UNIT-V

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 Accountant’s Handbook by Wixon, Kell and Bedford, “a ratio is an

expression of the quantitative relationship between two numbers”.

In the words of kennedy and mcmullen, “the relationship of one item to another expressed
in simple mathematical form is known as a ratio”.

A ratio may be expressed either in proportion or as rate as percentage. A ratio may take the
form of proportion. Here the figures of the two items used for computing the ratio or expressed in
common denominator. Example are current ratio = 5: 3 acid test ratio 1.3:1 etc.
Ratio analysis is the process of determining and presenting the relationship of items and
group of items in the statements. It is helpful to know about the liquidity, solvency, capital structure
and profitability of an organization.It is helpful tool to aid in applying judgment, otherwise
complex situations.
MANAGERIAL USE OF RATIO ANALYSIS:

 Ratio analysis helps in decision making from the information provided in these financial
statements.
 Ratios enable the financial analyst to summarize and simplify the voluminous financial data.
 The trend ratios enable the analyst to find out whether the firm has been improving its
performance or not over the year.
 Ratios are helpful in identifying the problem areas of firm and this will make the
management to take necessary corrective measures to improve the results in future.
 Ratio analysis helps to formulate policies for future including the capital expense decisions.
 Ratio analysis is important tools for both minimizing costs and maximizing revenues &
profits.

ADAVANTAGES OF RATIO ANALYSIS:

1. Helpful in analysis of Financial Statements.

2. Helpful in comparative Study.
3. Helpful in locating the weak spots of the business.
4. Helpful in Forecasting.
5. Estimate about the trend of the business.
6. Fixation of ideal Standards.
7. Effective Control.
8. Study of Financial Soundness.
LIMITATIONS OF RATIO ANALYSIS
1. Comparison not possible if different firms adopt different accounting policies.
2. Ratio analysis becomes less effective due to price level changes.
3. Ratio may be misleading in the absence of absolute data.
4. Limited use of a single data.
 5. Lack of proper standards.
6. False accounting data gives false ratio.
7. Ratios alone are not adequate for proper conclusions.
8. Effect of personal ability and bias of the analyst.

CLASSIFICATION OF RATIOS:
I. Liquidity Ratios
II. Profitability Ratios
III. Turnover Ratios
IV. Capital structure Ratios

I-LIQUIDITY RATIOS

Liquidity ratios measure the short term solvency of financial position of a firm. These ratios are
calculated to comment upon the short term paying capacity of a concern or the firm's ability to meet
its current obligations. Following are the most important liquidity ratios.

1. CURRENT RATIO:
Definition: Current ratio may be defined as the relationship between current assets and current
liabilities. This ratio is also known as "working capital ratio". It is a measure of general liquidity
and is most widely used to make the analysis for short term financial position or liquidity of a firm.
It is calculated by dividing the total of the current assets by total of the current liabilities.
Components:
The two basic components of this ratio are current assets and current liabilities. Current
assets include cash and those assets which can be easily converted into cash within a short period
of time, generally, one year.
Current Assets include Cash in hand, Cash at bank, marketable (short term) securities or readily
realizable investments, bills receivables or accounts receivable, sundry debtors, (excluding bad
debts or provisions), inventories (closing stock), work in progress, and prepaid expenses.
Current liabilities are those obligations which are payable within a short period of time generally
one year and include outstanding expenses, bills payable, sundry creditors, bank overdraft, accrued
expenses, short term advances, income tax payable, dividend payable, etc.
Current Ratio = Current Assets / Current Liabilities
Significance: Significance - It indicates the strength of working capital and measures short term
solvency of the business. It reflects the ability of business to pay its short term liabilities.
Standard: ratio equal to or near 2:1 is considered as a standard or normal or satisfactory.
2. QUICK RATIO:
Quick ratio is a measurement of a firm’s ability to convert its current assets quickly into cash in
order to meet its current liabilities. It is a measure of judging the immediate ability of the firm to
pay-off its current obligations. It is calculated by dividing the quick assets by current liabilities.
Quick Ratio = Quick Assets / Current Liabilities
Quick Assets = Current Assets-(closing stock + prepaid expenses)
Significance: It helps to know the immediate short term liabilities and abilities of business to pay
them.
Standard: Normally, 1:1 is the standard quick ratio which means quick assets must be at least
equal to quick liabilities.
II. TURNOVER RATIOS (ACTIVITY RATIOS)

Turnover ratios also referred to as activity ratios are concerned with measuring the efficiency in
asset management. Sometimes, these ratios are also called as efficiency ratios or asset utilization
ratios. These ratios reflect the speed and rapidity with which assets are converted into sales.The
greater the rate of turnover or conversion, the more efficient the utilization or management.

1. INVENTORY TURNOVER RATIO (ITR):

The ITR, also known as stock turnover ratio establishes the relationship between costs of
goods sold and average inventory. This ratio indicates whether investment in inventory is within
proper limit or not. In the words of S.C.Kuchal, “this relationship expresses the frequency with
which average level of inventory investment is turned over through operations”.
Cost of goods sold
Inventory Turnover Ratio (ITR) = -------------------------
Average stock
Cost of goods sold = Sales-Gross Profit
Average stock = (Opening stock + closing Stock)/2
*Inventory Holding Period = 365days/ITR

2. DEBTORS TURNOVER RATIO:

Receivables or debtors turnover ratio shows how quickly receivables or debtors are
converted into cash. In other words, the debtor’s turnover ratio is a test of the liquidity of the
debtors of a firm. The debtor’s turnover shows the relationship between credit sales and debtors of
a firm. Thus,
Credit Sales
Debtors Turnover Ratio = ---------------------
Average Debtors

Credit sales = Total credit sales – Sales returns

Average Debtors = (Opening debtors + Closing debtors)/2
*Debt Collection Period=365days/Debtors Turnover Ratio

III.PROFITABILITY RATIOS

Profitability ratios measure the results of business operations or overall performance and
effectiveness of the firm. Some of the most popular profitability ratios are as under:

1. GROSS PROFIT RATIO (GP Ratio):

Definition:
 Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed as a
percentage. It expresses the relationship between gross profit and sales.
Gross Profit Ratio = (Gross profit / Net sales) × 100
Significance: Gross profit ratio may be indicated to what extent the selling prices of goods per unit
may be reduced without incurring losses on operations. It reflects efficiency with which a firm
produces its products.
Standard: Higher the ratio the better the performance is.

2. NET PROFIT RATIO (NP Ratio):

Definition: Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed as
percentage. The two basic components of the net profit ratio are the net profit and sales.
Net Profit Ratio = (Net profit / Net sales) × 100
Significance: NP ratio is used to measure the overall profitability of the business.
Standard: Higher the ratio the better the performance is.

3. OPERATING RATIO:
Definition:
Operating ratio is the ratio of cost of goods sold plus operating expenses to net sales. It is
generally expressed in percentage.
Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100
Operating expenses = Office & Administrative expenses + Selling & Distribution expenses
Significance: Operating ratio shows the operational efficiency of the business. Lower operating
ratio shows higher operating profit and vice versa.
Standard: An operating ratio ranging between 75% and 80% is generally considered as standard
for manufacturing concerns.

4. EARNINGS PER SHARE :(EPS)

It shows earning per equity share, whether or not company declares dividend.
Earnings per share = (Net Profit after Tax – Preference Dividend)/Number of Equity Shares

Significance - Higher ratio signifies better utilization of funds available and the company may pay
dividend at a higher rate in future. Higher ratio indicates higher overall profitability and effective
utilization of equity capital.
Example:

Net Profit after Tax Rs.2,25,000

8% Preference Share Capital Rs.2,00,000
Paid up Equity Share Capital Rs.10,00,000
(Rs. 100/- each)
Earnings per Share =(Net Profit after Tax – Preference dividend)/No. of Equity Share
No. of Equity Shares = Share Capital/Face Value per Share
10,00,000/100 = 10,000 Shares
EPS = 2,25,000 – (8%of 2,00,000)/10,000
2,25,000 – 16,000/10,000
2,09,000/10,000
EPS = Rs. 20.90

5. PRICE EARNINGS (P/E) RATIO

It brings out the relationship between market price per share and earnings per share.

Price Earnings Ratio = Market Price Per share / Earnings per Share

Market price of one share is value of one share in the market.

Significance - It indicates the relationship between market price of share and current earnings
per share. It also helps in determining the future value of the share.

Example:
Net Profit after Tax Rs.3,25,000
7% Preference Share Capital Rs.2,00,000
Paid up Equity Share Capital of Rs. 100 per share Rs.10,00,000
Market Price per share Rs.210/-
Earnings per Share = Net Profit after Tax – Preference dividend/No. of Equity Shares
No. of Equity Shares = 10,00,000/100 = 10,000 Shares
EPS = 3,25,000 – 14,000/10,000 = 31.10
Price Earnings Ratio= 210/31.10 = 6.75

IV. CAPITAL STRUCTURE RATIOS OR LEVERAGE RATIOS:

1. DEBT-EQUITY RATIO:

The debt-equity ratio is determined to ascertain the soundness of the long-term financial policies of
the company. This ratio indicates the proportion between the shareholders’ funds (i.e. Tangible net
worth) and the total borrowed funds. Ideal ratio is 1. In other words, the investor may take debt
equity ratio as quite satisfactory if shareholders’ funds are equal to borrowed funds.
Debt
Debt-equity ratio = -----------
Equity
Debt (Outsiders Funds) = debentures, bonds, long-term loans, and so on.
Equity (Insiders funds) = Share capital (equity & Preference), reserves, retained earnings & so on.
2. INTEREST COVERAGE RATIO:
This ratio measures the debt servicing capacity of a firm in so far as fixed interest on long-term
loan is concerned. It is determined by dividing the operating profits or earnings before interest and
taxes (EBIT) by the fixed interest charges on loans. Thus,

EBIT
Interest Coverage = -----------------------------
 Fixed Interest Charge

Q. The following is the Balance Sheet of XYZ Ltd as on 31.12.2000

LIABILITIES AMOUNT ASSETS AMOUNT
Preference Share Capital 1,00,000 Land & Buildings 2,00,000
Equity Share Capital 1,50,000 Plant & Machinery 2,00,000
General Reserve 1,50,000 Furniture & Fixtures 1,00,000
Debentures @ 10% 3,00,000 Closing Stock 2,50,000
Creditors 2,00,000 Debtors 1,00,000
Bills Payable 1,50,000 Cash at Bank 2,50,000
Outstanding Expenses 50,000 Cash in Hand 1,25,000
P&L A/c (Net Profit) 1,00,000 Prepaid Expenses 50,000
Bank Loan @ 5% (Long term) 2,00,000 Marketable Securities 1,25,000
Total: 14,00,000 Total: 14,00,000
Earnings Before Interest and Tax (EBIT) Rs. 3,20,000
Calculate Liquidity Ratios and Capital Structure Ratios.
Sol:
LIQUIDITY RATIOS:
a. CURRENT RATIO:

CURRENT RATIO = CURRENT ASSEST

CURRENT LIABILITIES
Current Assets = 2,50,000 + 1,00,000 + 2,50,000 + 1,25,000 + 50,000 +1,25,000 = 9,00,000
Current Liabilities = 2, 00,000 + 1,50,000 + 50,000 = 4,00,000
CURRENT RATIO = 9,00,000/4,00,000
= 2.25 or 2.25 : 1
Comment: Standard Current Ratio is 2:1 Current Ratio of 2.25 : 1 near to the standard. It is good.

b. QUICK RATIO:
QUICK RATIO = QUICK ASSEST
CURRENT LIABILITIES
Quick Assets = Current Assets – (Closing Stock & Prepaid Expenses)
= 9,00,000 - (2,50,000 + 50,000) = 6,00,000
QUICK RATIO = 6,00,000 / 4,00,000
= 1.5 or 1.5:1
Comment: Standard Quick Ratio is 1:1.Quick Ratio of 1.5:1 is near to the standard. It is
satisfactory.

CAPITAL STRUCTURE RATIOS OR LEVERAGE RATIOS:

1. DEBT-EQUITYRATIO:

Debt
Debt-equity ratio = -----------
Equity
Debt (Outsiders Funds) = debentures, bonds, long-term loans, and so on.
Equity (Insiders funds) = Share capital (equity & Preference), reserves, retained earnings & so on.
Debt = 3,00,000 + 2,00,000 = 5,00,000
Equity = 1,00,000 + 1,50,000 + 1,50,000 + 1,00,000 = 5,00,000
DEBT-EQUITY RATIO = 5,00,000/5,00,000
= 1 or 1:1
 Comment: Standard Debt-Equity 1:1. Debt Equity Ratio of 1:1 is equal to standard and considered
satisfactory.
2. INTEREST COVERAGE RATIO:
EBIT
Interest Coverage = -----------------------------
Fixed Interest Charge

3,20,000
Interest Coverage = -----------------------------
(3,00,000*10% + 2,00,000*5%)

3,20,000
Interest Coverage = ----------------------------- = 8 or 8 Times
40,000

Q. Suppose net sales are 50,000 for a firm and Cost of Goods Sold (COGS) is Rs 20,000. The details of
expenses are as given below:
Administration Expenses 3,000
Selling & Distribution Expenses 4,000
Loss on sale of fixed asset 3,000
Interest on investment 2,000
Tax rate @ 20%
Calculate Gross profit ratio, Net profit ratio and Operating expenses ratio.

Sol:
PROFITABILITY RATIOS:
Calculation of Gross profit & Net profit:
Net Sales 50,000
- Cost of Goods Sold 20,000
Gross Profit = 30,000
- Administration Expenses 3,000
Selling & Distribution Expenses 4,000 7,000
Operating Profit 23,000
- Non Operating Exp. Loss on sale of Fixed asset 3,000
20,000
+ Non operating Profit Interest on investment 4,000
Net Profit 24,000
1. GROSS PROFIT RATIO (GP Ratio):
Net sales = Total sale minus sales returns. = 50,000
Gross profit = Net sales minus cost of goods sold. = (50,000 – 20,000) = 30,000
Cost of goods sold = (Opening stock + purchases (raw materials) + wages, direct expenses and all
manufacturing expenses) minus (closing stock).
Gross Profit Ratio = (Gross profit / Net sales) × 100 = (30,000/50,000) * 100 = 60%
Standard: Higher the ratio the better the performance is.
2. NET PROFIT RATIO (NP Ratio):
Net Profit Ratio = (Net profit / Net sales) × 100
= (24,000/50000) * 100 48%
Standard: Higher the ratio the better the performance is.
3. OPERATING RATIO:
Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100
Operating expenses = Office & Administrative expenses + Selling & Distribution expenses
= ( 20,000 + 7,000) = 27,000
= (27,000/50,000) * 100 = 54%
Standard: An operating ratio ranging between 75% and 80% is generally considered as standard
for manufacturing concerns.
4. EARNINGS PER SHARE: (EPS)
It shows earning per equity share, whether or not company declares dividend.
Earnings per share = (Net Profit after Tax – Preference Dividend)/Number of Equity
Shares
Significance - Higher ratio signifies better utilization of funds available and the company may pay
dividend at a higher rate in future. Higher ratio indicates higher overall profitability and
effective utilization of equity capital.

Example:

Net Profit after Tax Rs.2,25,000

8% Preference Share Capital Rs.2,00,000
Paid up Equity Share Capital Rs.10,00,000
(Rs. 100/- each)
Earnings per Share =(Net Profit after Tax – Preference dividend)/No. of Equity Share
No. of Equity Shares = Share Capital/Face Value per Share
10,00,000/100 = 10,000 Shares
EPS = 2,25,000 – (8%of 2,00,000)/10,000
2,25,000 – 16,000/10,000
2,09,000/10,000
EPS = Rs. 20.90

5. PRICE EARNINGS (P/E) Ratio

It brings out the relationship between market price per share and earnings per share.
Price Earnings Ratio = Market Price Per share / Earnings per Share
Market price of one share is value of one share in the market.
Significance - It indicates the relationship between market price of share and current earnings
per share. It also helps in determining the future value of the share.

Example:
Net Profit after Tax Rs.3,25,000
7% Preference Share Capital Rs.2,00,000
Paid up Equity Share Capital of Rs. 100 per share Rs.10,00,000
Market Price per share Rs.210/-
Earnings per Share = Net Profit after Tax – Preference dividend/No. of Equity Shares
No. of Equity Shares = 10,00,000/100 = 10,000 Shares
EPS = 3,25,000 – 14,000/10,000 = 31.10
 Price Earnings Ratio = 210/31.10 = 6.75 Times
Q. A firm sold Goods worth Rs 5,00,000, out of which 60% sales were on credit basis. Its Gross Profit
ratio is 20%. The inventory at the beginning of the year was 26,000 and at the end of the year was
24,000; the balance of debtors at the beginning and end of the year ware 25,000 and 15,000
respectively. Calculate Turnover ratios.
TURNOVER RATIOS (ACTIVITY RATIOS)

Sol: 1. INVENTORY TURNOVER RATIO (ITR):

Cost of goods sold
Stock turnover Ratio (ITR) = -------------------------
Average stock
Cost of goods sold = Opening stock + Purchases + Direct expenses - closing stock
Cost of goods sold = Sales – Gross Profit
= ((5,00,000 – (5,00,000*20%)) = (5,00,000-1,00,000) = 4,00,000
Average stock = (Opening stock + closing Stock)/2 = (26,000+24,000)/2 = 25,000
= 4,00,000/25,000 = 16 Times
2. INVENTORY HOLDIING PERIOD = 365days/ITR = 365/16 = 22.8 or 23days

3. DEBTORS TURNOVER RATIO:

Net Credit Sales
Debtors Turnover Ratio = ---------------------
Average Debtors

Net credit sales = Total credit sales – sales returns = (5,00,000*60%) = 3,00,000
Average Debtors = (Opening debtors + Closing debtors)/2 = (25,000+15,000)/2 = 20,000
= 3,00,000/20,000 = 15 Times
4. AVERAGE(DEBTOR) COLLECTION PERIOD:
Average Collection Period = Days in Year 365 / Debtors Turnover = 365/15 = 24 days

Fund Flow Statement:

Meaning of Fund Flow Statement:
A fund flow statement is a statement in summary form that indicates changes in terms of financial
position between two different balance sheet dates showing clearly the different sources from
which funds are obtained and uses to which funds are put.
It summarizes the financing and investing activities of the enterprise during an accounting period.
By depicting all inflows and outflows of fund, the statement shows their net impact on working
capital of the firm.
If the total of inflows is greater than the outflows, the excess goes to increase in working capital. If
there is deficit of funds during a particular accounting period, the working capital is impaired. So
fund flow statement is an important tool for working capital management.
Roy A. Fouke defines fund flow statement as “a statement of sources and application of funds is
a technical device designed to analyse the changes in the financial condition of a business
enterprise between two dates.”

According to R. N. Anthony:

“The funds flow statement describes the sources from which additional funds were derived and the
uses to which these funds were put.”

Objective and importance of funds flow statement

1. To explain the changes in financial position

2. To analyze the operational position

3. To help in proper allocation of resources

4. To evaluate financial position

5. To act as future guide

Preparation of Fund Flow Statement:

The fund flow analysis involves the preparation of two statements:

1. Statement or Schedule of Changes in Working Capital:

The primary purpose of a fund flow statement is to explain the net change in working capital, it will
be better to prepare first the schedule of changes in working capital before preparing a fund flow
statement.
The Schedule or Statement of changes in working capital is a statement that compares the change in
the amount of current assets and current liabilities on two balance sheet dates and highlights its
impact on working capital.

The format of this statement is:

2. Fund Flow Statement:
After preparing the schedule of changes in working capital, the next step is to prepare the Fund
Flow Statement to find out the different sources and applications of funds. While preparing this
statement the emphasis is given on the changes in the fixed assets and fixed liabilities. The
statement may be prepared either in ‘T form’ or in ‘Vertical form’.

A proforma of each of them is given:

 Cash Flow Statement
Meaning of Cash Flow Statement:

A cash flow statement is a statement of changes in the financial position of a firm on cash basis.
It reveals the net effects of all business transactions of a firm during a period on cash and explains
the reasons of changes in cash position between two balance sheet dates.

It shows the various sources (i.e., inflows) and applications (i.e., outflows) of cash during a
particular period and their net impact on the cash balance.

According to Khan and Jain:

“Cash Flow statements are statements of changes in financial position prepared on the basis of
funds defined as cash or cash equivalents.”

The Institute of Cost and Works Accountants of India defines Cash Flow statement as “a statement
setting out the flow of cash under distinct heads of sources of funds and their utilisation to
determine the requirements of cash during the given period and to prepare for its adequate
provision.”

Features of Cash Flow Statement:

The features or characteristics of Cash Flow Statement may be summarised in the following way:

1. It is a periodical statement as it covers a particular period of time, Day, month or year.

2. It shows movement of cash in between two balance sheet dates.

3. It establishes the relationship between net profit and changes in cash position of the firm.

4. It does not involve matching of cost against revenue.

5. It shows the sources and application of funds during a particular period of time.

6. It records the changes in fixed assets as well as current assets.

7. A projected cash flow statement is referred to as cash budget.

8. It is an indicator of cash earning capacity of the firm.

9. It reflects clearly how financial position of a firm changes over a period of time due to its
operating activities, investing activities and financing activities.

Objectives of Cash Flow Statement:

Cash Flow Statement is prepared to fulfill some objectives.

Some of the main objectives of Cash Flow Statement are:

(a) Measurement of Cash

(b) Generating Inflow of Cash

(c) Classification of Activities

(d) Prediction of Future

(e) Assessing Liquidity and Solvency Position

(f) Evaluation of Future Cash Flows

(g) Supply Necessary Information to the Users:

(h) Helps the Management to Ascertain Cash Planning

Advantages:

1. Evaluation of Cash Position

2. Planning and Control

3. Performance Evaluation

4. Framing Long-term Planning

5. Capital Budgeting Decision:

6. Liquidity Position

7. Answers to Different Questions

Limitations of Cash Flow Statement

1. Since cash flow statement does not consider non-cash items, it cannot reveal the actual net
income of the business.

2. Cash flow statement cannot replace fund flow statement or income statement. Each of them has a
separate function to perform which cannot be done by the cash flow statement.

3. The cash balance as disclosed by the projected cash flow statement may not represent the real
liquid position of the business since it can be easily influenced by the managerial decisions, by
making certain payments in advance.

4. It cannot be used for the purpose of comparison over a period of time. A company is not better
off in the current year than the previous year because its cash flow has increased.

5. It is not helpful in measuring the economic efficiency in certain cases e.g., public utility service
where generally heavy capital expenditure is involved.

Four Key Steps to Preparing the Statement of Cash Flows

 The four steps required to prepare the statement of cash flows are described as follows:

Step 1. Prepare the operating activities section by converting net income from an accrual
basis to a cash basis.
Step 2. Prepare the investing activities section by presenting cash activities for noncurrent
assets.
Step 3. Prepare the financing activities section by presenting cash activities for noncurrent
liabilities and owners’ equity.
Step 4. Reconcile the change in cash from the beginning of the period to the end of the
period.