[Ratio analysis]

1. Liquidity ratios:
a. Current ratios:
Current ratio indicates firms commitment to meet financial obligations. A very heavy ratio is
not desirable as it indicates less efficient use of funds.
Formula:

Current assets
Current liabilities

Ideal ratio: 2:1/1.33:1

Current assets are those assets which can be converted into cash within a period of
one year or normal operating cycle of the business whichever is longer
o Examples : Cash in hand, cash at bank ,stock, debtors, bills receivable,
prepaid expenses
Current liabilities are those liabilities payable within an year or operating cycle
o Examples: creditors, bills payable, bank overdraft, short term loan,
outstanding expense, provision for tax, unclaimed dividend or dividend
payable, cash credit etc.
b. Acid test/ Quick ratio: This ratio also indicates short term solvency of a firm
Formula:
Quick assets
Current liabilities
Ideal ratio: 1:1
Quick assets = current assets (stock + prepaid expenses)

c. Working capital ratio: it measures the companys ability to pay current liability.
Formula:
Current capital
Current liability
Ideal ratio: 1:1
Current capital= current assets- current liability

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d. Cash ratio:

Formula
Ideal ratio- 1:1

2. Activity ratio:
1)

Capital Turnover Ratio:

Capital turnover ratio establishes a relationship between net sales and capital employed.
Capital Turnover Ratio = Net Sales/Capital Employed
Ideal: higher is better.
Where Net Sales = Sales Sales Return
Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Longterm Loans Fictitious Assets.

2) Fixed Assets Turnover Ratio:

Fixed assets turnover ratio establishes a relationship between net sales and net fixed
assets.
Fixed Assets Turnover Ratio = Net Sales/Net Fixed Assets
Ideal: higher is better.
In case Net Sales are not given in the question cost of goods sold may also be used in
place of net sales. Net fixed assets are considered cost less depreciation.
3) Working Capital Turnover Ratio:

Working capital turnover ratio establishes a relationship between net sales and working
capital.
Working Capital Turnover Ratio = Net Sales or Cost of Goods Sold/Net Working Capital
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Ideal: higher is better.
Where Net Working Capital = Current Assets Current Liabilities
4) Stock Turnover Ratio:

Stock turnover ratio is a ratio between cost of goods sold and average stock.
Stock Turnover Ratio = Cost of Goods Sold/Average Stock
Where Average Stock = [Opening Stock + Closing Stock]/2
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses Closing Stock
5) Debtors Turnover Ratio:

Debtors turnover ratio indicates the relation between net credit sales and average
accounts receivables of the year.
Debtors Turnover Ratio = Net Credit Sales/Average Accounts Receivables
Ideal: higher is better.
Where Average Accounts Receivables = [Opening Debtors and B/R + Closing Debtors
and B/R]/2
Credit Sales = Total Sales Cash Sales
6) Debt Collection Period:

Debt collection period is the period over which the debtors are collected on an average
basis.
Debt Collection Period = 12 Months or 365 Days/Debtors Turnover Ratio
Or
Debt Collection Period = Average Trade Debtors/Average Net Credit Sales per day
Or
365 days or 12 months x Average Debtors/Credit Sales
It may be noted that some authors prefer to use 360 days instead of 365 days for the sake
of convenience.
Ideal: lower is better.
7) Creditors Turnover ratio(creditors velocity) (CTR):

Indicates the speed with which the payments for the credit purchases are made
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Formula:

Credit purchases/Average creditors

Ideal: higher is better.

Average creditors= opening creditors +bills receivable +closing creditors
+closing bills payable
8) Credit payment period

Indicates the promptness with which the payments are made to the creditors
Formula: Months in a year /CTR
Ideal: Low ratio is better

3. Profitability Ratio:
1) Gross Profit Ratio:
This ratio expresses the relationship between gross profit and net sales.
Formula: (Gross profit/ Net sales) X 100
Ideal: higher is better.
Gross profit = Sales- Cost of goods sold
Cost of goods sold (COGS) = opening stock +purchases+ all direct expenses
closing stock
2) Net Profit ratio:
This ratio expresses the relationship between net profit and Net sales.
Formula: (Net profit/ Net sales) X 100
Ideal: higher is better.
3) Net operating profit ratio:
Helps in determining the efficiency with which the affairs of the business being
managed.
Formula: (Net operating profit/ Net sales) X 100
Ideal: higher is better.
4) Operating Ratio:
This ratio is a test of operating efficiency with which the business is being carried.

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Formula: (operating cost/ Net sales) X 100
Ideal: Lower is better.
5) Fixed charges cover:
Important from lenders point of view.
Formula: PBIT /Interest
Ideal: 6 -7 times for an industrial concern
6) Debt Service coverage ratio:
Indicates ability of the company to repay principal.
Formula: PBIT/interest+(principal)/1-taxrate
7) Overall profitability ratio/Return on investment/return on capital employed:
Indicates the percentage return on capital employed in the business.
Formula: (Operating profit/Capital employed ) X100
Ideal: higher is better.
Capital employed= sum total of all the long term funds employed in the business
C E= Equity share capital+ preference share capital+ reserves+ profit and loss
account+ long term loans-fictitious assets
8) Return on share holders funds:
Indicates the percentage return on share holders funds.
Formula: (Profit after tax(PAT)/Share holders funds) X100
Ideal: higher is better.
Shareholders funds= Equity share capital +preference share capital +reserves
+profit and loss account-fictitious assets

9) Return on Equity share holders Funds: Indicates the percentage return on equity
shareholders funds.
Formula: (PAT-pref.dividend/ Eq.shareholders funds) X100
Ideal: higher is better.
Equity share holders funds= equity share capital + reserves+ profit and loss
account-fictitious assets
10) Price Earnings Ratio: Indicates the number of times the earning per share is covered
by the market price.
Formula: Market price per share/ Earnings per share
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Ideal: higher is better.
11) Earnings per share: Helps in estimating companys capacity to pay dividend to the
shareholders.
Formula: (PAT pref.dividend )/ No of Equity shares
Ideal: higher is better.

4. Solvency ratio:
1) Debt-Equity Ratio: Debt equity ratio shows the relationship between long-term debts
and shareholders funds. It is also known as External-Internal equity ratio.
Debt Equity Ratio = Debt/Equity
Ideal: 1:2
Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan,
Public Deposits, Loan from financial institution etc.
Equity (Shareholders Funds) = Share Capital (Equity + Preference) + Reserves and
Surplus Fictitious Assets
2) Debt to Total Funds Ratio: This ratio gives same indication as the debt-equity ratio
as this is a variation of debt-equity ratio. This ratio is also known as solvency ratio.
This is a ratio between long-term debt and total long-term funds.
Debt to Total Funds Ratio = Debt/Total Funds
Ideal: 2:3
Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan,
Public Deposits, Loan from financial institution etc.
Total Funds = Equity + Debt = Capital Employed
Equity (Shareholders Funds) = Share Capital (Equity + Preference) + Reserves and
Surplus Fictitious Assets
3) Fixed Assets Ratio: Fixed Assets Ratio establishes the relationship of Fixed Assets
to Long-term Funds.
Fixed Assets Ratio = Long-term Funds/Net Fixed Assets
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Where Long-term Funds = Share Capital (Equity + Preference) + Reserves and
Surplus + Long- term Loans Fictitious Assets
Net Fixed Assets means Fixed Assets at cost less depreciation. It will also include
trade investments.
4) Proprietary Ratio: Proprietary Ratio establishes the relationship between
proprietors funds and total tangible assets. This ratio is also termed as Net Worth to
Total Assets or Equity-Assets Ratio.
Proprietary Ratio = Proprietors Funds/Total Assets
Where Proprietors Funds = Shareholders Funds = Share Capital (Equity +
Preference) + Reserves and Surplus Fictitious Assets
Total Assets include only Fixed Assets and Current Assets. Any intangible assets
without any market value and fictitious assets are not included.
5) Interest Coverage Ratio: Interest Coverage Ratio is a ratio between net profit
before interest and tax and interest on long-term loans. This ratio is also termed as
Debt Service Ratio.
Interest Coverage Ratio = Net Profit before Interest and Tax/Interest on Long-term
Loans

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