Ratio-analysis is a concept or technique which is
as old as accounting concept. Financial analysis
is a scientific tool. It has assumed important role
as a tool for appraising the real worth of an
enterprise, its performance during a period of
time and its pit falls. Financial analysis is a vital
apparatus for the interpretation of financial
statements. It also helps to find out any crosssectional and time series linkages between various
Unlike in the past when security was considered to be
sufficient consideration for banks and financial
institutions to grant loans and advances, nowadays the
entire lending is need-based and the emphasis is on the
financial viability of a proposal and not only on security
alone. Further all business decision contains an element
of risk. The risk is more in the case of decisions relating to
credits. Ratio analysis and other quantitative techniques
facilitate assessment of this risk.
Ratio-analysis means the process of computing,
determining and presenting the relationship of
related items and groups of items of the financial
statements. They provide in a summarized and
concise form of fairly good idea about the
financial position of a unit. They are important
tools for financial analysis.
WHY FINANCIAL ANALYSIS
Lenders’ need it for carrying out the following
It’s a tool which enables the banker or lender to
arrive at the following factors :
Quality of the Management
Safety & Security of the loans & advances to be
or already been provided
Before looking at the ratios there are a number of cautionary
points concerning their use that need to be identified :
a.The dates and duration of the financial statements being
compared should be the same. If not, the effects of seasonality may
cause erroneous conclusions to be drawn.
b.The accounts to be compared should have been prepared on the
same bases. Different treatment of stocks or depreciations or asset
valuations will distort the results.
c.In order to judge the overall performance of the firm a group of
ratios, as opposed to just one or two should be used. In order to
identify trends at least three years of ratios are normally required.
The utility of ratio analysis will get further
enhanced if following comparison is possible.
1.Between the borrower and its competitor
2.Between the borrower and the best enterprise in
3.Between the borrower and the average
performance in the industry
4.Between the borrower and the global average
How a Ratio is expressed?
Percentage - such as 25% or 50% . For
example if net profit is Rs.25,000/- and the sales
is Rs.1,00,000/- then the net profit can be said to
be 25% of the sales.
- The above figures may be
expressed in terms of the relationship between
net profit to sales as 1 : 4.
As Pure Number /Times - The same can also be
expressed in an alternatively way such as the
sale is 4 times of the net profit or profit is 1/4th of
Classification of Ratios
P&L Ratio or
and Profit & Loss
Quick Asset Ratio
Debt Equity Ratio
Gross Profit Ratio
Net profit Ratio
Stock Turnover Ratio
Return on Total
Return on Own
Earning per Share
Format of balance sheet for ratio analysis
NET WORTH/EQUITY/OWNED FUNDS
Share Capital/Partner’s Capital/Paid up Capital/
Reserves ( General, Capital, Revaluation & Other
Credit Balance in P&L A/c
FIXED ASSETS : LAND & BUILDING, PLANT &
Original Value Less Depreciation
Net Value or Book Value or Written down value
FUNDS : Term Loans (Banks & Institutions)
Debentures/Bonds, Unsecured Loans, Fixed
Deposits, Other Long Term Liabilities
NON CURRENT ASSETS
Investments in quoted shares & securities
Old stocks or old/disputed book debts
Long Term Security Deposits
Other Misc. assets which are not current or fixed in
Capital Limits such as
Sundry /Trade Creditors/Creditors/Bills Payable,
Short duration loans or deposits
Expenses payable & provisions against various
CURRENT ASSETS : Cash & Bank Balance,
Marketable/quoted Govt. or other securities, Book
Debts/Sundry Debtors, Bills Receivables, Stocks &
inventory (RM,SIP,FG) Stores & Spares, Advance
Payment of Taxes, Prepaid expenses, Loans and
Advances recoverable within 12 months
Patent, Goodwill, Debit balance in P&L A/c,
Preliminary or Preoperative expenses
Some important notes
Liabilities have Credit balance and Assets have Debit balance
Current Liabilities are those which have either become due for payment
or shall fall due for payment within 12 months from the date of Balance
Current Assets are those which undergo change in their shape/form
within 12 months. These are also called Working Capital or Gross
Net Worth & Long Term Liabilities are also called Long Term Sources
Current Liabilities are known as Short Term Sources of Funds
Long Term Liabilities & Short Term Liabilities are also called Outside
Current Assets are Short Term Use of Funds
Some important notes
Assets other than Current Assets are Long Term Use of Funds
Installments of Term Loan Payable in 12 months are to be taken as
Current Liability only for Calculation of Current Ratio & Quick
If there is profit it shall become part of Net Worth under the head
Reserves and if there is loss it will become part of Intangible
Investments in Govt. Securities to be treated current only if these
are marketable and due. Investments in other securities are to be
treated Current if they are quoted. Investments in
allied/associate/sister units or firms to be treated as Non-current.
Bonus Shares as issued by capitalization of General reserves and
as such do not affect the Net Worth. With Rights Issue, change
takes place in Net Worth and Current Ratio.
1. CURRENT RATIO :A) It is the relationship between the current assets and current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and
Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000
The ideal Current Ratio preferred is 2:1
The Current Ratio expresses the relationship between current assets ( cash,
marketable securities, accounts receivable and inventories) and the current
liabilities (accounts payable, short-term loans, current maturities of long-term debt,
accrued income tax and other accrued expenses especially wages ).
The current ratio determines the short term liquidity of the enterprise in order to pay
off its short term obligations.
A higher current ratio is a clue that the company will be able to pay its debts
maturing within a year and vice-versa.
A lower current ratio would reflect an inadequacy of working capital which may
deter smooth functioning of the enterprise.
Current Ratio measures short term liquidity of the concern and its ability to
meet its short term obligations within a time span of a year.
It shows the liquidity position of the enterprise and its ability to meet current
obligations in time.
Higher ratio may be good from the point of view of creditors. In the long run
very high current ratio may affect the profitability ( e.g. high inventory carrying
The current ratio changes from time to time, so it is to be analyzed over the
year for various periods.
Current Ratio is to be studied with the changes of NWC. It is also necessary
to look at this ratio along with the Debt-Equity ratio.
However, an excess of current assets does not necessarily mean that the debts
can be paid promptly. If current assets contain a high proportion of
uncollectible accounts receivables or inventories, there will be slow down in the
intake of cash. Hence the composition of current assets is to be looked after
while computing the current ratio.
NET WORKING CAPITAL
: This is worked out as surplus of Long Term
Sources over Long Tern Uses, alternatively it is the difference of Current
Assets and Current Liabilities.
NWC = Current Assets – Current Liabilities
2. ACID TEST or QUICK RATIO : It is a measure of judging the immediate
ability of the firm to pay off its current liabilities. It is the ratio between Quick
Current Assets and Current Liabilities. Ideally it should be 1:1
Quick Current Assets : Quick current assets include those assets which
can be liquidated immediately and at minimum loss in order to meet the
financial obligations. For eg:- Cash/Bank Balances, Receivables upto 6
months, Quickly realizable securities such as Govt. Securities or quickly
marketable/quoted shares and Bank Fixed Deposits
Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
T. Current Assets
Current Ratio = >
= 1.5 : 1
3. Cash Position Ratio:-
It is calculated by relating cash and cash
equivalents to current liabilities. The
formula to calculate this ratio is :
Cash Position Ratio
= Cash and cash equivalents
The standard for this ratio is 1:1
II. LEVERAGE RATIO :1. DEBT EQUITY RATIO : It is the relationship between borrower’s
fund (Debt) and Owner’s Capital (Equity).
Long Term Outside Liabilities / Tangible Net Worth
Liabilities of Long Term Nature
Total of Capital and Reserves & Surplus Less Intangible Assets
For instance, if the Firm is having the following :
= Rs. 200 Lacs
Free Reserves & Surplus
= Rs. 300 Lacs
Long Term Loans/Liabilities = Rs. 800 Lacs
Debt Equity Ratio will be
=> 800/500 i.e. 1.6 : 1
2. Debt to Total Assets Ratio : It is calculated as the proportion of total debts and
the total assets.
Total Debts include :- Accounts payable ,
miscellaneous payable, mortgage and bonds
Total Assets include :- Fixed Assets + Current
Assets+ Intangible Assets
3. Long-term Debt to Total Capitalization :Mortgage+Bonds
III.ACTIVITY RATIO :1. Inventory Turnover Ratio :- It is computed by
dividing the cost of goods sold by the average
inventory for the period. This ratio gives the number
of times the inventory is replaced during a given
period, usually a year. Higher the ratio, better is the
performance of the firm, for it has managed to
operate with a relatively small average locking up of
Average Collection Period:- It is a measure of
receivable turnover. It consists of two steps. In the
first step, the annual sales is divided by 365 to get the
average daily sales. In the second step, daily sales are
divided into accounts receivable to find the number of
days sales it tied up in receivables. This gives the
average collection period because it represents the
length of time that the firm must wait after making a
3. TOTAL ASSETS TURNOVER RATIO:This ratio expresses relationship between the amount
invested in the assets and the results accruing in terms
of sales. This is calculated by dividing the net sales by
4. FIXED ASSETS TURNOVER RATIO :- This ratio is
expressed by dividing sales into fixed assets. It is used
to highlight the extent of utilization of the existing
IV. PROFITABILITY RATIOS:These ratios are, as a matter of fact, best indicators of overall
financial health and efficiency of a business concern because
they compare return of value over and above the values put into
a business with sale or service carried on by the firm with the
help of assets employed.
Profitability as related to sales :1.
Gross Profit Ratio:- This ratio establishes relationship between
gross profit and sales to measure the relative operating
efficiency of the firm and to reflect its pricing policies.
GP Ratio = Sales – Cost of goods sold
Here, (Sales – cost of goods sold) refers to the Gross Profit & Net
sales refers to the (Total sales – Sales return)
2. OPERATING PROFIT RATIO :This ratio expresses the relationship between operating profit and
sales. It is worked out by dividing operating profit by net sales. It
helps in judging the managerial efficiency which may not be
reflected in net profit ratio. For example, a firm may have a large
amount of non- operating income in the form of dividend and
interest which represents the major proportion of the net profit.
Hence, the operating profit provides the actual efficiency, since the
non-operating income has no relation with operating efficiency of
Formula :- Operating Profit
Operating Profit = Revenue – (cost of goods
sold+ labor + other day to day expenses)
3. Net Profit Ratio :It is calculated by dividing the net profit with net sales. Higher
ratio indicated a higher efficiency of the business and better
utilization of the resources. A low ratio would mean a poor
financial position of the company.
Formula :Net Profit
Profitability as related to investment :1.
Return on capital employed :- This is computed by dividing net
profit with capital employed. Net profit in this case means net
profit before taxes but less interest on short-term borrowings.
Capital employed is found out by subtracting current liabilities
from the total investment. Higher ratio indicates better
utilization of funds.
Formula :- Net Profit
2. RETURN ON NET WORTH :This ratio is obtained by dividing net profit after taxes by the total
net worth. This measures the productivity of shareholders’ funds.
A higher ratio indicates better utilization of owners’ funds and
3. RETURN ON ORDINARY SHAREHOLDERS’ EQUITY :- This
ratio helps us to judge whether the firm has earned a satisfactory
return for its equity holders or not. It is computed with the help
of the following formula :Formula :- Net profit after tax and preference dividend
Ordinary Shareholder’s funds
5. OTHER PROFITABILITIY RATIO :- It includes
1. Earning Per Share :- This ratio indicates
availability of the profit to the equity shareholders on
per share basis. The following formula is employed to
determine EPS :EPS = Net profit available for equity shareholders
Number of equity shareholders outstanding
no. of shares
Where, EBIT = Earnings before interest and tax.
2. DIVIDEND PAYOUT RATIO :This ratio attempts to establish relationship between earnings
belonging to the ordinary shareholders and the dividends paid to
them. This ratio shows what portions of net profits after taxes and
preferences dividend is disbursed among equity shareholders.
D/P = Total Dividend to equity shareholders
Total net profits belonging to equity-shareholders
3. YIELD :- There are two types of yield, namely earning yield and
dividend yield. The earning yield can be calculated by dividing
EPS by market value per share. This ratio helps the investors to
know the real worth of the firm.
Dividend yield ratio is measures relationship between
dividends per share and the market price per share.
Market value of shares
OTHER IMPORTANT RATIOS:1.
INVNENTORY TURNOVER RATIO :- It is the ratio of cost of
goods sold to average inventory. It is an activity/efficiency ratio
and it measures how many times per period a business sales and
replaces its inventory again.
Formula :Cost of goods sold
For eg : During the year ended 31st Dec’2010, Loud Corporation sold
goods costing Rs. 324000 Its inventory at the beginning and at
the ending of the year was. Rs. 9865 and Rs. 11650 respectively.
Calculate the inventory turnover ratio of the business from the
given information :
Sol: avg. inventory = (Rs.9865+Rs. 11650)/2 = Rs. 10757.5
Inventory turnover = Cost of goods sold / Average Inventory
=(Rs. 84270/10757.5) = 7.83 times
2. DEBTOR’S TURNOVER RATIO :It is the ratio of net credit sales to average account receivables. It
is an activity that measures average no. of times a business collect
its receivables during a period usually a year.
Formula :Net Credit Sales
Average Accounts Receivables
For eg : Net credit sales of a Co. A during the year ended 30 th
June’2010 were Rs. 644790. Its accounts receivables at 1 st
July’2009 and 30th June’2010 were Rs. 43300 and Rs. 51730
respectively . Calculate Debtor’s Turnover Ratio.
Sol.: Average accounts receivables =(Rs. 43300+Rs. 5173)
Receivable Turnover ratio = 644790/47515 = 13.57 times
3. CREDITOR’S TURNOVER RATIO :It is the ratio of net credit purchase of a business to its
average accounts payable during the period. It
measures short-term liquidity of the business, since it
shows how many during a period an amount equal to
average accounts payable is paid to supplier by a
Formula :- Net Credit Purchase
Avg. Accounts payable