RATIO ANALYSIS

DR.R.KATHAIAN
RAJAH SEFOJI GOVERNMENT COLLEGE
THANJAVUR
 INTRODUCTION
Ratio analysis is a very important tool of
financial analysis. It is the process of
establishing the significant relationship
between the items of financial statement to
provide a meaningful understanding of the
performance and financial position of a firm.
Ratio when calculated on the basis of
accounting information are called
‘Accounting Ratio’.
 Definitions
Kennedy and Mc Mulla. “The relationship of one to
another, expressed in simple term of mathematical is
know as ratio”

According to Accountant’s Handbook by Wixon, kell

and Bedford, a ratio “is an expression of the
quantitative relationship between two numbers”.
Hornby A.S. et al (2002) defines ratio as a “relation
between two amount determined by the number of
times one contains the other”
 Nature of Ratio Analysis
Ratio analysis is a technique of analysis and
interpretation of financial statements. It is the process
of establishing and interpreting various ratios for
helping in making certain decisions. However, ratio
analysis is not an end in itself. It is only a means of
better understanding of financial strengths and
weakness of a firm. There are a number of ratios
which can be calculated from the given information
given in the financial statements, but the analyst has
to select the appropriate data and calculate only a few
appropriate ratios from the same keeping in mind the
objectives of analysis. The following are the four
steps involved in the ratio analysis:
The following are the four steps involved in the ratio
analysis:

(i) Selection of relevant data from the financial

statements depending upon the objective of the
analysis.

(ii) Calculation of appropriate from the above data.

(iii) Comparison of the calculated ratios with the ratios of

the same firm in the past, or the ratios developed from the
projected financial statements or the ratios of some other
firms or the comparison with ratios of the industry to
which the firm belongs.

(iv) Interpretation of the ratios.

Objective/Use/Significance/Importance of
Ratio Analysis
The ratio analysis is one of the most powerful tools of
financial analysis. It is used as a device to analyse and
interpret the financial health of the enterprise, just like
a doctor examines the patient by recording his body
temperature, blood pressure, etc. before making his
conclusion regarding the illness and before giving his
treatment, a financial analyst analyses the financial
statements with various tools of analysis before
commencing upon the health or weakness of an
enterprise. ‘A ratio is known as a symptom like blood
pressure, the pulse rate or the temperature of an
individual.
(A)Usefulness for short term creditors:
Short term creditors are trade creditors, bills
payables, creditors for expenses etc. The concern pays short
term creditors out of its current assets. If the current assets
are quit4e sufficient to meet current liabilities then the
creditor will not hesitate in extending credit facilities.
Current and acid-test ratios will give an idea about the
current financial position of the concern.
(B)Usefulness for long term creditors:
Long term creditors are financial institutions, debenture
holders, mortgage creditors etc. are interested in analysing
the capacity of the unit of repay periodical interest, and
repayment of loan on schedule.
(C)Usefulness to Employees:
The employees are also interested in the
financial position of the concern. Their wages
increases and amount of fringe benefits are related
to the volume of profits earned by the concern. The
employees make use of information available in
financial statement. Various profitability ratios
relating to gross profit, operating ratio, net profit,
etc. enable employees to put forward their viewpoint
for the increase of wages and other benefits.
(D)Usefulness to the Government:
Government is interested in the financial
information of the units both at macro as well as micro
levels. Individual unit’s information regarding
production, sales and profit is required for exercise
duty, sales tax and income tax purposes. Group
information for the industry is required for formulating
national policies and planning. In the absence of
dependable information, govt. plans and policies may
not achieve desired results. Government is interested to
know the overall strength of the industry. The ration
may be used as indicators of overall strength of public
as well as private sector. In the absence if the reliable
economic information, governmental plans policies
may not prove successful.
(E)Usefulness for investors:
Investor’s first interest will be the
security of his investment and then a return in the
form of dividend or interest. The investors can
determine the magnitude and direction of the
movement in firm’s earnings with the help of
profitability ratios such as earning per share,
dividend yield, etc. After analyzing the relevant
ratios the present investors can decide whether to
hold, sell or purchase the shares and the
prospective investor can decide whether or not to
buy the shares.
(F)Usefulness to the management:
(i) Decision-making: Financial statements are
prepared primarily for decision making. Ratios
help in high-lighting the areas of deserving
attention and corrective action thus facilitating
decision making.
(ii) Financial forecasting and planning:
Planning and forecasting can be done only by
knowing the past and the present. Planning is
looking ahead and the ratios calculated for a
number of years work as a guide for the future.
Meaningful conclusions can be drawn for future
from these ratios.
(iii) Communication: The financial strength and
the weakness of a firm are communicated in a
more easy and understandable manner by use of
ratios.

(iv) Co-ordination is facilitated: Ratio even help

in coordination which is of outmost importance in
effective business management. Better
communication of efficiency and weakness of an
enterprise results in better co-ordination in the
enterprise.
(v) Control is more effective: Ratio analysis even help in
making effective control of the business. Standard ratio can
be based upon proforma financial statements and
variances or deviations, if any, can be found by comparing
the actual with the standards so as to take a corrective
action at the right time. The weakness or otherwise, if any,
come to the knowledge of the management which helps in
effective control of the business.

(vi) Other Uses: There are so many uses of ratio analysis. It

is an essential part of the budgetary control and standard
costing. Ratios are of immense importance in the analysis
Factors considered while undertaking Ratio Analysis
1. Quality/Accuracy of Financial Statement: The ratios are
calculated from the data available in financial statements.
The reliability of ratios is linked to the accuracy of
information in these statements. Before calculating ratios
one should see whether proper concepts and conventions
have been used for preparing financial or not.
2. Objectives/purposes of Analysis: The type of ratios to be
calculated will depend upon the purposes for which are
required. The purpose of user is also important for the
analysis of ratios. Creditors, a banker, an investor, a
shareholder, all have different objects for studying ratios.
The purpose or object for which ratios are required to be
studied should always be kept in mind for studying various
ratios. Different objects may require the study of different
ratios.
3. Selection of Ratios: Another precaution in ratio
analysis is the proper selection of appropriate ratios. The
ratios should match the purpose for which these are
required. Only those ratios should be selected which can
throw proper light on the matter to be discussed.

4. Use of standards: The ratios will give an indication

of financial position only when discussed with reference
to certain standards. These standard may be rule of
thumb as in case of current ratio (2:1) and acid-test ratio
(1:1), may be industry standards, may be budgeted or
projected ratios, etc.
5. Capability of the analyst: Analysis is a tool in the hands
of analyst. Knife in the hands of criminal may take the life
but the knife in the hands of a surgeon may give new life to
a patient. Interpretation depends on the educational
background; professional skill; experience and intuition of
the professional conducting it.

6. Ratio to be used only as guide: Ratios can provide, at

the best, the starting point. The analyst, before arriving at
the conclusion, should take into consideration all other
relevant factors financial and nonfinancial; macro and
micro.
Advantages of Ratio Analysis

1. Simplifies financial statements: Ratio analysis

simplifies the comprehension of financial statements.
Ratios tell the whole story of changes in the financial
condition of a business.

2. Facilitates inter firm comparison: Analysis provides

data for inter firm comparison. Ratios high-light the
factors associated with successful and unsuccessful
firms. They also reveal strong firms and weak firms,
overvalued and undervalued firms.
3. Makes inter-firm comparison possible: Ratio
analysis also makes possible comparison of the
performance of the different of the firm. The ratios are
helpful in deciding about their efficiency or otherwise in
the past and likely performance in the future.

4. Helps in planning:Ratio analysis helps in planning

and forecasting. Over a period of time a firm or industry
develops certain norms that may indicate future success
or failure. Thus ratios can assist management in its basic
function of forecasting, planning, co-ordination, control
and communication.
 Limitations of Ratio Analysis
The ratio analysis is one of the most powerful
tools of the financial management. Ratio analysis
is a widely used and useful technique to evaluate
the financial position and performance of any
business unit but it suffers from a number of
limitations. These limitations must be kept in
mind by the analyst while using this technique.
1. Limited use of a Single Ratio: A single ratio, usually,
does not convey much of a sense. To make a better
interpretation a number of ratios have to be calculated
which is likely to confuse the analyst than help him to in
making any meaningful conclusion.
2. Lack of adequate standards: There are no well
accepted standards or rules of thumb for all ratios which
can be accepted as norms. It renders interpretation of the
ratios difficult. 3
3. Inherent Limitation of accounting: Like financial
statements, ratios also suffer from the inherent weakness
of accounting records such as their historical nature.
Ratios of the past are not necessary true indicators of the
future.
4. Change of accounting procedure: Change in accounting
procedure by a firm often makes ratio analysis misleading,
e.g., a change in the valuation of methods of inventories,
from FIFO to LIFO increases the cost of sales and reduces
considerably the value of closing stocks which makes stock
turnover ratio to be lucrative and an unfavourable gross profit
ratio.

5. Personal Bias: Ratios are only means of financial analysis

and not an end in itself. Ratios have to be interpreted and
different people may interpret the same ratio in different
ways.
6. Incomparable: Not only industries differ in their nature
but also the firms of the similar business widely differ in
their size and accounting procedures, etc. It makes
comparison of ratios difficult and misleading. Moreover,
comparisons are made difficult due to differences in
definition of various financial terms used in the ratio
analysis.

7. Absolute Figures Distortive: Ratio devoid of absolute

figures may prove distortive as ratio analysis is primarily a
quantitative analysis and not a qualitative analysis.
8. Price level Changes: While making ratio analysis,
no consideration is made to the changes in price
levels and this makes the interpretation of ratio
invalid.

9. Ratios no Substitutes: Ratio analysis is merely a

tool of financial statements. Hence, ratios become
useless if separated from the statements from which
they are computed.

10.Clues not Conclusions: Ratios provide only clues

to analysts and not final conclusions. These ratios to
be interpreted by these experts and there are no
standard rules for interpretation.
 CLASSIFICATION OF RATIOS
I. Liquidity ratios:
These ratios analyse the short-term financial
position of a firm and indicate the ability of the firm to
meet its short-term commitments (current liabilities) out of
its short-term resources (current assets).
These are also known as ‘Short-term solvency ratios’. The
ratios which indicate the liquidity of a firm are:
• Current ratio
• Liquidity ratio or Quick ratio or acid test ratio
• Absolute Liquid ratio
 Current ratio
It express the relationship between current assets and
current liabilities. It is calculated by dividing current
assets by current liabilities.
Current ratio = Current Assets /Current Liabilities
(OR)
Current ratio = Current assets: Current liabilities

Conventionally a current ratio of 2:1 is

considered satisfactory
 Current Assets Current Liabilities
CASH IN HAND SUNDRY CERDITORS
CASH AT BANK BILLS PAYABLE
MARKETABLE SECURITIES OUTSTANDING EXPENSES
BILLS RECEIVABLE PROVISION FOR TAXATION
SUNDRY DEBTORS PROPOSED DIVIDENT
OUTSTANDING INCOME Income received in advance
STOCK BANK OVERDRAFT
PREPAID EXPENSES
 Quick Ratio or Acid Test Ratio
This is a ratio between quick current assets and quick
liabilities. It is calculated by dividing quick current assets
by quick liabilities.

Quick ratio = quick assets: quick liabilities

Conventionally a quick ratio of 1:1 is considered

satisfactory.

Quick assets = Current assets – (Stock +Prepaid Expenses)

Quick liabilities = Current Liabilities – ( Bank overdraft)
 Absolute Liquid ratio

This is a ratio between Absolute liquid assets and quick

liabilities. It is calculated by dividing Absolute liquid quick
by quick liabilities.

Quick ratio = Absolute liquid assets: quick liabilities

Conventionally a quick ratio of 0.5:1 is considered

satisfactory.

Absolute liquid assets = CASH +BANK

+MARKETABLE SECURITIES
Quick liabilities = Current Liabilities – ( Bank overdraft)
II. Solvency ratios :
These ratios indicate the long term solvency of a firm and
indicate the ability of the firm to meet its long-term
commitment with respect to

(i) repayment of principal on maturity or in predetermined

installments at due dates and

(ii) periodic payment of interest during the period of the

loan.
• Debt equity ratio

• Proprietary ratio
 Debt equity ratio

This ratio indicates the relative proportion of debt and

equity in financing the assets of the firm. It is calculated by
dividing long-term debt by shareholder’s
funds.
Debt equity ratio = long-term debts
-------------------
Shareholders funds
Generally, financial institutions favour a ratio of 2:1.

However this standard should be applied having regard

to size and type and nature of business and the degree of
risk involved.
LONG-TERM FUNDS are long-term loans
whether secured or unsecured like – debentures,
bonds, loans from financial institutions etc.

SHAREHOLDER’S FUNDS are Equity share

capital plus Preference share capital plus
Reserves and Surplus minus Fictitious assets (eg.
Preliminary expenses, past accumulated losses,
discount on issue of shares etc.)
 Proprietary ratio

This ratio indicates the general financial strength of

the firm and the long- term solvency of the business.
This ratio is calculated by dividing proprietor’s
funds by total funds.
Proprietary ratio = Proprietor’s funds
-----------------------
Total tangible assets

As a rough guide a 65% to 75% proprietary ratio is

advisable
III.Profitability ratios :

These ratios measure the operating efficiency of

the firm and its ability to ensure adequate returns to
its shareholders. The profitability of a firm can be
measured by its profitability ratios.

Further the profitability ratios can be determined

(i) in relation to sales and
(ii) in relation to investments
Profitability ratios
Profitability ratios in relation to sales:
Gross profit ratio = Gross profit
--------------- X 100
Net sales

Net profit ratio =Net Profit

----------------- X 100
Net Sales

Operating profit ratio = Operating profit

--------------------- X100
Net Sales
Operating ratio = Operating cost
------------------- X 100
Net Sales

Operating cost = cost of goods sold + operating expenses

or
Net profit +non-operating expenses– non
operating income
Expenses ratio = Concern expenses
----------------------- X 100
Net Sales
Expenses ratio
These ratios are calculated by dividing the various expenses by
sales. The variants of expenses ratios are:
Material consumed ratio = Material consumed
-------------------------- X 100
Net sales
Manufacturing expenses ratio = Manufacturing expenses
--------------------------- X 100
Net sales
Administration expenses ratio = Administration expenses
------------------------------- X 100
Net sales
Selling expenses ratio = Selling expenses
----------------------- X 100
Net sales
Financial expense ratio = Financial expenses x 100
- ------------------------
Net sales
Profitability ratios:
Profitability ratios in relation to investments

 Return on assets (ROA)

 Return on capital employed (ROCE)
 Return on shareholder’s equity (ROE)
 Earnings per share (EPS)
 Dividend per share (DPS)
 Dividend payout ratio (D/P)
 Price earning ratio (P/E)
Return on assets (ROA)
This ratio measures the profitability of the total funds ofa firm.
It measures the relationship between net profits and total assets.
The objective is to find out how efficiently the total assets have
been used by the management.
Return on assets =
Net profit after Taxes plus interest
--- ----------------------------- x 100
Total assets
Total assets exclude fictitious assets. As the total assets at the
beginning of the year and end of the year may not be the same,
average total assets may be used as the
denominator.
Return on capital employed (ROCE)
This ratio measures the relationship between netprofit and capital
employed. It indicates how efficiently the long-term funds of
owners and creditors are being used.
ROEC =Net profit after taxes plus interest
------------------------------------- X 100
Capital employed
CAPITAL EMPLOYED denotes shareholders funds and long-
term borrowings.
To have a fair representation of the capital employed, average
capital employed may be used as the denominator.
Return on ordinary shareholders equity =
net profit after taxes – pref. dividend
----------------------------------------------------- X 100
Ordinary shareholders equity or net worth

ORDINARY SHAREHOLDERS EQUITY

OR NET WORTH includes equity share capital
plus reserves and surplus minus fictitious assets.
Earnings per share (EPS)
This ratio measures the profit available to the
equity shareholders on a per share basis. This ratio
is calculated by dividing net profit available to
equity shareholders by the number of equity shares.
Earnings per share =
net profit after tax – preference dividend
------------------------------------------------
Number of equity shares
Dividend per share (DPS)
This ratio shows the dividend paid to the shareholder on
a per share basis. This is a better indicator than the EPS
as it shows the amount of dividend received by the
ordinary shareholders,
while EPS merely shows theoretically how much
belongs to the ordinary shareholders
Dividend per share =
Dividend paid to ordinary shareholders
--------------------------------------------------
Number of equity shares
Dividend payout ratio (D/P)
This ratio measures the relationship between theearnings
belonging to the ordinary shareholders and thedividend
paid to them.
Dividend pay out ratio =
Total dividend paid to ordinary shareholders
------------------------------------------------- x 100
Net profit after tax –preference dividend
(OR)
Dividend pay out ratio = Dividend per share
---------------------- x 100
Earnings per share
Price earning ratio (P/E)
This ratio is computed by dividing the market price of the
shares by the earnings per share. It measures the
expectations of the investors and market appraisal of the
performance of the firm.
Price earning ratio = Market price per share
--------------------------
Earnings per share
IV.Activity Ratios:
Activity ratios are calculated to measure the
efficiency with which the resources of a firm have been
employed. These ratios are also called turnover ratios
because they indicate the speed with which assets are being
turned over into sales. These ratio show the relationship
between sales and other assets .Various ratio under this
group are as follows:
• Stock turnover ratio
• Debtor turnover ratio
• Creditor turnover ratio
• Asset turnover ratio
Inventory /Stock turnover ratio

This ratio indicates the number of times inventory is

replaced during the year. It measures the relationship
between cost of goods sold and the inventory level.
Inventory turnover ratio = Cost of goods sold
---------------------------
Average stock
Cost of goods sold = Sales -- Gross profit
Or
Cost of goods sold = Opening Stock +Purchase--
Closing stock
AVERAGE STOCK can be calculated as
Opening stock + closing stock
-------------------------------------
2
A firm should have neither too high nor too
low inventory turnover ratio. Too high a ratio
may indicate very low level of inventory and
a danger of being out of stock and incurring
high ‘stock out cost’. On the contrary too low
a ratio is indicative of excessive inventory
entailing excessive carrying cost.
Debtors turnover ratio and average
collection period/ Debtor velocity ratio:

This ratio is a test of the liquidity of the debtors of a firm. It

shows the relationship between credit sales and debtors.

Debtors turnover ratio = Credit sales

--------------------
Average Debtors and bills receivables

Average collection period /

Debtor velocity ratio = Sundry debtors +Bills receivable
--------------------------------------- X no. of
Net credit sales working
days in
year
No.of working days = 365days Or 360 days
These ratios are indicative of the efficiency of
the trade credit management. A high turnover
ratio and shorter collection period indicate
prompt payment by the debtor. On the
contrary low turnover ratio and longer
collection period indicates delayed
payments by the debtor.

In general a high debtor turnover ratio and

short collection period is preferable.
Creditors turnover ratio and Average
credit period/ Creditor velocity ratio:
This ratio shows the speed with which payments are made to
the suppliers for purchases made from them. It shows the
relationship between credit purchases and average creditors.
Creditors turnover ratio = Credit purchases
---------------------------------
Average creditors & bills payables
Average credit period/ = Sundry creditor+ B/P No. of
----------------------------X working
Creditor velocity ratio Net credit purchase days in a year

Higher creditors turnover ratio and short credit period

signifies that the creditors are being paid promptly and it
enhances the creditworthiness of the firm.
Asset turnover ratio: Depending on the different
concepts of assets employed, there are many variants
of this ratio. These ratios measure the efficiency of a
firm in managing and utilising its assets.
Total asset turnover ratio = sales/cost of goods sold
--------------------------------
Total assets
Fixed asset turnover ratio = sales/cost of goods sold
---------------------------------
Fixed assets
Capital turnover ratio = sales/cost of goods sold
----------------------------------
Capital
Working capital turnover ratio = sales/cost of goods sold
-----------------------------------
Net working capital
THANK YOU !!!