Ratio Analysis

G.Krishna

Assoc.Profesor

ICBM-School of Business Excellence

Hyderabad

Meaning of Ratio Analysis

• It is an analysis of strength and weakness of an organisation by establishing the quantitative relation among the items of Balance Sheet or Income Statement of such an organisation

Purpose/Importance/Advantages

• Analysis of financial Position• Simplification of Accounting Figures• Assessment of Operational Efficiency• Determining Trends in the long-run• Identification of Strength & Weakness• Taking Remedial Measures• Comparison of Performance

Limitations of Ratio Analysis

• Based on Historical Data• Change in Real Value of Monetary Unit• No Standard Interpretation• Ignoring Qualitative Aspects• Difference in Accounting Methods make

comparison difficult• Ambiguity in Terms Used

Classification of Ratios

A. Liquidity Ratios-

B. Solvency Ratios- Leverage

C. Activity Ratios- Turnover

D. Profitability Ratios-

E. Shareholders' Ratios

Classification of Ratios

What is Liquidity ?

Classification of Ratios

-Ability to convert as asset to cash quickly

-Assets that can be easily bought & sold without loss.

It is an ratio to know short term solvency of the company

A. Liquidity Ratios

• Used to study the ability of the organisation in meeting short-term payments or obligations

• Includes:

1) Current Ratio,

2) Acid Test Ratio and

3) Working Capital Turnover Ratio

1) Current Ratio

• Relation between current assets and current liabilities

• Long Term Sources Financing the Current assets give a stable base for the liquidity of the organisation

• Normally , the ratio should not be less than 2 i.e., the current assets should be double the size of current liabilities

Measurement of Current Ratio

Current Ratio =

Ideal Ratio : 2:1

bilitiesCurrentLia

etsCurrentAss

2) Acid Test Ratio/Quick Ratio

• It is the ratio between quick assets and quick liabilities

• Quick assets include current assets except inventory and pre-paid expenses

• Quick liabilities include current liabilities other than bank overdraft

• A 1:1 ratio is healthy• Healthy indicator of cash management

Measurement of Acid Test Ratio

Acid Test Ratio =

Ideal Ratio; 1:1

litiesQuickLiabi

sQuickAsset

3) Working Capital Turn-over Ratio

• Shows the efficiency of usage of working capital

• Relation between Sales and Working Capital

• Determination of number of times the working capital is turned over to achieve the maximum profit

Measurement of Working Capital Turnover Ratio

Higher the ratio is Ideal

lkingCapitaAverageWor

NetSales

B. Solvency Ratios/Leverage

• Measure long-term liquidity ratio• Reflect the ability of the firm to pay interest

and repayment of loans at due dates on the long-term loans taken

• Avoidance of over-borrowing (over-leverage)

• Avoidance of bankruptcy by maintaining healthy solvency ratios

What is Leverage ?

The amount of debt used to finance a firm’s assets

A firm with significantly more debt than equity is considered

to be highly leveraged

Types of Solvency/ Leverage Ratios

1) Interest Coverage Ratio

2) Debt Ratio

3) Debt-Equity Ratio

4) Capital Gearing Ratio

5) Proprietary Ratio

1.Interest Coverage Ratio6 is Ideal

TermDebtLongIntereston

TaxInterestofitBefore

&Pr

2. Debt Ratio (Debt to Total Funds ratio)

rsFundsShareholdeLTDebt

LTDebt

3) Debt-Equity Ratio

rsFundsShareholde

btLongTermDe

4) Capital Gearing Ratio

ndeholdersFuEquityShar

curitieseBearingSeFixedIncom

5) Proprietary RatioNet worth/Total Assets

sTotalAsset

rsFundsShareholde

C] Activity Ratios/Turnover

1) Inventory Turnover Ratio

2) Debtors Turnover Ratio

3) Average Collection Period

4) Fixed Assets Turnover Ratio

5) Total Assets Turnover Ratio

6) Capital Turnover Ratio

1) Inventory Turnover Ratio8 is Ideal

ckAverageSto

sSoldCostofGood

ckAverageSto

sSoldCostofGood

2) Debtor Turnover Ratio

Higher Ratio – or 10-12

torsAverageDeb

sCreditSale

3) Average Collection Period

overRatioDebtorTurn

monthsaYearday )(12/)sin(365

4) Fixed Assets Turnover RatioHigher the Ratio is Ideal

setsNetFixedAs

NetSales

5) Total Assets Turnover Ratio

sTotalAsset

NetSales

6) Capital Turnover Ratio

TermFundsLong

NetSales

D] Profitability Ratios

1) Net Profit Ratio

2) Gross Profit Ratio

3) Return on Total Assets

4) Return on Equity

1) Net Profit Ratio

100Pr

XNetSales

axofitAfterT

2) Gross Profit Ratio

100Pr

XSales

ofitGross

3) Return on Total Assets

100Pr

XsTotalAsset

axofitAfterT

4) Return on Equity

100'

PrX

FundsrsShareholde

axofitAfterT

E) Shareholders‘ Ratio

1) Earning per Share (EPS)

2) Price-Earning Ratio (PE Ratio)

3) Dividend Yield Ratio

4) Dividend Pay-out Ratio

1) Earning per Share

uitySharesNumberofEq

axofitAfterTPr

2) PE Ratio

ShareEarningper

eiceperSharMar Prker

3) Dividend Yield Ratio

100Pr

XeiceperSharMarket

rShareDividendpe

4) Dividend Pay-out Ratio

100XShareEarningper

rShareDividendpe

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