Unit V- Financial Analysis through Ratios

Financial Analysis: Meaning, Significance, Methods of Financial Analysis.

Concept of Ratio Analysis, Liquidity Ratios, Solvency/Leverage Ratios, Turnover/Activity

Ratios, ProfitabilityRatios.

Financial Analysis: Meaning, Significance, Methods of Financial Analysis.

Financial Analysis:

Financial analysis is the process of evaluating businesses, projects, budgets, and

other finance-related transactions to determine their performance and suitability.
Typically, financial analysis is used to analyze whether an entity is stable,
solvent, liquid, or profitable enough to warrant a monetary investment.

Significance of Financial Analysis:

• Assessing the operational efficiency and managerial effectiveness of the

company.
• Analyzing the financial strengths and weaknesses and creditworthiness of
the company.
• Analyzing the current position of financial analysis,
• Assessing the types of assets owned by a business enterprise and the liabilities
which are due to the enterprise.
• Providing information about the cash position company is holding and how
much debt the company has in relation to equity.
• Studying the reasonability of stock and debtors held by the company.

• To assess whether the resources of the firm are used in the most efficient
manner
• Whether the financial condition of the firm is sound
• To determine the success of the company’s operations
• Appraising the individual’s performance
 • evaluating the system of internal control
• To investigate the future prospects of the enterprise.
• Appraising the ability of the company to meet its short-term obligations

• Judging the probability of firm’s continued ability to meet all its financial
obligations in the future.
• Firm’s ability to meet claims of creditors over a very short period of time.
• Evaluating the financial position and ability to pay off the concerns.
• To assess the relationship between various sources of funds (i.e. capital
structure relationships)
• To assess financial statements which contain information on past
performances and interpret it as a basis for forecasting future rates of return
and for assessing risk.
• For determining credit risk, deciding the terms and conditions of a loan if
sanctioned, interest rate, and maturity date etc.
Some of the Tools and techniques of financial statement analysis are

• Comparative Statement or Comparative Financial

• and Operating Statements.

• Common Size Statements.

• Ratio Analysis

• Average Analysis

___________________________________________________________________________________

RATIO ANALYSIS

"Ratio analysis is a technique of analysis and interpretation of financial statements. It is the

process! of establishing and interpreting various ratios for helping in making certain decisions,
However, ratio analysis is not an end in itself. It is only a means of better understanding of
financial strengths and weaknesses of J firm. Calculation of mere ratios does not serve any
purpose, unless several appropriate ratios are analysed and Interpret.
ADVANTAGES OF RATIO ANALYSIS:

1. Helps to understand efficacy of decisions: The ratio analysis helps you to understand
whether the business firm has taken the right kind of operating, investing and financing
decisions. It indicates how far they have helped in improving the performance.

2. Simplify complex figures and establish relationships: Ratios help in simplifying the
complex accounting figures and bring out their relationships. They help summarise the
financial information effectively and assess the managerial efficiency, firm’s credit
worthiness, earning capacity, etc.

3. Helpful in comparative analysis: The ratios are not be calculated for one year only.
When many year figures are kept side by side, they help a great deal in exploring the trends
visible in the business. The knowledge of trend helps in making projections about the
business which is a very useful feature.

4. Identification of problem areas: Ratios help business in identifying the problem areas as
well as the bright areas of the business. Problem areas would need more attention and bright
areas will need polishing to have still better results.

5. Enables SWOT analysis: Ratios help a great deal in explaining the changes occurring in
the business. The information of change helps the management a great deal in understanding
the current threats and opportunities and allows business to do its own SWOT (Strength
Weakness-Opportunity-Threat) analysis.

6. Various comparisons: Ratios help comparisons with certain benchmarks to assess as to

whether firm’s performance is better or otherwise. For this purpose, the profitability,
liquidity, solvency, etc. of a business, may be compared:

(i) over several accounting periods with itself (Intra-firm Comparison/Time Series Analysis),

(ii) with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis) and

(iii) with standards set for that firm/industry (comparison with standard (or industry
expectations).

Limitations of Ratio Analysis

Since the ratios are derived from the financial statements, any weakness in the original
financial statements will also creep in the derived analysis in the form of ratio analysis. Thus,
the limitations of financial statements also form the limitations of the ratio analysis. Hence,
to interpret the ratios, the user should be aware of the rules followed in the preparation of
financial statements and also their nature and limitations.

1. Means and not the End: Ratios are means to an end rather than the end by itself.
2. Lack of ability to resolve problems: Their role is essentially indicative and of whistle
blowing and not providing a solution to the problem.

3. Lack of standardised definitions: There is a lack of standardised definitions of various

concepts used in ratio analysis. For example, there is no standard definition of liquid
liabilities. Normally, it includes all current liabilities, but sometimes it refers to current
liabilities less bank overdraft.

4. Lack of universally accepted standard levels: There is no universal yardstick which

specifies the level of ideal ratios. There is no standard list of the levels universally
acceptable, and, in India, the industry averages are also not available.

5. Ratios based on unrelated figures: A ratio calculated for unrelated figures would
essentially be a meaningless exercise. For example, creditors of Rs. 1,00,000 and furniture of
Rs. 1,00,000 represent a ratio of 1:1. But it has no relevance to assess efficiency or solvency.

Hence, ratios should be used with due consciousness of their limitations while evaluating the
performance of an organisation and planning the future strategies for its improvement

________________________________________________________________________

TYPES OF RATIOS
 LIQUIDITY RATIOS
To meet its commitments, business needs liquid funds. The ability of the
business to pay the amount due to stakeholders as and when it is due is known
as liquidity, and the ratios calculated to measure it are known as ‘Liquidity
Ratios’. These are essentially short-term in nature.

1)Current ratio= Current assets/ Current

liabilities

It provides a measure of degree to which current assets cover current liabilities. The
excess of current assets over current liabilities provides a measure of safety margin
available against uncertainty in realisation of current assets and flow of funds

Normally, it is safe to have this ratio within the range of 2:1

2) Quick ratio= Quick assets/Current liabilities

Quick assets=current assets-(stock+ prepaid expenses)

The ratio provides a measure of the capacity of the business to meet its short-term obligations
without any flaw. Normally, it is advocated to be safe to have a ratio of 1:1 as unnecessarily low
ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in
otherwise less profitable short-term investments.

ACTIVITY/ TURNOVER RATIOS Activity ratios express how active the firm is in terms
of selling its stock, collecting its receivables and paying its creditors.

Debtors turnover ratio

Inventory turnover ratio

Inventory turn over ratio=Cost of goods sold/Average Inventory

Cost of good sold =sales- Gross Profit

Average Inventory=

opening inventory+closing inventory

Inventory Holding period=365/ITR

Debtors turnover ratio

 DTR= Credit sales/Average Debtors

Average Debtors=

Opening Debtors+ closing debtors

Debt collection period= 365/DTR

PROFITABILITY RATIOS: A company should earn profits to survive and grow over a period
of time. Therefore the financial manager should continuously evaluate the efficiency of the
company in terms of profits.

Gross profit ratio

Net profit ratio

Operating profit

P/E ratio

EPS

Gross profit ratio= Gross profit × 100

Sales

Net profit ratio= Net profit ×100

Sales

Operating profit ratio=Operating Expenses

Sales

Operating expenses=(Cost of good sold+ Administrative expenses +selling and distribution

expenses)

Earning per share

Earning per share is the relationship between net profits and the number of outstanding.
 EPS= Net Profits after taxes

No of shares

Price/earning ratio:

This is the share price divided by the earning per share

 P/E ratio= Market price per share

Earning per share

Leverage ratio/ Solvency ratio: Leverage ratio is defined as “the financial ratio, which focuses
on the long term solvency of the firm”. The long term solvency of the firm is always reflected in
its ability to meet its long term commitment such as payment of interest periodically without fail,
repayment of principal as and when due.

Debt-Equity ratio= Debt

Equity

Debt=Debenture capital +Long term loans from banks and financial institution +public deposits.

Equity= Equity share capital +reserve and surpluses+ Preferences share capital.

=====================================================================
=====================================================================
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
Scanned by CamScanner
1
 Unit-V
Preparation of Financial
Statements and Ratio Analysis
Financial Analysis Through Ratios- Computation,
Analysis and Interpretation of Liquidity Ratios
(Current and Quick Ratios), Activity Ratios
(Inventory Turnover Ratio and Debtors Turnover
Ratio), and Profitability Ratios (Gross Profit
Ratio-Net Profit Ratio-Operating Profit Ratio –
P/E Ratio and EPS), Leverage Ratio (Debt-Equity
Ratio). 2
 RATIO ANALYSIS
INTRODUTION
Ratio Analysis was pioneered by Alexander wall who
presented a system of ratio analysis in the year 1909.

RATIO
A Ratio is a mathematical relationship between two items
expressed in a Quantitativeform.

RATIO ANALYSIS
It is “The process of determining and presenting the relationship
of items and groups of items in the financial statements”.
STEPS IN RATIO ANALYSIS

✓ Selection of relevant information

✓ Comparison of calculated Ratio

✓ Interpretation and Reporting

 CLASSIFICATION OF RATIOS

ACTIVITY OR CAPITAL
LIQUIDITY RATIO TURNOVER PROFITABILITY STRUCTURE
RATIO RATIO OR LEVERAGE
RATIO

CURRENT QUICK DEBT

RATIO RATIO EQUITY
INVENTORY DEBTOR
TURNOVER TURNOVER
RATIO
RATIO RATIO

GROSS
NET OPERATI
PROFIT
PROFIT NG EPS P/E
RATIO PROFIT
RATIO Ratio RATIo
RATIO

EPS = Earnings Per Share

 LIQUIDITY RATIO
The term liquidity refers to the ability of the
company to meet its current liabilities.
Liquidity ratios assess capacity of the firm to
repay its short term liabilities.

Thus, liquidity ratios measure the firms’

ability to fulfil short term commitments out
of its liquid assets. The important liquidity
ratios are
(i) Current ratio
(ii) Quick ratio
 CURRENT RATIO
Current ratio is a ratio between current assets
and current liabilities of a firm for a particular
period.
The objective of computing this ratio is to
measure the ability of the firm to meet its
short term liability.
It compares the current assets and current
liabilities of the firm. This ratio is
calculated as under :
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Current Ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
 LIQUIDITY RATIO
a) Current Ratio
It indicates the ability of a concern to meet its current
obligations as and when they are due for payment.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Current Ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Standard : Current Ratio is 2:1. current Assets
shall be 2 times to currents Liabilities.
b) Quick Ratio
It is also called “Quick” or “Acid Text” ratio. This ratio
establishes a relationship between quick assets and
current liabilities.

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 −(𝑺𝒕𝒐𝒄𝒌+𝑷𝒓𝒆𝒑𝒂𝒊𝒅 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔)

Quick Ratio =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

Standard : Quick Ratio is 1.5 :1. current Assets shall be 1.5 times to
currents Liabilities.
 Problem
Calculate a) Current Ratio b) Quick Ratio from the
following table
PARTICULARS AMOUNT IN
RUPEES
LAND AND BUILDINGS 50,000
PLANT AND MACHINARY 1,00,000
FURNITURE AND FIXUTURES 25,000
CLOSING STOCK 25,000
SUNDRY DEBTORS 12,500
WAGES PREPAID 2,500
SUNDRY CREDITORS 8,000
RENT OUTSTANDING 2,000
(UNPAID)
 Solution
Calculate a) Current Ratio b) Quick Ratio from the
following table
PARTICULARS AMOUNT IN
RUPEES
LAND AND BUILDINGS 50,000 FA
PLANT AND MACHINARY 1,00,000 FA
FURNITURE AND FIXUTURES 25,000 FA
CLOSING STOCK 25,000 CA
SUNDRY DEBTORS 12,500 CA
WAGES PREPAID 2,500 CA
SUNDRY CREDITORS 8,000 CL
RENT OUTSTANDING 2,000 CL
(UNPAID)
FA- Fixed Assets CA – Current Assets CL – Current Liabilities
 SOLUTION
CURRENT ASSETS = SUNDRY DEBTORS + CLOSING STOCK + WAGES PREPAID
= 12,500 + 25,000 + 2,500
= 40,000

CURRENT LIABILITIES = SUNDRY CREDITORS + RENT OUTSTANDING

= 8,000 + 2,000
= 10,000

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Current Ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

= 40,000 / 10,000
=4
The Ratio is 4: 1 is more than the standard ratio of 2:1
 SOLUTION
CURRENT ASSETS = SUNDRY DEBTORS + CLOSING STOCK + WAGES PREPAID
= 12,500 + 25,000 + 2,500
= 40,000

CURRENT LIABILITIES = SUNDRY CREDITORS + RENT OUTSTANDING

= 8,000 + 2,000
= 10,000

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔 −(𝑺𝒕𝒐𝒄𝒌+𝑷𝒓𝒆𝒑𝒂𝒊𝒅 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 )

Quick Ratio =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

= 40,000- (25,000+ 2500) / 10,000

= 1.25
The Ratio is 1.25: 1 is less than the standard ratio of 1.50:1
 Activity Turnover Ratio

Activity ratios measure the efficiency or effectiveness

with which a firm manages its resources.

These ratios are also called turnover ratios because

they indicate the speed at which assets are converted
or turned over in sales.
These ratios are expressed as ‘times’ and should
always be more than one. Some of the important
activity ratios are :
(i) Inventory or Stock turnover ratio
(ii) Debtors turnover ratio
 Activity Turnover Ratio

Inventory Turnover Ratio

 It is also called stock velocity Ratio.

 More the turnover more the profit for the company

 It Indicates whether the investment is optimum.

 The quantity of stock should be enough to meet the

requirements of the business.

 But it should not be too excessive

 In short, the number of times the inventory is turned over
during a particular accounting period.
stock Turnover Ratio = Cost of Goods Sold
Avg. Inventory (or)

= Net Sales- Gross profit

(Opening + Closing Stock )/2 (or)

Average Stock Inventory = (opening stock + closing stock) / 2

Cost of Goods Sold = (op. stock+ purchase+ direct exp) - cls. Stock
(or)
= (Total cost of production+ op. Stock of
finished goods) – cls. Stock
(or)
= sales - Grossprofit.

High ratio = Efficient Inventory mgt.

B. Stock turnover period/ inventory turnover
period
 Inventory turnover Ratio can be related to “time”
 The ratio can be expressed in term of “ Days or Months”.
Days or Months in the year
Avg.Inventory Turnover =
Ratio Inventory Turnover Ratio

 It refers with in a particular days or months the stock can used

or sold.
 Problem
Calculate Inventory Turnover Ratio from following
table
PARTICULARS AMOUNT IN
RUPEES
Opening Stock 9,000
Closing Stock 7,000
Sales 75,000
Gross Profit 35,000
 Solution
PARTICULARS AMOUNT IN RUPEES

Opening Stock 9,000

Closing Stock 7,000
Sales 75,000
Gross Profit 35,000

Cost of Goods Sold

Inventory Turnover Ratio =
Avg. Inventory
Cost of goods sold = Sales – Gross Profit
= 75,000 – 35,000 = 40,000

Average Stock Inventory = (opening stock + closing stock) / 2

= (9000+ 7000) / 2
= 8,000

inventory Turnover ratio = 40000 / 8000

=5
 Solution
PARTICULARS AMOUNT IN RUPEES

Opening Stock 9,000

Closing Stock 7,000
Sales 75,000
Gross Profit 35,000

Average selling period is computed by dividing 365 by

inventory turnover ratio:
Days or Months in the year
Avg.Inventory Turnover =
Inventory Turnover Ratio
Ratio
= 365 days / 5 times
= 73 days

The company will take 73 days to sell average inventory.

Debtors Turnover Ratio
Debtors turnover ratio is an indication of the
speed with which a company collects its debts.

The higher the ratio, the better it is because it

indicates that debts are being collected quickly.

In general, a high ratio indicates the shorter

collection period which implies prompt
payment by debtor and a low ratio indicates a
longer collection period which implies delayed
payment for debtors
 DEBTOR S TURN OVER RATIO
 It is also called, Receivable turnover Ratio or debtors velocity.
 It measures the number of times the receivables are rotated in a year in
terms of sales.
 It is relationship between total sales and closing balance of debtors.
D.T.R = Net Credit sales (total sales- [cash sales + sales
returns])
Avg. Trade receivables (net)
Note :
Avg. Trade Receivables (Net) = (opening receivables + Closing Receivables ) / 2
The higher ratio indicates that the debts are
being collected promptly.
AVERAGE COLLECTION PERIOD ( Avg. No of days for which a firm
has to wait before its receivables are collected into cash).
A.C.P= Months or days in a year
Debtors turnover Ratio
 Problem
Calculate Debtor Turnover Ratio from following
table
PARTICULARS FIRM “X”
TOTAL SALES 1,60,000
CASH SALES 80,000
ACCOUNTS RECEIVABLES-OPENING 32,000
ACCOUNTS RECEIVABLES-CLOSING 26,000

Formula
 Solution
Net Credit Sales = Total Sales – Cash Sales
= 160000 - 80000
= 80000

AverageTrade Receivables = (Opening receivables + Closing Receivables) / 2

= ( 32000 + 26000)/2

= 29000

Debtors turnover ratio = 80,000 / 29,000 = 2.75

Avg Time Period of Debtor = No of days in a year / debtors turnover ratio

= 365 / 2.75
= 132 days

Generally, a high ratio indicates that the receivables are more liquid and
are being collected promptly. A low ratio is a sign of less liquid receivables
and may reduce the true liquidity of the business
 Profitability Ratio
A profitability ratio is a measure of profitability, which is a way to
measure a company's performance.
Profitability is simply the capacity to make a profit, and a profit is what
is left over from income earned after you have deducted all costs and
expenses related to earning the income.

 “Profit” is an absolute measure of earning capacity. “Profitability”

depends on sales, cost and utilisation of resources.
The profitability Ratioare
✓ Gross Profit Ratio
✓ Net Profit Ratio
✓ Operating Profit Ratio
✓ Earnings Per Share Ratio
✓ Price-Earning Ratio
 Profitability Ratio Formulas
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 = X 100
𝑆𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 X 100
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑆𝑎𝑙𝑒𝑠

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝑃𝑟𝑜𝑓𝑖𝑡
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 = X 100
𝑆𝑎𝑙𝑒𝑠

Earnings Per Share = Net Profit After Tax

No. of shares

Market value per share

Price – Earning Ratio =
Earnings Per Share

Higher Ratio Indicates HigherProfitability

 Profitability Ratio - Proforma

SALES XXXX
LESS COST OF GOODS XXXX
GROSS PROFIT XXXX
LESS ADMN. & SALES EXPENSES XXXX

OPERATING PROFIT XXXX

ADD NON OPERATING PROFIT XXXX
LESS NON OPERATING EXPENSES XXXX

NET PROFIT XXXX

NOTE :
NON OPERATING PROFIT : Interest, Dividend, Discounts
NON OPERATING EXPENSES : Loss on Sales, Tax
 Profitability Ratio Problem
The Net sale of a company is Rs.50,000, cost of goods sold is
Rs 20,000. The details of expenditure is given in the table.

PARTICULARS FIRM “X”

ADMINISTRATIVE EXPENSES 3000
SELLING & DISTRIBUTION 4000
LOSS ON SALES - EXPENSES 2000
INTEREST ON INVESTMENTS 3000
TAX @20% @20%

CALCULATE 1) a) Gross Profit Ratio b) Net Profit Ratio c) Operating

Profit Ratio
2) The company capital investment is Rs.30,000 @ Rs. 10 per share and
market value per share is Rs.80.
Calculate i) EPS ii) P-E Ratio
 Profitability Ratio- solution

SALES 50,000
LESS COST OF GOODS 20,000
GROSS PROFIT 30,000
LESS ADMN. & SALES EXPENSES
Admn exp 3000
Selling & Distr 4000 7,000

OPERATING PROFIT 23,000

ADD NON OPERATING PROFIT 2,000
-----------------

LESS NON OPERATING EXPENSES 3,000

PROFIT BEFORE TAX 22,000

LESS TAX @20% 4,400
NET PROFIT 17,600
 Profitability Ratio - SOLUTION
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 = X 100 = 30,000 / 50,000 X 100 = 60%
𝑆𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 = X 100 = 17,600 / 50,000 X 100 = 35.2%
𝑆𝑎𝑙𝑒𝑠

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔𝑃𝑟𝑜𝑓𝑖𝑡 X 100
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑆𝑎𝑙𝑒𝑠
= 23,000 / 50,000 X 100 = 46%

Earnings Per Share = Net Profit After Tax

= 17,600 / (30,000/10) = 5.86
No. of shares

Market value per share

Price – Earning Ratio = = 80/5.86 = 13.65
Earnings Per Share
 Problem : 2
Alpha Manufacturing Company Ltd. has drawn up the following profit and loss
account for the year ended March 31, 2018.
Rs. Rs.
To Opening Stock 26,000 By Sales 1, 60,000
To Purchases 80,000 By Closing Stock 38,000
To Wages 24,000
To Manufacturing Exp. 16,000
To Gross Profit 52,000

1, 98,000 1, 98,000
To Selling and distribution
Expenses 4,000 By Gross profit 52,000
To Admin. Expenses 22,800 By Profit on sale of land 4,800
To General Expenses 1,200
To Bad Debts 800
To Net Profit 28,000

56,800 56,800
You are required to find out
a) Gross Profit ratio b) Operating expenses ratio
c) Operating profit ratio d) Net profit ratio.
 Profitability Ratio - SOLUTION
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 = X 100 = 52,000 / 1,60,000 X 100 =
𝑆𝑎𝑙𝑒𝑠
32.5%
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑅𝑎𝑡𝑖𝑜 = X 100 = 28,000 / 1,60,000 X 100 = 17.5%
𝑆𝑎𝑙𝑒𝑠

𝐶𝑂𝐺𝑆 + 𝑂𝑡ℎ𝑒𝑟 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑋𝑝𝑒𝑛𝑠𝑒𝑠

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑅𝑎𝑡𝑖𝑜 =
𝑆𝑎𝑙𝑒𝑠 X 100

COGS = Cost of Goods Sold = Sales – Gross Profit

= 1,60,000 – 52,000 = 1,08,000

1,08,000+28,800
= = 0.855
1,60,000

Operating Profit Ratio = (1 - Operating Expenses Ratio) x 100

= (1 – 0.855) x 100
= 14.145%
 ❖ Debt Equity Ratio
The ratio of the total long term debt to equity
capital in the business is called the debt-equity
ratio.
The D/E ratio indicates how much debt a company
is using to finance its assets relative to the value of
shareholders’ equity.

The formula for calculating D/E ratios is:

Debt/Equity Ratio = Total Liabilities or Debt

Shareholders' Equity
The standard ratio is 1:1
 Important points to remember
in Debt Equity Ratio
Debt is outsiders fund
Equity is insiders fund

Debt = Debentures or bonds + bank loan + Mortgage

Equity = Shareholders Equity + Reserve Fund + Owners

Capital
 Debt Equity Ratio Problem
Calculate Debt equity ratio from the following table

PARTICULARS FIRM “X”

DEBENTURES 4,20,000
EQUITY SHARES 3,00,000
RESERVE FUNDS 2,40,000
 Debt Equity Ratio Problem
Calculate Debt equity ratio from the following table

Debt = outsiders funds = 4,20,000

Equity = Equity shares + Reserve funds

= 3,00,000 + 2,40,000
= 5,40,000

Debt/Equity Ratio = Total Liabilities or Debt

Shareholders' Equity

= 4,20,000 / 5,40,000
= 0.77

CONCLUSION : THE DEBT EQUITY RATIO IS 0.77 : 1 IS LESS THAN THE

STANDARD RATIO 1:1.
 Debt Equity Ratio Problem
Calculate Debt equity ratio from the following table
 Debt Equity Ratio Problem
Calculate Debt equity ratio from the following table

Debt/Equity Ratio = Total Liabilities or Debt

Shareholders' Equity
= 7250 / 8500
= 0.85

CONCLUSION : THE DEBT EQUITY RATIO IS 0.85 : 1 IS LESS

THAN THE STANDARD RATIO 1:1.