RATIO ANALYSIS

- Ratio analysis is an important and powerful technique or method, generally, used

for analysis of Financial Statements.
- Ratios are used as a yardstick for evaluating the financial condition and
performance of a firm.
- Ratio Analysis helps to ascertain the financial condition of the firm. In financial
analysis, a ratio is compared against a benchmark for evaluating the financial
position and performance of a firm.

There are several groups of persons — creditors, investors, lenders,

management and public — interested in the interpretation of the financial
statements.
• They interpret ratios, for those purposes they are interested in, to take
appropriate decisions to serve their own individual interests

A. Liquidity Ratios: They measure the firm’s ability to meet current obligations.
B. Leverage Ratios: These ratios show the proportion of debt and equity in
financing the firm’s assets.
C. Activity Ratios: They reflect the firm’s efficiency in utilizing the assets.
D. Profitability Ratios: These ratios measure overall performance and
effectiveness of the firm.
- Analysis means methodical classification of data and presentation in a simplified
form for easy understanding.
- Interpretation means assigning reasons for the behavior in respect of the data,
presented in the simplified form.
*Analysis of ratios, without interpretation, is meaningless and
interpretation, without analysis, is impossible.
 LIMITATIONS OF FINANCIAL RATIO
• Absence of identical situations
• Change in accounting policies
• Based on historical data
• Qualitative factors are ignored
• Ratios are only indicators, not final
• Over use could be dangerous • Window dressing
• Problems of price level changes
• No fixed standards

LIQUIDITY RATIOS
1. Current Ratio- is defined as the relationship between current assets and
current liabilities.
• It is also known as working capital ratio.
• This is calculated by
dividing total current assets by
total current liabilities

Interpretation of Current Ratio

• As a conventional rule, a current ratio of 2:1 is considered satisfactory.
• The rule is based on the logic that in the worst situation, even if the value of
current assets becomes half, the firm will be able to meet its obligations, fully
• • A ‘two to one ratio’ is referred to as ‘Rule of thumb’ or arbitrary standard of the
liquidity of the firm.
• This current ratio represents a margin of safety for creditors.
• Realization of assets may decline. However, all the liabilities have to be paid, in
full.

*Current ratio is a test of quantity, not test of quality. It is essential to verify the
composition and quality of assets before, finally, taking a decision about the adequacy
of the ratio
A high current ratio, due to the following causes, may not be favorable for the
following reasons:
1. Slow-moving or dead stock/s, piled up due to poor sales.
2. Figure of debtors may be high as debtors are not capable of paying or debt collection
system of the firm is not satisfactory.
3. Cash or bank balances may be high, due to idle funds
On the other hand, a low current ratio may be due to the following reasons:
1. Insufficiency of funds to pay creditors.
2. Firm may be trading beyond resources and the resources are inadequate to the high
volume of trade.
LEVERAGE RATIOS
• Debt-Equity Ratio is also known as External-Internal Equity Ratio.
• This ratio is calculated to measure the relative claims of outsiders and owners against
the firm’s assets.
The ratio shows the
relationship between
the external equities
(outsiders’ funds) and internal equities (shareholders’ funds).

INTERPRETATION OF DEBT EQUITY RATIO

• Debt-Equity Ratio indicates the extent to which debt financing has been used in
business.
• Total debt to net worth of 1:1 is considered satisfactory, as a thumb rule.
• This ratio shows the level of dependence on the outsiders. • As a general rule, there
should be a mix of debt and equity.
• The owners want to conduct business, with maximum outsiders’ funds to take less risk
for their investment.
• At the same time, they want to maximize their earnings, at the cost and risk of
outsiders’ funds.
TOTAL DEBT EQUITY RATIO
- Total Debt Ratio compares
the total debts (long-term
as well as short-term) with total assets.

INTERPRETATION OF TOTAL DEBT RATIO

• This ratio depicts the proportion of total assets, financed by total liabilities. •
Impliedly, the remaining assets are financed by the shareholders.
• A higher DE ratio or TD ratio shows the firm is trading on equity.
• In case, the rate of return of the firm is more than the cost of debt, it implies high
return to the shareholders.
• On the other hand, a lower ratio implies low risk to lenders and creditors of the
firm and non-existence of trading on equity. So, neither the higher nor the lower
ratio is desirable from the point of view of the shareholders
• A higher ratio is a threat to the solvency of the firm.
• A lower ratio is an indication that the firm may be missing the available
opportunities to improve profitability
• A balanced proportion of debt and equity is required so as to take care of the
interests of lenders, the shareholders and the firm, as a whole.
ACTIVITY RATIOS
Inventory Turnover Ratio /
Inventory Velocity
• Inventory turnover
ratio is also known as
stock turnover ratio.
• This is calculated by dividing cost of goods sold by average inventory

Interpretation of Inventory Turnover Ratio

• Inventory turnover ratio shows the velocity of stocks.
• A higher ratio is an indication that the firm is moving the stocks better so profitability, in
such a situation, would be more.
• However, a very high ratio may show that the firm has been maintaining only fast
moving stocks.
• The firm may not be maintaining the total range of inventory and so may be missing
business opportunities, which may otherwise be available.
• It is better to compare the turnover ratio, with the industry or its immediate competitor
Days Sales in Inventory (DSI), sometimes known as inventory days or days in inventory,
is a measurement of the average number of days or time required for a business to
convert its inventory into sales. In addition, goods that are considered a “work in
progress” (WIP) are included in the inventory for calculation purposes.
The DSI value is calculated by dividing the inventory balance (including work-in
progress) by the amount of cost of goods sold. The number is then multiplied by the
number of days in a year, quarter, or month. DSI = (Inventory / Cost of Sales) x (No. of
Days in the Period) or = No. of days in the period / Inventory turn-over
Interpretation of No. of Days Inventory Holding
• Ideal Standard: There is no standard ratio.
• The ratio depends upon the nature of business.
• The ratio has to be compared with the ratio of the industry, other firms or past ratio of
the same firm.
• Every firm has to maintain certain level of inventory, be it raw materials or finished
goods, to carry on the business, smoothly, without interruption of production and loss of
business opportunities.
• Inventory Turnover Ratio is a test of inventory management.
This level of inventory should be neither too high nor too low. If the ratio is too high, it
is an indication of the following:
(i) Blocking unnecessary funds that can be utilized somewhere else, more profitably.
(ii) Unnecessary payment for extra godown space for piled stocks.
(iii) Chances of obsolescence and pilferage are more.
(iv) Likely deterioration in quality and
(v) Above all, slow movement of stocks means slow recovery of cash, tied in stocks
On the other hand, if the ratio is too low:
(i) Stoppage of production, in the absence of continuous availability of raw materials
and
(ii) Loss of business opportunities as range of finished goods is not available, at all
times.
To avoid the situation, the firm should know the position, periodically, whether it is
carrying excessive or inadequate stocks for necessary corrective action, in time. It is
always better to compare the ratios of the firm with the ratios of industry and other firms,
in competition, for proper evaluation of the performance of the firm.
Debtors’ (Receivables)
Turnover Ratio / Debtors’
Velocity
• Firms sell goods on cash and
credit. As and when goods are sold on credit, debtors (receivables) appear in accounts.
Debtors are expected to be converted into cash, over a short period, and they are
included in current assets.
• To judge the quality or liquidity of debtors, financial analysts apply three ratios, which
are: (a) debtors turnover ratio (b) collection period (c) aging schedule of debtors
• Debtors’ Turnover Ratio: Debtors turnover is found out by dividing credit sales by
average debtors

Interpretation of Debtors’ (Receivables) Turnover Ratio

• Debtors’ turnover ratio indicates the number of times debtors are turned over, each
year. • The higher the debtors’ turnover, more efficient is the management of credit.
• If Bills Receivable is outstanding, they are to be added to the debtors as bills
receivable have come into balance sheet, in place of debtors, which are, still,
outstanding.
Working Capital Turnover Ratio
• The WCT Ratio indicates the velocity of utilization of working capital of the firm, during
the year.
• The working capital refers to net working capital, which is equal to total current assets
less current liabilities. The ratio is calculated as follows:

Interpretation of Working Capital Turnover Ratio

• This ratio measures the efficiency of working capital management.
• A higher ratio indicates efficient utilization of working capital and a low ratio shows
otherwise.
• A high working capital ratio indicates a lower investment in working capital has
generated more volume of sales.
• Higher ratio improves the profitability of the firm.
• But, a very high ratio is also not desirable for any firm. • This may also imply
overtrading, as there may be inadequacy of working capital to support the increasing
volume of sales. This may be a risky proposition to the firm.
PROFITABILITY RATIOS
GROSS
PROFIT
RATIO
Profit is a factor
of sales.
• Profit is
earned, after
meeting all

expenses, as and when sales are made.

• The Gross Profit ratio reflects the efficiency with which a firm produces/sells its
different products

Interpretation of Gross Profit Ratio

• Gross Profit Ratio indicates the spread between the cost of goods sold and revenue.
• Analysis gives the clues to the management how to improve the depressed profit
margins.
• The ratio indicates the extent to which the selling price can decline, without resulting in
losses on operations of a firm.
• High gross profit ratio is a sign of good management

Reasons for high gross profit ratio:

• High sales price, cost of goods remaining constant
• Lower cost of goods sold, sales price remaining constant
• A combination of factors in sales price and costs of different products, widening the
margin
• An increase in proportion of volume of sales of those products that carry a higher
margin and Overvaluation of
closing stock due to misleading factors.
Reasons for fall in gross profit ratio:
Reasons may be:
• Purchase of raw materials, at unfavorable rates
• Over investment and/ or inefficient utilization of plant and machinery, resulting in
higher cost of production
• Excessive competition, compelling to sell at reduced prices
*The finance manger has to analyze the reasons for the fall and initiate the action,
necessary to improve the situation
NET PROFIT RATIO
• Net profit is obtained, after deducting operating expenses, interest and taxes from
gross profit.
• Net profit includes non-operating income so the later may be deducted to arrive at
profitability arising from operations.
• The net profit ratio is calculated by
Interpretation of Net Profit Ratio
• Net Profit ratio indicates the overall efficiency of the management in manufacturing,
administering and selling the products.
• Net profit has a direct relationship with the return on investment. If net profit is high,
with no change in investment, return on investment would be high.
• If there is fall in profits, return on investment would also go down.
Operating Expenses Ratio
• To identify the cause of fall or rise in net profit, each operating expense ratio is to be
calculated.
• This can be calculated by

INTERPRETATION OF OPERATING EXP.

• The behavior of specific expenditure is to be seen, in comparison to the earlier years,
in the same firm.
• This throws the light on the managerial policies and actions.
• For example, advertisement expenditure may be going up, from year to year, with no
significant increase in sales.
• This may be due to ineffective sales promotional expenditure in not bringing increased
sales, despite more expenditure on advertisement.
• A general rise in advertisement expenses, throughout the industry, or inefficiency of
marketing / advertisement department of the firm, alone, may be the contributing factor.
The real reason can be better understood, once the