Ratio Analysis Ratio Analysis

Submitted by:- Hardik Baghmar

Liquidity Ratios Leverage Ratios Efficiency Ratios Profitability Ratios

Liquidity Ratios Leverage Ratios Efficiency Ratios Profitability Ratios

A ratio is a numerical relationship between two numbers in financial statements.

A ratio is a numerical relationship between two numbers in financial statements.

Liquidity RatiosLiquidity Ratios

Current Ratio

It is the most popularly used ratio to judge liquidity of a firm. It is defined as the ratio between current assets and current liabilities i.e.

Current Ratio = Current Assets/Current Liabilities

Current Assets include cash, debtors, marketable securities, bills receivable, inventories, loans and advances, and prepaid expenses, while Current Liabilities include loans and advances (taken), creditors, bills payable, accrued expenses and provisions.

Current Ratio

It is the most popularly used ratio to judge liquidity of a firm. It is defined as the ratio between current assets and current liabilities i.e.

Current Ratio = Current Assets/Current Liabilities

Current Assets include cash, debtors, marketable securities, bills receivable, inventories, loans and advances, and prepaid expenses, while Current Liabilities include loans and advances (taken), creditors, bills payable, accrued expenses and provisions.

It measures a firm’s ability to meet short term obligations. The higher the current ratio, the more is the firm’s ability to meet current obligations, and greater is the safety of funds of short term creditors.

A current ratio of 1.5:1 implies that for every one rupee of current liability, current assets of one-and-half rupees are available to meet the obligation

It measures a firm’s ability to meet short term obligations. The higher the current ratio, the more is the firm’s ability to meet current obligations, and greater is the safety of funds of short term creditors.

A current ratio of 1.5:1 implies that for every one rupee of current liability, current assets of one-and-half rupees are available to meet the obligation

Acid Test Ratio/ Quick Ratio

Though a higher current ratio implies the greater short term solvency of the firm, the break up of the current assets is very important to assess the liquidity of a firm. A firm with a large proportion of current assets in the form of cash and accounts receivable is more liquid than a firm with a high proportion of inventories even though two firms might have the same ratio.

Acid Test Ratio/ Quick Ratio

Though a higher current ratio implies the greater short term solvency of the firm, the break up of the current assets is very important to assess the liquidity of a firm. A firm with a large proportion of current assets in the form of cash and accounts receivable is more liquid than a firm with a high proportion of inventories even though two firms might have the same ratio.

A more rigorous way to ascertain a firm's liquidity is found out by acid-test/quick ratio. Inventory and prepaid expenses are excluded from the current assets, leaving only the more liquid assets to be divided by current liabilities. It is found by:

Acid-Test Ratio

= Current Assets - (Inventory + Prepaid Expenses)/Current Liabilities

A more rigorous way to ascertain a firm's liquidity is found out by acid-test/quick ratio. Inventory and prepaid expenses are excluded from the current assets, leaving only the more liquid assets to be divided by current liabilities. It is found by:

Acid-Test Ratio

= Current Assets - (Inventory + Prepaid Expenses)/Current Liabilities

Leverage RatiosLeverage Ratios

Financial Leverage refers to the use of debt finance. Leverage Ratios help in assessing the risk arising from the use of debt capital.

The key ratios in this category are:

Debt-Equity ratio

Debt-Asset Ratio

Interest Coverage Ratio

Financial Leverage refers to the use of debt finance. Leverage Ratios help in assessing the risk arising from the use of debt capital.

The key ratios in this category are:

Debt-Equity ratio

Debt-Asset Ratio

Interest Coverage Ratio

Debt-Equity RatioDebt-Equity Ratio

Shows the relative contributions of creditors and owners

D-E ratio = Debt / Equity

Debt consists of all long term debt. Equity signifies the net worth.

Shows the relative contributions of creditors and owners

D-E ratio = Debt / Equity

Debt consists of all long term debt. Equity signifies the net worth.

Debt Asset RatioDebt Asset Ratio

Measures the extent to which borrowed funds support the firm’s assets.

D-A ratio = Debt (s/t + l/t)/ Assets

Measures the extent to which borrowed funds support the firm’s assets.

D-A ratio = Debt (s/t + l/t)/ Assets

Interest Coverage RatioInterest Coverage Ratio

Also called as the times interest earned ratio:

= PBIT / Interest

Used by lenders to assess a firm’s Debt capacity

Also called as the times interest earned ratio:

= PBIT / Interest

Used by lenders to assess a firm’s Debt capacity

Efficiency RatiosEfficiency Ratios

More popularly known as activity ratios or asset management ratios which help measure how efficiently the assets are employed by a firm under consideration.

Some of the important turnover ratios are:

More popularly known as activity ratios or asset management ratios which help measure how efficiently the assets are employed by a firm under consideration.

Some of the important turnover ratios are:

Inventory Turnover Ratio

It measures how many times a firm's inventory has been sold during a year. It is found by:

Inventory Turnover Ratio = Cost of Goods Sold/Inventory

Inventory Turnover Ratio

It measures how many times a firm's inventory has been sold during a year. It is found by:

Inventory Turnover Ratio = Cost of Goods Sold/Inventory

The higher the ratio, the more efficient the inventory management (i.e. how quickly/fast the inventory is sold. A high ratio is considered good from the view point of liquidity and vice versa.

The higher the ratio, the more efficient the inventory management (i.e. how quickly/fast the inventory is sold. A high ratio is considered good from the view point of liquidity and vice versa.

Debtors’ Turnover

This ratio shows how many times sundry debtors turn over during the year. The higher the ratio, the greater the efficiency of credit management:

= Net Credit Sales / Average Sundry Debtors (receivables)

Debtors’ Turnover

This ratio shows how many times sundry debtors turn over during the year. The higher the ratio, the greater the efficiency of credit management:

= Net Credit Sales / Average Sundry Debtors (receivables)

Average Collection Period

It represents the number of days taken to collect an account. It is defined as:

Average Sundry Debtors (accounts receivable) / Average Daily Credit Sales

Average Collection Period

It represents the number of days taken to collect an account. It is defined as:

Average Sundry Debtors (accounts receivable) / Average Daily Credit Sales

Fixed Asset Turnover

This ratio is used to measure the efficiency with which fixed assets are employed. A high ratio indicates an efficient use of fixed assets.

= Net Sales / Net Fixed Assets

Fixed Asset Turnover

This ratio is used to measure the efficiency with which fixed assets are employed. A high ratio indicates an efficient use of fixed assets.

= Net Sales / Net Fixed Assets

Profitability RatiosProfitability Ratios

Gross Profit Margin : Shows the margin left after meeting manufacturing costs. It measures the efficiency of production as well as pricing.

Net Profit Margin: Shows the earnings left for shareholders as a percentage of net sales.

Gross Profit Margin : Shows the margin left after meeting manufacturing costs. It measures the efficiency of production as well as pricing.

Net Profit Margin: Shows the earnings left for shareholders as a percentage of net sales.

ROA = PAT / Avg total assets

ROE = Equity Earnings / Average Equity

ROA = PAT / Avg total assets

ROE = Equity Earnings / Average Equity