Financial Accounting, Management Accounting

1. RATIO ANALYSIS
UNIT-2

2. DEFINITIOS
Ratio analysis is a method or process by which the relationship of items or
groups of items in the financial statements are computed, and presented.
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.
Ratio analysis is a widely-used tool of financial analysis. It can be used to
compare the risk and return relationship of firm of different sizes.

6. 1. LIQUIDITY RATIO
The function of the liquidity ratios is to measure the ability of the firm and to meet
the present obligations. Some of the common ratios that come under the liquidity
ratios are as follows:
A. Current ratio
B. Quick ratio
C. Cash ratio
D. Network capital ratio

7. A. CURRENT RATIO
The current ratio is a liquidity ratio that measures a company’s ability to pay short-term
obligations or those due within one year. It tells investors and analysts how a company can
maximize the current assets on its balance sheet to satisfy its current debt and other payables.
Current assets = cash, accounts receivable, inventory, and other current assets (OCA) that
are expected to be liquidated or turned into cash in less than one year.
Current liabilities include accounts payable, wages, taxes payable, short-term debts, and the
current portion of long-term debt.
Current Ratio= Current liability/ Current assets​​

8. B. QUICK RATIO
The quick ratio is a financial ratio used to gauge a company's liquidity. The quick ratio is
also known as the acid test ratio.
The quick ratio compares the total amount of cash and cash equivalents + marketable
securities + accounts receivable to the amount of current liabilities.
 Quick Ration=

9. C: CASH RATIO
Cash ratio is the ratio which measures the ability of the company to repay the short
term debts with the cash or cash equivalents and it is calculated by dividing the total
cash and the cash equivalents of the company with its total current liabilities.
Network capital ratio: The net working capital ratio is the net amount of all elements of working
capital. It is intended to reveal whether a business has a sufficient amount of net funds available in the
short term to stay in operation. Use the following formula to calculate the net working capital ratio:
Cash Ratio Formula = Cash + Cash Equivalents / Total Current Liabilities
Current assets - Current liabilities = net working capital ratio

12. Leverage ratios: The leverage ratios are the long-term financial strength and
they indicate the proportions of debt and equity in financing the firm’s assets.
Few ratios that come under leverage ratios are as below:
A. Debt ratio
B. Debt-equity ratio
C. Capital employed in the net worth ratio
D. Coverage ratio

13. DEBT RATIO
The debt ratio is a financial leverage ratio that measures the portion of company
resources (pertaining to assets) that is funded by debt (pertaining to liabilities). A
company with a high debt ratio is known as a “leveraged” firm.

14. Mr. Rajesh has a bakery with total assets of 50,000$ and liabilities of 20,000$, the
debt ratio is 40%, or 0.40. This debt ratio is calculated by dividing 20,000$ (total
liabilities) by 50,000$ (total assets). If the debt ratio is 0.4, the company is in
good shape and may be able to repay the accumulated debt.
Mr. Max is running a clothing store and pays its employees 50,000$ and has total
assets amounting to 100,000$. To calculate the debt ratio, divide
50,000$ (liabilities) by 100,000$ (assets). This means the store has a debt ratio of
0.5 which is generally considered favorable.

15. DEBT TO EQUITY RATIO
The Debt to Equity ratio (also called the “debt-equity ratio”, “risk ratio”, or “gearing
ratio”), is a leverage ratio that calculates the weight of total debt and financial
liabilities against total shareholders’ equity. Unlike the debt-assets ratio which uses
total assets as a denominator, the D/E Ratio uses total equity. This ratio highlights how
a company’s capital structure is tilted either toward debt or equity financing.
Debt to Equity Ratio = (short term debt + long term debt + fixed payment obligations)
/ Shareholders’ Equity

16. X Company has the following information –
Current Liabilities – $49,000
Non-current Liabilities – $111,000
Common Stocks – 20,000 shares of $25 each
Preferred Stocks – $140,000
Find out the debt-equity ratio of the Youth Company.
Total liabilities = (Current liabilities + Non-current liabilities) = ($49,000 + $111,000) = $160,000.
Total shareholders’ equity = (Common stocks + Preferred stocks) = [(20,000 * $25) + $140,000]
= [$500,000 + $140,000] = $640,000.
Debt equity ratio = Total liabilities / Total shareholders’ equity = $160,000 / $640,000 = ¼ = 0.25.
the debt to equity of X Company is 0.25.

17. COVERAGE RATIO
A coverage ratio, broadly, is a metric intended to measure a company's ability to service its debt
and meet its financial obligations, such as interest payments or dividends. The higher the coverage
ratio, the easier it should be to make interest payments on its debt or pay dividends. The trend of
coverage ratios over time is also studied by analysts and investors to ascertain the change in a
company's financial position.

19. 2. PROFITABILITY RATIO
The profitability ratios have the strength of long-term earning and they measure the overall performance of the industry along with the
effectiveness of the industry. Two important types of profitability ratios are as follows:
A. Profitability in relation to sales
B. Profitability in relation to investment
Some of the profitability ratios are as follows:
A. Net profit margin
B. Operating expense ratio
C. Return on investment
D. Return on equity
E. Earnings per share
F. Dividends per share
G. Dividend payout rule

21. PROFITABILITY IN RELATION TO INVESTMENT
These ratios relate Profit to Investments. Return On Investments (ROI) is related to three categories
of Assets, Shareholders’ Equity / Funds and Capital Employed
Return on Assets= Net Profit After Taxes + Interest
Total Assets
Operating expenses ratio= Operating Cost X100
Net Sales OR
Operating Expenses Ratio= Cost of Goods Sold+ Operating Expenses X100
Net Sales

22. PROFITABILITY IN RELATION TO INVESTMENTS
Return to Shareholders
Return on Total Shareholders’ Equity = Net Profit after Tax / Shareholders’ Funds
Shareholders’ Funds = Equity Share Capital + Preference Share Capital + Reserves & Surplus
– Accumulated losses, if any)
Return on Equity Capital (ROE)
ROE = Profit after tax – Preference Dividend / Shareholders’ Equity or Net Worth

23. RETURN ON EQUITY CAPITAL (ROE)
ROE = PROFIT AFTER TAX – PREFERENCE DIVIDEND / SHAREHOLDERS’
EQUITY OR NET WORTH

24.  Earnings Per Share (EPS)
EPS is the amount equity holders can get on every share held
EPS = Net Profit available to equity holders (Net Profit after tax – Preference Dividend) / Number of
Equity Shares.
XYZ Ltd has a net income of $1 million in the third quarter. The company announces dividends of
$250,000. Total shares outstanding is at 11,000,000.
The EPS of ABC Ltd. would be:
EPS = ($1,000,000 – $250,000) / 11,000,000
EPS = $0.068
Since every share receives an equal slice of the pie of net income, they would each receive $0.068.

25. Dividend Per Share (DPS)
The earnings distributed to the shareholders as cash dividends
DPS = Earnings paid to shareholders / Number of Equity Shares
A Pvt Ltd announced a total dividend of $750,000 to be paid to shareholders in the closing
financial year. The company 200000 shares outstanding in its balance sheet.
7,50,000 = .$ 3.75 per share
2,00,000

26. Dividend Payout Ratio
Joe’s Kitchen is a restaurant change that has several shareholders. Joe reported $10,000 of net income on
his income statement for the year. Joe’s issued $3,000 of dividends to its shareholders during the year. Here
is Joe’s dividend payout ratio calculation.
3000/10000 = 30%

27. Earnings Yield and Dividend Yield
The yield is expressed in terms of the market value per share
Company A trades at a price of $45. Over the course of one year, the company paid consistent
quarterly dividends of $0.30 per share. The dividend yield ratio for Company A is calculated as
follows:
Dividend Yield Ratio = $0.30 + $0.30 + $0.30 + $0.30 / $45 = 0.02666 = 2.7%

28. 3. ACTIVITY RATIOS
The activity ratios reflect the efficiency of the industry in making use of the industry’s
assets. Few activity ratios are as follows:
1. Inventory turnover ratio
2. Inventory conversion period
3. Debtors’ turnover ratio
4. Average collection period
5. Net assets turnover ratio
6. Current assets turnover
7. Total assets turnover
8. Fixed assets turnover
9. Working capital turnover ratio

29. Average Inventory= Opening Stock+ Closing Stock
2
Inventory Conversion Period determines how much time it takes to convert the inventory
into sales i.e the time taken from the purchase of the new inventory to the actual sale of the
product. It is calculated as inventory divided by average sales or cost of sales and multiplied
by 365 so as to know the exact days of conversion of inventory into sales.
Inventory Conversion Period = Inventory / Cost of Sales * 365

35. Current AssetTurnover Ratio
Fixed Asset Turnover Ratio This ratio measures the efficiency of a company’s PP&E in generating
sales. It assesses whether a company is investing wisely in its assets. A high asset turnover ratio
indicates greater efficiency to generate sales from fixed assets.
Fixed Asset Turnover = Sales / Net fixed assets

37. Asset Turnover Ratio: The asset turnover ratio is an efficiency ratio that measures a
company’s ability to generate sales from its assets by comparing net sales with
average total assets. In other words, this ratio shows how efficiently a company can
use its assets to generate sales.
Asset Turnover Ratio= Net Sales/ Average Total Assets
*Average total assets are usually calculated by adding the beginning and ending total
asset balances together and dividing by two.

39. Working Capital Turnover Ratio
Working Capital Turnover Ratio is used to do an analysis of the utilization of short
term resources for sales. Working Capital Turnover Ratio is the ratio of net sales to
working capital.
Formula For Working Capital Turnover Ratio
Working Capital Turnover Ratio = Turnover (Net Sales) / Working Capital
Working capital is Current Assets – CurrentLiabilities.

42.  Calculating Net Sales
It is important to note that Net sales need to be considered and not Gross sales.
Net sales value for both the companies can be obtained from the Income Statement.
 Company A
Gross Sales = $2,000
Sales return = $200
Net Sales = $2,000 -$ 200 = $1,800
Company B
Gross Sales = $3,000
Sales return = $150
Net Sales = $3,000 -$ 150 = $2,850
Now, take a look at the Balance Sheet extract for both the companies.

43. DIVIDEND COVERAGE RATIO
The general formula for calculating DCR is as follows:
Dividend Coverage Ratio = Net income / Dividend declared
Net income is the earnings after all expenses, including taxes, are paid
Dividend declared is the amount of dividend entitled to shareholders
The first variation is used to determine the number of times a company can pay dividends to common
shareholders when the company also has preferred shares to take into consideration.
DCR = (Net income – Required preferred dividend payments) / Dividends declared to common
shareholders.
This variation can also be used to determine the number of times a company can pay dividends to preferred
shareholders:
DCR = Net income / Dividends declared to preferred shareholders

44. Company A reported the following figures:
Profit before tax: $500,000
Corporate tax rate: 30%
Dividend to preferred shareholders: $20,000
Dividend to common shareholders: $25,000
Determine the dividend coverage ratio for preferred and common shareholders:
DCR (Common shareholders) = ($500,000 x 70% – $20,000) / $25,000 = 13.2
DCR (Preferred shareholders) = ($500,000 x 70%) / $20,000 = 17.5

45. The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock
price and earnings per share (EPS). It is a popular ratio that gives investors a better
sense of the value of the company. The P/E ratio shows the expectations of the market
and is the price you must pay per unit of current earnings (or future earnings, as the
case may be).
 P/E = Stock Price Per Share / Earnings Per Share
or
 P/E = Market Capitalization / Total Net Earnings