RATIO ANALYSIS

Meaning and definition of ratio analysis:

Ratio analysis is a widely used tool of financial analysis. It is defined

as the systematic use of ratio to interpret the financial statements so that the
strength and weaknesses of a firm as well as its historical performance and
current financial condition can be determined. The term ratio refers to the
numerical or quantitative relationship between two variables.

Significance or Importance of ratio analysis:

• It helps in evaluating the firms performance:

With the help of ratio analysis conclusion can be drawn

regarding several aspects such as financial health, profitability and
operational efficiency of the undertaking. Ratio points out the
operating efficiency of the firm i.e. whether the management has
utilized the firm’s assets correctly, to increase the investor’s wealth. It
ensures a fair return to its owners and secures optimum utilization of
firms assets

• It helps in inter-firm comparison:

Ratio analysis helps in inter-firm comparison by providing

necessary data. An interfirm comparison indicates relative position.It
provides the relevant data for the comparison of the performance of
different departments. If comparison shows a variance, the possible
reasons of variations may be identified and if results are negative, the
action may be intiated immediately to bring them in line.

• It simplifies financial statement:

The information given in the basic financial statements serves

no useful Purpose unless it s interrupted and analyzed in some
comparable terms. The ratio analysis is one of the tools in the hands of
those who want to know something more from the financial
statements in the simplified manner.
• It helps in determining the financial position of the concern:

Ratio analysis facilitates the management to know

whether the firms financial position is improving or deteriorating or is
constant over the years by setting a trend with the help of ratios The
analysis with the help of ratio analysis can know the direction of the
trend of strategic ratio may help the management in the task of
planning, forecasting and controlling.

• It is helpful in budgeting and forecasting:

Accounting ratios provide a reliable data, which can be

compared, studied And analyzed.These ratios provide sound footing
for future prospectus. The ratios can also serve as a basis for preparing
budgeting future line of action.

• Liquidity position:

With help of ratio analysis conclusions can be drawn regarding

the Liquidity position of a firm. The liquidity positon of a firm would
be satisfactory if it is able to meet its current obligation when they
become due. The ability to met short term liabilities is reflected in the
liquidity ratio of a firm.

• Long term solvency:

Ratio analysis is equally for assessing the long term financial

ability of the Firm. The long term solvency s measured by the
leverage or capital structure and profitability ratio which shows the
earning power and operating efficiency, Solvency ratio shows
relationship between total liability and total assets.

• Operating efficieny:

Yet another dimension of usefulness or ratio analysis, relevant

from the View point of management is that it throws light on the
degree efficiency in the various activity ratios measures this kind of
operational efficiency.
 Classification of ratios:

Different ratios are used for different purpose these ratios can
be grouped into various classes according to the financial activity.
Ratios are classified into four broad categories.

1. Liquidity Ratio

2. Leverage Ratio

3. Profitability Ratio

4. Activity Ratio

1. Liquidity Ratio:

Liquidity ratio measures the firms ability to meet its

currentobligations i.e. ability to pay its obligations and when they become
due. Commonly used ratios are:

• Current ratio:
Current ratio is the ratio, which express relationship between current
asset and current liabilities. Current asset are those which can be converted
into cash within a short period of time, normally not exceeding one year. The
current liabilities which are short- term maturing to be met.

Current ratio
Current Asset =

Current liabilities

• Acid test ratio:

The acid test ratio is a measure of liquidity esigned to overcome the

 Defect of current ratio. It is often referred to as quick ratio because it
is a measurement of firms ability to convert its current assets quickly
into cash in order to meet its current liabilities.

Current asset -Inventories

Acid test ratio =
Current liabilities

2. Leverage or capital structure ratio:

Leverage or capital structure ratios are the ratios, which

indicate the relative interest of the owners and the creditors in an
enterprise. These ratios indicate the funds provided by the long-term
creditors and owners.

To judge the long term financial position of the firm following

ratios are applied.

1. Debt –equity ratio:

Debt-equity ratio which expresses the relatonship between debt and

equityThis ratio explains how far owned funds are sufficient to pay
outside liabilities. It is calculated by following formula

Long term +short term debts +current liabilities

Debt equity ratio =
Net worth

.
2. Total Debt ratio:

This ratio explains how far owned and borrowed funds are sufficient
to pay debt of the firm
 Long term+short term borrowing+current liabilities

Capital employed

3. Profitability ratio:

Profitability ratio are the best indicators of overall efficiency of

the business concern, because they compare return of value over and
above the value put into business with sales or service carried on by
the firm with the help of assets employed. Profitablity ratio can be
determined on the basis of:

• Sales
• Investment

• Profitability ratios related to sale:

1. Gross profit to sales ratio.

2. Net profit to sales ratio or net profit of margin.

1. Gross profit to sales ratio:

The gross profit to sales ratio establishes relationship between

gross profit And sales to measure the relative operating efficency of
the firm to reflect pricing policy

Sales-cost of goods sold

Gross profit to sales ratio = * 100
Sale

2. Net profit margin:

 The net margin indicates the managements ability to earn
sufficient profit on sales to earn sufficient profit on sales not only to
cover all revenue operating expenses of the business, the cost of
borrowed funds and the cost of goods or servicing, but also to have
sufficient margin to pay reasonable comparison to shareholders on
their contributions to the firm.

Net profit after tax and interest

Net profit margin = *100

Sales

3. Profitability ratios related to investments:

a. Return on assets
b. Return on capital employed

a. Return on assets:

The profitability ratio here measures the relationship between net

profit and assets.

Net profit after tax

Return on assets =

Fixed assets

b. Return on capital employed:

Net profit after taxes

Return on capital employed =
Total capital employed
3. Activity ratio:

Activity ratio are sometimes are called efficiency ratios. Activity

ratios are concerned with how efficiency the assets of the firm are
managed.

These ratio express relatonship between level of sales and the

investment in various assets inventores, receivables, fixed assets etc.

The important activity ratios are as follows:

1. Inventory turnover ratio:

Raw materials consumed

Inventory turnover ratio =
Average stock of raw materials

2. Debt turnover ratio:

This ratio shows quickly debtors are converted into cash

Total sales
=
Debtors
3. Average collection period ratio:

This ratio indicates how quickly the inventory is converted into

cash.

Days in a year
=
Debtors turnover

4. Working capital turnover ratio:

 This ratio shows the number of times the working capital
turns in trading transaction. If it has an increasing trend over the previous
year it shows that the working capital is being used efficiently.

LIQUIDITY RATIOS

Meaning of liquidity:

The term liquidity refers to ability to pay its obligations

when they become due. Liquidity ratios measure the ability of a firm to
meet its short-term obligations and reflect the short-term financial
strength or solvency of a firm.

Liquidity ratios are classified into two types:

1. Short term liquidity and

2. Long term liquidity

1. short term liquidity:

Short term liquidity refers to finance required by a firm for a

period of one year or less. Short –term finance is also called working
capital finance as it is required for investment in working capital or
current assets like cash and bank balances, inventories, accounts
receivables and marketable securities.

Further short term liquidity ratios are categories into three

types they are as follows:
 1. Current ratio:
The current ratio is the ratio of total current assets to total
current liabilities it is calculated by dividing current assets by current
liabilities.Current assets include cash an bank balances, marketable
securities, inventory of raw material s,semi-finished and finished goods,
bills receivable and prepaid expenses.

The current liabilities which are short- term obligations to be met it

consist of trade creditors, bills payable, bank credit, provision for
taxation and outstanding expenses.
Current assets
Current ratio =
Current liabilities

20015866
for the year 2003-2004 = ________ = 3.3:1

24146864

24146864
for the year 2004 -2005 ________ = 2.4:1

9934397

17410682
for the year 2005-2006 = ________ = 1.7:1

10002148

Interpretation:
 The current ratio for the year 2003-2004 is 3.30 compared to standard
ratio 2:1 this ratio is higher which shows high short term liquidity efficiency
at the same time holding more than sufficient current assets means
inefficient use of resources

The ratio for the year 2004-2005 is 2.4:1 it is as good as maintaining

standard of 2:1
The ratio for the year is 1:7:1 shows below standard of 2:1 which
means efficient use of funds but at the risk of low liquidity.
 DECLARATION

I M/S Neelamma .M. Halyal here by declare that the project

titled

“RATIO ANALYSIS” submitted in partial fulfillment of requirement for

award of the

degree of “BACHELOR OF BUSINESS ADMINIATRATION” by

Karnataka

university Dharwad is my original work and not submitted else where for
award of any

degree or diploma

Date:

Place: Hubli Neelamma.M.

Halyal.