Ratio Analysis

Ratio as a term….

 It is the relationship of one variable to another of which the quotient is the

measure i.e a simple division of two numbers.
 Simple or pure ratio : It is received by dividing simply one number with the
other.
 Percentages: Ratios are expressed in percentage form when the simple ratios
are multiplied by 100.
 Rates : Ratios for a period in terms of number of times
 So Ratio is a method by which the relationship of items in the financial
statements are determined.
 Ratios analysis will be more meaningful when certain standards and norms or
certain benchmarks are laid down.
 This will help ratios to get compared.
 Ratio analysis can be particularly useful as an indicator of the performance of
business in relation to organization’s old performance and its contemporary
peers.
Analysis and Interpretation

 Analysis of Financial statement is a systematic and specialized treatment of

the information presented in financial statement.
 This helps to measure profitability, liquidity, solvency, activity, valuation etc.
 Interpretation means establishment of meaning or a fact or a significance
from the analysis.
Income Statement Ratios

 As per financial statements….

 Balance Sheet Ratios – Current Ratio
 Income Statement Ratio- Expense to sales
 Inter Statement Ratio – Sundry Debtors to Sales
Functional Classification of Ratios

 Liquidity Ratios: Shows short term and immediate financial position of a

business and indicate its ability to meet short term commitments.
 Leverage Ratios : Capital Structure Ratios that shows the relationship
between proprietor’s funds and borrowed funds.
 Activity Ratio : This shows how efficiently the resources of the business are
used.
 Profitability Ratios : It shows the result of business enterprises related to its
sales. It shows the effectiveness and efficiency of the business.
Liquidity Ratio

 Current Ratio : Current Asset/ Current Liabilities

 Quick Ratio : Quick Asset / Current Liabilities
 Cash Position Ratio : Cash or Near Cash Assets/Current Liabilities.
 Current ratio is the barometer of short term liquidity
 An index of adequacy of working capital in an enterprise.
 An indicator of economic health of an enterprise .
 Standard current ratio is always subjective.
Liquid Ratio

 This shows the liquid financial position of the enterprise.

 Quick assets are those current assets which can be realized immediately at a
very short notice.
 They are also called near cash asset.
 Quick assets are Current asset less Inventory and Prepaid Expenses.
 Quick liability is calculated as current liabilities less Bank Overdraft.
 It indicates immediate solvency position of the business.
 If two firms have the same current ratio but different quick ratio then what
can be the possible significance.
Cash Position Ratio

 Cash on hand and Bank/Current Liabilities

 Higher the cash position ratio less will be role of receivables in quick ratio.
 Solvency is the ability of an entity or individual to pay the debts.
 It means the ability to meet the long term fixed expenses.
 Liquidity is the ability of a firm to pay its current liability .
 It is the ability to easily convert assets into cash.
Inventory Working Capital Ratio

 Calculated as Stock or Inventory/Working Capital

 Stock is valued at cost price or market price whichever is lower
 Stock is the average closing stock as on the date the balance sheet is
prepared. It is ( Opening Stock + Closing Stock)/2
 Working Capital is Current Asset minus Current Liabilities.
 This ratio measures the extent to which the firm has invested its working
capital to less liquid inventory.
 In other words it indicates the degree of importance of inventory in the
working capital of business.
 A higher ratio indicates weak working capital and doubtful immediate
liquidity and solvency position.
Other Ratios

Stock to Gross Working Capital

 Implication : Higher the ratio means higher the quantum of Inventory in
working capital so lower the liquidity.
 So we can say this ratio and liquidity of enterprise will have inverse
relationship.
Assignment 1

A firms current assets and current

liabilities are 1600 and 1000
respectively. Calculate the net
working capital and current ratio.
How much can it borrow on a short
term basis without reducing the
current ratio below 1.25.
Assignment

Determine the sales of the firm

from the following details.
Current ratio= 1.4
Quick Ratio = 1.2 &
Current liabilities = 1600
Inventory Turnover Ratio = 8 times.
Assignment

The current ratio and liquid ratio

of a firm is 2.5 and 1.5.The
working capital is 1,50,000.
Calculate Current Asset, Current
Liability and closing stock.
Assignment

 The following information is given for Alpha

Corporation
 Sales 3600
 Current ratio 1.5
 Acid test ratio 1.2
 Current liabilities 1000
 What is the inventory turnover ratio?
Assignment

 The following information is given for Beta

Corporation.
 Sales 5000
 Current ratio 1.4
 Inventory turnover 5
ratio
 Acid test ratio 1.0
 What is the level of current liabilities?
Assignment

 Calculate Current Ratio and

Quick ratio from the following
information:
Profitability Ratios

 Gross Profit Ratio : It is known as margin or trading margin ratio.

 Gross Profit/ Net Sales expressed as a percentage of net sales.
 It measures the results of trading account or manufacturing operations
 It shows the gap between revenue and expense at a point after which the
enterprise makes non-manufacturing expenses.
 It shows the efficiency of two departments Marketing and Production
 If the ratio is low then cost of goods sold will be high which could be a result
of unfavourable purchase policy, lower selling price, too much of competition
etc.
 Ratio of cost of goods sold to sales = 1- Gross Profit ratio
Assignment

 Total Sales (Cash and Credit) – Rs.40000

 Sales Return - Rs. 2000
 Cost of Sales Rs. 30000
 Calculate Gross profit ratio
 Ratio of cost of goods sold to sales.
Operating Ratio and Operating Profit
Ratio
 It is calculated as (Cost of Goods Sold + other operating expenses) / Net Sales
* 100.
 So it is a ratio that shows a relationship between cost of trading activities and
net sales.
 So it explains what percentage of operating expense bear to net sales.
 The higher the operating ratio less favourable to the firm since it will leave
small margin to cover interest rate , income tax etc.
 Other operating expenses include marketing administration and finance
inputs.
 Operating Profit = Net sales – Operating Cost
 Operating Profit ratio – Operating Profit/Net sales*100
Assignment

 Calculate the operating ratio from the following

details.
 Cost of goods sold Rs.30000
 Selling and Distribution expenses – Rs.4000
 Admin and office expenses – Rs.5000
 Sales – 60000
 Sales Return – Rs. 6000
Assignment

 Find out the operating profit ratio from the

following
 Cost of goods sold Rs. 60000
 Admin Expense Rs.2000
 Selling and Distribution expense – 2400
 Sales -- Rs.90000
 Sales Return - 1600
Net profit ratio & Cash Profit Ratio

 Net profit ratio = (Net profit / Net sales)*100

 Here net profit is calculated after tax.
 It is the overall measure of the profitability of the firm.
 So higher the net profit higher the profitability.
 Cash profit ratio = (Cash Profit/ Net Sales) *100
 Cash profit = Net profit plus depreciation.
Assignment

 Tax Rs.40000
 EBT Rs.92000
 Net sales Rs.130000
 Calculate net profit ratio

 Ans:40%
Assignment

 Depreciation for the year Rs.80000

 Net Profit for the year Rs.180000
 Sales for the year Rs.1800000
 Returns from Customer Rs.10000
 Compute the cash profit ratio for the year.

Ans:14.52%.
Expense Ratio

 Expense ratio highlights the relationship of different expenses to net sales.

 Lower the expense ratio greater will be the profitability for the firm.
 Particular Expense Ratio
 Cost of Goods sold Ratio
 Admin Expense ratio
 Selling and Distribution Expense ratio
 Non-operating expense ratio.
Contribution Analysis

 It is calculated as difference of sales and variable cost.

 It is excess of sales after deducting marginal cost which is used for fixed cost
and profit expectation of the firm.
 If contribution is equal to fixed cost the firm is said to be in break-even point.
 Contribution margin is useful in understanding the risk characteristics of
business.
 It shows the degree of margin of safety that management reaps in pricing and
expense control under different economic conditions.
 It helps in decision making process and fixing the selling price of a commodity.
 It also helps in selection of optimal product mix to optimize profit.
Assignment

 From the following determine the amount of profit earned during the year.
 Fixed cost Rs.10,00,000
 Variable Cost Rs.20 per unit
 Selling Price Rs.30 per unit
 Output level 300000 units

 Ans:20,00,000
Assignment

 Determine variable cost from the following data

 Sales Rs.120000
 Fixed Cost Rs.20000
 Profit Rs.30,000

 Ans:70000
Return on Investment

 ROI = (Net Profit after int. & taxes/Shareholders’ funds) *100

 Shareholders’ Funds = (Equity Share capital + Preference Share capital +
Reserve and Surplus – Accumulated Loss)
 It shows the overall efficiency of the firm i.e. how efficiently the resources of
the firm is employed.
 Higher the ratio better the effects and this also helps in inter firm
comparison.
Assignment

Item Amount in Rs.

1000 ordinary shares of Rs.10 each 10000
2000 preference share of Rs.10 each 20000
General reserve 40000
Capital reserve 48000
Special reserve 30000
Accumulated Loss 10000
Net profit before interest and tax 90000
Interest expense 10000
Income tax @50%
Compute the Return On investment
Ans:28.99%
Return on capital employed

 ROCE= (Net Profit/ Capital Employed)

 Capital Employed = All Fixed Asset + Investment + All Current Asset-All current
Liabilities-Idle & Intangible Asset
 ROCE is principal test of corporate efficiency.
 Return on Equity
 Earnings available for shareholders / Total Equity
 ESH = Net profit after tax-Preference Dividend
 Total equity = Paid up equity+ Reserve and Surplus+ share Premium –
Accumulated loss.
 Earning Per share = (ESH/NOS)
Assignment

 ABC Ltd provides you the following information

 1000 equity shares of Rs.10 each whose paid up value is Rs.8
 10% Preference share (500 shares @rs. 30 each)
 Profit before tax Rs.9000
 Tax rate 50%
 Calculate ROE and EPS.

 Ans:37.5,3
Importance of EPS

 EPS is used for inter firm comparison

 EPS is used for comparing with average of industries
 Trend analysis can be done to understand the growth in earnings
Dividend Yield and Pay out ratio
 Dividend yield depicts the relationship between dividend per share and
market per share.
 Dividend Yield = (DPS/MPS)
 DPS = (Proposed dividend / Number of share)
 Shareholders are owner so they want to know how much return they get on
their investment.
 Market Capitalization = Number of shares * MPS.
 Dividend Payout ratio shows the proportion of earnings of the company that is
paid as dividend.
 DPOR = DPS/EPS (It shows actually how much earning is retained by firm.
 Used for inter firm comparison
Price Earning Ratio
 P/E ratio = Market price per share/EPS. (Also called Price Earning Multiple)
 Higher the ratio the better it is for the shareholders.
 If the ratio falls the reason should be investigated.
 It helps in determination of the value of market price per share.
 Price to Book Value Ratio = MPS/BVPS
 BVPS = (Shareholder’s equity/NOS outstanding)
 This indicates net worth per equity share
 A higher Price to book value implies greater market confidence.
 Cover for Preference Dividend = Profit after tax/ Preference Dividend
 Coverage for equity shareholders = Earning available for shareholders/Equity
dividend.
Assignment

 Star electricals has provided the following information

 10000 equity shares of Rs.10 each.
 10% preference shares having 20000 shares @ Rs.10 each.
 Profit after tax Rs.24000
 Equity Dividend Paid @ 12%
 Market price per share Rs.32
 Please find Dividend Yield, EPS, PE Ratio, Coverage for Preference Dividend,
Coverage for equity dividend.
Assignment

Equity share capital of Rs 20 each 50000000

Secured Loan @ 15% 25000000
Unsecured Loan @ 12% 10000000
Operating Profit 25000000
Income Tax rate 40%
Market Price per share 50
Calculate PE Ratio.
Ans:10.39
Coverage ratio
 Interest Coverage Ratio:
 The ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by the
company's interest expense. A higher interest coverage ratio (ICR) means a company is more
poised to pay its debts; a low ICR indicates that its debts are higher than its earnings.
 Debt coverage ratio:
The formula to calculate the debt service coverage ratio (DSCR) divides the net operating
income (NOI) of a property by its annual debt service.
Debt Service Coverage Ratio (DSCR) = Net Operating Income (NOI) ÷ Annual Debt Service
Where:
• Net Operating Income (NOI) → The NOI metric is used in the real estate industry to analyze the
operating profitability of properties. NOI is the total income generated by a property – inclusive
of rental income and ancillary income – minus direct operating expenses such as property
management fees, maintenance costs, property taxes, and property insurance.
• Annual Debt Service → The annual debt service is the total financing obligations that a property
must fulfill, most notably the mandatory principal repayments on a mortgage loan and the
periodic interest payments.
Activity Ratios

 It shows how efficiently the assets are used to generate sales.

 Effective utilization of asset depends upon different managerial decisions
regarding current assets and fixed assets.
 Inventory Turnover ratio
 Debtors Turnover ratio
 Creditors Turnover ratio
 Working capital Turnover ratio
Activity Ratio

 Inventory Turnover ratio shows how fast the inventory is moving through the
enterprise and generating sales. Also known as stock turnover ratio.
 ITOR = (Cost of Goods Sold/Average Inventory) or (Sales/ Average Inventory)
 Higher the inventory turnover the greater the efficiency of inventory
management.
 COGS= Sales-Gross profit
 COGS = op. stock+ Purchase+ cost of production- closing stock.
 Average inventory = (opening stock + Closing stock)/2
 A low ratio indicates over stocking thereby making unnecessary cost on
inventory.
 Age of Inventory = No. of periods in a year/Inventory Turnover
Assignment
 From the following information, calculate stock turnover
ratio. Opening stock Rs 58,000; Excess of Closing stock
opening stock Rs. 4,000; sales Rs. 6,40,000; Gross Profit
@ 25% on cost.
Debtors and Creditors Turnover ratio
 Commonly known as receivable turnover ratio. (Debtors=SD+B/R)
 This highlights the number of times debtors are turned over during a year.
 (Net annual credit sales / Average debtors)
 Higher the debtors turnover the more liquid is the firms’ debtors.
 Average collection Period = (Month in a Year/Debtors Turnover)
 Lower ratio means inefficient management of asset.
 Creditors turnover ratio is (net credit purchases/Average creditors)
 This ratio is important for creditors as he is interested in finding out how
much time the enterprise is likely to avail to repay the creditors.
 Average payment period = Number of periods in a year/Creditors Turnover
 Where Average Daily purchase = Annual Purchase / no of working days in a
year.
Assignment
Working Capital Turnover ratio

 WCTR = Sales / Working Capital.

 WCTR = Cost of Sales/Average working Capital.
 This ratio indicates the extent of working capital turns over in generating
sales of the enterprise.
 Higher ratio tells the efficient use of working capital.
 Fixed asset turnover ratio = Net sales / Net Fixed asset
 Higher the ratio greater is the intensive utilization of fixed asset.
Test of Solvency

 It means long term solvency that signifies long term financial stability of the
firm.
 The concept solvency refers to the ability of an enterprise to meet its long-
term liabilities.
 Long term liabilities includes Debenture and term loans from institution.
 So long term creditors will try to test whether firm will be able to meet the
interest at regular interval and redemption principal at maturity.
 Debt equity ratio, Proprietary ratio, Fixed assets to Net worth and different
coverage ratios.
Debt Equity Ratio
 Termed as External-Internal Equity ratio which measures the relative claims
of outsiders and owners against the assets of the enterprise.
 Outsiders’ funds include all long-term debt to outsiders.
 Components of owners’ fund include equity share capital, reserve and surplus
and credit balance of profit and loss account.
 Accumulated losses and deferred expenses are subtracted . This is commonly
called Net worth.
 Debt equity ratio of 2:1 is said to be ideal one . Low ratio indicates that the
firm is unable to utilize the debt to earn more profits.
 A higher ratio signifies more financial risk of the firm as long-term creditors
will have lesser margin of safety.
Status of Preference Share capital.

 Usually, the preference share capital is eliminated from debt.

 But if the DER is to disclose the effect of utilizing fixed interest sources on
earnings of shareholders, then it is to be included.
 If the debt equity ratio is to investigate the financial solvency, then the
preference share shall not be a part of the capital.
 Preference share is included in calculating Capital Gearing Ratio.
 Capital Gearing ratio = (Fixed Income Bearing Funds/ Equity Shareholder’s Fund)
 Fixed Income Bearing Securities include debentures , long term loans, preference
capital
 Equity shareholder’s fund includes Equity capital and Reserve & Surplus.
 This ratio signifies the degree of vulnerability of earnings available for equity
shareholders.
Proprietary ratio
Proprietary Ratio = Proprietors' Funds / Total Assets.
• Proprietors' Funds = Equity Share Capital + Preference Share Capital + Reserves and
Surplus (excluding fictitious assets) + Money received against share warrants.
• Total Assets = Current Assets + Non-Current Assets (including deferred revenue
expenses).

• The proprietary ratio assesses how much of a company's assets are financed through
(shareholder funds) rather than external debt.

• A higher proprietary ratio indicates a stronger capital structure with minimal reliance
on borrowed funds, which can provide confidence to creditors and vice versa.
Assignment
Assignment
 XYZ has made plans for next year. It is estimated that
company will employ total assets of Rs.1600000. Fifty
percent of assets being financed by borrowed capital at
an interest rate of 16% per annum. The direct costs for
the year are estimated at Rs.9,60,000. All other operating
expenses are estimated at Rs.1,60,000. The Goods will be
sold to the customer at 150% of the direct cost. Income
tax rate is assumed to be 50%. You are required to
calculate i. Net Profit Margin ii. Assets Turnover iii. Return
on owner’s equity.

 Ans:6.67% ; 0.9 times ; 12%.

Assignment

 Study the following data given carefully:

 Current ratio = 2.5:1
 Liquid ratio = 1.5:1
 Proprietary Ratio = 0.6 [FA to Proprietor’s Fund]
 Working capital = 150000
 Reserve and surplus = 130000
 Calculate:
 Closing stock (Inventory) , Quick Asset and Fixed Asset
 Share capital and Current liabilities
 Prepare Balance Sheet.