Q:- Define Ratio Analysis and its types.

Ans:- Ratio analysis is a financial tool used to assess a company's performance by

looking at various aspects like profitability, liquidity, solvency, and efficiency. It
involves calculating ratios using numbers from a company's financial statements,
primarily the balance sheet and income statement.

Ratios can be classified into several categories based on the financial aspects they
analyze. Here are the main classifications:

1. Liquidity Ratios: These ratios measure a company's ability to meet its short-term
obligations with its short-term assets. Examples include the current ratio and the
quick ratio.

2. Profitability Ratios: These ratios assess a company's ability to generate profits from
its operations. Examples include return on equity, return on assets, and gross profit
margin.

3. Solvency Ratios: These ratios evaluate a company's ability to meet its long-term
debt obligations. Examples include the debt-to-equity ratio and interest coverage ratio.

4. Activity Ratios (or Efficiency Ratios): These ratios measure how efficiently a
company uses its assets to generate sales or revenue. Examples include the asset
turnover ratio and inventory turnover ratio.

5. Valuation Ratios: These ratios compare a company's stock price to certain financial
metrics, such as earnings per share or book value per share. Examples include the
price-to-earnings ratio and price-to-book ratio.

These classifications help investors, creditors, and analysts assess different aspects of
a company's financial performance and health.

Q:- Explain Liquidity Ratio.

Ans:- Liquidity ratios assess a company's ability to meet its short-term financial
obligations using its short-term assets. These ratios are crucial for understanding a
company's ability to cover immediate expenses and debts without relying on long-term
financing or selling assets.

Importance: Liquidity ratios provide insight into whether a company has enough liquid
assets to cover its short-term liabilities, such as bills and payments. Lenders and
creditors use liquidity ratios to evaluate a company's ability to repay short-term debts.
Higher liquidity ratios may indicate lower credit risk. Maintaining healthy liquidity
ratios suggests efficient management of working capital and effective cash flow
management.
Types:

1. Current Ratio: This ratio compares a company's current assets to its current
liabilities. It indicates the company's ability to cover short-term obligations with its
short-term assets. Generally, 2:1 is treated as the ideal ratio, but it depends on
industry to industry.

Formula: Current Assets/ Current Liability

High current ratio may also indicate that the firm is not efficiently utilizing its assets.
(Under trading and over capitalization). Low ratio indicates over trading and under
capitalization.

2. Quick Ratio (Acid-Test Ratio): Acid Test Ratio or Quick Ratio: This ratio is the
best measure of liquidity in the company. This ratio is more conservative than the
current ratio. The quick asset is computed by adjusting current assets to eliminate
those assets which are not in cash.

Generally, 1:1 is treated as an ideal ratio.

Formula: Quick Assets/ Current Liability, where,

Quick Assets = Current Assets – Inventory – Prepaid Expenses

A high acid test ratio typically indicates that a company has strong short-term
liquidity and it can meet its current or liquid liabilities in time. Conversely, a low acid
test ratio may indicate that a company may struggle to meet its short-term obligations
with its available liquid assets alone.

3. Absolute Liquidity Ratio (Cash Ratio): The Absolute Liquidity Ratio, also known
as the Cash Ratio. It measures a company's ability to cover its short-term liabilities
with its most liquid assets, such as cash and cash equivalents. It provides insight into
a company's ability to meet its immediate financial obligations without relying on
other assets.

Ideal Ratio is 1:2

A higher Absolute Liquidity Ratio indicates a stronger ability to cover short-term

liabilities with cash on hand. However, an excessively high ratio may suggest that the
company is holding too much cash and could be using its resources more efficiently.
Q: SOLVENCY RATIO

Ans:- Solvency means having enough money or assets to pay off debts and bills over
the long term. If someone or a company is solvent, it means they're financially stable
particularly towards external stakeholders. The ratios calculated to measure solvency
position are known as ‘Solvency Ratios’.

The following ratios are normally computed for evaluating solvency of the business.

1. Debt-Equity Ratio: Debt-to-Equity Ratio shows how much of a company's funding

comes from borrowing (like loans and bonds) compared to how much comes from the
money invested by shareholders.

Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus + Money

received against share warrants + Share application money pending allotment

Shareholders’ Funds (Equity) = Non-current Assets + Working capital – Non-current

liabilities

Working Capital = Current Assets – Current Liabilities

Normally, it is considered to be safe if debt equity ratio is 2:1.

A higher Debt-to-Equity Ratio indicates that the company relies more on debt
financing, while a lower ratio suggests a greater reliance on equity financing. This ratio
is important for investors and creditors to assess a company's financial leverage and
risk.

2. Debt to Capital Employed Ratio: Debt to Capital Employed Ratio shows how
much of a company's funding comes from borrowing compared to the total amount of
money invested in the business, including both debt and equity.

Debt to Capital Employed Ratio=Total Long Term Debt

Total Long Term Debt+Total Equity(Shareholder funds)

A higher Debt to Capital Employed Ratio indicates that the company relies more on
debt financing relative to its total capital employed, while a lower ratio suggests a
lower reliance on debt financing. This ratio is important for investors and creditors to
assess a company's financial leverage and risk.

3. Proprietary Ratio: Proprietary ratio expresses relationship of proprietor’s

(shareholders) funds to net assets and is calculated as follows :
Proprietary Ratio (Liability approach) = Shareholders’ Funds/Capital employed (or net
assets)

Proprietary Ratio (Asset approach) = Shareholders’ Funds/Total assets

Higher proportion of shareholders funds in financing the assets is a positive feature as

it provides security to creditors.

4. Total Assets to Debt Ratio: This ratio measures the extent of the coverage of long-
term debts by assets. It is calculated as:

Total assets to Debt Ratio = Total assets/Long-term debts

The higher ratio indicates that assets have been mainly financed by owners' funds and
the long-term loans are adequately covered by assets.

5. Interest Coverage Ratio: The Interest Coverage Ratio is like a measure of how
easily a company can pay its interest bills. It evaluates whether a company generates
enough operating income to cover its interest payments.

or

Operating Income/ Interest Expenses

If the ratio is high, it means the company has enough money from its operations to
cover its interest expenses comfortably. But if the ratio is low, it might mean the
company is having trouble covering its interest costs with its earnings.
Activity or Turnover Ratio (Efficiency Ratio):

Activity or Turnover ratios, also known as efficiency ratios, measure how effectively a
company uses its assets to generate sales or revenue. These ratios assess the
efficiency of a company's operations and asset management.

In simple terms, activity ratios show how well a company is using its resources to
generate income. They help investors and managers understand how efficiently a
company is operating and how effectively it is managing its assets.

1. Inventory Turnover Ratio: The inventory turnover ratio is a financial metric

that tells that how efficiently a business manages its stock. it reflects how many
times a company sells and replaces its inventory over a specific period, like a
year.

The formula for its calculation is as follows:

Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory

Where average inventory refers to: (Opening inventory + closing inventory)/2

The cost of revenue from operations means: Revenue from operations - gross profit

2. Accounts (Trade) Receivable Turnover Ratio: The ratio measures how quickly
a company collects payments from its customers. In easy words, it shows how
many times a company "turns over" its accounts receivable or how often it
collects money owed by customers.

Formula:

Net Credit Sales represent the total sales made on credit (not cash), and Average
Accounts Receivable is the average amount of money owed by customers during a
specific period. This ratio also helps in working out the average collection period.

3. Trade Payable Turnover Ratio: The Trade Payable Turnover Ratio measures
how quickly a company pays its suppliers for goods or services purchased on
credit. In simple terms, it shows how many times a company "turns over" its
accounts payable or how often it pays its bills. Here's the formula:

Net Credit Purchases represent the total purchases made on credit (not cash), and
Average Accounts Payable is the average amount owed to suppliers during a specific
period.
4. Net Assets or Capital Employed Turnover Ratio: The Net Assets Turnover
Ratio, also known as the Capital Employed Turnover Ratio, measures how
efficiently a company generates sales revenue relative to its net assets or capital
employed. It assesses the company's ability to utilize its assets to generate
sales. In simpler terms, this ratio shows how effectively a company is using its
invested capital to generate revenue.

The formula is:

A higher net assets turnover ratio indicates that the company is generating
more sales revenue per unit of net assets or capital employed, which is
generally favorable as it reflects efficient asset utilization.
 Profitability Ratios

Profitability ratios are a type of accounting ratio that helps in determining the financial
performance of business at the end of an accounting period. Profitability ratios show
how well a company is able to make profits from its operations.

Gross Profit Ratio: Gross Profit Ratio is a profitability ratio that measures the
relationship between the gross profit and net sales revenue. When it is expressed as a
percentage, it is also known as the Gross Profit Margin.

Formula for Gross Profit ratio is

Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100

A fluctuating gross profit ratio is indicative of inferior product or management

practices.

Operating Ratio: Operating ratio is calculated to determine the cost of operation in

relation to the revenue earned from the operations.

The formula for operating ratio is as follows

Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) ×100

Net Revenue from Operations

Operating Profit Ratio: Operating profit ratio is a type of profitability ratio that is
used for determining the operating profit and net revenue generated from the
operations. It is expressed as a percentage.

The formula for calculating operating profit ratio is:

Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100

Or Operating Profit Ratio = 100 – Operating ratio

Net Profit Ratio : Net profit ratio is an important profitability ratio that shows the
relationship between net sales and net profit after tax. When expressed as percentage,
it is known as net profit margin.

Formula for net profit ratio is

Net Profit Ratio = Net Profit after tax ÷ Net sales

Or

Net Profit Ratio = Net profit/Revenue from Operations × 100

It helps investors in determining whether the company’s management is able to

generate profit from the sales and how well the operating costs and costs related to
overhead are contained.

Expense Ratio: The expense ratio, also known as the operating expense ratio, is a
financial metric used to evaluate the efficiency of an investment fund or company by
comparing its operating expenses to its total assets under management (for funds) or
total revenue (for companies).

Formula is

The expense ratio helps investors assess how much of their investment returns are
eaten up by fees and expenses.

Return on Capital Employed (ROCE) or Return on Investment (ROI) : Return on

capital employed (ROCE) or Return on Investment is a profitability ratio that measures
how well a company is able to generate profits from its capital. It is an important ratio
that is mostly used by investors while screening for companies to invest.

The formula for calculating Return on Capital Employed is:

ROCE or ROI = EBIT ÷ Capital Employed × 100

Where EBIT = Earnings before interest and taxes or Profit before interest and taxes

Capital Employed = Total Assets – Current Liabilities

Return on Equity: It is a financial ratio that measures a company's profitability

relative to the amount of shareholder equity. In simple terms, it shows how much
profit a company generates for each dollar of shareholder equity invested.

The formula for ROE is:

ROE indicates how efficiently a company is using its shareholders' equity to generate
profit.

Return on Net Worth : This is also known as Return on Shareholders funds and is
used for determining whether the investment done by the shareholders are able to
generate profitable returns or not.

It should always be higher than the return on investment which otherwise would
indicate that the company funds are not utilised properly.

The formula for Return on Net Worth is calculated as:

Return on Shareholders’ Fund = Profit after Tax / Shareholders’ Funds × 100

Or Return on Net Worth = Profit after Tax / Shareholders’ Funds × 100

Earnings Per Share (EPS) : Earnings per share or EPS is a profitability ratio that
measures the extent to which a company earns profit. It is calculated by dividing the
net profit earned by outstanding shares.

The formula for calculating EPS is:

Earnings per share = Net Profit ÷ Total no. of shares outstanding

Having higher EPS translates into more profitability for the company.

Book Value Per Share :Book value per share is referred to as the equity that is
available to the the common shareholders divided by the number of outstanding
shares

Equity can be calculated by:

Equity funds = Shareholders funds – Preference share capital

The formula for calculating book value per share is:

Book Value per Share = (Shareholders’ Equity – Preferred Equity) / Total Outstanding
Common Shares.

Dividend Payout Ratio: Dividend payout ratio calculates the amount paid to
shareholders as dividends in relation to the amount of net income generated by the
business.

It can be calculated as follows:

Dividend Payout Ratio (DPR) : Dividends per share / Earnings per share
Price Earning Ratio: This is also known as P/E Ratio. It establishes a relationship
between the stock (share) price of a company and the earnings per share. It is very
helpful for investors as they will be more interested in knowing the profitability of the
shares of the company and how much profitable it will be in future.

P/E ratio is calculated as follows:

P/E Ratio = Market value per share ÷ Earnings per share

It shows if the company’s stock is overvalued or undervalued.