What is a ratio?

A ratio:- It is the mathematical relationship between two

quantities in the form of a fraction or percentage.

A ratio on its own has little or no meaning at all.

Significance of using ratios:

1. It is compared with other ratios in the same set of financial statements.

2. It is compared with the same ratio in previous financial statements (trend analysis).

3. It is compared with a standard of performance (industry average).

WHAT IS RATIO ANALYSIS?

DEFINITION:-

It refers to an analysis of the relationships of items in financial statements & thereby an investigation into the financial performance of an entity using a series of ratios.

Classification of ratios:-Generally ratios are divided into four areas which provide different

kinds of information:-

1. Leverage Ratios

2. Liquidity Ratios

3. Profitability Ratios

4. Other ratios

LIQUIDITY RATIOS

MEANING:-

It measures the ability of a firm to meet its short term obligations & reflects the short term financial solvency of firm.

Classification:-

1. Current ratio

2. Acid-test ratio

LIQUIDITY RATIOS

Current ratio:-

It is the ratio of total current assets to total current liabilities.

Formula:-

current assets

current liabilitiesCurrent ratio =

LIQUIDITY RATIOS

Acid-test ratio:- It measures the firm’s ability to

convert its current assets quickly into cash in order to meet its current liabilities. Hence also known as Quick ratio.

Formula: Quick assets current liabilities

Acid-test ratio =

Leverage ratios

Meaning:-

It is defined as financial ratio which throws light on long term solvency of a firm with regards to the following two aspects:-

ability to repay the principal & regular payment of interest

Leverage ratios

Classification:-

1. Debt-equity ratio

2. Capital gearing ratio

3. Interest coverage ratio

4. Debt service coverage ratio

Leverage ratios

Debt-equity ratio:-

It indicates the relationship between borrowed funds and owners capital.

Formula:-

Total debt

Shareholders equity D/E ratio =

Leverage ratios

Capital gearing ratio:-

It indicates the relationship between equity funds and fixed income bearing funds.

Formula:-

Equity funds

Fixed income bearing fundsCGR =

Leverage ratios

Interest coverage ratio:-

It measures the debt servicing capacity of the firm. It is determined by dividing the EBIT by the fixed interest charges.

Formula:-

EBIT

Interest Interest coverage ratio =

Leverage ratios

Debt service coverage ratio:-

It computes the debt service capacity of a business firm. In general 2:1 is considered as satisfactory ratio.

Formula:-

EAT+Interest+Depreciation+OA

Installment

DSCR =

Profitability ratios

Meaning:-These ratios tell us whether a business is

making profits - and if so whether at an acceptable rate.

It uses margin analysis and show the return on

sales and capital employed.

Profitability ratios

Classification:-

The key profitability ratios are:

1. Gross profit ratio

1. Operating profit ratio

2. Return on Capital employed ratio

Profitability ratios

Operating profit ratio:-

It refers to a company's ability to control its other operating costs or overheads.

Formula:-

EBIT

Net SalesOperating profit ratio =

Profitability ratios

Gross profit ratio:-

It refers to ability of the business to consistently control its production costs or to manage the margins its makes on products its buys and sells.

Formula:-

Gross Profit

Sales

Gross profit margin =

Profitability ratios

Return on capital employed:-

It measures the profits related to return on capital employed. The term capital employed refers to long term funds supplied by lenders and owners of the firm.

Formula:-

EBIT

Average total capital employedROCE =

Other Ratios

Earning per share:- It measures the profit available to the equity

shareholders on a share. It is calculated by dividing the profits available to the equity shareholders by the number of outstanding shares.

Formula:- Net profit available to equity-holders

Number of ordinary shares outstanding

EPS =

Other Ratios

Price-earnings ratio:-

It measures investors’ expectations and the market appraisal of the performance of a firm.

Formula:-

Market price of share

EPSP/E ratio =

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