types of ratios
 Financial ratios
a) Liquidity ratios
b) Stability ratios
 Profitability analysis
ratio
 Coverage ratios
 Turnover or Activity
Analysis Ratios
Liquidity Analysis Ratios

 A firm needs liquid assets to meet day to day

payments. Therefore, liquidity ratios highlight the
ability of the firms to convert its assets into cash.
 If the ratios are low then it means that money is tied
up in stocks and debtors. Thus, money is not
available to make payments. This may cause
considerable problems for firms in the short run.
 It is often viewed that a value less than 1.5 implies
that the company may run out of money as its cash is
tied up in unproductive assets.
 Liquidity ratio helps in assessing the firm’s ability to
meet its current obligations.
Current ratio
 The current ratio shows the relationship between the current assets
and the current liabilities.
 Current assets include cash in hand, cash at bank and all other assets
which can be converted into cash in the ordinary course of business,
for instance, bills receivable, sundry debtors (good debts only),
short-term investments, stock etc.
 Current liabilities consists of all the obligations of payments that
have to be met within a year. They comprise sundry creditors, bills
payable, income received in advance, outstanding expenses, bank
overdraft, short-term borrowings, provision for taxation, dividends
payable, long term liabilities to be discharged within a year.
 The following formula is used to compute this ratio:
 Current ratio= Current assets
Current liabilities
Quick ratio
 The acid test ratio is similar to the current ratio as it highlights
the liquidity of the company. A ratio of 1:1 (i.e., a value of
approximately 1) is satisfactory. However, if the value is
significantly less than 1 it implies that the company has a
large amount of its cash tied up in unproductive assets, so the
company may struggle to raise money in the short term.
 Quick Ratio =Quick Assets
Current Liabilities
 Quick Assets = Current Assets – (Inventories+ Prepaid
expenses)
Absolute liquidity ratios (super quick
ratios)
 Absolute liquid ratio extends the logic further and eliminates
accounts receivable (sundry debtors and bills receivables)
also. Though receivables are more liquid as comparable to
inventory but still there may be doubts considering their time
and amount of realization. Therefore, absolute liquidity ratio
relates cash, bank and marketable securities to the current
liabilities. Since absolute liquidity ratio lays down very strict
and exacting standard of liquidity, therefore, acceptable norm
of this ratio is 50 percent.
 Absolute liquid ratio = Absolute liquid assets / Current
liabilities
Where absolute liquid assets = Cash + Bank + marketable
securities.
Net Working Capital Ratio

 The working capital ratio can give an indication of the ability of

your business to pay its bills. Generally a working capital ratio of
2:1 is regarded as desirable. However, the circumstances of every
business vary and you should consider how your business operates
and set an appropriate benchmark ratio.
 A stronger ratio indicates a better ability to meet ongoing and
unexpected bills therefore taking the pressure off your cash flow.
 A weaker ratio may indicate that your business is having greater
difficulties meeting its short-term commitments and that additional
working capital support is required.
 Ratios should be considered over a period of time (say three years),
in order to identify trends in the performance of the business.
 The calculation used to obtain the ratio is:
Net Working Capital Ratio =Net Working Capital
Total Assets
 Net Working Capital = Current Assets - Current Liabilities
Stability ratios
 These ratios concentrate on the long-term health
of a business - particularly the effect of the
capital/finance structure on the business:
1. Fixed assets ratio
2. Ratio of current assets to fixed assets
3. Debt equity ratio
4. Proprietary ratio
5. Capital gearing ratio
Fixed assets ratio
 This ratio explains whether the firm has raised adequate long
term funds to meet its fixed assets requirements
 Fixed assets ratio= Fixed assets
Capital employed
This ratio gives an idea as to what part of the capital
employed has been used in purchasing the fixed assets fro the
concern. The ideal ratio is 2/3.
Ratio of current assets to fixed assets

 It is the percentage of current assets to fixed assets.

 Decrease in ratio means trading is slack or there is more
mechanisation
 Increase in ratio reveals inventories and debtors unduly
increased or fixed assets have been intensively used
 Current assets to fixed assets= Current assets/Fixed assets
Debt equity ratio
 It shows the relationship between borrowed funds and owner’s
funds, or external funds (debt) and internal funds (equity). The
purpose of this ratio is to show the extent of the firm’s dependence
on external liabilities or external sources of funds.
 In order to calculate this ratio, the required components are external
liabilities and owner’s equity or net worth.
 ‘External liabilities, include both long-term as well as short-term
borrowings. The term ‘owners equity’ includes past accumulated
losses and deferred expenditure. Since there are two approaches to
work out this ratio, there are two formulas as shown below :
 i) Debt -Equity Ratio = Long-Term Debt
Owner's Equity
 ii) Total Debt-Equity Ratio = Total Debt
Owner's Equity
 The ratio of long term debt to equity is generally regarded as safe if it
is 2:1.
 Proprietary ratio
 This ratio is also known as Equity Ratio or Net worth to Total Assets
Ratio. It
is a variant of Debt-Equity Ratio, and shows the relationship between
owners’ equity and total assets of the firm.
 The purpose of this ratio is to indicate the extent of owners’
contribution towards the total value of assets. In other words, it gives
an idea about the extent to which the owners own the firm.
 The components required to compute this ratio are proprietors’ funds
and total assets. Proprietors’ funds include equity capital, preference
capital, reserves and undistributed profits. If there are accumulated
losses they are deducted from the owners’ funds. ‘Total assets’ include
both fixed and current assets but exclude fictitious assets, such as
preliminary expenses; debit balance of profit and loss account etc.
Intangible assets, if any, like goodwill, patents and copy rights are
taken at the amount at which they can be realised .
 The formula of this ratio is as follows :
Proprietary Ratio = Proprietors’ Funds
Total Assets
Capital gearing ratio

 This ratio establishes the relationship between equity share capital on one
hand and fixed interest and fixed dividend bearing funds on the other. It
does not take current liabilities into account. The purpose of this ratio is to
arrive at a proper mix of equity capital and the source of funds bearing
fixed interest and fixed dividend.
 For the calculation of this ratio, we require the value of (i) equity share
capital including reserve and surpluses, and (ii) preference share capital
and the sources bearing fixed rate of interest like debentures, public
deposits, long-term loans, etc.
 The following formula is used to compute this ratio :
 Capital Gearing Ratio = Fixed Dividend and Interest bearing securities
/Equity Capital including Reserves and Surplus
Profitability Analysis Ratios

 Profitability ratios are the most significant - and telling - of

financial ratios.
 Gross Profit Margin
 Net Profit Margin
 Operating Profit Margin
 ROCE
 ROE
 EPS
 PE Ratio
 Earnings yield
 Dividend payout ratio
 Dividend yield ratio
 Gross profit margin
 This is also known as gross profit ratio or gross profit to sales ratio. This
ratio may indicate to what extent the selling prices of goods per unit may be
reduced without incurring losses on operations. This ratio is useful
particularly in the case of wholesale and retail trading firms. It establishes
the relationship between gross profit and net sales. Its purpose is to show the
amount of gross profit generated for each rupees of sales.
 Gross profit margin is computed as follows:

 Gross profit = Gross profit x 100

Net Sales
 The amount of gross profit is the difference between net sales income and
the cost of goods sold which includes direct expenses. To keep the ratio
high, management has to minimise cost of goods sold and improve sales
performance.
 Higher the ratio, the greater would be the margin to cover operating
expenses and vice versa.
Net Profit Margin

 This ratio is called net profit to sales ratio and explains the
relationship between net profit after taxes and net sales.
 The purpose of this ratio is to reveal the amount of sales
income left for shareholders after meeting all costs and
expenses of the business. It measures the overall profitability
of the firm.
 The higher the ratio, the greater would be the return to the
shareholders and vice versa. A net profit margin of 10% is
considered normal. This ratio is very useful to control costs
and to increase the sales. It is calculated as follows:
 Net Profit Margin = Net Profit after taxes x 100
Net Sales
Operating Profit Margin

 This ratio is a modified version of Net Profit Margin. It

studies the relationship between operating profit (also known
as PBIT — Before Interest and Taxes) and sales.
 The purpose of computing this ratio is to find out the amount
of operating profit for each rupee of sale. While calculating
operating profit, non operating expenses such as interest, (loss
on sale of assets etc.) and non-operating income (such as
profit on sale of assets, income on investment etc.) have to be
ignored.
 The formula for this ratio is as follows:
Operating Profit Margin = Operating Profit x 100
Sales
Profitability in Relation to Capital Employed
(Investment)

 Profitability ratio, as stated earlier, can also be

computed by relating profits to capital or investment.
This ratio is popularly known as Rate of Return on
Investment (ROI). The term investment may be used
in the sense of capital employed or owners’ equity.
 Two ratios are generally calculated:
i) Return on Capital Employed (ROCE), and
ii) Return on Shareholders’ Equity.
Return on Capital Employed (ROCE)

 The ratio establishes the relationship between total capital and net
operating profit of the business. The purpose of this ratio is to find out
whether capital employed is effectively utilised or not. The formula for
calculating Return on Capital Employed is:
 Return on Capital Employed = Net Operating Profit x 100
Capital Employed
 The term ‘Net Operating Profit’ means ‘Profit before Interest and Tax’.
The term ‘Interest’ means ‘Interest on Long-term borrowings’. Interest on
short-term borrowings will be deducted for computing operating profit.
 Similarly, non-trading incomes such as income from investments made
outside the business etc. or non trading losses or expenses will also be
excluded while calculating profit.
Capital employed
 The term ‘capital employed’ has been given different
meanings by different accountants.
 Three widely accepted terms are as follows:
1) Gross Capital Employed = Fixed Assets + Investments +
Current Assets
2) Net Capital Employed = Fixed Assets + Investments + Net
Working Capital (Current Assets - Current Liabilities).
3) Sum total of long term funds = Share capital + Reserves
and Surpluses + Long Term Loans - Fictitious Assets - Non
business Assets.
 In managerial decisions the term capital employed is
generally used in the meaning given in the third point above.
Significance of ROCE
 Return on capital employed ratio is very significant as it
reflects the overall efficiency of the firm.
 The higher the ratio, the greater is the return on long-term
funds invested in the firm. It is also an indication of the
effective utilisation of capital employed.
 However, it is very difficult to set a standard ratio of return on
capital employed as a number of factors such as business risk,
the nature of the industry, economic conditions etc., may
influence such rate.
 This ratio could be supplemented with a number of ratios
depending upon the purpose for which it is computed.
Return on Investment (ROI)
or Return on Shareholders’ Equity (ROE)

 This ratio shows the relationship between net profit after taxes and
Shareholders’ equity. It reveals the rate of return on owners’/shareholders’
funds. The term shareholders’ equity is also known as ‘net worth’ and
includes Equity Capital, Share Premium and Reserves and Surplus. The
formula of this ratio is as follows:
 Return on Equity = Net Profit after Tax and Preference Dividend
Shareholders’ Equity
 The term ‘Net Profit’ means ‘Net Income after Interest and Tax’. This is
because the shareholders are interested in Total Income after Tax
including Net non operating income.
 The higher the ratio, the greater is the efficiency of the firm in generating
profits on shareholders’ equity and vice versa. The ratio is very important
for the investors to judge whether their investment in the firm generates a
reasonable return or not.
Earnings Per Share

 Earnings per Share (EPS) is an important ratio from equity

shareholders’ point of view as this ratio affects the market
price of share and the amount of dividend to be given to the
equity shareholders. The earnings per share is calculated as
follows:
 EPS = Net profit after Tax - Preference Dividend
Number of Equity Shares

 The Earnings Per Share is useful in determining the market

price of equity share and capacity of the company to pay
dividend. A comparison of earning per share with another
company helps to know whether the equity capital is
effectively used in the business or not.
 P/E ratio
 The P/E ratio (price-to-earnings ratio) of a stock is a measure of
the price paid for a share relative to the annual net
income or profit earned by the firm per share. The P/E ratio can
therefore alternatively be calculated by dividing the
company's market capitalization by its total annual earnings.
 A higher P/E ratio means that investors are paying more for
each unit of net income, so the stock is more expensive
compared to one with a lower P/E ratio. 
  The P/E ratio can be seen as being expressed in years, in the
sense that it shows the number of years of earnings which
would be required to pay back purchase price,
ignoring inflation.
 The P/E ratio also shows current investor demand for a
company share.
P/E ratio
 P/E ratio= Market price per equity share
Earnings per share
 By comparing price and earnings per share for a company, one can
analyze the market's stock valuation of a company and its shares
relative to the income the company is actually generating.
 Stocks with higher (and/or more certain) forecast earnings
growth will usually have a higher P/E, and those expected to have
lower (and/or riskier) earnings growth will usually have a lower
P/E.
 Investors can use the P/E ratio to compare the value of stocks: if
one stock has a P/E twice that of another stock, all things being
equal (especially the earnings growth rate), it is a less attractive
investment. Companies are rarely equal, however, and comparisons
between industries, companies, and time periods may be
misleading.
 Earnings yield
 The reciprocal of the P/E ratio is known as the earnings yield.
The earnings yield is an estimate of the expected return from
holding the stock 
 The earnings yield can be used to compare the earnings of
a stock, sector or the whole market against bond yields.
 Generally, the earnings yields of equities are higher than the
yield of risk-free treasury bonds reflecting the additional risk
involved in equity investments. The average P/E ratio for U.S.
stocks from 1900 to 2005 is 14,which equates to an earnings
yield of over 7%.
Dividend payout ratio
 Dividend payout ratio is the fraction of net income a firm pays
to its stockholders in dividends:
 DPR= Dividend per share
Earnings per share
 The part of the earnings not paid to investors is left for
investment to provide for future earnings growth. Investors
seeking high current income and limited capital growth prefer
companies with high Dividend payout ratio.
 However investors seeking capital growth may prefer lower
payout ratio.
 High growth firms in early life generally have low or zero
payout ratios. As they mature, they tend to return more of the
earnings back to investors.
Dividend yield ratio
 The dividend yield or the dividend-price ratio on a
company stock is the company's total
annual dividend payments divided by its market capitalisation,
or the dividend per share, divided by the price per share. It is
often expressed as a percentage.
 DYR= DPS
Market price per share
 A high dividend yield can be considered to be evidence that a
stock is under priced or that the company has fallen on hard
times and future dividends will not be as high as previous
ones.
 Similarly a low dividend yield can be considered evidence that
the stock is overpriced or that future dividends might be
higher. 
Coverage ratios
 These ratios indicate the extent to which the interest
of the persons entitled to get a fixed return (i.e.,
interest or dividend) or a scheduled repayment as per
agreed terms are safe.
 Higher the cover, the better it is.
 Following are the important coverage ratios
Fixed interest cover
Fixed dividend cover
Debt service coverage ratio
Fixed interest cover
 This ratio is also known as ‘times interest earned’
ratios. It is used to assess the firm’s debt servicing
capacity. It establishes the relationship between Net
Profit or Earnings before interest and Taxes (EBIT).
 The purpose of this ratio is to reveal the number of
times that the Interest charges are covered by the Net
Profit before Interest and Taxes.
 The formula for this ratio is as follows:

Interest Coverage Ratio = Net Profit before Interest

and Taxes / Interest Charges
Fixed dividend cover
 This ratio indicates the relationship between Net
Profit and Preference dividend.
 Net profit means Net Profit, after Interest and Taxes
but before dividend on preference capital is paid.
 The purpose of this ratio is to show the number of
times preference dividend is covered by Net Profit
after Interest and Taxes.
 To compute this ratio, following formula is used:
 Dividend Coverage Ratio = Net Profit after Interest
and Taxes / Preference Dividend
Debt service coverage ratio
 This ratio is calculated in order to know the ability
of a company to make payment of principal
amounts on time. It is calculated as follows:
 DSCR= EBIT
-----------------------------------------------
[Interest + {Principal payment instalment/(1-Tax
rate)}]
Turnover/performance/activity ratios

1. Sales to capital employed

2. Sales to fixed assets
3. Working capital turnover ratio
4. Asset turnover ratio
5. Stock turnover ratio
6. Debtors turnover ratio
7. Creditors turnover ratio
Sales to capital employed(Capital turnover
ratio)
 It is calculated by using the formula
S to CE=Sales or COGS / Capital employed
 A measure of total asset utilisation. Helps to
answer the question - what sales are being
generated by each pound's worth of assets invested
in the business.
Sales to fixed assets (Fixed assets
turnover ratio)
 Sales or COGS / Fixed Assets
 This ratio is about fixed asset capacity. A reducing
sales or profit being generated from each pound
invested in fixed assets may indicate overcapacity
or poorer-performing equipment.
Working capital turnover ratio
 Working capital turnover ratio establishes relationship
between cost of sales and net working capital. As working
capital has direct and close relationship with cost of goods
sold, therefore, the ratio provides useful idea of how
efficiently or actively working capital is being used.
 Interpretation of this ratio should be done when inter-firm or
inter-period comparison is being done. Increasing ratio
indicates that working capital is more active; it is supporting,
comparatively, higher level of production and sales; it is being
used more intensively.
 Formula:
 Working capital turnover ratio =  Sales or COGS / Average
net working capital
Asset turnover ratio

 Asset turnover is a financial ratio that measures the

efficiency of a company's use of its assets in generating sales
revenue or sales income to the company
 Asset turnover ratio=Sales or COGS /Total assets(FA+CA)
 The higher the ratio, the more sales that a company is
producing based on its assets. Thus, a higher ratio would be
preferable to a lower one. However, different industries can
not be compared to one another as the assets required to
perform business functions will vary.
 An example of this would be comparing an ecommerce store
that requires little assets with a manufacturer who requires
large manufacturing facilities and storage warehouses.
Stock turnover ratio

 COGS or Materials consumed or Purchases

Average Stock Value
 Stock turnover helps answer questions such as "have we got
too much money tied up in inventory"?. An increasing stock
turnover figure or one which is much larger than the "average"
for an industry, may indicate poor stock management.
 An item whose inventory is sold (turns over) once a year has
higher holding cost than one that turns over twice, or three
times, or more in that time.Stock turnover also indicates the
briskness of the business. The purpose of increasing inventory
turns is to reduce inventory for three reasons.
 However high turns may indicate that the inventory is too low.
This often can result in stock shortages.
Stock turnover period
  This is another estimated figure, obtainable from
publish accounts, which indicates the average
number of days that items of stock are held for.
 As with the average debt collection period, however,
it is only an approximate estimated figure, but one
which should be reliable enough for comparing
changes year on year. 
 The number of stock turnover days = (Stock / Cost of
goods sold) X 365 
Debtors turnover ratio
 An accounting measure used to quantify a firm's effectiveness in
extending credit as well as collecting debts. The receivables
turnover ratio is an activity ratio, measuring how efficiently a firm
uses its assets.
 Accounts receivable turnover=
COGS of net credit sales or Net credit sales or sales
Average receivables
 By maintaining accounts receivable, firms are indirectly extending
interest-free loans to their clients.
 A high ratio implies either that a company operates on a cash basis
or that its extension of credit and collection of accounts receivable
is efficient. 
 A low ratio implies the company should re-assess its credit policies
in order to ensure the timely collection of imparted credit that is not
earning interest for the firm. 
Average Collection Period
 The average collection period ratio represents the
average number of days for which a firm has to
wait before its debtors are converted into cash.
 Formula= (Trade Debtors × No. of Working
Days) / Net Credit Sales
Creditors turnover ratio
  It compares creditors with the total credit purchases. It
signifies the credit period enjoyed by the firm in paying
creditors
  Accounts payable include both sundry creditors and bills
payable.
 Creditors Turnover Ratio = Credit Purchase or purchases /
Average Trade Creditors
 A high creditors turnover ratio or a lower credit period ratio
signifies that the creditors are being paid promptly. This
situation enhances the credit worthiness of the company.
 However a very favorable ratio to this effect also shows that
the business is not taking the full advantage of credit facilities
allowed by the creditors.
Average Payment Period

 Average payment period ratio gives the average credit period

enjoyed from the creditors. It can be calculated using the
following formula:
 Average Payment Period = Trade Creditors / Average Daily
Credit Purchase
where Average Daily Credit Purchase=Total Credit Purchase /
No. of working days in a year
Or
 Average Payment Period = (Trade Creditors × No. of
Working Days) / Net Credit Purchase
 The average payment period ratio represents the number of
days by the firm to pay its creditors
Importance or advantages of ratio analysis

1. Useful in financial position analysis

2. Simplifying accounting figures
3. Assessing operational efficiency
4. Forecasting future figures
5. Identifying the areas to improve
6. For promoting comparison
Limitations of ratio analysis
 Can be mislead if accounting data is wrong
 Ratios analysis is a postmortem analysis
 Variation in accounting methods
 Price level changes not considered
 No common standards
 Different meanings assigned to same terms
 Ignores qualitative factors