Important Topics:
- Meaning and Objectives of Ratio Analysis
- Advantages and Limitations of Ratio Analysis
- Types of Ratios (Liquidity, Solvency, Activity, Profitability)
- Liquidity Ratios: Current Ratio, Quick Ratio (Acid Test Ratio)
- Solvency Ratios: Debt-Equity Ratio, Debt to Capital Employed Ratio, Proprietary Ratio, Total Assets to Debt Ratio, Interest Coverage Ratio
- Activity (Turnover) Ratios: Inventory Turnover, Trade Receivables Turnover, Trade Payables Turnover, Working Capital Turnover, Fixed Assets Turnover, Capital Employed Turnover
- Profitability Ratios: Gross Profit Ratio, Operating Ratio, Operating Profit Ratio, Net Profit Ratio, Return on Investment (ROI), Return on Shareholders' Funds (RONW), Earnings per Share (EPS), Book Value per Share, Dividend Payout Ratio, Price/Earning Ratio
Meaning of Accounting Ratios
A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage and a number of times. When ratios are calculated on the basis of accounting information, they are called Accounting ratios. Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements.
Objectives of Ratio Analysis
- To know the areas of the business which need more attention.
- To know about the potential areas which can be improved.
- To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business.
- To provide information for inter-firm and intra-firm comparisons.
- To provide information useful for making projections and estimates for the future.
- To provide information for decision making.
Advantages of Ratio Analysis
- Helps to understand efficacy of decisions.
- Simplifies complex accounting figures and establishes relationships.
- Helpful in analyzing the performance of a company.
- Helps in identifying problem areas of business.
- Enables SWOT (Strength, Weakness, Opportunities, Threat) analysis.
- Determines profitability of business.
- Helps in evaluating solvency of business.
- Important tool for forecasting.
- Allows comparisons with other firms, industry standards, etc.
- Assists in trend analysis.
Limitations of Ratio Analysis
- Ignores price-level changes (inflation).
- Ignores qualitative or non-monetary aspects.
- No standard definitions of ratios.
- Different parties may interpret the same ratio differently (personal bias).
- Not the only technique of analysis.
- Based on historical data.
- A single ratio cannot convey much meaning.
- Considers position on a particular date, not over a period.
Types of Ratios
Ratios can be classified in two ways:
i) Traditional Classification (based on financial statements):
- Statement of Profit and Loss Ratios: Both figures from P&L (e.g., Gross Profit Ratio).
- Balance Sheet Ratios: Both figures from Balance Sheet (e.g., Current Ratio).
- Composite Ratios: One figure from P&L and one from Balance Sheet (e.g., Inventory Turnover Ratio).
ii) Functional Classification (based on purpose):
- Liquidity Ratios: Measure short-term solvency (ability to pay short-term debts).
- Solvency Ratios: Measure long-term solvency (ability to pay long-term debts).
- Activity (Turnover) Ratios: Measure efficiency of operations and asset utilisation.
- Profitability Ratios: Measure earning capacity and profitability.
1. Liquidity Ratios
Liquidity ratios measure the firm's ability to meet its current (short-term) obligations. Higher liquidity ratios indicate a greater margin of safety.
a) Current Ratio
Current Ratio = Current Assets / Current Liabilities
Ideal Ratio: 2:1
Current Assets include: Current investments, inventories, trade receivables (debtors, bills receivable), cash and cash equivalents, short-term loans and advances, prepaid expenses, advance tax, accrued income.
Current Liabilities include: Short-term borrowings, trade payables (creditors, bills payable), other current liabilities, short-term provisions.
b) Quick Ratio (Acid-Test Ratio)
Quick Ratio = Quick Assets / Current Liabilities
Ideal Ratio: 1:1
Quick Assets = Current Assets - (Inventories + Prepaid Expenses + Advance Tax). Quick assets are those that can be converted into cash quickly.
2. Solvency Ratios
Solvency ratios measure the firm's ability to meet its long-term obligations (debts). They indicate long-term financial stability.
a) Debt-Equity Ratio
Debt-Equity Ratio = Long-term Debts / Shareholders' Funds (Equity)
Ideal Ratio: 2:1
Long-term Debts include: Long-term borrowings, debentures, long-term provisions.
Shareholders' Funds (Equity) = Share Capital + Reserves and Surplus + Money received against share warrants. Alternatively, Equity = Non-current assets + Working Capital - Non-current liabilities.
b) Debt to Capital Employed Ratio
Debt to Capital Employed Ratio = Long-term Debts / Capital Employed (or Net Assets)
Capital Employed = Shareholders' Funds + Long-term Debts = Total Assets - Current Liabilities.
Significance: Shows the proportion of long-term debt in the total long-term funds of the business.
c) Proprietary Ratio
Proprietary Ratio = Shareholders' Funds / Capital Employed (or Net Assets)
Significance: Indicates the proportion of total assets funded by the owners. A higher ratio is safer for creditors.
d) Total Assets to Debt Ratio
Total Assets to Debt Ratio = Total Assets / Long-term Debts
Significance: Measures the extent to which total assets cover long-term debts. A higher ratio indicates more security for lenders.
e) Interest Coverage Ratio
Interest Coverage Ratio = Net Profit before Interest and Tax (PBIT) / Interest on Long-term Debts
Significance: Measures the number of times interest is covered by profits. A higher ratio indicates greater safety for lenders that interest will be paid on time.
3. Activity (Turnover) Ratios
Activity ratios measure how efficiently a company uses its assets. They indicate the speed of converting assets into sales or cash. These are also called Efficiency Ratios.
a) Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory
Average Inventory = (Opening Inventory + Closing Inventory) / 2
Cost of Revenue from Operations = Sales - Gross Profit (or Opening Inventory + Purchases + Direct Expenses - Closing Inventory).
Significance: Shows how many times inventory is sold and replaced during the year. A higher ratio indicates efficient inventory management. A low ratio may indicate overstocking or obsolete inventory.
b) Trade Receivables Turnover Ratio
Trade Receivables Turnover Ratio = Net Credit Revenue from Operations / Average Trade Receivables
Average Trade Receivables = (Opening Debtors + Bills Receivable + Closing Debtors + Bills Receivable) / 2
Average Collection Period = (Number of days in a year) / Trade Receivables Turnover Ratio
Significance: Indicates how quickly a company collects cash from its credit sales. A higher ratio means faster collection.
c) Trade Payables Turnover Ratio
Trade Payables Turnover Ratio = Net Credit Purchases / Average Trade Payables
Average Trade Payables = (Opening Creditors + Bills Payable + Closing Creditors + Bills Payable) / 2
Average Payment Period = (Number of days in a year) / Trade Payables Turnover Ratio
Significance: Indicates how quickly a company pays its suppliers. A lower ratio might mean slower payment, which could affect creditworthiness.
d) Working Capital Turnover Ratio
Working Capital Turnover Ratio = Net Revenue from Operations / Working Capital
Working Capital = Current Assets - Current Liabilities
Significance: Shows how efficiently working capital is used to generate sales. A higher ratio indicates better utilisation.
e) Fixed Assets Turnover Ratio
Fixed Assets Turnover Ratio = Net Revenue from Operations / Net Fixed Assets
Significance: Shows how efficiently fixed assets are used to generate sales.
f) Capital Employed (Net Assets) Turnover Ratio
Capital Employed Turnover Ratio = Net Revenue from Operations / Capital Employed
Significance: Shows how efficiently the total long-term funds are used to generate sales.
4. Profitability Ratios
Profitability ratios measure the company's ability to generate earnings relative to sales, assets, and equity.
a) Gross Profit Ratio
Gross Profit Ratio = (Gross Profit / Net Revenue from Operations) × 100
Significance: Indicates the margin available to cover operating expenses and generate profit. A higher ratio is generally better.
b) Net Profit Ratio
Net Profit Ratio = (Net Profit after Tax / Net Revenue from Operations) × 100
Significance: Shows the overall profitability after all expenses and taxes. Reflects the efficiency of the entire business.
c) Operating Ratio
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses) / Net Revenue from Operations × 100
Operating Expenses include: Office, administrative, selling, distribution expenses, depreciation, employee benefits, etc.
Significance: Indicates the proportion of sales consumed by operating costs. A lower operating ratio is a sign of operational efficiency.
d) Operating Profit Ratio
Operating Profit Ratio = (Operating Profit / Net Revenue from Operations) × 100
Operating Profit = Revenue from Operations - Operating Cost = Net Sales - (Cost of Goods Sold + Operating Expenses).
Alternatively, Operating Profit Ratio = 100 - Operating Ratio.
e) Return on Investment (ROI) or Return on Capital Employed (ROCE)
ROI = (Profit before Interest and Tax (PBIT) / Capital Employed) × 100
Significance: Measures the overall efficiency with which capital is used in the business. It is a key measure of profitability and performance.
f) Return on Shareholders' Funds (Return on Net Worth - RONW)
Return on Shareholders' Funds = (Profit after Tax / Shareholders' Funds) × 100
Significance: Measures the return earned on the owners' investment. Important from the shareholders' perspective.
g) Earnings per Share (EPS)
EPS = (Profit after Tax - Preference Dividend) / Number of Equity Shares
Significance: Shows the profit earned per equity share. A key metric for investors and stock market valuation.
h) Book Value per Share
Book Value per Share = Equity Shareholders' Funds / Number of Equity Shares
Equity Shareholders' Funds = Shareholders' Funds - Preference Share Capital.
Significance: Indicates the value of each share based on the company's books. Can be compared with market price.
i) Dividend Payout Ratio
Dividend Payout Ratio = (Dividend per Share / Earnings per Share) × 100
Significance: Shows the proportion of earnings distributed as dividends to shareholders. Reflects the company's dividend policy.
j) Price/Earning Ratio (P/E Ratio)
P/E Ratio = Market Price per Share / Earnings per Share
Significance: Reflects investors' expectations about the company's future growth. A high P/E may indicate high growth expectations.
പ്രധാന പാഠഭാഗങ്ങൾ (മലയാളത്തിൽ):
- അനുപാത വിശകലനത്തിന്റെ അർത്ഥവും ലക്ഷ്യങ്ങളും
- അനുപാത വിശകലനത്തിന്റെ ഗുണങ്ങളും പരിമിതികളും
- അനുപാതങ്ങളുടെ തരങ്ങൾ (ലിക്വിഡിറ്റി, സോൾവൻസി, ആക്റ്റിവിറ്റി, പ്രോഫിറ്റബിലിറ്റി)
- ലിക്വിഡിറ്റി അനുപാതങ്ങൾ: കറന്റ് റേഷ്യോ, ക്വിക്ക് റേഷ്യോ
- സോൾവൻസി അനുപാതങ്ങൾ: ഡെറ്റ്-ഇക്വിറ്റി റേഷ്യോ, പ്രൊപ്രൈറ്ററി റേഷ്യോ, പലിശ കവറേജ് റേഷ്യോ
- ആക്റ്റിവിറ്റി അനുപാതങ്ങൾ: ഇൻവെന്ററി ടേണോവർ, ട്രേഡ് റിസീവബിൾസ് ടേണോവർ, വർക്കിംഗ് ക്യാപിറ്റൽ ടേണോവർ
- പ്രോഫിറ്റബിലിറ്റി അനുപാതങ്ങൾ: ഗ്രോസ് പ്രോഫിറ്റ് റേഷ്യോ, നെറ്റ് പ്രോഫിറ്റ് റേഷ്യോ, ഓപ്പറേറ്റിംഗ് റേഷ്യോ, റിട്ടേൺ ഓൺ ഇൻവെസ്റ്റ്മെന്റ് (ROI), എണ്ണിംഗ് പെർ ഷെയർ (EPS), പ്രൈസ്/എണ്ണിംഗ് (P/E) റേഷ്യോ
Important Exam Questions
Very Short Answer Type (1 Mark)
- Name the concept of financial management which increases the return to equity shareholders due to the presence of fixed financial charges. (From Ch.9)
- Write the term that denotes the mix between owners fund and borrowed fund. (2022 Mar)
- Give the full form of RoI. (2024 Mar)
- What is meant by capital structure? (From Ch.9)
Short Answer Type (2/3/4 Marks)
- What do you mean by Ratio Analysis?
- What are various types of ratios? (Based on functional classification)
- What relationships will be established to study: (a) Inventory turnover (b) Trade receivables turnover (c) Trade payables turnover (d) Working capital turnover
- The liquidity of a business firm is measured by its ability to satisfy its long-term obligations as they become due. What are the ratios used for this purpose? (Correct the statement: should be short-term obligations for liquidity ratios)
- Explain the importance of current and liquid ratio.
- How would you study the Solvency position of the firm?
- What are various profitability ratios? How are these worked out?
- Calculate current ratio from the following: Total Assets ₹15,00,000; Non-current Liabilities ₹6,00,000; Shareholders' Funds ₹7,00,000; Non-current Assets ₹10,00,000. (Based on Illustration 5)
- Current ratio of a company is 4.5:1 and quick ratio is 3:1. If inventory is ₹36,000, calculate current assets and current liabilities. (Based on Question 4 from Numerical Questions)
Long Answer Type (5/6/8 Marks)
- Explain the advantages and limitations of ratio analysis.
- What are liquidity ratios? Discuss the importance of current and liquid ratio.
- How would you study the Solvency position of the firm? Explain the various solvency ratios.
- What are various profitability ratios? How are these worked out? Explain with formulas and significance.
- From the following information, calculate: (i) Current Ratio (ii) Liquid Ratio (iii) Debt-Equity Ratio (iv) Interest Coverage Ratio (v) Inventory Turnover Ratio. (Refer to Illustration 25 in textbook)
- From the following Balance Sheet and other information, calculate: (i) Debt-Equity Ratio (ii) Working Capital Turnover Ratio (iii) Trade Receivables Turnover Ratio. (Refer to Question 17 in textbook)
- From the following details, calculate Return on Investment (ROI), Earnings per Share (EPS), Book Value per Share, and P/E Ratio. (Refer to Illustration 22 in textbook)
| Ratio | Formula | Ideal / Significance |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | 2:1 – Measures short-term solvency |
| Quick Ratio (Acid Test) | (Current Assets - Inventories - Prepaids) / Current Liabilities | 1:1 – Strict measure of liquidity |
| Debt-Equity Ratio | Long-term Debts / Shareholders' Funds | 2:1 – Measures long-term financial leverage |
| Interest Coverage Ratio | PBIT / Interest on Long-term Debt | Higher is better – Safety of interest payments |
| Inventory Turnover Ratio | Cost of Revenue from Operations / Average Inventory | Higher is better – Efficiency of inventory management |
| Trade Receivables Turnover | Net Credit Sales / Average Trade Receivables | Higher is better – Efficiency of collection |
| Gross Profit Ratio | (Gross Profit / Net Sales) × 100 | Higher is better – Profitability on sales |
| Net Profit Ratio | (Net Profit after Tax / Net Sales) × 100 | Higher is better – Overall profitability |
| Return on Investment (ROI) | (PBIT / Capital Employed) × 100 | Higher is better – Efficiency of capital use |
| Earnings per Share (EPS) | (PAT - Pref. Dividend) / No. of Equity Shares | Higher is better – Profit per share |
| Price/Earning Ratio (P/E) | Market Price per Share / EPS | Reflects market expectations |