Ratio Analysis

By:- Arvind Kumar 02 Manoj Gupta 05 Dharmendra 07 Nitin Singh 15 Rohit Kumar 31

Ratio Analysis
 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

Purpose
 Ratios allow for better comparison through time or

between companies.  As we look at each ratio, ask yourself what the ratio is trying to measure and why that information is important.  Ratios are used both internally and externally.

Classification of Ratios
Balance Sheet Ratio P&L Ratio or Income/Revenue Statement Ratio
Operating Ratio

Balance Sheet and Profit & Loss Ratio

Financial Ratio

Composite Ratio

Current Ratio Quick Asset Ratio Proprietary Ratio Debt Equity Ratio

Gross Profit Ratio Operating Ratio Expense Ratio Net profit Ratio Stock Turnover Ratio

Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors Turnover Ratio,

Format of balance sheet for ratio analysis

LIABILITIES
NETWORTH/EQUITY/OWNED FUNDS Share Capital/Partners Capital/Paid up Capital/ Owners Funds Reserves ( General, Capital, Revaluation & Other Reserves) Credit Balance in P&L A/c LONG TERM LIABILITIES/BORROWED FUNDS : Term Loans (Banks & Institutions) Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities

ASSETS
FIXED ASSETS : LAND & BUILDING, PLANT & MACHINERIES OriginalValue Less Depreciation NetValue or Book Value orWritten down value

NON CURRENT ASSETS Investments in quoted shares & securities Old stocks or old/disputed book debts LongTerm Security Deposits Other Misc. assets which are not current or fixed in nature 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 INTANGIBLE ASSETS Patent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses

CURRENT LIABILTIES Bank Working Capital Limits such as CC/OD/Bills/Export Credit Sundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or deposits Expenses payable & provisions against various items

1. Current Ratio : 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 = 2 : 1 The ideal Current Ratio preferred by Banks is 1.33 : 1 2. 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

Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished Goods, Debtors, Bills Receivables, Cash. Current Liabilities : Sundry Creditors, Installments of Term Loan, DPG etc. payable within one year and other liabilities payable within one year. This ratio must be at least 1.33 : 1 to ensure minimum margin of 25% of current assets as margin from long term sources.

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 profitability ( e.g. high inventory carrying cost) Shows the liquidity at a particular point of time. The position can change immediately after that date. So trend of the current ratio over the years to be analyzed. 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.

3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current

Assets and Current Liabilities. The should be at least equal to 1.
Quick Current Assets : 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

Example : Cash 50,000 Debtors 1,00,000 Inventories 1,50,000 Total Current Assets 3,00,000

Current Liabilities 1,00,000

Current Ratio = > Quick Ratio =>

3,00,000/1,00,000 1,50,000/1,00,000

= 3:1 = 1.5 : 1

4. 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 : Capital = 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

5. PROPRIETARY RATIO : This ratio indicates the extent to which Tangible Assets are financed by Owner s Fund. Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100 The ratio will be 100% when there is no Borrowing for purchasing of Assets. 6. GROSS PROFIT RATIO : By comparing Gross Profit percentage to
Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, it can also be interpreted as below :

Gross Profit Ratio = [ (Sales x 100

Cost of goods sold)/ Net Sales]

A higher Gross Profit Ratio indicates efficiency in production of the unit.

7. OPERATING PROFIT RATIO : It is expressed as => (Operating Profit / Net Sales ) x 100

Higher the ratio indicates operational efficiency

8. NET PROFIT RATIO : It is expressed as => ( Net Profit / Net Sales ) x 100

It measures overall profitability.

9. STOCK/INVENTORY TURNOVER RATIO :

(Average Inventory/Sales) x 365 for days (Average Inventory/Sales) x 52 for weeks (Average Inventory/Sales) x 12 for months

Average Inventory or Stocks = (Opening Stock + Closing Stock) -----------------------------------------

2
. This ratio indicates the number of times the inventory is rotated during the relevant accounting period

10. DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or Average Collection Period or Period of Credit given . (Average Debtors/Sales ) x 365 for days (52 for weeks & 12 for months) 11. ASSET TRUNOVER RATIO : 12. FIXED ASSET TURNOVER RATIO : Net Sales/Tangible Assets Net Sales /Fixed Assets

13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets 14. CREDITORS TURNOVER RATIO : This is also called Creditors Velocity Ratio, which determines the creditor payment period. (Average Creditors/Purchases)x365 for days (52 for weeks & 12 for months)

15. RETRUN ON ASSETS :

Net Profit after Taxes/Total Assets

16. RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period.

Composite Ratio
17. RETRUN ON EQUITY CAPITAL (ROE) : Net Profit after Taxes / Tangible Net Worth 18. EARNING PER SHARE : EPS indicates the quantum of net profit of the year that would be ranking for dividend for each share of the company being held by the equity share holders. Net profit after Taxes and Preference Dividend/ No. of Equity Shares 19. PRICE EARNING RATIO : PE Ratio indicates the number of times the Earning Per Share is covered by its market price. Market Price Per Equity Share/Earning Per Share

20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most important one which indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals and forms the basis for fixation of the repayment schedule in respect of the Term Loans raised for a project. (The Ideal DSCR Ratio is considered to be 2 ) PAT + Depr. + Annual Interest on Long Term Loans & Liabilities --------------------------------------------------------------------------------Annual interest on Long Term Loans & Liabilities + Annual Installments payable on Long Term Loans & Liabilities ( Where PAT is Profit after Tax and Depr. is Depreciation)

Uses
y Different companies operate in different industries each

having different environmental conditions such as regulation, market structure, etc. Such factors are so significant that a comparison of two companies from different industries might be misleading. y Financial accounting information is affected by estimates and assumptions. Accounting standards allow different accounting policies, which impairs comparability and hence ratio analysis is less useful in such situations. y Ratio analysis explains relationships between past information while users are more concerned about current and future information.

Significance
 Decision Making  Financial Forecasting and Planning  Communication  Co-ordination is Facilitated  Control is more Effective:

y Decision making :Mass of information contained in the

financial statements may be unintelligible a confusing. Ratios help in highlighting the areas deserving attention and corrective action facilitating decision making. y Financial Forecasting and Planning:Planning and forecasting can be done only by knowing the past and the present. Ratio help the management in understanding the past and the present of the unit. These also provide useful idea about the existing strength and weaknesses of the unit.

y Communication: Ratios have the capability of

communicating the desired information to the relevant persons in a manner easily understood by them to enable them to take stock of the existing situation. y Control is more Effective: System of planning and forecasting establishes budgets, develops forecast statements and lays down standards. Ratios provide actual basis. Actual can be compared with the standards. Variances to be computed an analyzed by reasons and individuals. So it is great help in administering an effective system of control.

Limitation of ratio Analysis

 Ratios are tools of quantitative analysis, which ignore

qualitative points of view.  Ratios are generally distorted by inflation  Ratios give false result, if they are calculated from incorrect accounting data  Ratios are calculated on the basis of past data. Therefore, they do not provide complete information for future forecasting.  Ratios may be misleading, if they are based on false or window-dressed accounting information

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