BUSINESS ECONOMICS & FINANCIAL ANALYSIS

(22SS0MB01)
SUBJECT CODE: 22SS0MB01
II B. tech -II Semester
DEPARTMENT OF SPECIAL BATCH
AY: 2024-2025
 UNIT - V

Financial Analysis through Ratios

Concept of Ratio Analysis, Liquidity Ratios, Turnover Ratios,
Profitability Ratios, Proprietary Ratios, Solvency, Leverage
Ratios (simple problems). Introduction to Fund Flow and Cash
Flow Analysis (simple problems).

Prepared By : M. SARATH CHANDRA

Introduction
Profit is essential for any business, but management cannot rely solely on
profit figures.
They must analyze financial statements and key factors affecting profitability
over the short, medium, and long term.
Ratio analysis helps interpret financial statements and measure a business’s
performance quickly.
Ratio analysis helps them assess the business's financial health and make
informed decisions.

Prepared By : M. SARATH CHANDRA

Prepared By : M. SARATH CHANDRA
Uses of ratio analysis
Ratio analysis is used for many reasons. Some of them include the following –

➢ To depict the actual financial position of a company.

➢ To calculate and compare financial data against competitors in similar
industries.
➢ To assess the performance and operational efficiency.
➢ To analyse trends (Trend analysis becomes easier with ratio analysis. You
can check the trend of how the company has performed over the years).
➢ To rectify deviations and make improvements if needed.

Prepared By : M. SARATH CHANDRA

 Types of Ratios

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Liquidity Ratios
➢ Liquidity ratios express the ability of the firm to meet its short-term
obligations as when they become due.
➢ Short-term creditors, lenders, and investors are keen to measure a
company’s ability to pay its short-term debt obligations and to pay vendors.
What are Liquid Assets?
Assets that can be quickly converted into cash.
➢ Liquidity in accounting refers to the asset’s ability to be converted to
cash quickly within a given time frame.
➢ In the balance sheets, liquid assets are recorded as part of current assets.
➢ Liquid assets are normally cash equivalents or easily cash convertible at
very short notice.

Prepared By : M. SARATH CHANDRA

 ➢ Some examples of liquid assets are:

Current Assets Current Liabilities

Cash in hand Sundry Creditors
Cash at bank Bills Payable
Sundry Debtors Outstanding and Accrued
Bills Receivable Expenses
Marketable Securities Income tax payable
Loans & advances Short term advances
Inventories: Unpaid or unclaimed dividend
Stock of raw materials Bank Overdraft
Stock of work in progress
Stock of finished goods

Prepared By : M. SARATH CHANDRA

The important liquidity ratios are given below.
Current Ratio
Quick Ratio
Absolute Liquid Ratio
Current Ratio:-
It is also called as working capital ratio. It is the ratio between current assets
and current liabilities.
The firm is in comfortable position if its current ratio is 2:1. It means for every
rupee of current liability, there should be two rupees worth of current assets
Current Assetts
current ratio =
Current Liabilities
Current assets = Cash + cash in bank + marketable securities + short term
investments + bills receivables +debtors + inventory + stock + work-in-
progress + pre-paid expenses + incomes receivable (accrued income) etc.
Current liabilities = Expenses payable + bills payable + creditors + short term
loans + income tax to be paid + dividend payable + bank over draft + long
term loans and debentures to be paid within one year + provision for tax +
shortBy term
Prepared advances
: M. SARATH CHANDRA etc.
 Importance of the Current Ratio
1. Assess Short-Term Financial Health: To determine the company's
capacity to meet its short-term liabilities with its current assets.
2. Evaluate Liquidity: To measure how easily the company can convert its
current assets into cash to pay off its current liabilities.
3. Inform Stakeholders: To provide valuable information to investors,
creditors, and management about the company’s liquidity and operational
efficiency.
4. Identify Potential Issues: To highlight potential liquidity problems that
could affect the company’s ability to operate smoothly and meet its
financial commitments.

Prepared By : M. SARATH CHANDRA

 Quick Ratio:- It is also called as working Acid test ratio or liquid ratio.
It is the ratio between quick assets and current liabilities. The firm is in
comfortable position if its current ratio is 1:1.
Unlike the current ratio, the quick ratio excludes inventory from current
assets, as inventory may not be quickly convertible to cash.
It means for every rupee of current liability, there should be one rupee worth
of quick assets. Quick assets can be converted into cash quickly.
Quick Assetts
Quick ratio =
Current Liabilities

Quick assets = All current assets except stock and prepaid expenses.

Current liabilities = Expenses payable + bills payable + creditors + short

term loans + income tax to be paid + dividend payable + bank
over draft + long term loans and debentures to be paid within
one year + provision for tax + short term advances etc.

Prepared By : M. SARATH CHANDRA

 Importance of the Current Ratio
1. Assess Immediate Liquidity: To evaluate a company's ability to pay off
its current liabilities without relying on the sale of inventory.
2. Evaluate Financial Stability: To measure the financial resilience of a
company in meeting its short-term obligations using its most liquid
assets.
3. Provide a Conservative Measure: To offer a conservative view of the
company's liquidity by focusing only on assets that can be quickly
converted into cash.
4. Aid Stakeholders in Decision-Making: To give investors, creditors, and
management a clear understanding of the company’s ability to handle
unexpected financial demands.

Prepared By : M. SARATH CHANDRA

 Absolute Liquid Ratio
The absolute liquid ratio, also known as the cash ratio or super quick ratio.
It measures a company’s ability to meet its short-term liabilities using its most liquid assets,
specifically cash and cash equivalents.
This ratio excludes receivables and inventory, providing the most stringent test of a
company's short-term solvency.
Importance of Absolute liquid Ratio
1. Assess Immediate Solvency: To evaluate a company's capacity to pay off its current
liabilities instantly with its absolute liquid assets.
2. Provide a Conservative Liquidity Measure: To offer a conservative assessment of liquidity
by focusing only on cash and cash equivalents.
3. Highlight Financial Safety: To indicate the level of financial safety and preparedness for
unexpected cash requirements.
4. Support Decision-Making: To aid creditors, investors, and management in making
decisions based on the company’s immediate financial strength.
Formula:
Absolute Liquid Assets
Absolute Liquid Ratio =
Current Liabilities
cash and bank balances + Marketable securities + Current investments
=
Current Liabilities
Prepared By : M. SARATH CHANDRA
 Sl.no Ratio Formula Interpret
ation
1 Current Ratio Current ratio=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 2:1
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

2 Quick Ratio Quick Ratio=

Quick Assets 1:1
Current liabilities

3 Absolute liquid Absolute Liquid ratio= 0.5:1 or

Ratio Absolute Liquid Assets 1:2
Current Liabilities

Prepared By : M. SARATH CHANDRA

 Example 1:
From the Balance Sheet of XYZ Co. Ltd., calculate liquidity ratios.(Rs. in
thousands)
Capital & Liabilities Amount Assets Amount
Preference share capital 100 Land and Buildings 225
Equity share capital 150 Plant and machinery 250
General reserve 250 Furniture and Fixtures 100
Debentures 400 Stock 250
Creditors 200 Debtors 125
Bills payable 50 Cash at Bank 250
Outstanding expenses 50 Cash in hand 125
Profit and loss account 100 Prepaid expenses 50
Bank loan(Long term) 200 Marketable securities 125
1500 1500

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 Solution:
Current Assetts
current ratio =
Current Liabilities
Current assets = Stock + Debtors + Cash at Bank + Cash in hand + Prepaid
expenses + Marketable securities.
= 250 + 125 + 250 + 125 + 50 + 125
= 925
Current liabilities = Creditors + Bills payable + Outstanding expenses.
= 200+ 50 + 50 = 300 925
Current Ratio = = 3.08
300
Current ratio = 3.08:1

Prepared By : M. SARATH CHANDRA

 Quick Ratio
Quick Assetts
Quick ratio =
Current Liabilities
Quick assets = Debtors + Cash at Bank + Cash in hand + Marketable securities.

= 125 + 250 + 125 + 125

= 625
Current liabilities = Creditors + Bills payable + Outstanding expenses.
= 200+ 50 + 50 = 300
625
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = = 2.08
300
Quick ratio = 2.08:1

Prepared By : M. SARATH CHANDRA

Example 2: The following is the Balance Sheet of Bharath Electronic Limited for the year
ending 31stDec 2020.
Liabilities Rs. Assets Rs.
Capital 6,00,000 Fixed assets 10,00,000
Reserves & Surplus 4,00,000 Investments 3,00,000
Debentures 7,00,000 Cash 50,000
Sundry creditors 60,000 Debtors 1,50,000
Bills payable 1,00,000 Marketable securities 2,00,000
O/S expenses 10,000 Stock 3,00,000
Bank overdraft 1,30,000
20,00,000 20,00,000

From the above balance sheet, ascertain:

(a) Current ratio (b) Quick ratio (c) Absolute liquid ratio
(d) Comment on these ratios.
Prepared By : M. SARATH CHANDRA
 Current assets = Cash 50,000+ Debtors 1,50,000+ Marketability Securities 2,00,000+
Stock 3,00,000 = 7,00,000
Current Liability = Sundry Creditors 60,000+Bills Payable 1, 00,000+ Outstanding
Expenses 10,000+Bank overdraft 1,30,000 =3,00,000
Current Assets
Current ratio =
Current Liabilities
7,00,000
= = 2.33
3,00,000
Current Ratio=2.33:1
Quick Assets= Current asset - (Stock+ Prepaid expenses)
Quick Assets = 7, 00,000-3, 00,000 = 4, 00,000
𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠
𝑞𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
4,00,000
= = 1.33
3,00,000
Quick Ratio=1.33

Prepared By : M. SARATH CHANDRA

Absolute Liquid Assets = cash 50,000 + marketability securities 2, 00,000 =2, 50,000

Absolute Liquid Assets

Absolute Liquid ratio =
Current Liabilities
2,50,000
= = 0.83
3,00,000
Absolute Liquid Ratio = 0.83
Comment on these ratios
a) Current Ratio (2.33): This ratio being significantly higher than the standard 2:1 indicates
a strong ability to meet short-term obligations. The company has more than enough current
assets to cover its current liabilities, providing a comfortable cushion.
b) Acid-Test Ratio (1.33): This ratio focuses on the most liquid assets and is considered a
more conservative measure. Even with the exclusion of inventory, the company still has a
healthy ratio exceeding the standard 1:1. This suggests the company can readily meet its
immediate short-term needs.
c) Absolute Liquid Ratio (0.83): This ratio solely considers cash and marketable securities,
providing the most stringent test of immediate liquidity. While lower than the standard 0.5 to
1 range, the ratio is still considerably high, further strengthening the company's short-term
financial position.

Prepared By : M. SARATH CHANDRA

Activity Ratios
Activity ratios are called as Turnover ratios.
These ratios tell how active the firm is in selling stocks, collecting money from debtors and
paying to creditors.
It gives an idea to the stakeholders regarding how fast the business is able to sell the
goods and services that is has acquired as inventory or manufactured using the raw
materials.
Activity ratios indicate how efficiently the Working Capital and Inventory are being used
to obtain revenue from operations. It indicates the speed or number of times the capital
employed has been rotated in the process of doing business.
They are given below.
1. Inventory Turnover ratio
2. Debtors Turnover ratio
3. Creditors Turnover ratio

Prepared By : M. SARATH CHANDRA

Activity Ratios
Inventory Turnover Ratio:- It is also called as Stock turnover ratio.
➢ It indicates the number of times the company sells and replaces its inventory within a
specific period, usually a year.
➢ It indicates the number of times the average stock is being sold during a given
accounting period.
➢ The higher the ratio, the better is the performance of the firm in selling its stock. It is the
rate at which inventories are converted into sales and then to cash.
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝
Inventory Turnover Ratio=
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤
Cost of goods sold = Opening stock + Purchases + Manufacturing expenses – Closing
stock
Or
= Slales – Gross Profit

Opening stock + Closing stock

Average stock =
𝟐

Prepared By : M. SARATH CHANDRA

Activity Ratios
Importance of Inventory turnover ratio
A high turnover ratio suggests that the company is effectively selling and replacing its
inventory, leading to:
1. Reduced inventory carrying costs: Lowering the average amount of inventory held
reduces storage and financing costs.
2. Improved cash flow: Faster inventory turnover leads to quicker conversion of inventory
into cash, improving the company's financial health.
3. Increased sales: Efficient inventory management can support higher sales by ensuring
sufficient stock availability to meet customer demand.

Example 1:
A firm sold goods worth Rs. 500000 and its gross profit is 20% of sales value. The
inventory at the beginning of the year was Rs. 16000 and at end of the year was
14000. Compute inventory turnover ratio and also the inventory holding period.

Prepared By : M. SARATH CHANDRA

Solution:
Cost of goods sold = Opening stock + Purchases + Manufacturing expenses – Closing
stock
Or
= Slales – Gross Profit
= 500000 – 500000×20% = 400000

Opening stock + Closing stock

Average stock =
𝟐
𝟏𝟔𝟎𝟎𝟎 + 𝟏𝟒𝟎𝟎𝟎
= = 𝟏𝟓𝟎𝟎𝟎
𝟐
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝 𝟒𝟎𝟎𝟎𝟎𝟎
Inventory Turnover Ratio= = = 𝟐𝟔. 𝟔𝟔
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐬𝐭𝐨𝐜𝐤 𝟏𝟓𝟎𝟎𝟎
Inventory holding period

𝟑𝟔𝟓 𝟑𝟔𝟓
Inventory holding period= =
Inventory Turnover Ratio 𝟐𝟔. 𝟔𝟔
= 𝟏𝟒 𝒅𝒂𝒚𝒔

Prepared By : M. SARATH CHANDRA

Activity Ratios
2. Debtors Turnover Ratio:- It reveals the number of times the average debtors are
collected during a given accounting period. The firms usually prepare the aged list of
debtors showing the details of when to collect and how much to collect from debtors. The
higher the ratio, the better is the performance of the firm in collecting money from
debtors.
𝐍𝐞𝐭 𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬
Debtors Turnover Ratio=
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐃𝐞𝐛𝐭𝐨𝐫𝐬

Net credit sales = Credit sales – Returns

Note: When credit sales are not given, total sales are taken.

Opening Debtors + ClosingDebtors

Average Debtors =
𝟐
Note: if the opening debtors is not given, closing trade debtors should be considered as
Average Debtors
𝟑𝟔𝟓 𝐝𝐚𝐲𝐬
Debtors collection period=
Debtors Turnover Ratio

Prepared By : M. SARATH CHANDRA

Activity Ratios
Importance of Debtors turnover ratio
The main objectives of analyzing the Debtors Turnover Ratio are:
1. Assess the efficiency of credit management: A high ratio suggests that the company is effectively
collecting its receivables and has a strong credit policy.
2. Evaluate the collection period: The ratio helps determine how long it takes the company to collect
its outstanding debts, which can impact its cash flow and financial health.
3. Identify areas for improvement: By analyzing the ratio over time, companies can identify potential
issues in their credit and collection processes and implement corrective measures.
High turnover: A very high ratio might suggest overly strict credit policies, potentially limiting
sales opportunities.
Low turnover: A low ratio could indicate ineffective collection processes, leading to delayed
payments and potential bad debts.

Example 1
A firm’s sales during the year was Rs. 400000 of which 60% were credit sales. The
balance of debtors at the beginning and ending year were 25000 and 15000
respectively. Calculate debtors turnover ratio of the firm. Also find out debt
collection period.
Prepared By : M. SARATH CHANDRA
Activity Ratios
Solution:
Net credit sales = Sales × 60/100 = 400000 ×60/100 = 240000
Average debtors = (Opening debtors + closing debtors) /2
= (25000 + 15000) /2 =20000

𝐍𝐞𝐭 𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬 𝟐𝟒𝟎𝟎𝟎𝟎

Debtors Turnover Ratio= = = 𝟏𝟐
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐃𝐞𝐛𝐭𝐨𝐫𝐬 𝟐𝟎𝟎𝟎𝟎

Debtors Collection Period

𝟑𝟔𝟓 𝟑𝟔𝟓
Debtors collection period= = − 𝟑𝟎. 𝟒𝟏 𝒅𝒂𝒚𝒔
Debtors Turnover Ratio 𝟏𝟐

Prepared By : M. SARATH CHANDRA

Activity Ratios
Creditors Turnover Ratio:- also known as the Accounts Payable Turnover Ratio It reveals
the number of times the average creditors are paid during a given accounting period.
The firms usually prepare the aged list of creditors showing the details of when to pay and
how much to pay to its creditors. It shows how promptly the firm is in a position to pay
its creditors.

Net credit Purchases

Creditors Turnover Ratio=
Average Creditors
Note: 1. When credit purchases are not given, total purchases are taken.

Opening Creditors + Closing Creditors

Average Creditors=
𝟐
Note 1: If opening creditors are not given, closing creditors should be Considered as ‘average creditors’.

Creditors Payment Period

𝟑𝟔𝟓 𝐝𝐚𝐲𝐬
Creditors Payment Period =
Debtors Turnover Ratio

Prepared By : M. SARATH CHANDRA

Activity Ratios
The main objectives of analyzing the Creditors Turnover Ratio are:
Evaluate payables management: A high ratio suggests that the company is effectively
managing its accounts payable and taking advantage of favorable payment terms.
Assess supplier relationships: A healthy ratio indicates that the company is paying its
suppliers promptly, which can strengthen relationships and potentially lead to better terms.
Identify potential cash flow issues: A very high or low ratio could indicate potential problems
with cash flow management or supplier relationships.
Interpretation:
A higher Creditors Turnover Ratio generally indicates more efficient payables management and
potentially stronger supplier relationships.
High turnover: A very high ratio might suggest overly aggressive payables
management, potentially straining relationships with suppliers.
Low turnover: A low ratio could indicate the company is taking longer to pay its
suppliers, which could lead to strained relationships and potential late payment penalties
EXAMPLE
A firm’s purchases during the year was Rs. 400000 of which 50% were credit purchases. The
balance of creditors at the beginning and ending year were 30000 and 10000 respectively.
Calculate creditors turnover ratio of the firm. Also find out creditors payment period.
Prepared By : M. SARATH CHANDRA
 Solution:
Creditors Turnover Ratio
Net credit purchases = Purchases × 50/100 = 400000 × 50/100 = 200000

Opening Creditors + Closing Creditors

Average Creditors=
𝟐
𝟑𝟎𝟎𝟎𝟎 + 𝟏𝟎𝟎𝟎𝟎
= = 𝟐𝟎𝟎𝟎𝟎
𝟐

Net credit Purchases

Creditors Turnover Ratio=
Average Creditors
200000
= = 10
20000
creditors payment period
𝟑𝟔𝟓 𝐝𝐚𝐲𝐬
Creditors Payment Period =
Debtors Turnover Ratio
𝟑𝟔𝟓
= = 𝟑𝟔. 𝟓 𝒅𝒂𝒚𝒔
𝟏𝟎

Prepared By : M. SARATH CHANDRA

 Sl.no Ratio

1. Stock Turnover Cost of goods sold

Stock Turnover Ratio =
Average Stock
Ratio
Cost of Goods Sold (COGS):
Cost of goods sold = Opening Stock + Purchases + Direct Expenses - Closing
Stock
(Opening Stock + Closing Stock)
Average Stock = 2
2. Debtors Turnover Net Credit Sales
Debtors Turnover Ratio =
Ratio Average accounts receivables
Net Credit Sales = Gross credit sales- sales return

(𝐨𝐩𝐞𝐧𝐢𝐧𝐠 𝐝𝐞𝐛𝐭𝐨𝐫𝐬 + 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐝𝐞𝐛𝐭𝐨𝐫𝐬)

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐃𝐞𝐛𝐭𝐨𝐫𝐬 =
𝟐
3 Creditors Net Credit purchases
Creditors Turnover Ratio =
Turnover Ratio 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑟𝑎𝑑𝑒 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
Net credit purchase = gross credit purchases – purchase returns

opening creditors + closing creditors

Average creditors =
2
Prepared By : M. SARATH CHANDRA
 Profitability Ratios
Profitability ratios are a crucial set of financial metrics used to assess a company's ability to
generate profit from its operations.
They provide valuable insights into a company's financial health and efficiency in
converting revenue into earnings.

PROFITABILITY RATIOS
1. Gross Profit Ratio
2. Net Profit Ratio
3. Operating Ratio
4. Return On Investment (ROI)
5. Return On Equity
6. Earning Per Share (EPS)
7. Dividend Yield Ratio
8. Price/Earning Ratio
9. Earning Power Ratio

Prepared By : M. SARATH CHANDRA

Profitability Ratios
Gross Profit Ratio
It is the ratio between gross profit and net sales. It is expressed in percentage.
The Gross Profit Ratio (GPR) measures the percentage of revenue remaining after deducting the
cost of goods sold (COGS).
It indicates the efficiency of the company's core business in generating profit from sales.
Gross profit
Gross profit Ratio= × 100
Net Sales
Assess the effectiveness of cost management and pricing strategies: A higher GPR
suggests that the company is effectively managing its production costs and pricing its products
or services competitively.
Evaluate the profitability of the core business: The GPR provides a snapshot of the
company's ability to generate profit from its core operations before considering other expenses.
Interpretation:
• A higher GPR is generally considered better, indicating more efficient cost management and
pricing strategies.
• However, it's important to compare the GPR with industry benchmarks and the company's
historical performance for a more accurate assessment.

Prepared By : M. SARATH CHANDRA

Profitability Ratios
Gross profit = Net sales – Cost of goods sold
(or)
= (sales + closing stock) – (opening stock + purchases)
Net sales = Total sales – sales returns
Cost of goods sold = Opening stock + Net purchases + production expenses – closing
stock
(or)
= Net sales – Gross profit

𝐆𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 𝐑𝐚𝐭𝐢𝐨 = × 𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
Example 1: Net sales is Rs. 50000 for a firm and cost of goods sold is Rs. 20000. Calculate
gross profit ratio.
𝐆𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 𝐑𝐚𝐭𝐢𝐨 = × 𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
Gross profit = Net sales – Cost of goods sold = 50000 – 20000 = 30000
𝟑𝟎𝟎𝟎𝟎
𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 𝐑𝐚𝐭𝐢𝐨 = × 𝟏𝟎𝟎 = 𝟔𝟎%
𝟓𝟎𝟎𝟎𝟎

Prepared By : M. SARATH CHANDRA

Profitability Ratios
Net Profit Ratio
The Net Profit Ratio, also known as the Net Profit Margin.
It is the ratio between net profit after tax and net sales. It is expressed in percentage.
It indicates the percentage of revenue remaining after deducting all expenses.
𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 (𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱)
𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐫𝐚𝐭𝐢𝐨 =
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
Net Profit after Tax = (Operating Profit + Non-operating Income) – (Non- operating Expenses +
Taxes)
Operating Profit = (Net Sales – Operating Cost)
Operating Cost = (Cost of goods sold + Operating expenses)
Operating Expenses = (Office and Administration expenses + Sales and Distribution
expenses)
Example 1: Calculate net profit ratio from the following data.
Net sales Rs. 50000
Cost of goods sold Rs. 20000
Administration Expenses Rs. 3000
Selling and Distribution expenses Rs 4000
Loss on sale of fixed assets Rs. 3000
Interest on investment received Rs. 2000 Tax 20%

Prepared By : M. SARATH CHANDRA

 Particulars Rs Rs
Sales 50000
Less: Cost of goods sold 20000
Gross Profit 30000
Less: Administration expenses 3000
Selling and Distribution expenses 4000 7000
Net Profit 23000
Add: Interest on investments 2000
25000
Less: Loss on sale of Asset 3000
22000
Tax 20% 4400
Net Profit After Tax 17600

𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 (𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱) 𝟏𝟕𝟔𝟎𝟎

𝐍𝐞𝐭 𝐩𝐫𝐨𝐟𝐢𝐭 𝐫𝐚𝐭𝐢𝐨 = = × 𝟏𝟎𝟎
𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬 𝟓𝟎𝟎𝟎𝟎
= 𝟑𝟓. 𝟐%

Prepared By : M. SARATH CHANDRA

Profitability Ratios
Operating Ratio:- It is the ratio between cost of goods sold plus operating expenses and
net sales. It is expressed as percentage to sales.
The Operating Ratio, also known as the Expense Ratio, shows how much of a company's
revenue is used to cover its operating costs.
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐜𝐨𝐬𝐭
𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐢𝐨 = × 𝟏𝟎𝟎
𝐍𝐞𝐭 𝐒𝐚𝐥𝐞
Operating cost = Cost of goods sold +operating expenses (Administration Expenses +
Selling & Distribution exp)
Cost of goods sold = Sales – Gross Profit
• A lower Operating Ratio is generally considered better, indicating more efficient
expense management and operational control.

Example 1: Calculate operating ratio from the following data.

Net sales Rs. 50000
Cost of goods sold Rs. 20000
Administration Expenses Rs. 3000
Selling and Distribution expenses Rs 4000
Loss on sale of fixed assets Rs. 3000
Interest on investment received Rs. 2000 Tax 20%
Prepared By : M. SARATH CHANDRA
Solution:
Operating Cost = Cost of goods sold + Operating expenses(Administration Expenses +
Selling & Distribution exp)

= (20000+3000+4000) = 27000

𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐜𝐨𝐬𝐭
𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐫𝐚𝐭𝐢𝐨 = × 𝟏𝟎𝟎
𝐍𝐞𝐭 𝐒𝐚𝐥𝐞
𝟐𝟕𝟎𝟎𝟎
= × 𝟏𝟎𝟎 = 𝟓𝟒%
𝟓𝟎𝟎𝟎𝟎

Operating Profit Ratio.=100 – Operating ratio

= 100 -

Prepared By : M. SARATH CHANDRA

 Profitability Ratios
Return On Investment (ROI):- This ratio is also called as Return On Capital Employed
(ROCE). The firm is interested to assess the return on capital employed.

Profit Before Interest and Tax (PBIT)

Return On Investment = × 𝟏𝟎𝟎
𝐍𝐞𝐭 𝐀𝐬𝐬𝐞𝐭𝐬𝐨𝐫𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝

Profit Before Interest and Tax (PBIT) = Gross profit – All expenses and losses +
All incomes

Capital employed = Equity share capital + preference share capital + reserves + long term
loans + debentures + intangible Assets
(or)
Fixed Assets + Current Assets – Current Liabilities

Prepared By : M. SARATH CHANDRA

Profitability Ratios
Return On Equity (ROE):- The equity shareholders are interested to assess the return on
equity capital employed.
It measures the profitability of a company in relation to its shareholders' equity.
It indicates how effectively the company is utilizing the investments made by its shareholders
to generate profit.
𝑷𝑨𝑻 −𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅
ROE =
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′𝐬 𝑬𝒒𝒖𝒊𝒕𝒚

Share holders equity= equity share holder fund + preference share holders fund
+reserve and surplus – fictitious assets (if any)
Interpretation:
• A higher ROE is generally considered better, indicating more efficient use of
shareholder investments and potentially higher returns for shareholders.

Prepared By : M. SARATH CHANDRA

Profitability Ratios
Earning Per Share (EPS):- EPS is the relationship between net profit and the number of
equity shares outstanding at eth end of the given period.

PAT – Preference Dividend

Earning Per Share =
No. of Equity Shares

Example 1: Given that the number of share is Rs.10000 and the net profit after taxes
for a given period is Rs. 450000, the EPS can be calculated as follows:

450000– 0
Earning Per Share = ------------------------
10000

= Rs. 45

Prepared By : M. SARATH CHANDRA

Profitability Ratios
Dividend Yield Ratio (D/Y Ratio):- Yield means the amount of total return the investor
will receive for a given period of time for the amount of his investment. Dividend
yield refers to the percentage return on the price paid for shares. It is calculated as
given below:
Dividend Per Share
Dividend Yield Ratio =
Market Value Per Share

Example 1: Given that current market price of a share Rs. 300; face value of the
share is Rs. 100; percentage of dividend declared is 20%, the yield is;

Dividend Per Share = Face value of share * 20/100

= 100 * 20/100 = 20

300
x 100
Return On Equity =------------------------
20
= 6.67%
Prepared By : M. SARATH CHANDRA
Profitability Ratios
Price Earning Ratio (P/E Ratio):- This is the ratio of the market value of a share and
Earnings Per Share.

Market Value of Equity Share

Price Earnings Ratio= ---------------------------------------
Earnings Per Share
Example 1: Given that market price of a share is Rs. 340 and EPS
is 10, calculate P/E ratio.

340
Price Earnings Ratio =---------------
10

= 34

Prepared By : M. SARATH CHANDRA

Solvency Ratio
Solvency ratios measure the ability of a company to pay its long-term
liabilities, such as debt and the interest on that debt.
It indicates whether a company's cash flow is sufficient to cover its long-term
liabilities, providing insights into its overall financial health.
The below are the most commonly used
➢ Debt –Equity Ratio
➢ Interest coverage ratio

Prepared By : M. SARATH CHANDRA

Solvency Ratio
Debt- Equity Ratio
The Debt-to-Equity (D/E) Ratio measures the extent to which a company finances its
operations with debt compared to its shareholders' equity
It refers to the financial ratio that compares the capital contributed by the creditors and
the capital contributed by the shareholder.
Importance
Assess financial leverage: The D/E Ratio helps evaluate the company's risk profile and its
ability to meet its debt obligations.
Analyze capital structure: It provides insights into the company's mix of debt and equity
financing, allowing for comparisons with industry benchmarks and competitors.
Identify potential financial risks: A high D/E Ratio can indicate a higher risk of default and
financial distress if the company faces economic challenges.
Total Long term Debts
Debt − Equity ratio =
Shareholders′ Equity
long term debt mean long term loans whether secured or un secured (Debentures, bonds,
loans from financial institutions)
Share holders’ equity means equity share capital + preference share capital + reserves
and surplus-fictitious assets (e.g., preliminary expenses)

Prepared By : M. SARATH CHANDRA

Debt- Equity Ratio
Interpretation:
• Higher D/E Ratio: Generally indicates higher financial leverage and potential risk, as the
company relies more on debt financing.
• Lower D/E Ratio: Suggests a more conservative capital structure with less reliance on
debt, potentially indicating lower financial risk.

Prepared By : M. SARATH CHANDRA

Debt- Equity Ratio
Let us take a simple example of a company with a balance sheet. Calculate the debt-to-
equity ratio of the company based on the given information.

Total Liabilities = $25,000 + $24,000

Total Liabilities = $49,000

Total Equity = Shareholder’s Equity

Total Equity = $65,000

Debt to Equity Ratio = Total Liabilities

Solution: / Total Equity

Total Liabilities = Non-Current Liabilities + Debt to Equity Ratio = $49,000 /

Current Liabilities $65,000
Debt to Equity Ratio = 0.75

Therefore, the debt-to-equity ratio of

the company is 0.75.
Prepared By : M. SARATH CHANDRA
 Interest Coverage Ratio
The Interest Coverage Ratio (ICR), also known as the Times Interest Earned (TIE) Ratio,
measures a company's ability to meet its interest payments on outstanding debt.
It indicates how easily the company can cover its interest expenses with its earnings before
interest and taxes (EBIT).
The ICR is commonly used by lenders, creditors, and investors to determine the riskiness
of lending capital to a company.

𝐄𝐁𝐈𝐓
Interest Coverage Ratio =
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐄𝐱𝐩𝐞𝐧𝐬𝐞

Prepared By : M. SARATH CHANDRA

 Interest Coverage Ratio
Importance
1. Assess debt servicing capacity: The ICR helps evaluate a company's financial health and
its ability to fulfill its debt obligations.
2. Analyze profitability and risk: A higher ICR suggests that the company has sufficient
earnings to comfortably cover its interest expenses, indicating lower financial risk.
3. Compare with industry benchmarks: Comparing the ICR with industry averages provides
insights into the company's relative financial strength and debt management compared to
its competitors.
Interpretation:
• Higher ICR: Generally considered better, indicating a stronger ability to meet interest
obligations and lower financial risk.
• Lower ICR: Suggests a tighter financial situation and potential difficulty in covering interest
expenses, raising concerns about financial stability.

Prepared By : M. SARATH CHANDRA

Interest Coverage Ratio
Example: XYZ Ltd. has the following financial information for the year ending 31st December
2023:
Earnings before Interest and Taxes (EBIT): ₹600,000
Interest Expense: ₹150,000
Calculate the Interest Coverage Ratio and interpret the results based on the provided
information.
Solution:
EBIT=₹600,000 Interest Expense=₹150,000
Calculate the Interest Coverage Ratio
EBIT
Interest Coverage Ratio =
Interest Expense
6, 00,000
Interest Coverage Ratio=
1,50,000
Interest Coverage Ratio= 4
Interpretation:
Interest Coverage Ratio of 4: This indicates that XYZ Ltd. earns four times its interest
expense before taxes and interests are considered.

Prepared By : M. SARATH CHANDRA

Proprietary ratio
The proprietary ratio, also known as the equity ratio or net worth ratio, measures the
proportion of a company's total assets financed by its shareholders' equity.
It essentially reflects the extent to which a company relies on internal funds as opposed to
external debt.
The proprietary ratio is a tool to understand the firm's financial efficiency in the long run.
It thus determines the proportion of the stockholders' equity to the business's total
assets. It is mathematically represented as:

Prepared By : M. SARATH CHANDRA

 Equity Ratio
The Equity Ratio, also known as the Shareholders' Equity Ratio or Net worth Ratio,
measures the proportion of a company's total assets financed by its shareholders' equity.

𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬′ 𝐄𝐪𝐮𝐢𝐭𝐲
Equity Ratio =
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
Importance
1. Assess financial stability and solvency: A higher Equity Ratio suggests a stronger
financial position, as the company has a larger cushion against potential financial
difficulties and relies less on debt.
2. Evaluate reliance on equity financing: The ratio helps understand the company's capital
structure and financing strategy.
3. Compare with industry benchmarks: Comparing the Equity Ratio with industry averages
provides insights into the company's relative financial position and risk profile compared to
its competitors.

Prepared By : M. SARATH CHANDRA

Interpretation:
• Higher Ratio: Generally considered better, indicating a stronger financial position with less
reliance on debt.
• Lower Ratio: Suggests a higher dependence on debt, which can increase financial risk and
make the company more vulnerable to economic downturns.

Prepared By : M. SARATH CHANDRA

 Example: XYZ Ltd. has the following financial information for the year ending 31st December
2023:
Total Assets: ₹4,000,000
Total Liabilities: ₹1,500,000
Calculate the Equity Ratio and interpret the results based on the provided information
Solution:
Equity Ratio= Shareholders’ Equity/Total Assets
Calculate Shareholders' Equity:
Shareholders’ Equity=Total Assets−Total Liabilities
Shareholders’ Equity=₹4,000,000−₹1,500,000
Shareholders’ Equity=₹2,500,000
25,00,000
Equity Ratio=
4,00,0000
Equity Ratio= 0.625
Interpretation: Equity Ratio of 0.625: This indicates that 62.5% of XYZ Ltd.'s total assets are
financed by shareholders' equity

Prepared By : M. SARATH CHANDRA

 Leverage Ratio
Leverage Ratio measures a company’s inherent financial risk by quantifying the reliance on
debt to fund operations and asset purchases, whether it be via debt or equity capital.

Suppose there’s a company with the following balance sheet

data:

Total Assets = $70 million

Total Debt = $30 million
Total Equity = $40 million
To calculate the B/S ratios, we’d use the following formulas:

Debt-to-Equity = $30 million ÷ $40 million = 0.8

Debt-to-Assets = $30 million ÷ $70 million = 0.4
Debt-to-Total Capitalization = $30 million ÷ ($30 million
+ $40 million) = 0.4

Prepared By : M. SARATH CHANDRA

FUNDS FLOW ANALYSIS
INTRODUCTION
➢ Balance sheet and profit and loss A/C show the financial status
and profitability of the firm respectively.
➢ Balance sheet discloses the value of fixed assets as well as current assets,
the decrease or increase of all assets and liabilities can be ascertained by
comparing with the previous balance sheet.
➢ But it does not disclose the reasons for increasing or decreasing the
assets/liabilities.
➢ However, the “ Funds flow statement” is to be prepared to know such
reasons. In this concept fund means “ net working”.

Prepared By : M. SARATH CHANDRA