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RATIO ANALYSIS

RATIO ANALYSIS

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 cross-sectional and
time series linkages between various ratios.

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

WHY FINANCIAL 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.

Lenders need it for carrying out the following

Technical Appraisal
Commercial Appraisal
Financial Appraisal
Economic Appraisal
Management Appraisal

Before looking at the ratios there are a number of cautionary

points concerning their use that need to be identified :

Ratio Analysis
Its a tool which enables the banker or lender to
arrive at the following factors :

Liquidity position

Profitability

Solvency

Financial Stability

Quality of the Management

Safety & Security of the loans & advances to be
or already been provided
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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.
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How a Ratio is expressed?

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 the industry
3.Between the borrower and the average
performance in the industry
4.Between the borrower and the global
average

 As 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.
 As Proportion
- 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 the sales.

Format of balance sheet for ratio analysis

Classification of Ratios
Balance Sheet
Ratio

P&L Ratio or
Income/Revenue
Statement Ratio

Balance Sheet and

Profit & Loss Ratio

Financial Ratio

Operating 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

LIABILITIES

ASSETS

NET WORTH/EQUITY/OWNED FUNDS

FIXED ASSETS : LAND & BUILDING, PLANT &
Share Capital/Partners Capital/Paid up Capital/ MACHINERIES
Owners Funds
Original Value Less Depreciation
Reserves ( General, Capital, Revaluation & Other Net Value or Book Value or Written down value
Reserves)
Credit Balance in P&L A/c

Fixed Asset Turnover

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

LONG TERM LIABILITIES/BORROWED 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
nature

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

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

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Some important notes

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 Sheet
Current Assets are those which undergo change in their
shape/form within 12 months. These are also called Working
Capital or Gross Working Capital
Net Worth & Long Term Liabilities are also called Long Term
Sources of Funds
Current Liabilities are known as Short Term Sources of Funds
Long Term Liabilities & Short Term Liabilities are also called
Outside Liabilities
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Current Assets are Short Term Use of Funds

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 Ratio.
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 Assets
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.
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Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished

Goods, Debtors, Bills Receivables, Cash.

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 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.

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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 Ratio = >

Quick Ratio
=>

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4. DEBT EQUITY RATIO : It is the relationship between

borrowers fund (Debt) and Owners 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 :

Current Liabilities 1,00,000

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

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

= 3:1
= 1.5 : 1
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5. PROPRIETARY RATIO : This ratio indicates the extent to which

Tangible Assets are financed by Owners 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

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7. OPERATING PROFIT RATIO :

It is expressed as =>

(Operating Profit / Net Sales ) x 100

Higher the ratio indicates operational efficiency

Net Sales we can arrive at the Gross Profit Ratio which indicates the
manufacturing efficiency as well as the pricing policy of the concern.

8. NET PROFIT RATIO :

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100
It is expressed as =>
Alternatively , since Gross Profit is equal to Sales minus Cost of
Goods Sold, it can also be interpreted as below :

( Net Profit / Net Sales ) x 100

It measures overall profitability.

Gross Profit Ratio = [ (Sales Cost of goods sold)/ Net Sales]

x 100
A higher Gross Profit Ratio indicates efficiency in production of the unit.

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9. STOCK/INVENTORY TURNOVER RATIO :

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)

(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)

-----------------------------------------

11. ASSET TRUNOVER RATIO :

Net Sales/Tangible Assets

12. FIXED ASSET TURNOVER RATIO :

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.

. This ratio indicates the number of times the inventory is

rotated during the relevant accounting period

(Average Creditors/Purchases)x365 for days

(52 for weeks & 12 for months)

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Composite Ratio
15. RETRUN ON ASSETS :

Net Profit after Taxes/Total Assets

17. RETRUN ON EQUITY CAPITAL (ROE) :

Net Profit after Taxes / Tangible Net Worth

16. RETRUN ON CAPITAL EMPLOYED :

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 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.

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

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EXERCISE 1

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)

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LIABILITES
Capital
Reserves

ASSETS
180 Net Fixed Assets
20 Inventories

Term Loan

300 Cash

Bank C/C

200 Receivables

Trade Creditors

50 Goodwill

Provisions

50
800

a.
b.
c.
d.
e.
f.

400
150
50
150
50
800

What is the Net Worth : Capital + Reserve = 200

Tangible Net Worth is : Net Worth - Goodwill = 150
Outside Liabilities : TL + CC + Creditors + Provisions = 600
Net Working Capital : C A - C L = 350 - 250 = 50
Current Ratio : C A / C L
= 350 / 300 = 1.17 : 1
Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

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EXERCISE 2
LIABILITIES

2005-06

2006-07

2005-06

2006-07

Capital

300

350 Net Fixed Assets

730

750

Reserves

140

160 Security Electricity

30

30

Bank Term Loan

320

280 Investments

110

Bank CC (Hyp)

490

580 Raw Materials

150

Unsec. Long T L

150

170 S I P

Creditors (RM)

120

70 Finished Goods

Bills Payable

40

80 Cash

Expenses Payable

20

30 Receivables

Provisions

20

40 Loans/Advances
Goodwill

Total

1600

1760

Exercise 3.
LIABIITIES

ASSETS

Equity Capital

200 Net Fixed Assets

110

Preference Capital

100 Inventory

300

170

Term Loan

600 Receivables

150

20

30

140

170

30

20

310

240

30

190

50

50

1600

1760

Bank CC (Hyp)

400 Investment In Govt. Secu.

Sundry Creditors

100 Preliminary Expenses

Total

1400

800

50
100
1400

1. Debt Equity Ratio will be : 600 / (200+100)

= 2:1

2. Tangible Net Worth : Only equity Capital i.e. = 200

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70)
820 /800 = 1.02
3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
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4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

Exercise 4.

Exercise 4.
LIABILITIES

ASSETS

Capital + Reserves

355 Net Fixed Assets

P & L Credit Balance

265

100 Receivables

38 Stocks

Creditors

26 Prepaid Expenses

9 Intangible Assets

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9 Intangible Assets

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Q What is the Quick Ratio ?

Provision of Tax

15

Proposed Dividend
550

Ans : (1+125 +128+1) / (38+26+9+15)

: 255/88 = 2.89 : 1

contd9

P & L Credit Balance

Loan From S F C

7 Cash
100 Receivables

265

38 Stocks

Creditors

26 Prepaid Expenses

9 Intangible Assets

30

Proposed Dividend

128

Exercise 6. A Company has Net Worth of Rs.5 Lac, Term

Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and
Current Assets are Rs.25 Lac. There is no intangible Assets
or other Non Current Assets. Calculate its Net Working
Capital.
Answer
Total Assets
= 16 + 25 = Rs. 41 Lac
Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac
Current Liabilities = 41 15 = 26 Lac

15
550

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Answer : Net Profit Ratio = (Net Profit / Sales ) x 100

2
= (5 x100) /Sales
Therefore Sales = 500/2 = Rs.250 Lac

1
125

Bank Overdraft
Provision of Tax

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover
Ratio in Times ? Ans : Net Sales / Average Inventories/Stock
1500 / 128 = 12 times approximately

Exercise 5. : Profit to sales is 2% and amount of profit is say

Rs.5 Lac. Then What is the amount of Sales ?

ASSETS
355 Net Fixed Assets

550

Q . What is the Net Working Capital ?

Ans : C. A - C L. = 255 - 88 = 167

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Capital + Reserves

128

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100

[ (362 - 30 ) / (550 30)] x 100
(332 / 520) x 100 = 64%

Ans : LTL / Tangible NW

= 100 / ( 362 30)
= 100 / 332 = 0.30 : 1

LIABILITIES

125

15
550

Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ?

100 Receivables

Bank Overdraft

Q. What is the Current Ratio ?

265

128

38 Stocks
26 Prepaid Expenses

550

Net Fixed Assets

7 Cash

Loan From S F C

Creditors
Proposed Dividend

P & L Credit Balance

ASSETS
355

125

Bank Overdraft
Provision of Tax

Capital + Reserves

26

contd9

LIABILITIES

7 Cash

Loan From S F C

Exercise 4.

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200

= 11 : 2

550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.
Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12
= 1 month
Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?
Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
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Therefore Net Working Capital = C. A C.L

= 25 26 = (- )1 Lac
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Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio

is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune
of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long
Term Liabilities?

Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net

Working Capital ?
Answer : It suggest that the Current Assets is equal to Current Liabilities
hence the NWC would be NIL ( since NWC = C.A - C.L )

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac
i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current
Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net
Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity
Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs.
Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What

is the amount of Current Assets ?
Answer : 4a - 1a = 30,000
Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000
Hence Current Assets would be 4a = 4 x 10,000 = Rs.40,000/-

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being

Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10
Lac. What would be the Current Liabilities?

Exercise 9. The amount of Term Loan installment is Rs.10000/ per

month, monthly average interest on TL is Rs.5000/-. If the amount
of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What
would be the DSCR ?
DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment
= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 10
i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure
which should be Rs. 10 Lac

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EXERCISE 12. A firm sold its stocks in CASH, in order to meet its liquidity
needs. Which of the following Ratio would be affected by this?

EXERCISE 15. Under which of the following methods of depreciation on

Fixed Assets, the annual amount of depreciation decreases?

1.
2.
3.
4.

1.
2.
3.
4.

Debt Equity Ratio

Current Ratio
Debt Service Coverage Ratio
Quick Ratio

EXERCISE 13. A company is found to be carrying a high DEBT EQUITY

Ratio. To improve this, a bank may suggest the company to :
1.
2.
3.
4.

Written Down Value method

Straight Line method
Annuity method
Insurance policy method

EXERCISE 16 Debt Service Coverage Ratio (DSCR) shows :

1. Excess of current assets over current liabilities
2. Number of times the value of fixed assets covers the amount of loan
3. Number of times the companys earnings cover the payment of
interest and repayment of principal of long term debt
4. Effective utilisation of assets

Raise long term interest free loans from friends and relatives
Raise long term loans from Institutions
Increase the Equity by way of Bonus Issue
Issue Rights share to existing share holders.

EXERCISE 14. Which of the following is a fictitious Asset?

EXERCISE 17. Which of the following is not considered a Quick Asset?

1.
2.
3.
4.

1.
2.
3.
4.

Goodwill
Preliminary Expenses
Pre-operative expenses
Book Debts which have become doubtful of recovery

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Cash and Bank balances

Bank Fixed Deposits
Current Book Debts
Loans and Advances

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Exercise 18. From the following financial statement calculate (i) Current Ratio (ii)
Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v)
Average Creditors payment period.
C.Assets
Sales
1500
Inventories
125
Cost of sales 1000
Debtors
250
Gross profit
500
Cash
225
C. Liabilities
Trade Creditors
200
(i) Current Ratio : 600/200 = 3 : 1
(ii) Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1
(iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times
(iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 =
61 days
(v) Average Creditors payment period : (Trade Creditors/Cost of sales) x 365
(200/100) x 365 = 73 days

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