# Financial Statement Analysis Notes: Ratio Analysis

Unit – 2: Ratio Analysis
Meaning of Ratio Analysis
A ratio is one figure expressed in terms of another figure. It is mathematical yardstick of measuring relationship of two figures or items or group of items, which are related, is each other and mutually inter-dependent. It is simply the quotient of two numbers. It can be expressed in fraction or in decimal point or in pure number. Accounting ratio is an expression relating to two figures or two accounts or two set accounting heads or group of items stated in financial statement.
Ratio analysis is the method or process of expressing relationship between items or group of items in the financial statement are computed, determined and presented. It is an attempt to draw quantitative measures or guides concerning the financial health and profitability of an enterprise. It can be used in trend and static analysis. It is the process of comparison of one figure or item or group of items with another, which make a ratio, and the appraisal of the ratios to make proper analysis of the strengths and weakness of the operations of an enterprise.
According to Myers, “Ratio analysis of financial statements is a study of relationship among various financial factors in a business as disclosed by a single set of statements and a study of trend of these factors as shown in a series of statements."
Objectives of Ratio analysis
1. To know the area of the business which need more attention.
2. To know about the potential areas which can be improved with the effort in the desired direction.

3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business.
4. To provide information for decision making.
5. To Judge Operational efficiency
6.  Structural analysis of the company
7. Proper Utilization of resources and
8. Leverage or external financing
Advantages and Uses of Ratio Analysis
There are various groups of people who are interested in analysis of financial position of a company used the ratio analysis to workout a particular financial characteristic of the company in which they are interested. Ratio analysis helps the various groups in the following manner:
1)      To workout the profitability: Accounting ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern.
2)      Helpful in analysis of financial statement: Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc.
3)      Helpful in comparative analysis of the performance: With the help of ratio analysis a company may have comparative study of its performance to the previous years. In this way company comes to know about its weak point and be able to improve them.
4)      To simplify the accounting information: Accounting ratios are very useful as they briefly summaries the result of detailed and complicated computations.
5)      To workout the operating efficiency: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilising the resources.
6)      To workout short-term financial position: Ratio analysis helps to workout the short-term financial position of the company with the help of liquidity ratios. In case short-term financial position is not healthy efforts are made to improve it.
7)      Helpful for forecasting purposes: Accounting ratios indicate the trend of the business. The trend is useful for estimating future. With the help of previous years’ ratios, estimates for future can be made.
Limitations of Ratio Analysis
In spite of many advantages, there are certain limitations of the ratio analysis techniques. The following are the main limitations of accounting ratios:

1)      Limited Comparability: Different firms apply different accounting policies. Therefore the ratio of one firm can not always be compared with the ratio of other firm.
2)      False Results: Accounting ratios are based on data drawn from accounting records. In case that data is correct, then only the ratios will be correct. For example, valuation of stock is based on very high price, the profits of the concern will be inflated and it will indicate a wrong financial position. The data therefore must be absolutely correct.
3)      Effect of Price Level Changes: Price level changes often make the comparison of figures difficult over a period of time. Changes in price affect the cost of production, sales and also the value of assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison.
4)      Qualitative factors are ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision making. For example, average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis.
5)      Effect of window-dressing: In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way.
6)      Costly Technique: Ratio analysis is a costly technique and can be used by big business houses. Small business units are not able to afford it.
7)      Misleading Results: In the absence of absolute data, the result may be misleading. For example, the gross profit of two firms is 25%. Whereas the profit earned by one is just Rs. 5,000 and sales are Rs. 20,000 and profit earned by the other one is Rs. 10, 00,000 and sales are Rs. 40, 00,000. Even the profitability of the two firms is same but the magnitude of their business is quite different.
CLASSIFICATION OF RATIOS
The ratios are used for different purposes, for different users and for different analysis. The ratios can be classified as under:
2)      Functional classification
3)      Classification from user‘s point of view
1) Traditional classification: As per this classification, the ratios readily suggest through their names, their respective resources. From this point of view, the ratios are classified as follows.
a) Balance Sheet Ratio: This ratio is also known as financial ratios. The ratios which express relationships between two items or group of items mentioned in the balance sheet at the end of the year. Example: Current ratio, Liquid ratio, Stock to Working Capital ratio, Capital Gearing ratio, Proprietary ratio, etc.
b) Revenue Statement Ratio: This ratio is also known as income statement ratio which expresses the relationship between two items or two groups of items which are found in the income statement of the year. Example: Gross Profit ratio, Operating ratio, Expenses Ratio, Net Profit ratio, Stock Turnover ratio, Operating Profit ratio.
c) Combined Ratio: These ratios show the relationship between two items or two groups of items, of which one is from balance sheet and another from income statement (Trading A/c and Profit & Loss A/c and Balance Sheet). Example: Return on Capital Employed, Return on Proprietors' Fund ratio, Return on Equity Capital ratio, Earning per Share ratio, Debtors' Turnover ratio, Creditors Turnover ratio.
2) Functional Classification of Ratios: The accounting ratios can also be classified according their functions as follows.
a) Liquidity Ratios: These ratios show relationship between current assets and current liabilities of the business enterprise. Example: Current Ratio, Liquid Ratio.
b) Leverage Ratios: These ratios show relationship between proprietor's fund and debts used in financing the assets of the business organization. Example: Capital gearing ratio, debt-equity ratio, and proprietary ratio. This ratio measures the relationship between proprietors fund and borrowed funds.
c) Activity Ratio: This ratio is also known as turnover ratio or productivity ratio or efficiency and performance ratio. These ratios show relationship between the sales and the assets. These are designed to indicate the effectiveness of the firm in using funds, degree of efficiency, and its standard of performance of the organization. Example : Stock Turnover Ratio, Debtors' Turnover Ratio, Turnover Assets Ratio, Stock working capital Ratio, working capital Turnover Ratio, Fixed Assets Turnover Ratio.
d) Profitability Ratio: These ratios show relationship between profits and sales and profit & investments. It reflects overall efficiency of the organizations, its ability to earn reasonable return on capital employed and effectiveness of investment policies. Example : i) Profits and Sales : Operating Ratio, Gross Profit Ratio, Operating Net Profit Ratio, Expenses Ratio etc. ii) Profits and Investments : Return on Investments, Return on Equity Capital etc.
e) Coverage Ratios: These ratios show relationship between profit in hand and claims of outsiders to be paid out of profits. Example: Dividend Payout Ratio, Debt Service Ratio and Debt Service Coverage Ratio.
3) Classification from the view point of user: Ratio from the users' point of view is classified as follows:
a) Shareholders' point of view: These ratios serve the purposes of shareholders. Shareholders, generally expect the reasonable return on their capital. They are interested in the safety of shareholders investments and interest on it. Example: Return on proprietor's funds, Return on capital, Earning per share. 78
b) Long term creditors: Normally leverage ratios provide useful information to the long term creditors which include debenture holders, vendors of fixed assets, etc. The creditors interested to know the ability of repayment of principal sum and periodical interest payments as and when they become due. Example: Debt equity ratio, return on capital employed, proprietary ratio.
c) Short term creditors: The short-term creditors of the company are basically interested to know the ability of repayment of short-term liabilities as and when they become due. Therefore, the creditors has important place on the liquidity aspects of the company's assets. Example: a) Liquidity Ratios - Current Ratio, Liquid Ratio. b) Debtors Turnover Ratio. c) Stock working capital Ratio.
d) Management: Management is interested to use borrowed funds to improve the earnings. Example: Return on capital employed, Turnover Ratio, Operating Ratio, Expenses Ratio.
Meaning, Objective and Method of Calculation of various types of ratios
a) Current Ratio: Current ratio is calculated in order to work out firm’s ability to pay off its short-term liabilities. This ratio is also called working capital ratio. This ratio explains the relationship between current assets and current liabilities of a business. It is calculated by applying the following formula:
Current Ratio = Current Assets/Current Liabilities
Current Assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Stock of Goods, Short-term Investments, Prepaid Expenses, Accrued Incomes etc.
Current Liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Current ratio shows the short-term financial position of the business. This ratio measures the ability of the business to pay its current liabilities. The ideal current ratio is supposed to be 2:1. In case, if this ratio is less than 2:1, the short-term financial position is not supposed to be very sound and in case, if it is more than 2:1, it indicates idleness of working capital.
b) Liquid Ratio: Liquid ratio shows short-term solvency of a business. It is also called acid-test ratio and quick ratio. It is calculated in order to know whether or not current liabilities can be paid with the help of quick assets quickly. Quick assets mean those assets, which are quickly convertible into cash.
Liquid Ratio = Liquid Assets/Current Liabilities
Liquid assets includes Cash in hand, Cash at Bank, Sundry Debtors, Bills Receivable, Short-term investments etc. In other words, all current assets are liquid assets except stock and prepaid expenses.
Current liabilities includes Sundry Creditors, Bills Payable, Bank Overdraft, Outstanding Expenses etc.
Objective and Significance: Liquid ratio is calculated to work out the liquidity of a business. This ratio measures the ability of the business to pay its current liabilities in a real way. The ideal liquid ratio is supposed to be 1:1. In case, this ratio is less than 1:1, it shows a very weak short-term financial position and in case, it is more than 1:1, it shows a better short-term financial position.
c) Gross Profit Ratio: Gross Profit Ratio shows the relationship between Gross Profit of the concern and its Net Sales. Gross Profit Ratio can be calculated in the following manner:
Gross Profit Ratio = Gross Profit/Net Sales x 100
Where Gross Profit = Net Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
And Net Sales = Total Sales – Sales Return
Objective and Significance: Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses and is able to cover its fixed expenses. This ratio can also be used in stock-inventory control. Maintenance of steady gross profit ratio is important .Any fall in this ratio would put the management in difficulty in the realisation of fixed overheads of the business.
d) Net Profit Ratio: Net Profit Ratio shows the relationship between Net Profit of the concern and Its Net Sales. Net Profit Ratio can be calculated in the following manner:
Net Profit Ratio = Net Profit/Net Sales x 100
Where, Net Profit = Gross Profit – Selling and Distribution Expenses – Office and Administration Expenses – Financial Expenses – Non Operating Expenses + Non Operating Incomes.
And Net Sales = Total Sales – Sales Return
Objective and Significance: In order to work out overall efficiency of the concern Net Profit ratio is calculated. This ratio is helpful to determine the operational ability of the concern. While comparing the ratio to previous years’ ratios, the increment shows the efficiency of the concern.
e) Operating Profit Ratio: Operating Profit Ratio shows the relationship between Operating Profit and Net Sales. Operating Profit Ratio can be calculated in the following manner:
Operating Profit Ratio = (Operating Profit/Net Sales) x 100
Where Operating Profit = Gross Profit – Operating Expenses
Or Operating Profit = Net Profit + Non Operating Expenses – Non Operating Incomes
And Net Sales = Total Sales – Sales Return
Objective and Significance: Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earning from the other sources. It shows whether the business is able to stand in the market or not.
f) Operating Ratio: Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means Cost of goods sold plus Operating Expenses.
Operating Ratio = Operating Cost/Net Sales x 100
Where Operating Cost = Cost of goods sold + Operating Expenses
(Operating Expenses = Selling and Distribution Expenses, Office and Administration Expenses, Repair and Maintenance.)
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Or Cost of Goods Sold = Net sales – Gross Profit
Objective and Significance: Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percentage of cost means higher margin to earn profit.
g) Return on Investment or Return on Capital Employed: This ratio shows the relationship between the profit earned before interest and tax and the capital employed to earn such profit.
Return on Capital Employed = Net Profit before Interest, Tax and Dividend/Capital Employed x 100
Where Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets
Or
Capital Employed = Fixed Assets + Current Assets – Current Liabilities
Objective and Significance: Return on capital employed measures the profit, which a firm earns on investing a unit of capital. The profit being the net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also to management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.
h) Return on Equity: Return on equity is also known as return on shareholders’ investment. The ratio establishes relationship between profit available to equity shareholders with equity shareholders’ funds.
Return on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders’ Funds x 100
Where Equity Shareholders’ Funds = Equity Share Capital + Reserves and Surplus – Fictitious Assets
Objective and Significance: Return on Equity judges the profitability from the point of view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of equity funds invested in the firm. The investors favour the company with higher ROE.
i) Earning Per Share: Earning per share is calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares.
Earning Per Share = Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares
Objective and Significance: Earning per share helps in determining the market price of the equity share of the company. It also helps to know whether the company is able to use its equity share capital effectively with compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.
j) 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
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
Objective and Significance: This ratio is a measure of owner’s stock in the business. Proprietors are always keen to have more funds from borrowings because:
(i) Their stake in the business is reduced and subsequently their risk too
(ii) Interest on loans or borrowings is a deductible expenditure while computing taxable profits. Dividend on shares is not so allowed by Income Tax Authorities.
The normally acceptable debt-equity ratio is 2:1.
k) 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
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
Objective and Significance: - Debt to Total Funds Ratios shows the proportion of long-term funds, which have been raised by way of loans. This ratio measures the long-term financial position and soundness of long-term financial policies. A higher proportion is not considered good and treated an indicator of risky long-term financial position of the business.
l) 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
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.
Objective and Significance: This ratio indicates as to what extent fixed assets are financed out of long-term funds. It is well established that fixed assets should be financed only out of long-term funds. This ratio workout the proportion of investment of funds from the point of view of long-term financial soundness. This ratio should be equal to 1. If the ratio is less than 1, it means the firm has adopted the impudent policy of using short-term funds for acquiring fixed assets. On the other hand, a very high ratio would indicate that long-term funds are being used for short-term purposes, i.e. for financing working capital.
m) 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.
Objective and Significance: This ratio indicates the general financial position of the business concern. This ratio has a particular importance for the creditors who can ascertain the proportion of shareholder’s funds in the total assets of the business. Higher the ratio, greater the satisfaction for creditors of all types.
n) 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
Objective and Significance: This ratio expresses the satisfaction to the lenders of the concern whether the business will be able to earn sufficient profits to pay interest on long-term loans. This ratio indicates that how many times the profit covers the interest. It measures the margin of safety for the lenders. The higher the number, more secure the lender is in respect of periodical interest.
o) Capital Turnover Ratio: Capital turnover ratio establishes a relationship between net sales and capital employed. The ratio indicates the times by which the capital employed is used to generate sales. It is calculated as follows:
Capital Turnover Ratio = Net Sales/Capital Employed
Where Net Sales = Sales – Sales Return
Capital Employed = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets.
Objective and Significance: The objective of capital turnover ratio is to calculate how efficiently the capital invested in the business is being used and how many times the capital is turned into sales. Higher the ratio, better the efficiency of utilisation of capital and it would lead to higher profitability.
p) Fixed Assets Turnover Ratio: Fixed assets turnover ratio establishes a relationship between net sales and net fixed assets. This ratio indicates how well the fixed assets are being utilised.
Fixed Assets Turnover Ratio = Net Sales/Net Fixed Assets
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.
Objective and Significance: This ratio expresses the number to times the fixed assets are being turned over in a stated period. It measures the efficiency with which fixed assets are employed. A high ratio means a high rate of efficiency of utilisation of fixed asset and low ratio means improper use of the assets.
q) Working Capital Turnover Ratio: Working capital turnover ratio establishes a relationship between net sales and working capital. This ratio measures the efficiency of utilisation of working capital.
Working Capital Turnover Ratio = Net Sales or Cost of Goods Sold/Net Working Capital
Where Net Working Capital = Current Assets – Current Liabilities
Objective and Significance: This ratio indicates the number of times the utilisation of working capital in the process of doing business. The higher is the ratio, the lower is the investment in working capital and the greater are the profits. However, a very high turnover indicates a sign of over-trading and puts the firm in financial difficulties. A low working capital turnover ratio indicates that the working capital has not been used efficiently.
r) Stock Turnover Ratio: Stock turnover ratio is a ratio between cost of goods sold and average stock. This ratio is also known as stock velocity or inventory turnover ratio.
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
Objective and Significance: Stock is a most important component of working capital. This ratio provides guidelines to the management while framing stock policy. It measures how fast the stock is moving through the firm and generating sales. It helps to maintain a proper amount of stock to fulfill the requirements of the concern. A proper inventory turnover makes the business to earn a reasonable margin of profit.
s) Debtors’ Turnover Ratio: Debtors turnover ratio indicates the relation between net credit sales and average accounts receivables of the year. This ratio is also known as Debtors’ Velocity.
Debtors Turnover Ratio = Net Credit Sales/Average Accounts Receivables
Where Average Accounts Receivables = [Opening Debtors and B/R + Closing Debtors and B/R]/2
Credit Sales = Total Sales – Cash Sales-Return Inward
Objective and Significance: This ratio indicates the efficiency of the concern to collect the amount due from debtors. It determines the efficiency with which the trade debtors are managed. Higher the ratio, better it is as it proves that the debts are being collected very quickly.
t) Debt Collection Period: Debt collection period is the period over which the debtors are collected on an average basis. It indicates the rapidity or slowness with which the money is collected from debtors.
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 (360 days can also be used instead of 365 days)

Objective and Significance: This ratio indicates how quickly and efficiently the debts are collected. The shorter the period the better it is and longer the period more the chances of bad debts. Although no standard period is prescribed anywhere, it depends on the nature of the industry.