## Ratio AnalysisFinancial Statements Analysis NotesB.Com Notes 6th Sem CBCS Pattern

**Unit – 2: Ratio
Analysis**

**Q. What is
Ratio analysis? What are its characteristics? Mention its advantages and
Disadvantages. 2014, 2017, 2018, 2019**

**Q. What
are various classes of ratios? (Profitability Ratio, Solvency Ratio, Activity
Ratio, Profit and Loss Account Ratio, Balance sheet and Composite Ratios) 2015, 2016**

**Q. Explain
the purpose of calculating the following Ratios:**

**a.
Current Ratio b. Liquid
Ratio c. Gross Profit
Ratio d. Net Profit
Ratio**

**e.
Operating Profit Ratio f.
Debtor’s Turnover ratio and Debtor’s Collection Period**

**g.
Creditor’s Turnover ratio and Average Payment Period h. Stock Turnover Ratio**

**g.
Debt-Equity Ratio h. Proprietory
Ratio i. Return On Investment Ratio**

**j.
Return on Shareholder’s Fund k.
Earnings per Share**

**Q.
Practical Problems: Two types of questions are expected**

**1.
****Preparation of P/L account and balance sheet from given ratios**

**2.
****Calculation of various types ratio from the given financial
information**

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**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*

*Objectives of Ratio analysis*

a) To
know the area of the business which need more attention.

b) To
know about the potential areas which can be improved with the effort in the
desired direction.

c) To
provide a deeper analysis of the profitability, liquidity, solvency and
efficiency levels in the business.

d) To
provide information for decision making.

e) To
Judge Operational efficiency

f)
Structural analysis of the company

g) Proper
Utilization of resources and

h) 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:

a) 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.

b) 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.

c) 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.

d) To
simplify the accounting information: Accounting ratios are very useful as they
briefly summaries the result of detailed and complicated computations.

e) 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.

f)
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.

g) 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:

a) 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.

b) 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.

c) 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.

d) 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.

e) 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.

f)
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.

g) 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:

a) Traditional
classification

b) Functional
classification

c) 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.

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.

### ðŸ‘‰ðŸ‘‰Financial Statements Analysis

**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) Earnings
Per Share: **Earnings per share is calculated by dividing
the net profit (after interest, tax and preference dividend) by the number of
equity shares.

Earnings 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.