Ratio Analysis concepts

1. RATIO ANALYSIS

2. What are Financial
Statements:
1. Balance Sheet/Position statement
2. Profit and Loss Account/income Statement
3. Statement of Retained Earnings/Profit and Loss
Appropriation Account
4. Cash Flow Statement

3. Methods of Analyzing
Financial Statements
1. Comparative Statements
2. Common Size Statements
3. Ratio Analysis
4. Cash Flow Statement

4. Ratio Analysis
• A comparative study of the relationship between various
factors of statements.
• It shows the profitability, liquidity, solvency.
• It helps for forecasting.
• It is helpful for interfirm comparison and intrafirm
comparison.
• These are useful for both internal as well as external
stakeholders.

5. Classification of Ratios
• 1. Profitability Ratio: It reflects the relationship between
profit and sales, assets or capital employed. It judges the
efficiency of the business.
• 2.Turnover ratio/ Activity Ratio: It measures the
effectiveness of the usage of capital or assets employed in
the business.
• 3. Financial Ratio/solvency Ratio: It judges the
solvency in short term and long term of the company.
• 4. Market Test ratios: It tells the market value of the
company/ shares.

6. Profitability Ratio
1. Return on Investment:
How much company is earning on its investment.
ROI= (Net Operating Profit*100)/ Capital employed
Notes:
• Operating profit is EBIT.
• Non business income should not be included.
• Capital includes share capital, reserve and surplus, long
term loans – non operating assets and fictitious assets.
• It can be net fixed assets + working capital
• ROI= (operating profit/sales) * (sales/capital)
• ROI= net profit ratio * turnover ratio

7. Numerical 1
• Q. Suppose a company has the following items on the
liabilities side and it shows fictitious asset of Rs. 1,00,000
on the assets side:
13% Preference capital 10,00,000
Equity capital 30,00,000
Reserves 26,00,000
Loans @15% 30,00,000
Current liabilities 15,00,000
Its profit after paying tax @ 50% is Rs. 14,00,000.
Calculate ROI?

8. SOLUTION
• PBIT= PAT+ TAX+INTEREST ON LOAN
• = 14,00,000+ 14,00,000 + 4,50,000
• = 32,50,000
• Capital employed = 10,00,000+ 30,00,000+
26,00,000+30,00,000-1,00,000= 95,00,000
• ROI= (32,50,000/95,00,000)*100= 34.21%

9. Profitability ratios
• Return on shareholders’ funds/ return on net worth:
• = (PAT*100)/shareholders' funds
• Capital should be after deducting long term loans.
• It would reflect profitability for the shareholders.
Return on assets:
• It shows whether assets are being properly utilized or not.
• = PAT*100/ Total assets
• Gross profit ratio/gross margin:
• Gross profit is profit before admin, selling and financing
expenses.
• =Gross profit*100/sales
• This ratio should be enough high to cover other costs and
for proper returns to owners.

10. • Net profit ratio:
• = operating profit *100/sales
• Net profit= gross profit- admin charges- selling &
distribution charges.
• Non operating incomes and expenses are ignored.
• It shows the expenses for admin and selling are less or
high.

11. Activity ratio/ turnover ratio
• It shows the effectiveness of the resources employed in
business.
• 1) capital turnover ratio:
• = net sales/ capital employed
• Higher the ratio greater the profit.
• 2) total assets turnover ratio:
• = net sales/ total assets
• It can be divided in following parts:
• 2.a.)Fixed assets turnover ratio:
• = net sales/ FA
• FA should be taken after depreciation.

12. • Working capital turnover ratio:
• = net sales/ working capital
• Stock /inventory turnover ratio:
• = COGS/ avg. inventory
• =sale/avg inventory
• Debtors turnover ratio:
• = net sales/average debtors
• Debtor collection period:
• = (Months or days I a year)/ debtors turnover

13. • Q. From the following information calculate Debtors
turnover ratio and avg collection period:
• Total debtors opening balance 2,00,000
• Cash sales 1,50,000
• Credit sales 10,00,000
• Cash collected 7,80,000
• Sales return 60,000
• Bad debts 40,000
• Discount allowed 20,000
• Provision for bad debts 20,000
• No of days in a year 360

14. • Creditors’ turnover ratio:
• = credit purchase/avg creditors
• Debt payment period:
• =( Months or days in a year)/ creditors turnover

15. Financial ratios/ solvency ratios
1. Liquidity ratio: short term solvency ratio
In short term firm should be able to meet all its short term
obligations.
a. Current ratio= current assets/ current liabilities
2:1 is an ideal ratio.
If it is too high it is not a good sign it will effect the
profitability.
b. Quick ratio/ liquid ratio= quick assets/ current
liabilities
Quick assets = current assets – inventory – prepaid
expenses
1:1 is an ideal ratio.

16. • 2. Long term solvency ratio:
• 2.a. debt-equity ratio:
• External-internal equity ratio
• Debt include debentures, Long term loan from FIs.
• Equity means preference, equity share capital, reserves less loss and
fictitious assets as preliminary expenses.
• = Debt/ Equity
• In India 2:1 is ideal.
• It means a company can take debt twice of equity or it can finance
2/3 portion from debt.
• 2.b. Debt service coverage ratio:
• Fixed charges cover/ interest cover ratio.
• It covers the debt servicing capacity of the company.
• = PBT/ Interest charges
• Ideal ration is 6-7.

17. • 2.c.Capital gearing ratio:
• Proportion of fixed interest or dividend bearing funds and
non fixed interest or dividend bearing funds in total
capital.
• = fixed interest bearing funds/ equity shares funds

18. Market test ratios
• These are used for the companies whose shares are
trading in the market.
• Following ratios reflect the market value of shares:
• 1. EPS/ earning per share
• EPS= net profit/ no of equity shares
• Net profit should be calculated after preference shares’
dividend.
• It should consider all operating , non operating income
and expenses.
• High EPS, high share price, vice versa.

19. • 2. Price Earning ratio/ PE Ratio:
it establishes the relation between market price and earning
of a share.
= MP of a equity share/ EPS
It helps to decide whether the share is undervalued or
overvalued.
3. Pay out ratio:
It shows what is available as earning per share and what is
actually paid as dividend out of earnings.
It shows the dividend policy of a company.
= DPS/EPS
4. Dividend yield ratio:
It shows the return shareholders are getting on market price
of the shares.
= DPS/ MPS * 100

20. • From the following information, calculate ( i) Net Assets Turnover
(ii) Fixed Assets Turnover and (iii ) Working Capital Turnover
Ratios iv) debt- equity ratio v) debtors turnover ratio vi) creditors
turnover ratio :
• Preference Shares Capital 4,00,000 Plant and Machinery 8,00,000
• Equity Share Capital 6,00,000 Land and Building 5,00,000
• General Reserve 1,00,000 Motor Car 2,00,000
• Profit and Loss Account 3,00,000 Furniture 1,00,000
• 15% Debentures 2,00,000 Stock 1,80,000
• 14% Loan 2,00,000 Debtors 1,10,000
• Creditors 1,40,000 Bank 80,000
• Bills Payable 50,000 Cash 30,000
• Outstanding Expenses 10,000
• Sales for the year 2005 were Rs. 30,00,000.

21. • Solution
• Sales = Rs. 30,00,000
• Capital Employed = Share Capital + Reserves and Surplus +
Long-term Debt (or Net Assets)
• = (Rs.4,00,000 + Rs.6,00,000) + (Rs.1,00,000 + Rs.3,00,000) +
(Rs.2,00,000 + Rs.2,00,000) = Rs. 18,00,000
• Fixed Assets = Rs.8,00,000 + Rs.5,00,000 + Rs.2,00,000 +
Rs.1,00,000 = Rs. 16,00,000
• Working Capital = Current Assets – Current Liabilities =
Rs.4,00,000 – Rs.2,00,000 = Rs. 2,00,000
• Net Assets Turnover Ratio = Rs.30,00,000/Rs.18,00,000 = 1.67
times
• Fixed Assets Turnover Ratio = Rs.30,00,000/Rs.16,00,000 =
• 1.88 times
• Working Capital Turnover = Rs.30,00,000/Rs.2,00,000 = 15
• times.