Introduction

A tool used by individuals to conduct a quantitative analysis of information in a company's

financial statements. Ratios are calculated from current year numbers and are then compared to
previous years, other companies, the industry, or even the economy to judge the performance of
the company. Ratio analysis is predominately used by proponents of fundamental analysis.
Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication
of a firm's financial performance in several key areas. The ratios are categorized as Short-term
Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and
Market Value Ratios.
Ratio Analysis as a tool possesses several important features. The data, which are provided by
financial statements, are readily available. The computation of ratios facilitates the comparison
of firms which differ in size. Ratios can be used to compare a firm's financial performance with
industry averages. In addition, ratios can be used in a form of trend analysis to identify areas
where performance has improved or deteriorated over time.
Because Ratio Analysis is based upon Accounting information, its effectiveness is limited by the
distortions which arise in financial statements due to such things as Historical Cost Accounting
and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis,
to obtain a quick indication of a firm's performance and to identify areas which need to be
investigated further.

Advantages

Financial ratio analysis is a useful tool for users of financial statement. It has following
advantages:
1.

It simplifies the financial statements.

2.

It helps in comparing companies of different size with each other.

3.

It helps in trend analysis which involves comparing a single company over a period.

4.

It highlights important information in simple form quickly. A user can judge a company
by just looking at few numbers instead of reading the whole financial statements.

Limitations
Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits of
financial ratio analysis are:
1.

Different companies operate in different industries each having different environmental

conditions such as regulation, market structure, etc. Such factors are so significant that a
comparison of two companies from different industries might be misleading.

2.

Financial accounting information is affected by estimates and assumptions. Accounting

standards allow different accounting policies, which impairs comparability and hence ratio
analysis is less useful in such situations.

3.

Ratio analysis explains relationships between past information while users are more
concerned about current and future information.

Objectives of ratio analysis

2

Ratios are worked out to analyse the following aspects of a business organization :
a)
b)
c)
d)
e)
f)
g)
h)

Solvency: (i) long-term ; (ii) short-term ; (iii) immediately.

Stability.
Profitability.
Operational efficiency.
Credit standing.
Structural analysis.
Effective utilization of resources.
Leverage or external financing.

Nature of ratio analysis

Though ratio analysis is al the range among the users of accounting information, it is better to
understand the nature of ratios so, that they can be employed judicious under appropriate
conditions.
a) The relation between two or more financial data brought about by accounting ratio is not
an end in itself. They are, means to get to know the financial position of an organization.
b) An individual ratio may not be capable of providing the answers required for the various
problems facing an executive. Industrial ratio may provide valuable information only
when they are studies and compared with several other related ratios.
c) Ratio analysis will tend to be more meaningful when certain standards and norms are
laid down so that what the ratios indicate can be compared with the said standards. This
provides base for decision-making assist in taking measures to rectify any drawback or
deficiency.
CLASSIFICATIONS OF THE RATIOS
There is no dearth of financial ratios today. There are ratios for different purpose, for different
types of users and for different types of analysis:
Ratios can be grouped under the following heads :
a) Traditional classification
b) Functional classification
c) Users angle
These ratios are explained below:

Traditional classification of ratios

Under this classification, the ratios readily suggest through their names, their respective sources.
From this point of view ratios are classified as under :
a) Balance sheet ratios or financial ratios : They deal with the relationship between two
items, which are together found in the balance sheet. Ratios of current assets and current
liabilities ratio of stock to working capital etc.
b) Reserve statement ratios or Income statement ratios : These ratios deals with the
relationship between two items, which are both found in the income statement.
Examples : the ratio of net profit to sales, ratio of expenses to sale etc.
These ratios are also known s Operating ratios as they deal with the operating results of
an organization.
c) Inter-statement ratios or combined ratios : These ratios indicate the relationship between
two items or two groups of items, of which one is found in the balance sheet and the
other in the income statement ( Profit and loss account ).

Functional classification of ratios

The ratios may be grouped in accordance with the purposes they serve of the different users of
accounting information. On this basis, the ratios are classified as follows :
a) Liquidity Ratios : These ratios analyse short-term and immediate financial position of a
business organization and indicate the ability of the firm to meet its short-term commitments
(current liabilities) out of its short-term resources (current assets). They are also known as
Solvency Ratios.
b) Leverage Ratios : These ratios measure the relationship between proprietors funds and
borrowed funds. They indicate the degree of debt-financing in a firm.

c) Activity Ratios : These ratios are designed to indicate the effectiveness of the firm in
utilizing its funds, its degree of efficiency, and its standards of performance. Hence, they are
also known as Efficiency and Performance Ratios.
d) Profitability Ratios : These ratios are intended to reflect the overall efficiency of the
organization, its ability to earn a reasonable return on capital employed or on shares issued and
the effectiveness of its investment policies.

Classification from the view point of users

Ratios may also be classified from the view point of users of accounting information. Thus, we
can have the following groups of ratios :
a) from shareholders point of view : There are certain ratios which serve the purposes of
shareholders. Shareholders, in general, expect a reasonable return on their capital and
reasonable capital appreciation. They are also interested in the safety of their investments. The
major point of interest to the shareholders is the profitability of the organization.
Example : Earnings per share, Return on Proprietors funds, etc.
b) from short-term creditors point of view : Short-term creditors of a company are basically
interested in knowing the companys ability to pay its short-term liabilities as and when they
become due. Hence, creditors place much importance+ on the liquidity aspect of the companys
assets.
Example : Current and Liquid ratios.
c) from long-term creditors and the Management point of view :
Leverage ratios provide useful information to long-term creditors. Long-term creditors include
debenture holders, vendors of fixed assets and term-lending institutions. These creditors are
primarily interested in the companys ability to repay the principal sum and make periodical
interest payments as and when they become due. Besides, the management may use borrowed
funds as a lever to improve earnings.
BALANCE SHEET RATIOS
The Balance Sheet ratios which are discussed in the chapter are :
a) Current Ratio
b) Liquid Ratio
c) Proprietary Ratio
d) Stock-working Capital Ratio
5

e) Capital Gearing Ratio and

f) Debt Equity Ratio.
Current Ratio
Current Ratio is also known as Working Capital Ratio, Solvency Ratio or 2 to 1 ratio. This
ratio expresses the relationship between current assets and current liabilities.
Calculation
The current ratio is calculated by dividing the current assets by current liabilities. This can be
expressed as pure number or percentage ratio. Generally, it is expressed as a pure ratio.
Working Capital
Working capital is the difference between current assets and current liabilities. Working capital
is defined as the net current assets.
Working capital = Current Assets less Current Liabilities.
Since, current ratio indicates the working capital position of the business, it is also known as the
Working Capital Ratio.
Liquid ratio
Liquid ratio is also known as Quick ratio or Quick asset ratio or Acid test ratio or Near
money ratio, or 1 to 1 ratio.
This ratio is design to indicate the financial position of an enterprise. Thus, the ratio shows the
firms ability to meet its immediate obligations promptly. It measures the relationship between
quick assets and quick liabilities.
Calculation:
The quick ratio or liquid ratio is calculated by dividing quick assets by quick liabilities. This is
generally expressed as a pure ratio.
Quick ratio =
Quick assets
Quick liabilities
This is also known as acid test ratio as there are possibilities of becoming cash insolvent in a
very short time, if major part of the current assets is locked in inventories.
Proprietary ratio
Proprietary Ratio is a test of the financial and credit strength of the business. It relates
shareholders funds to total assets i.e. , total funds. This ratio determines the long term or
ultimate solvency of the company.
In other words, proprietary ratio determines as to what extent the owners interests and
expectations are fulfilled from the total investments made in the business operations.
Trading on Equity

This phenomenon occurs when borrowed capital is employed in the business. The essence of
Trading on Equity is to borrow and use external funds at an explicit cost and employ them
efficiently so as to obtain a return higher than the cost of such funds.
This results in higher returns on equity shareholders funds. Thus, the phenomenon of making
higher rates of return available to the Equity shareholders of the company by means of greater
utilisation of borrowed funds obtained at an explicit or lower cost is termed as Trading on
Equity.
Standard Ratio
It is always desirable to have external and proprietors funds well-balanced. The proprietary
ratio should neither be too high nor too low.
What is a safe ratio is a matter to be decided only after due consideration of various other
factors.
Stock working capital ratio
The stock working ratio brings out the relationship between stock and working capital. It is
alternatively known as inventory-working capital ratio or inventory net current assets ratio.
Standard Ratio
It is very difficult to lay down a standard stock-working capital ratio as the level of stock to be
maintained differs from business to business.
However, 1:1 may be considered as a reasonable standard.
The difficulty in fixing a standard for the ratio is due to the fact that it is necessary to build up
stock in the initial stages in case of a newly started business.

Capital Gearing Ratio

Capital Gearing Ratio brings out the relationship between two types of capital i.e., capital
carrying fixed rate of interest or fixed dividend and capital that does not carry fixed rate of
interest or fixed dividend. It is a modified counterpart of Debt Equity Ratio. In short, capital
gearing ratio indicates the degree to which capital has been geared in the capital structure of a
company.
This ratio is also known as Leverage Ratio or Financial Leverage Ratio, or Capital Structure
Ratio.
Debt Equity Ratio
Meaning

It expresses the relation between the external equities and internal equities or the relationship
between borrowed capital and owners capital.
a) Debt Equity Ratio =
Long Term Debts
Shareholders Funds
b) Debt Equity Ratio =
Long Term Debts
Shareholders Funds +Long Term Debts

REVENUE STATEMENT RATIO

Revenue profit ratios are those ratios which highlight the relationship between two revenue
statement items. The following five revenue statement ratios are discussed in this chapter.
a)
b)
c)
d)
e)
f)

Gross Profit Ratio

Operating Ratio
Expenses Ratio
Net Profit Ratio
Stock Turnover Ratio and
Net Operating Profit Ratio.

Gross Profit Ratio

Gross Profit ratio brings out the relationship between Gross Profit and Net Sales. It is also
known as Turnover ratio or Margin or Gross margin ratio or Rate of gross profit. It is
expressed as a percentage of net sales.
Calculation
Gross Profit 100
sales
High and low ratios
A low gross profit ratio may indicate unfavorable purchase and mark policies, inability to
increase sales volume and excessive competition.
A high gross profit ratio may indicate efficiency of the sales department and effectiveness of
cost control measures.
Standard ratio

it is very difficult to lay down the standard gross profit ratio as it refers from industry to
industry and from year to year in a firm.
In any case, the gross profit ratio must atleast be maintained at a consistent level if cannot be
Improved. Steps should be taken to earn gross profit atleast sufficient to cover the operating
expenses and fixed interest charges.
Operating Ratio
Operating ratio is the relationship between cost of activities and net sales. This ratio brings out
the relationship between total cost of goods sold and net sales.
In other words, operating ratio shows at what percentage the operating expenses are comprised
in net sales. This is expressed as a percentage.
High and low operating ratios
Lower the operating ratio, the better is the operational efficiency of the business. If the
operating ratio is higher, it would lead to lower profits and therefore will be less favorable
because what would be left out of operating profits for the shareholders will be meager. When
more capital is needed, the operating ratio should be low.
Standard ratio
Though a standard operating ratio cannot be precisely laid down, the ratio in the case of
manufacturing concerns is normally high, while in case of other firms, the ratio may be low.
Expenses Ratio
The ratio of each item of expenses or each group of expenses to net sales is known as an
Expense Ratio and such ratios are collectively known as Expense Ratios. Thus, expense ratio
brings out the relationship between various elements of operating costs and net sales.
Expense ratios analyse each individual item of expense or group of expenses and express them
as a percentage in relation to net sales.

Calculation
a) Ratio of Administrative expenses:
Administrative expenses 100
Net sales
b) Ratio of Selling expenses:
Selling expenses
100
Net sales
c) Material consumed ratio:
Material consumed 100
9

Net sales
d) Conversion cost ratio:
Manufacturing expenses 100
Net sales
e) Ratio of non-operating expenses:
Non-operating expenses 100
Net sales
Net Profit Ratio
Net Profit ratio indicates the relationship between net profit and net sales. Net profit can be
either operating net profit or net profit after tax or net profit before tax. This ratio is also known
as Margin on Sales Ratio.
Calculation
Net profit ratio is calculated as under :
a)
Net profit 100
Net sales

NAT
Net sales

100

b)

NBT
100
Net sales
This ratio is expressed as a percentage.
Net Operating Profit Ratio
It is a relationship between net operating profit and net sales which is expressed in percentage
Formula
Net Operating Profit Ratio =
Net Operating Profit 100
Net Sales
Stock Turnover Ratio
Stock Turnover ratio is also known as Inventory ratio or Inventory Turnover ratio or Stock
Turn ratio or Merchandise Turnover ratio or Stock Velocity ratio or simply Velocity of
Stock
This ratio measures the number of times stock turns or flows or rotates in an accounting period
compared to the sales effected during that period.
In other words, the ratio indicates the frequency of inventory replacement i.e., the number of
times inventory has been sold and replaced during a given period of time.
Calculation
Stock Turnover ratio is the relationship between inventory and cost of goods sold and is
calculated as under :
Stock Turnover Ratio =

Cost of goods sold

Average Stock
The ratio is expressed as a number, so many times in a year.

10

Average Stock
Average stock on hand as at the end of a period is calculated by adding inventory in the
beginning of the period to the inventory at the close of the period and the product is divided by
two.
Average Stock =

Opening Stock + Closing Stock

2
When the opening stock figure is not available, closing stock can be considered as the average
stock.
For greater accuracy, average inventory for a year may be taken. This is calculated by adding
inventory as at the beginning of the year and inventories as at the end of every month and
dividing the total by 13.
Standard Ratio
It is difficult to establish a standard inventory ratio as inventory levels differ from industry to
industry.
Generally speaking, the rate of stock turnover will be much higher in food, provision and chain
stores than in engineering concerns and firms dealing in capital goods or durable consumer
goods.
However, the following general guidelines may be considered as reasonable :
a) inventory of raw material not to exceed 2 to 4 months consumption in a year.
b) inventory of finished goods not to exceed 2 to 3 months sales.
c) Work-in-progress not to exceed 15 to 30 days sales, depending upon the process time.
However, both high and low turnover ratios are not conducive for profitability and a reasonable
level of inventories has to be maintained based on past experience.
High and Low Inventory Ratios
A high inventory ratio may indicate any of the following :
a) possibility of over-trading;
b) effective inventory management;
c) inadequate inventory resulting in loss of customer patronage;
d) sales at lower prices resulting in lower profits;
e) deflated inventory valuation;
A low inventory turnover ratio may indicate any of the following :
a) slackness in business activities
b) over-investment in inventory;
c) anticipation of rise in prices;
d) accumulation of obsolete and dead stock;
e) deflated inventory valuation;
f) inflated inventory valuation;
COMBINED RATIOS
Combined ratios or Inter-Statement Ratios relate two items or two groups of items of which one
is from Balance Sheet and one of the revenue statements.
Return on Capital Employed
11

This ratio explains the relationship between total profits earned by the business and total
investments made or total assets employed. This ratio, thus measures the overall efficiency of
the business operations.
This ratio is alternatively known as Return of Total Resources.
Calculation
Return on total resources is calculated by dividing Net Profit before preference dividend and
interest on loans and debentures by total assets (fixed and current). This is always expressed as a
percentage.
=
Net Profit before interest & tax
Capital Employed

100

Return on Proprietors Funds

Alternatively known as Return on Proprietors Equity or Return on Shareholders
Investment or Investors Ratio, the above ratio indicates the relationship between net profit
earned and total Proprietors Funds.
Calculation
The formula for calculating the Return on Proprietors Funds will be,
NPAT
100
Proprietors Funds
Return on Equity Share Capital
This ratio indicates the rate of earning on the Equity or ordinary share capital. This is expressed
as a percentage or in absolute monetary terms. Alternatively, this may be expressed as an
amount of return per equity share but as a percent of the equity capital it is easily understood.
This ratio is also known as The Rate of Return on Equity Capital.
Calculation
The formula for calculating the ratio is :
=
Net Profit after tax less Pref. dividend
Equity Share Capital
Alternatively, the following formula may be employed for calculating the Return per equity
share :
Net Profit after Tax less Preference Dividend
Number of Equity Shares
Earning per share
Meaning
Earning per share is calculated to find out overall profitability of the organization.
Earning per share represents earning of the company whether or not dividends are declared. If
there is only one class of shares, the earnings per share are determined by dividing net profit by
the number of equity shares. If there are both equity and preference shares the net profit should
12

be reduced by the amount necessary to pay preference dividend. It is calculated by the following
formula.
Formula
Earning per Share =
E.P.S

Net Profit after Tax - Preference Dividend

Number of Equity Shares

Dividend Payout Ratio

Meaning
The purpose of this ratio is to find out the proportion of earning used for payment of dividend
and the proportion of earning retained. The ratio is a relationship between earning per equity
share and dividend per equity share. The ratio can be calculated as follows :
Formula
Dividend per Equity Share
Earning per Equity Share
Dividend Yield Ratio
Meaning
It is a relationship between dividend and market price.
Formula
Dividend Yield =
Dividend per Share
Market Price per Share
Price-Earning Ratio
Meaning
It is a proportion between market price and earning per share.
Formula
P/E Ratio =

Market Price per Equity Share

Earning per Share

Debt Service Ratio

Meaning
This ratio is also called as interest coverage ratio. The purpose of this ratio is to find out the
number of times the fixed financial charges are covered by income before interest and tax. The
ratio is calculated by the following formula :
Formula
=
Net Profit before interest and tax
Fixed interest Charges
Debt Service Coverage Ratio
Interest coverage ratio tells about the ability of a company to pay interest regularly. It does not
tell about the ability of a company to make payment of principal amount on time. For this
purpose, debt service coverage ratio has to be calculated as follows :
Debt Service
=
Net profit before Interest and Tax
Coverage Ratio
Interest + Principal Payment Instalment
1 - Tax Rate
Creditors Turnover Ratio
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Meaning
It is similar to Debtors Turnover Ratio. It shows the speed with which payments are made to
the suppliers for purchases made from them. It is a relationship between net credit purchases
and average creditors.
Formula
Credit Purchases
Average Accounts Payable
Average Creditors
For the purpose of calculation of this ratio, average monthly balance of creditors and bills
payable should be taken. If this information is not available average of opening and closing
balances of creditors should be taken. If opening balance is not available, year end balance
should be considered.
Creditors turnover ratio may be further used to find out the average rate of payables by
using the following formula :
=
Days in a Year
OR
Creditors Turnover
Average Accounts Payable
No. of days or months in a year.
Credit Purchases in a Year
Debtors Turnover Ratio (Debtors Velocity)
Debtors Turnover Ratios is alternatively known as Turnover of Debtors Ratio or Accounts
Receivable Turnover Ratio. Some analysts prefer to call this ratio as Debtors Turnover
period or as Average collection period.
This ratio attempts to measure the collectability of debtors and other accounts
receivables. In other words, it shows the rate at which the trade debts are being collected.
Sundry Debtors and Other Accounts Receivable
These items represent the amount outstanding and receivable as on a particular date, usually as
on the balance sheet date. The total receivables will be the total of Sundry Debtors and bills
Receivable.
Accounts Receivable should not include debtors or bills arising from non-operating transactions
i.e., activities other than trading.
Debtors Turnover ratio is calculated as under :
=
Credit Sales
Average Accounts Receivables
Debt Collection Period
The ratio indicated the extent to which the debts have been collected in time. It gives the
average debt collection period. The ratio helps the lenders to known whether their borrowers are
collecting money from debtors within a stipulated period.
14

Formula
Debtors + Bills Receivable
Average daily or monthly Credit Sales
Average daily sales is calculated as follows :
=
Net Credit Sales
OR
Months or days in a year
No. of days in the year
Debtors Turnover
OR
Average Accounts Receivable
Months or days in a year
Credit Sales for the year
Assets Turnover Ratio
Fixed Assets Turnover Ratio
It is a relationship between Sales and Fixed Assets.
Formula
Fixed Assets Turnover Ratio :
Sales
Fixed Assets
Total Assets Turnover Ratio
Meaning
It shows the number of times total assets are being turned over in a year.
Formula
Total Assets Turnover Ratio
=
Sales
Total Assets
Working Capital Turnover Ratio
Formula
Sales
Working Capital
Capital Turnover Ratio
Meaning
It is a relationship between Sales and Capital employed.
Formula
Capital Turnover Ratio =
Sales
Capital Employed

Illustration 1 :

15

From the following financial statements of Sunshine Ltd., calculate the companys
accounting ratios and offer brief comments on the companys :
(1) Financial stability, (2) Financial management, and (3) Efficiency (profitability)
Trading and Profit & Loss A/c
For the year ended 31st March, 2006
Rs.
Sales (Net)
Opening Stock
Purchases

Rs.
6,00,000

65,000
3,35,000
4,00,000
40,000

Less : Closing Stock

Gross Profit
General Expenses
Directors Emoluments
Depreciation
Audit Fees
Debenture Interest

1,36,280
10,000
6,200
500
2,520

Income from Investments

Profit prior to Taxation
Taxation @ 40%
Profit after Taxation
Balance brought forward from previous year
Excess Tax Provision of previous year written back

3,60,000
2,40,000

1,55,500
84,500
8,700

93,200
37,280
55,920
10,580
1,000

Transfer to General Reserve

Transfer to Dividend Equalisation Reserve

11,580
67,500

10,000
5,000
15,000

Proposed Dividend :
5% Preference Dividend
30% Equity Dividend
Balance carried forward

500
12,000

27,500
40,000

Balance Sheet as on 31st March, 2006

Cost
Rs.
Funds used in Fixed Assets :
Land and Buildings
Plant and Machinery
Motor Vehicles
Furnitures and Fittings

50,000
35,000
15,000
3,000

Investments (Market Value Rs. 99,000)

Current Assets :
16

Depreciation
Rs.
21,000
7,500
600

Net
Rs.
50,000
14,000
7,500
2,400
73,900
87,000

Prepaid Expenses
Stock in Trade
Debtors
Bills Receivable
Tax Credit Certificates
Bank
45,000
5,500
39,800

Less Current Liabilities :

Trade Creditors
Accrued Expenses
Provision for Taxation

12,500

Proposed Dividend
Net Current Assets or Working Capital
10,000
40,000
4,000

Reserve and Surplus :

Securities Premium
General Reserve
Dividend Equalisation Reserve
Profit and Loss A/c
Shareholders Funds
Loan Capital : 7% Debentures
(Decured on Land)

90,000
5,000
40,000

2.

Liquid Ratio

3.

Proprietary Ratio

=
=

Capital Gearing Ratio

1,39,000

Stock
Working Capital
40,000
= 0.62:1
1,66,900 - 1,02,800
Fixed Interest Bearing Securities
Equity Capital + Reserves

=
5.

1,89,000

Current Assets
Current Liabilities
1,66,900
= 1.62:1
1,02,800
Liquid Assets
Current Liabilities
1,06,900
= 1.04:1
Proprietors Equity
Total Assets
1,89,000
= 0.58:1
3,27,800

=
Stock-Working
Capital Ratio

50,000

36,000
2,25,000

4.

64,100
2,25,000
1,02,800

Financed by :
Share Capital
100, 5% Preference Shares of
Rs. 100 each
40,000 Equity Shares of Rs. 1 each

Solution :
Financial Management Ratios :
1.
Current Ratio

20,000
40,000
50,000
1,100
16,000
39,800
1,66,900

17

46,000
= 0.27:1
1,79,000
OR
Fixed Interest Bearing Securities
Equity Capital
46,000
= 1.15:1
40,000

=
=
Profitability Ratio :
Gross Profit Ratio

Operating Ratio

=
=

Gross Profit
100
Net Sales
=
2,40,000
100 = 40%
6,00,000
Operating Cost 100
Net Sales
Cost of Goods sold + Operating Exps. 100
Net Sales
=

Net Profit Ratio

Stock Turnover Ratio

3,60,000 + (1,36,280,+ 16,700) 100

6,00,000
=
5,2,980 100
= 85.5%
6,00,000
Net Operating Profit 100
Net Sales
=
Gross Profit - Operating Exps. 100
Sales
=
2,40,000 - 1,52,980 100
6,00,000
=
87,020 100
= 14.5%
6,00,000
Cost of Goods Sold
Average Inventory
=

Return on Capital employed

3,60,000
= 6086 times
65,000 +40,000
2
Opening Net Profit (before Tax & Interest)
Capital employed
87,020
100
= 38.68%
2,25,000

=
=

Return of Proprietors Equity

=
=

Return on Equity Capital

Debtors Turnover Ratio

/ Collection Period

Net Profit after Tax

Proprietors Equity
55,920
100 = 29.59%
1,89,000
Net Profit after tax & Pref. dividend 100
Equity Capital
=
55,920 - 500
100 = 138.55%
40,000
Accounts Receivable
18

365

Net Sales
50,000 + 1,100
6,00,000

365 = 31 days

Comments :
a)
Financial Stability : Long-term : The long-term financial position of the company is
indicated by the proprietary ratio. The proprietary ratio of the company is 0.58:1. This indicates
that for every one rupee of the total assets, contribution of 58 paise has come from the
proprietors. The contribution made by the proprietors to total assets is more than that of the
outsiders. The ratio is satisfactory. Therefore, the firm can be considered financially stable in the
long run.
Short term : The short-term financial position of the company is indicated by the current and
liquid ratios. The current ratio of the Company is 1.62:1 which is not favourable. Hence, the
short-term financial position of the company is not strong, whereas the immediate solvency
position as revealed by liquid ratio (1.04:1) seems to be satisfactory. The company is in a
position to meet its current obligations out of its current assets as and when they fall due for
payment.
b)
Financial Management : The proportion of fixed interest bearing securities to equity
shareholders funds is 0.27:1. This indicates that the capital structure of the company is lowgeared. Considering the proportion of fixed interest bearing securities to equity capital, the
structure of capital seems to be slightly high geared. The gearing of capital structure of capital
structure has profound influence+ on the quantum of profits available to the equity shareholders.
The stock to Working Capital ratio is 62:1 which shows that out of every rupee of working
capital, 62 paise are locked up in inventories. This has influence on the working capital position
of the company and consequently on its liquid position.
The collection period of debtors is not very long. The average collection period of 31 days is
quite reasonable.

19

c)

Profitability : Gross Profit ratio is 40% and the net operating profit ratio is 14.5%.

This indicates that out of every Rs. 100 worth of sales Rs. 14.50 is operating profit and Rs.
85.50 is the operating cost.
The return on total resources is 36.14% and the return on equity capital is 138.55%. Equity
shareholders earn Rs. 138.55 on every Rs. 100/- of capital subscribed and paid by them and Rs.
29.59 on every Rs. 100/- employed by them as resources.
This shows that the profitability of the company seems to be satisfactory. However, whether
there is an improvement in the profitability or not depends on the comparative study of figures
of the previous accounting periods.

Illustration 2:
The following are the summarised Profit & Loss Account of Siddhartha Product Limited for the
years ending 31st December, 2005 and the balance sheet as on that date:
Profit & Loss A/c

To Opening Stock
To Purchases
To Incidental Expenses
To Gross Profit c/d
To Operating Expenses:
Selling and Distribution

Rs.
99,000
5,45,250
14,250
3,40,000
9,99,000
30,000
20

By Sales
By Closing Stock

Rs.
8,50,000
1,49,000
9,99,000

By Gross Profit b/d

By
Non-operating

3,40,000

Administration
Finance

1,50,000
15,000
1,95,000

To Non-operating Expenses :
Loss on Sale of Assets
Net Profit

Incomes :
Interest
Profit on Sale
Of Shares

3,000
9,000
6,000

4,000
1,50,000
3,49,000

3,49,000

Balance Sheet as at______

Liabilities
Issued Capital :
2,000 Equity Shares
Of Rs. 100 each
Reserves
Current Liabilities
Profit & Loss A/c

Rs.

Assets
Land & Building
Plant & Machinery
Stock-in-Trade
Sundry Debtors
Cash & Bank Balance

2,00,000
90,000
1,30,000
60,000
4,80,000

Rs.
1,50,000
80,000
1,49,000
71,000
30,000
4,80,000

From the above statements you are required to calculate the following ratios and state the
purposes they serve :
a) Current ratio,
b) Operating ratio
c) Stock turnover
d) Return on capital employed,
e) Earning per equity share,
f) Opening profit ratio.
Solution :
a) Current Ratio
=

Current Assets
Current Liabilities
=
1,49,000 + 71,000 + 30,000
1,30,000
=
2,50,000
1,30,000
= 1.92
The purpose is to test the short-term financial position of the company.
The ratio is near the standard ratio of 2:1. It appears that the short-term financial position of the
company is not bad. However, the position is not satisfactory as a large portion of current assets
is represented by stock-in-trade.
b) Operating Ratio
=

Cost of Goods sold + Operating Expenses 100

Net Sales

21

Cost of goods sold

Operating Ratio

Opening Stock + Purchases + Expenses chargeable to

=
=
=

trading A/c - Closing Stock

(99,500 + 5,45,250 + 14,250) - 1,49,000
6,59 000 - 1,49,000
5,10,000

5,10,000 + 1,95,000
100
8,50,000
=
7,05,000
100
8,50,000
= 83%. (approx)
The purpose of the ratio is to test the operating efficiency of the company. This ratio is also used
to find out what portion of sales is absorbed by operating costs. In this case, out of every Rs. 83
is the operating cost.
c) Stock Turnover Ratio

=
=
=

Calculation of Average Stock:

Average Stock

Cost of goods sold

Average Stock
5,10,000
1,24,250
4.1 times.

Opening Stock + Closing Stock

2
=
2,48,500
2
= 1,24,250
The purpose of this ratio is to measure the operating efficiency of the company and of inventory
management. Higher the ratio, greater is the efficiency. In this example, the stock turnover is
slightly more than 4 times on an average.
d) Return on Capital Employed

Net Profit
100
Capital Employed
=
1,50,000
100
4,80,000
=
31% (approx)
Sometimes, the ratio is calculated by considering the operating profit. If this approach is
adopted, the ratio will be :
=
=

1,45,000
100
4,80,000
30% (approx)

Net Operating Profit is calculated as under :

Rs.
1,50,000
4,000

Net Profit
Add : Non-operating Expenses
22

1,54,000
9,000
1,45,000

Less : Non- operating Income

The purpose of this ratio is to test the manner in which the resources are utilized. It is also used
to test the overall profitability of the company.
In this case, the ratio is 31%. It means, that the company has earned Rs.31 on every Rs. 100
employed as resources.
e) Earning per Equity Share

=
=

Net Profit after tax & preference dividend

No. of equity shares
1,50,000
2,000
Rs. 75

=
The purpose is to find out possibility of dividend.
f) Net Operating Profit Ratio
=
Net Operating Profit
Net Sales
=
1,45,000
100
8,50,000
= 17.06%
The purpose is to judge the operating efficiency of the management.

100

Illustration 3 :
Shown below are the comparative balance sheets and operating data of Alpha Company
for the years ended on 31st December, 2004, 2005 and 2006 :
Comparative Balance Sheets
2004
Rs.

23

2005
Rs

2006
Rs.

Current Assets :
Cash
Debtors
Stock
[A]

1,200
14,800
14,800
30,800

1,900
12,400
16,200
30,500

400
10,400
19,800
30,600

[B]
[A + B]

9,800
15,700
5,000
30,500
61,300

12,000
16,300
5,000
33,300
63,800

12,800
18,000
5,000
35,800
66,400

7,500
6,300
1,200
15,000

3,000
11,200
1,600
15,800

5,000
13,400
2,900
21,300

30,000
16,300
46,300
61,300

30,000
18,000
48,000
63,800

30,000
9,600
39,600
66,4000

Fixed Assets (Net) :

Equipments
Buildings
Land
Total Assets
Current Liabilities :
Bills Payable
Creditors
Accrued Liabilities
Long term Loans : Debentures 6%)
Owners Equity
Equity Capital (Rs. 100 each)
Retained Earnings

[A]
[B]

[C]
[A +B+C]

Total Liabilities
Additional Information :

2004
Rs.
1,00,000
5,000
3,000

Total Sales
Net Profit after Tax
Dividend paid

2005
Rs.
1,05,000
5,7000
3,000

2006
Rs.
93,000
2,400
1,000

You are required to :

1. Compute the following for each of the three years :
i) Current Ratio,
ii) Acid Test Ratio,
iii) Proprietary Ratio,
iv) Return on Proprietors Equity.
2. Discuss the financial condition of the company as on 31st December 2004, and the trends
shown by the comparative data and the ratios.
Solution :
.
Current Ratio
=
2004 :

2005 :

30,800
15,000

Current Assets
Current Liabilities
2.05:1

30,500
15,800

24

1.93:1

2006 :
2.

3.
2004 :
2005 :
2006 :

30,600
21,300

1.44:1

Acid Test Ratio

2004 :

Quick Assets
Current Liabilities
1.07:1

0.91:1

0.51:1

Net Profit
100
Proprietors Equity

16,000
15,000
2005 :
14,300
15,800
2006 :
10,800
21,300
Proprietary Ratio
5,000
46,300
5,700
48,000
2,400
39,600

100

10.8%

100

11.88%

100

6.06%

Comments :
a)
Short-term financial position : Short-term financial position is reflected in the
Current Ratio and Acid Test Ratio. The Current Ratio and Acid Test Ratio of the company for
2004 are favourable. The position of the company for 2004 seems to be satisfactory. In 2005
both the ratios have declined. The position of the company for 2006 has become worst as there
is a drastic decline in the ability of the company to meet its current obligations out of its current
assets.
b)
Long-term financial position : The proprietary ratio in 2004 was 1.76:1, in 2005,
0.75:1 and in 2006, 0.6:1.
The financial position of the company seems to be satisfactory as the proprietors contribution to
total assets is more than the contribution by outsiders.
However, the ratio is showing a downward tendency. This means that the interest of the
proprietors is decreasing. This should be checked.
c)
Profitability : The profitability position of the company showed improvement in 2005
as it is indicated by the increase in the return on proprietors equity and earnings per share as
compared to the previous year. However, ratios of both the years have decreased in 2006.
Return on proprietors equity has fallen from 11.88% in 2005 to 6.06% in 2006.
25

The profitability position of the company is not satisfactory.

BIBLIOGRAPHY
Book :1. Advanced Financial management, L. N. Chopde, sheth publication, june, 2010.
Websites:1. http://accountingexplained.com/financial/ratios/advantages-limitations
2. http://www.investopedia.com/terms/r/ratioanalysis.asp

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