7/29/2019 Ratio Analysis and its types

1/9

RATIO ANALYSIS

Introduction:

Analysis and interpretation of financial statements with the help of

ratios is termed as ratio analysis. Ratio analysis involves the process of

computing determining and presenting the relationship of items or groups of

items of financial statements.

Ratio analysis was pioneered by alexander wall who presented a system

of ratio analysis in the year 1909. Alexanders contention was that interpretation

of financial statements can be made easier by establishing quantitive

relationships between various items of financial statements.

Meaning of ratio:

A ratio is a mathematical relationship between two items expressed in a

quantitative form.

Meaning of ratio analysis:

Ratio analysis is an age old technique of financial analysis. It is the

process of determining and presenting the relationship of items and groups of

items in the financial statements. The information provided by the financial

statements in absolute form is historical and static, conveying very little

meaning to the users. Accounting ratios are designed to show how one number

is related to another and the meaning of such relationships. A ratio is worked out

by another number. Accounting ratios measures and indicate efficiency of an

enterprise in all aspects.

7/29/2019 Ratio Analysis and its types

2/9

Profitability ratios:

Profit making is the main objective of business. Aim of every business

concern is to earn maximum profits in absolute terms and also in relative terms.

Profit is to be maximum in terms of risk undertaken and capital employed.

Ability to make maximum profit from optimum utilisation of resources by a

business concern is termed as profitability. Profit is an absolute measure of

earning capacity. Profitability depends on sales, costs and utilisation of

resources. The following are various ratios used to analyse profitability.

Return on investment or overall profitability ratio Gross profit ratio Operating ratio Operating profit ratioNet profit ratio

Return on investment:

Return on investment is used to measure the operational and managerial

efficiency. A comparison of ROI with that of similar firms, with that of industry

and with past ratio will be helpful in determining how efficiency the long-term

funds of owners and creditors being put into use. Higher the ratio, the more

efficient is the use of the capital employed.

R.O.I= operating profit X100

Capital employed

Gross profit ratio:

This ratio is also known as gross margin or trading margin ratio. Gross

profit ratio indicates the difference between sales and direct costs. Gross profit

ratio and net sales.

7/29/2019 Ratio Analysis and its types

3/9

Gross profit ratio= gross profit X 100

Net sales

Operating ratio:

Operating ratio measures the amount of expenditure incurred in

production sales and distribution of output. It indicates operational efficiency of

the concern. Lower the ratio more is the efficiency. The ratio should be low

enough to provide fair returns to the shareholders and other investors.

Operating ratio= cost of sales + operating expenses X100

Net sales

Operating profit ratio:

It is the ratio of profit made from operating sources to the sales, usually

shown as percentage. It shows the operational efficiency of the firm and is a

measure of the managements efficiency in running the routine operations of the

firm.

Operating profit ratio= operating profit X 100

Sales

Net profit ratio:

This ratio is also called net profit to sales ratio. It is a measure of

managements efficiency in operating the business successfully from the

owners point of view. It indicates the return on shareholders investments.

Higher the ratio better is the operational efficiency of the business concern.

Net profit ratio= net profit after tax X100

Net sales

7/29/2019 Ratio Analysis and its types

4/9

Turnover ratios or activity ratios:

These ratios are also called performance ratios. Activity ratios highlight

the operational efficiency of the business concern. The term operational

efficiency refers to effective, profitable and rational use of resources available to

the concern. In order to examine the judicious utilisation of resource as well as

the wisdom and farsightedness in observing the financial policies laid down in

this regard, certain ratios are computed and they are collectively called turnover

or activity or performance ratios. Following are various activity ratios.

Inventory or stock turnover ratio Debtors turnover ratio Working capital turnover ratio Fixed assets turnover ratio

Inventory or stock turnover ratio:

This ratio is also called stock velocity ratio. It is calculated to ascertain

the efficiency of inventory management in terms of capital investment. It shows

the relationships between the sales and the amount of average inventory. This

ratio is helpful in evaluating and review of inventory policy. It indicates the

number of times the inventory is turned over during a particular accounting

period.

Stock turnover ratio= Net sales

Average inventory cost

Debtors turnover ratio:

Debtors turnover ratio is also called as receivables turnover ratio or

debtors velocity. A business concern generally adopts different methods of sales.

One of them is selling on credit. Goods are sold on credit based on credit policy

adopted by the firm. The customers who purchase on credit are called debtors or

7/29/2019 Ratio Analysis and its types

5/9

book debts. Debtors and bills receivables together are called accounts

receivables. Some of the customers may be prepared to accept bills for goods

purchased on credit. Bills or handiest are termed as bills receivables.

Debtors turnover= net credit sales

Average receivables

Working capital turnover ratio:

Working capital ratio measures the effective utilisation of working

capital. It also measures the smooth running of business or otherwise. The ratio

establishes relationship between cost of sales and working capital. Working

capital turnover ratio is calculated with the help of followings.

Working capital turnover ratio= sales/cost of sales

Net working capital

Fixed assets turnover ratio:

This ratio determine efficiency of utilisation of fixed assets and

profitability of a business concern. Higher the ratio, more is the efficiency in

utilisation of fixed assets. A lower ratio is the indication of underutilisation of

fixed assets.

Fixed assets turnover ratio= sales

Net fixed assets

Capital turnover ratio:

Managerial efficiency is also calculated by establishing the relationship

between cost of sales or sales with the amount of capital invested in the

business. Capital turnover ratio is calculated with the help of the following..

7/29/2019 Ratio Analysis and its types

6/9

Capital turnover= sales

Capital employed

Solvency or financial ratios:

Solvency or financial ratio include all ratios which express financial

position of the concern. Financial ratios are calculated on the basis of items of

the balance sheet. Therefore, they are also called balance sheet ratios. Financial

position may mean differently to different persons interested in the business

concern. Creditors, banks, management, investors and auditors have different

views about financial position. The term financial position generally refers to

short-term and long-term solvency of the business concern, indicating safety of

different interested parties. Financial ratios are also analysed to find judicious

use of funds. The significant financial ratios are classified as short-term

solvency ratios and long-term solvency ratios.

Therefor financial ratios are as under.

Short-term solvency or liquidity ratios:-

Current ratio Liquid ratio Cash position ratio

Long-term solvency ratios:-

Fixed assets ratio Debt equity ratio Proprietary ratio Capital gearing ratio

7/29/2019 Ratio Analysis and its types

7/9

Short-term solvency or liquidity ratios:

Current ratio:

The ratio of current assets to current liabilities is called current ratio. Inorder to measure the short-term liquidity or solvency of a concern, comparison

of current assets and current liabilities is inevitable. Current ratio indicates the

ability of a concern to meet its current obligations as and when they are due for

payment.

Current ratio=current assets

Current liabilities

Liquid ratio:

This ratio is also called Quick or Acid test ratio. It is calculated by

comparing the quick assets with current liabilities.

Liquid assets= quick assets or liquid assets

Current liabilities

Cash position ratio:

This ratio is also called Absolute liquidity ratio or Super quick ratio.

This is a variation of quick ratio. This ratio is calculated when liquidity is highly

restricted in terms of cash and cash equivalents. This ratio measures liquidity in

terms of cash and near cash items and short-term current liabilities. Cash

position ratio is calculated with the help of the following.

Cash position ratio=cash and bank balance + marketable securities

Current liabilities

7/29/2019 Ratio Analysis and its types

8/9

Long-term solvency ratios:

Fixed assets ratio:

The ratio establishes the relationship between fixed assets and long-term

funds. The objectives of calculating this ratio is to ascertain the proportion of

long-term funds invested in fixed assets. The ratio is calculated with given

below.

Fixed assets ratio= fixed assets

Long-term funds

Debt equity ratio:

This ratio is ascertained to determine long-term solvency position of a

company. Debt equity ratio is also called external-internal equality ratio.

Debt-equity ratio= external equalities

Internal equalities

Proprietary ratio:

This ratio compares the shareholder funds or owners funds and total

tangible assets. In other words this ratio expresses the relationship between the

proprietors funds and the total tangible assets.

This ratio shows the general soundness of the company. It is of particular

interest to the creditor of the company as it helps them to ascertain the

shareholder funds in the total assets of the business. A high ratio indicates safety

to the creditors and a low ratio shows greater risk to the creditors.

Proprietary ratio= shareholders funds

Total tangible assets

7/29/2019 Ratio Analysis and its types

9/9

Capital gearing ratio:

This ratio is also known as capitalisation or leverage ratio. It is also one

of the long-term solvency ratios. It is used to analyse the capital structure of the

company. The ratio establishes relationship between fixed interest and dividend

bearing funds and equity shareholder funds. The capital gearing ratio is

calculated with the help of the following.

Capital gearing =long-term loans + debentures + preference share capital

Equity shareholders funds