RATIO ANALYSIS Meaning of Ratio:- A ratio is simple arithmetical expression of the relationship of one number to another.

It may be defined as the indicated quotient of two mathematical expressions. According to Accountants Handbook by Wixon, ell and !edford, "a ratio is an expression of the quantitati#e relationship between two numbers$. Ratio Analysis:- %atio analysis is the process of determining and presenting the relationship of items and group of items in the statements. According to !atty &. 'anagement Accounting "%atio can assist management in its basic functions of forecasting, planning coordination, control and communication$. It is helpful to know about the liquidity, sol#ency, capital structure and profitability of an organi(ation. It is helpful tool to aid in applying )udgement, otherwise complex situations. %atio analysis can represent following three methods. %atio may be expressed in the following three ways * +. Pure Ratio or Simple Ratio :- It is expressed by the simple di#ision of one number by another. ,or example , if the current assets of a business are %s. -..... and its current liabilities are %s. +....., the ratio of /0urrent assets to current liabilities will be -*+. -. Rate or So Many Times :- In this type , it is calculated how many times a figure is, in comparison to another figure. ,or example , if a firms credit sales during the year are %s. -..... and its debtors at the end of the year are %s. 1.... , its 2ebtors 3urno#er %atio is -.....41.... 5 6 times. It shows that the credit sales are 6 times in comparison to debtors.

7. Per entage :- In this type, the relation between two figures is expressed in hundredth. ,or example, if a firms capital is %s.+...... and its profit is %s.-..... the ratio of profit capital, in term of percentage, is -.....4+......8+.. 5 -.9 A!"ANTA#$ O% RATIO ANALYSIS +. Helpful in analysis of ,inancial :tatements. -. Helpful in comparati#e :tudy. 7. Helpful in locating the weak spots of the business. 1. Helpful in ,orecasting. 6. ;stimate about the trend of the business. <. ,ixation of ideal :tandards. =. ;ffecti#e 0ontrol. >. :tudy of ,inancial :oundness. LIMITATIONS O% RATIO ANALYSIS +. 0omparison not possible if different firms adopt different accounting policies. -. %atio analysis becomes less effecti#e due to price le#el changes. 7. %atio may be misleading in the absence of absolute data. 1. ?imited use of a single data. 6. ?ack of proper standards.

<. ,alse accounting data gi#es false ratio. =. %atios alone are not adequate for proper conclusions. >. ;ffect of personal ability and bias of the analyst. &LASSI%I&ATION O% RATIO %atio may be classified into the four categories as follows* A' Li(ui)ity Ratio a. 0urrent %atio b. @uick %atio or Acid 3est %atio *' Le+erage or &apital Stru ture Ratio a. 2ebt ;quity %atio b. 2ebt to 3otal ,und %atio c. Aroprietary %atio d. ,ixed Assets to Aroprietors ,und %atio e. 0apital Bearing %atio f. Interest 0o#erage %atio &' A ti+ity Ratio or Turno+er Ratio a. :tock 3urno#er %atio b. 2ebtors or %ecei#ables 3urno#er %atio c. A#erage 0ollection Aeriod d. 0reditors or Aayables 3urno#er %atio

e. A#erage Aayment Aeriod f. ,ixed Assets 3urno#er %atio g. Working 0apital 3urno#er %atio !' Profita,ility Ratio or In ome Ratio

-A. Profita,ility Ratio ,ase) on Sales : a. Bross Arofit %atio b. Cet Arofit %atio c. Dperating %atio d. ;xpenses %atio

EB. Profita,ility Ratio *ase) on In+estment : I' Return on &apital $mploye)

II' Return on S/are/ol)ers %un)s : a. %eturn on 3otal :hareholders ,unds b. %eturn on ;quity :hareholders ,unds c. ;arning Aer :hare d. 2i#idend Aer :hare e. 2i#idend Aayout %atio f. ;arning and 2i#idend Field g. Arice ;arning %atio

LI01I!ITY RATIO (A. Li(ui)ity Ratio:- It refers to the ability of the firm to meet its current liabilities. 3he liquidity ratio, therefore, are also called /:hortGterm :ol#ency %atio. 3hese ratio are used to assess the shortGterm financial position of the concern. 3hey indicate the firms ability to meet its current obligation out of current resources. In the words of :aloman &. ,link, "?iquidity is the ability of the firms to meet its current obligations as they fall due$. ?iquidity ratio include two ratio *G a. 0urrent %atio b. @uick %atio or Acid 3est %atio a. &urrent Ratio:- 3his ratio explains the relationship between current assets and current liabilities of a business. ,ormula*

Current Assets:-/0urrent assets includes those assets which can be con#erted into cash with in a years time. 0urrent Assets 5 0ash in Hand H 0ash at !ank H !4% H :hort 3erm In#estment H 2ebtorsE2ebtors I Aro#isionJ H :tockE:tock of ,inished Boods H :tock of %aw 'aterial H Work in ArogressJ H Arepaid ;xpenses.

&urrent Lia,ilities :- /0urrent liabilities include those liabilities which are repayable in a years time. 0urrent ?iabilities 5 !ank D#erdraft H !4A H 0reditors H Aro#ision for 3axation H Aroposed 2i#idend H Knclaimed 2i#idends H Dutstanding ;xpenses H ?oans Aayable with in a Fear. Signifi an e :- According to accounting principles, current ratio of -*+ is supposed to be an ideal ratio. a

It means that current assets of a business should, at least , be twice of its current liabilities. 3he higher ratio indicates the better liquidity position, the firm will be able to pay its current liabilities more easily. If the ratio is less than -*+, it indicate lack of liquidity and shortage of working capital. 3he biggest drawback of the current ratio is that it is susceptible to "window dressing$. 3his ratio can be impro#ed by an equal decrease in both current assets and current liabilities. ,' 0ui 2 Ratio:- @uick ratio indicates whether the firm is in a position to pay its current liabilities with in a month or immediately. ,ormula*

/?iquid Assets means those assets, which will yield cash #ery shortly. ?iquid Assets 5 0urrent Assets I :tock I Arepaid ;xpenses

Signifi an e :- An ideal quick ratio is said to be +*+. If it is more, it is considered to be better. 3his ratio is a better test of shortGterm financial position of the company. L$"$RA#$ OR &APITAL STR1&T1R$ RATIO -*. Le+erage or &apital Stru ture Ratio :- 3his ratio disclose the firms ability to meet the interest costs regularly and ?ong term indebtedness at maturity. 3hese ratio include the following ratios * a. !e,t $(uity Ratio:- 3his ratio can be expressed in two ways* ,irst Approach * According to this approach, this ratio expresses the relationship between long term debts and shareholders fund. ,ormula*

Long Term Loans:- 3hese refer to long term liabilities which mature after one year. 3hese include 2ebentures, 'ortgage ?oan, !ank ?oan, ?oan from ,inancial institutions and Aublic 2eposits etc. S/are/ol)ers %un)s :- 3hese include ;quity :hare 0apital, Areference :hare 0apital, :hare Aremium, Beneral %eser#e, 0apital %eser#e, Dther %eser#e and 0redit !alance of Arofit L ?oss Account. Se on) Approa / : According to this approach the ratio is calculated as follows*G

,ormula*

2ebt equity ratio is calculated for using second approach. Signifi an e :- 3his %atio is calculated to assess the ability of the firm to meet its long term liabilities. Benerally, debt equity ratio of is considered safe. If the debt equity ratio is more than that, it shows a rather risky financial position from the longGterm point of #iew, as it indicates that more and more funds in#ested in the business are pro#ided by longGterm lenders. 3he lower this ratio, the better it is for longGterm lenders because they are more secure in that case. ?ower than -*+ debt equity ratio pro#ides sufficient protection to longGterm lenders. ,' !e,t to Total %un)s Ratio : 3his %atio is a #ariation of the debt equity ratio and gi#es the same indication as the debt equity ratio. In the ratio, debt is expressed in relation to total funds, i.e., both equity and debt. ,ormula*

Signifi an e :- Benerally, debt to total funds ratio of ..<=*+ Eor

<=9J is considered satisfactory. In other words, the proportion of long term loans should not be more than <=9 of total funds. A higher ratio indicates a burden of payment of large amount of interest charges periodically and the repayment of large amount of loans at maturity. Aayment of interest may become difficult if profit is reduced. Hence, good concerns keep the debt to total funds ratio below <=9. 3he lower ratio is better from the longGterm sol#ency point of #iew. ' Proprietary Ratio:- 3his ratio indicates the proportion of total funds pro#ide by owners or shareholders. ,ormula*

Signifi an e :- 3his ratio should be 779 or more than that. In other words, the proportion of shareholders funds to total funds should be 779 or more. A higher proprietary ratio is generally treated an indicator of sound financial position from longGterm point of #iew, because it means that the firm is less dependent on external sources of finance. If the ratio is low it indicates that longGterm loans are less secured and they face the risk of losing their money. )' %i3e) Assets to Proprietors %un) Ratio :- 3his ratio is also know as fixed assets to net worth ratio. ,ormula*

Signifi an e :- 3he ratio indicates the extent to which proprietors E:hareholdersJ funds are sunk into fixed assets. Cormally , the purchase of fixed assets should be financed by proprietors funds. If this ratio is less than +..9, it would mean that proprietors fund are more than fixed assets and a part of working capital is pro#ided by the proprietors. 3his will indicate the longGterm financial soundness of business. e' &apital #earing Ratio:- 3his ratio establishes a relationship between equity capital Eincluding all reser#es and undistributed profitsJ and fixed cost bearing capital. ,ormula*

Whereas, ,ixed 0ost !earing 0apital 5 Areference :hare 0apital H 2ebentures H ?ong 3erm ?oan Signifi an e:- If the amount of fixed cost bearing capital is more than the equity share capital including reser#es an undistributed profitsJ, it will be called high capital gearing and if it is less, it will be called low capital gearing. 3he high gearing will be beneficial to equity shareholders when the rate of interest4di#idend payable on fixed cost bearing capital is lower than the rate of return on in#estment in business.

3hus, the main ob)ecti#e of using fixed cost bearing capital is to maximi(e the profits a#ailable to equity shareholders. f' Interest &o+erage Ratio:- 3his ratio is also termed as /2ebt :er#ice %atio. 3his ratio is calculated as follows* ,ormula*

Signifi an e :- 3his ratio indicates how many times the interest charges are co#ered by the profits a#ailable to pay interest charges. 3his ratio measures the margin of safety for longGterm lenders. 3his higher the ratio, more secure the lenders is in respect of payment of interest regularly. If profit )ust equals interest, it is an unsafe position for the lender as well as for the company also , as nothing will be left for shareholders. An interest co#erage ratio of < or = times is considered appropriate. A&TI"ITY RATIO OR T1RNO"$R RATIO
-&. A ti+ity Ratio or Turno+er Ratio :- 3hese ratio are calculated on the bases of /cost of sales or sales, therefore, these ratio are also called as /3urno#er %atio. 3urno#er indicates the speed or number of times the capital employed has been rotated in the process of doing business. Higher turno#er ratio indicates the better use of capital or resources and in turn lead to higher profitability.

It includes the following * a' Sto 2 Turno+er Ratio:- 3his ratio indicates the relationship between the cost of goods during the year and a#erage stock kept during that year. ,ormula*

Here, 0ost of goods sold 5 Cet :ales I Bross Arofit A#erage :tock 5 Dpening :tock H 0losing :tock4Signifi an e:- 3his ratio indicates whether stock has been used or not. It shows the speed with which the stock is rotated into sales or the number of times the stock is turned into sales during the year. 3he higher the ratio, the better it is, since it indicates that stock is selling quickly. In a business where stock turno#er ratio is high, goods can be sold at a low margin of profit and e#en than the profitability may be quit high. ,' !e,tors Turno+er Ratio :- 3his ratio indicates the relationship between credit sales and a#erage debtors during the year * ,ormula*

While calculating this ratio, pro#ision for bad and doubtful debts is not deducted from the debtors, so that it may not gi#e a false impression that debtors are collected quickly. Signifi an e :- 3his ratio indicates the speed with which the amount is collected from debtors. 3he higher the ratio, the better it is, since it indicates that amount from debtors is being collected more quickly. 3he more quickly the debtors pay, the less the risk from badG debts, and so the lower the expenses of collection and increase in the liquidity of the firm. !y comparing the debtors turno#er ratio of the current year with the pre#ious year, it may be assessed whether the sales policy of the management is efficient or not. ' A+erage &olle tion Perio) :- 3his ratio indicates the time with in which the amount is collected from debtors and bills recei#ables. ,ormula*

Here, 0redit :ales per day 5 Cet 0redit :ales of the year 4 7<6 :econd ,ormula *G

A#erage collection period can also be calculated on the bases of /2ebtors 3urno#er %atio. 3he formula will be*

Signifi an e :- 3his ratio shows the time in which the customers are paying for credit sales. A higher debt collection period is thus, an indicates of the inefficiency and negligency on the part of management. Dn the other hand, if there is decrease in debt collection period, it indicates prompt payment by debtors which reduces the chance of bad debts. )' &re)itors Turno+er Ratio :- 3his ratio indicates the relationship between credit purchases and a#erage creditors during the year . ,ormula*G

Note :- If the amount of credit purchase is not gi#en in the question, the ratio may be calculated on the bases of total purchase. Signifi an e :- 3his ratio indicates the speed with which the amount is being paid to creditors. 3he higher the ratio, the better it is, since it will indicate that the creditors are being paid more quickly which increases the credit worthiness of the firm.

). A+erage Payment Perio) :- 3his ratio indicates the period which is normally taken by the firm to make payment to its creditors. ,ormula*G

3his ratio may also be calculated as follows *

Signifi an e :- 3he lower the ratio, the better it is, because a shorter payment period implies that the creditors are being paid rapidly. )' %i3e) Assets Turno+er Ratio :- 3his ratio re#eals how efficiently the fixed assets are being utili(ed. ,ormula*G

Here, Cet ,ixed Assets 5 ,ixed Assets I 2epreciation Signifi an e:- 3his ratio is particular importance in manufacturing concerns where the in#estment in fixed asset

is quit high. 0ompared with the pre#ious year, if there is increase in this ratio, it will indicate that there is better utili(ation of fixed assets. If there is a fall in this ratio, it will show that fixed assets ha#e not been used as efficiently, as they had been used in the pre#ious year. e' 4or2ing &apital Turno+er Ratio :- 3his ratio re#eals how efficiently working capital has been utili(ed in making sales. ,ormula *G

Here, 0ost of Boods :old 5 Dpening :tock H Aurchases H 0arriage H Wages H Dther 2irect ;xpenses G 0losing :tock Working 0apital 5 0urrent Assets I 0urrent ?iabilities Signifi an e :- 3his ratio is of particular importance in nonG manufacturing concerns where current assets play a ma)or role in generating sales. It shows the number of times working capital has been rotated in producing sales. A high working capital turno#er ratio shows efficient use of working capital and quick turno#er of current assets like stock and debtors. A low working capital turno#er ratio indicates underG utilisation of working capital. Profita,ility Ratios or In ome Ratios -!. Profita,ility Ratios or In ome Ratios:- 3he main ob)ect of e#ery business concern is to earn profits. A business must be able to earn adequate profits in relation to

the risk and capital in#ested in it. 3he efficiency and the success of a business can be measured with the help of profitability ratio. Arofitability ratios are calculated to pro#ide answers to the following questions* i. ii. iii. i#. #. Is the firm earning adequate profitsM What is the rate of gross profit and net profit on salesM What is the rate of return on capital employed in the firmM What is the rate EshareholdersJ fundsM of return on proprietors

What is the earning per shareM

Arofitability ratio can be determined on the basis of either sales or in#estment into business. -A. Profita,ility Ratio *ase) on Sales : a. #ross Profit Ratio : 3his ratio shows the relationship between gross profit and sales. ,ormula *

Here, Cet :ales 5 :ales I :ales %eturn Signifi an e:- 3his ratio measures the margin of profit a#ailable on sales. 3he higher the gross profit ratio, the better it is. Co ideal standard is fixed for this ratio, but the gross profit ratio should be adequate enough not only to

co#er the operating expenses but also to pro#ide for deprecation, interest on loans, di#idends and creation of reser#es. ,. Net Profit Ratio:- 3his ratio shows the relationship between net profit and sales. It may be calculated by two methods* ,ormula*