Index Serial
erial
S Topic age
P
Number number
1 Introduction And Meaning Of Ratio Analysis 1
2 Objectives Of Ratio Analysis 2
3 Advantages And Uses Of Ratio Analysis 3
4 Classification of Ratio Analysis 4
5 Liquidity ratio 5
6 Solvency Ratio 6
7 Activity Ratio 7
8 Profitability Ratio 8
9 Practical problems 9
10 Conclusion 10
11 Bibliography 11
Introduction & Meaning Of Ratio Analysis
‘Ratio’ is an arithmetical expression of the relationship between two related or independent
items. To make important financial decisions, business owners, analysts, and other
stakeholders examine, compare, and interpret this financial data. However, such information
is interpreted using financial statement analysis tools and methodologies. One such
popularly used tool is accounting ratio analysis. Ratios calculated based on accounting data
are called Accounting ratios or Financial ratios.
atio Analysis studies the relationship among various financial factors in a business. It is an
R
accounting tool that can be used to measure a business's solvency, profitability, and overall
financial strength by analyzing its financial accounts, such as the balance sheet and the
profit and loss account. These are easy to calculate and enable a business to highlight which
areas of its finances are weak and require immediate attention. Such ratios can be stated as
a fraction, %, proportion, or number of times.
atio analysis is a cornerstone of fundamental equity analysis. It is a process of determining
R
and interpreting relationships between the related or independent items of financial
statements to have a meaningful understanding of an enterprise's performance and financial
position.
Objectives of Ratio Analysis
1] Measure of Profitability –
rofit is the ultimate aim of every organization. Context is required to measure profitability,
P
which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratios, Expense Ratios,
etc provide a measure of the profitability of a firm.
2] Ensure Suitable Liquidity –
very firm has to ensure that some of its assets are liquid, in case it requires cash
E
immediately. So a firm's liquidity is measured by ratios such as the Current ratio and Quick
Ratio. These help a firm maintain the required level of short-term solvency.
3] Overall Financial Strength –
ome ratios help determine the firm’s long-term solvency. They help determine if there is a
S
strain on the assets of a firm or if the firm is over-leveraged. The management will need to
quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are
Debt-Equity ratios etc.
4] Comparison with Industry Standards and Competitors –
o acquire a better picture of the organization’s finances, the ratios must be compared to
T
industry standards. If the company fails to meet market criteria, the management can take
orrective measures. The ratios can also be compared to past years’ ratios to evaluate how
c
far the company has progressed. Trend analysis is the term for this.
Advantages & Uses of Ratio Analysis
1]Analysis of Financial Statements and Profitability-
ccounting Ratios are useful for understanding the financial position of the enterprise.
A
Management and Investors can determine the profitability concerning Revenue from
Operations and Capital Employed.
2]Simplifies accounting data-
omplex accounting statements and financial data are reduced to simple ratios of operating
C
efficiency, financial efficiency, solvency, long-term positions, and so on.
3]Assess operating efficiency and locate the weak areas-
atio analysis assists in identifying issue areas and drawing management’s attention to
R
them. Some information is lost in the complicated accounting statements, and ratios will aid
in identifying these issues.
4]Comparsinter-firm and intra-firm-
llows the company to compare itself to other companies, industry standards, and intra-firm
A
comparisons, among other things. This will assist the firm in gaining a better understanding
of its financial situation in the economy.
5]Forecasts future-
atios are helpful in business planning and forecasting. What should be the future course of
R
action is decided, many times, based on the trend of ratios.
Classification of Ratio Analysis
Liquidity Ratio Solvency Ratio Activity Ratio Profitability Ratio
urrent Ratio”
C ebt Equity Ratio”
D rade Receivable
T ross Profit Ratio "
G
Quick Ratio / Acid Proprietary Ratio” Turnover Ratio” Net Profit Ratio "
Test Ratio” Debt to Total Asset Trade Payable Operating Ratio "
Ratio” Turnover Ratio” Operating Profit
Interest Coverage Working Capital Ratio "
Ratio” Turnover Ratio“ Earning Per Share "
Inventory Turnover Price Earning Ratio"
Ratio” Return On
Investment”
Liquidity Ratios
Current Ratio
he ideal current ratio is 2:1. The ratio measures whether there are enough current assets to
T
pay the current debts with a margin of safety for potential losses in the realization of the
current assets.
Current Ratio=Current Assets
Current Liabilities
Quick Ratio/Acid-test Ratio
he ideal Ratio is 1:1 in which it measures whether there are enough readily convertible
T
quick funds to pay the current debts.
Quick Ratio or Acid-test Ratio=Quick Assets
Current Liabilities
Solvency Ratio
Debt Equity Ratio
easures the relative proportions of outsiders’ funds and shareholders’ funds invested in the
M
company.
Debt Equity Ratio=Debt /Long Term Debt
Equity / Shareholder’s Funds
Proprietary Ratio
easure the relative proportions of outsiders’ funds and shareholders’ funds
M
invested in the company.
Proprietary Ratio=Shareholders’ Funds / Equity
Total assets
Debt to Total Asset Ratio
easures the safety margin available to the lenders of long- term debt.
M
Debt to Total Asset Ratio=Debt Total
Asset
Interest Coverage Ratio
scertains the amount of profit available to cover the interest and indicates whether an
A
enterprise can increase its borrowing.
Interest Coverage Ratio=Net Profit before Interest and Tax
Interest on Long Term Borrowings
Activity Ratio
Trade Receivable Turnover Ratio
hows the number of times amount invested in trade receivables is turned over in a year in
S
relation to Revenue from Operations.
Trade Receivable Turnover Ratio=Credit Revenue from Operations
Average Trade Receivables
Trade Payable Turnover Ratio
etermines the efficiency with which Trade Payables are managed and paid.
D
Trade Payable Turnover Ratio=Net Credit Purchases
Average Trade Payables
Working Capital Turnover Ratio
scertains whether or not working capital has been utilised efficiently
A
in making sales.
Working Capital Turnover Ratio=Revenue from Operations
Working Capital
Inventory Turnover Ratio
etermines the efficiency with which inventory is being used (inventory management).
D
Inventory Turnover Ratio=Cost of Revenue from Operations
Times Average Inventory
Profitability Ratio
Gross Profit Ratio
higher Gross Profit Ratio leaves a higher margin to meet operating expenses and the
A
creation of reserves.
Gross Profit Ratio = (Gross Profit/Revenue from Operations) x 100
Net profit ratio
Indicates the overall efficiency of the business.
Net Profit Ratio = (Net Profit/Net Sales) x 100
Operating Ratio
ssess the operational efficiency of the business.
A
Operating Ratio =(Operating cost/Revenue from Operations) x 100
Operating Profit Ratio
etermines the operational efficiency of the business.
D
Operating Profit Ratio = (Operating Profit/Revenue from Operations) x 100
Earning Per Share
elps in evaluating the prevailing market price of a share in the light of profit-earning
H
capacity.
Earning Per Share = Net profit after tax and preference dividend/Number of Equity Shares
Price Earning Ratio
inds the expectations of the shareholders.
F
Price Earning Ratio = Market value of an equity share/Earnings per share
Return On Investment
easures how efficiently the resources of the business are used.
M
Return on Investment = (Net Profit before Interest, Tax and Dividend/Capital Employed)x100
Conclusion
atio analysis helps interpret the financial data of a company to understand its true standing.
R
Using ratio analysis, one can determine a company’s liquidity, profitability and overall
performance. It is also an important tool for investors to understand the worth of a company
when investing.
o, by understanding ratio analysis and its types, you can assess the company’s
S
performance before investing.
Bibliography
I have gathered the above information from the following books and websites:
• investopedia.com
• toppr.com
• en.wikipedia.org
• T.S Grewal’s Management Accounting XII ISC
