RATIO ANALYSIS

R K MOHANTY
FACULTY MEMBER, SIR SPBT COLLEGE,
CENTRAL BANK OF INDIA, MUMBAI
 RATIO ANALYSIS
Ratio-analysis is a concept or technique
which is as old as accounting concept.
Financial analysis is a scientific tool. It has
assumed important role as a tool for
appraising the real worth of an enterprise, its
performance during a period of time and its pit
falls. Financial analysis is a vital apparatus for
the interpretation of financial statements. It
also helps to find out any cross-sectional and
time series linkages between various ratios.
 RATIO ANALYSIS

Unlike in the past when security was considered to

be sufficient consideration for banks and financial
institutions to grant loans and advances, nowadays
the entire lending is need-based and the emphasis is
on the financial viability of a proposal and not only
on security alone. Further all business decision
contains an element of risk. The risk is more in the
case of decisions relating to credits. Ratio analysis
and other quantitative techniques facilitate
assessment of this risk.
 RATIO ANALYSIS

Ratio-analysis means the process of

computing, determining and presenting the
relationship of related items and groups of
items of the financial statements. They
provide in a summarized and concise form
of fairly good idea about the financial
position of a unit. They are important tools
for financial analysis.
WHY FINANCIAL ANALYSIS

Lenders need it for carrying out the following

Technical Appraisal

Commercial Appraisal

Financial Appraisal

Economic Appraisal

Management Appraisal
RATIO ANALYSIS
Its a tool which enables the banker or lender to
arrive at the following factors :
Liquidity position
Profitability
Solvency
Financial Stability
Quality of the Management
Safety & Security of the loans & advances to be or
already been provided
Before looking at the ratios there are a number of cautionary
points concerning their use that need to be identified :

a. The dates and duration of the financial statements being

compared should be the same. If not, the effects of
seasonality may cause erroneous conclusions to be drawn.

b. The accounts to be compared should have been prepared

on the same bases. Different treatment of stocks or
depreciations or asset valuations will distort the results.

c. In order to judge the overall performance of the firm a

group of ratios, as opposed to just one or two should be
used. In order to identify trends at least three years of
ratios are normally required.
The utility of ratio analysis will get further
enhanced if following comparison is
possible.

1.Between the borrower and its competitor

2.Between the borrower and the best
enterprise in the industry
3.Between the borrower and the average
performance in the industry
4.Between the borrower and the global
average
HOW A RATIO IS EXPRESSED?
As Percentage - such as 25% or 50% . For example
if net profit is Rs.25,000/- and the sales is
Rs.1,00,000/- then the net profit can be said to be
25% of the sales.
As Proportion - The above figures may be expressed
in terms of the relationship between net profit to sales
as 1 : 4.
As Pure Number /Times - The same can also be
expressed in an alternatively way such as the sale is 4
times of the net profit or profit is 1/4th of the sales.
CLASSIFICATION OF RATIOS
Balance Sheet P&L Ratio or Balance Sheet and
Ratio Income/Revenue Profit & Loss Ratio
Statement Ratio

Financial Ratio Operating Ratio Composite Ratio

Current Ratio Gross Profit Ratio Fixed Asset Turnover
Quick Asset Ratio Operating Ratio Ratio, Return on
Proprietary Ratio Expense Ratio Total Resources
Debt Equity Ratio Net profit Ratio Ratio,
Stock Turnover Ratio Return on Own Funds
Ratio, Earning per
Share Ratio, Debtors
Turnover Ratio,
 FORMAT OF BALANCE SHEET FOR RATIO ANALYSIS
LIABILITIES
NET WORTH/EQUITY/OWNED FUNDS
Share Capital/Partners Capital/Paid up Capital/ MACHINERIES
Owners Funds
Reserves ( General, Capital, Revaluation & Other Net Value or Book Value or Written down value
Reserves)
Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED FUNDS :
Term Loans (Banks & Institutions)
Debentures/Bonds, Unsecured Loans, Fixed
Deposits, Other Long Term Liabilities
CURRENT LIABILTIES
Bank Working Capital Limits such as
CC/OD/Bills/Export Credit
Sundry /Trade Creditors/Creditors/Bills Payable,
Short duration loans or deposits
Expenses payable & provisions against various
items
ASSETS
FIXED ASSETS : LAND & BUILDING, PLANT &
Original Value Less Depreciation
NON CURRENT ASSETS
Investments in quoted shares & securities
Old stocks or old/disputed book debts
Long Term Security Deposits
Other Misc. assets which are not current or fixed
in nature
CURRENT ASSETS : Cash & Bank Balance,
Marketable/quoted Govt. or other securities,
Book Debts/Sundry Debtors, Bills Receivables,
Stocks & inventory (RM,SIP,FG) Stores & Spares,
Advance Payment of Taxes, Prepaid expenses,
Loans and Advances recoverable within 12
months
INTANGIBLE ASSETS
Patent, Goodwill, Debit balance in P&L A/c,
Preliminary or Preoperative expenses
SOME IMPORTANT NOTES
Liabilities have Credit balance and Assets have Debit balance
Current Liabilities are those which have either become due for
payment or shall fall due for payment within 12 months from
the date of Balance Sheet
Current Assets are those which undergo change in their
shape/form within 12 months. These are also called Working
Capital or Gross Working Capital
Net Worth & Long Term Liabilities are also called Long Term
Sources of Funds
Current Liabilities are known as Short Term Sources of Funds
Long Term Liabilities & Short Term Liabilities are also called
Outside Liabilities
Current Assets are Short Term Use of Funds
SOME IMPORTANT NOTES
Assets other than Current Assets are Long Term Use of Funds
Installments of Term Loan Payable in 12 months are to be taken as
Current Liability only for Calculation of Current Ratio & Quick Ratio.
If there is profit it shall become part of Net Worth under the head
Reserves and if there is loss it will become part of Intangible Assets
Investments in Govt. Securities to be treated current only if these are
marketable and due. Investments in other securities are to be
treated Current if they are quoted. Investments in
allied/associate/sister units or firms to be treated as Non-current.
Bonus Shares as issued by capitalization of General reserves and as
such do not affect the Net Worth. With Rights Issue, change takes
place in Net Worth and Current Ratio.
1. Current Ratio : It is the relationship between the current
assets and current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a concern are
Rs.4,00,000 and Rs.2,00,000 respectively, then the
Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
The ideal Current Ratio preferred by Banks is 1.33 : 1

2. Net Working Capital : This is worked out as surplus of Long

Term Sources over Long Tern Uses, alternatively it is the
difference of Current Assets and Current Liabilities.
NWC = Current Assets Current Liabilities
Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished
Goods, Debtors, Bills Receivables, Cash.

Current Liabilities : Sundry Creditors, Installments of Term Loan, DPG etc.

payable within one year and other liabilities payable within one year.

This ratio must be at least 1.33 : 1 to ensure minimum margin of 25% of current
assets as margin from long term sources.

Current Ratio measures short term liquidity of the concern and its ability to
meet its short term obligations within a time span of a year.
It shows the liquidity position of the enterprise and its ability to meet current
obligations in time.
Higher ratio may be good from the point of view of creditors. In the long run
very high current ratio may affect profitability ( e.g. high inventory carrying cost)
Shows the liquidity at a particular point of time. The position can change
immediately after that date. So trend of the current ratio over the years to be
analyzed.
Current Ratio is to be studied with the changes of NWC. It is also necessary to
look at this ratio along with the Debt-Equity ratio.
3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current
Assets and Current Liabilities. The should be at least equal to 1.

Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months +

Quickly realizable securities such as Govt. Securities or quickly marketable/quoted
shares and Bank Fixed Deposits

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example :
Cash 50,000
Debtors 1,00,000
Inventories 1,50,000 Current Liabilities 1,00,000
Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3:1

Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1
4. DEBT EQUITY RATIO : It is the relationship between
borrowers fund (Debt) and Owners Capital (Equity).

Long Term Outside Liabilities / Tangible Net Worth

Liabilities of Long Term Nature

Total of Capital and Reserves & Surplus Less Intangible Assets

For instance, if the Firm is having the following :

Capital = Rs. 200 Lacs

Free Reserves & Surplus = Rs. 300 Lacs
Long Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1

5. PROPRIETARY RATIO : This ratio indicates the extent to which
Tangible Assets are financed by Owners Fund.
Proprietary Ratio = (Tangible Net Worth/Total Tangible
Assets) x 100
The ratio will be 100% when there is no Borrowing for purchasing
of Assets.

6. GROSS PROFIT RATIO : By comparing Gross Profit percentage to

Net Sales we can arrive at the Gross Profit Ratio which indicates the
manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of

Goods Sold, it can also be interpreted as below :

Gross Profit Ratio = [ (Sales Cost of goods sold)/ Net Sales]

x 100
A higher Gross Profit Ratio indicates efficiency in production of the unit.
7. OPERATING PROFIT RATIO :

It is expressed as => (Operating Profit / Net Sales ) x 100

Higher the ratio indicates operational efficiency

8. NET PROFIT RATIO :

It is expressed as => ( Net Profit / Net Sales ) x 100

It measures overall profitability.

 9. STOCK/INVENTORY TURNOVER RATIO :

(Average Inventory/Sales) x 365 for days

(Average Inventory/Sales) x 52 for weeks
(Average Inventory/Sales) x 12 for months

Average Inventory or Stocks = (Opening Stock + Closing Stock)

-----------------------------------------
2
. This ratio indicates the number of times the inventory is
rotated during the relevant accounting period
 10. DEBTORS TURNOVER RATIO : This is also called Debtors
Velocity or Average Collection Period or Period of Credit given .

(Average Debtors/Sales ) x 365 for days

(52 for weeks & 12 for months)

11. ASSET TRUNOVER RATIO : Net Sales/Tangible Assets

12. FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets

13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets

14. CREDITORS TURNOVER RATIO : This is also called Creditors

Velocity Ratio, which determines the creditor payment period.

(Average Creditors/Purchases)x365 for days

(52 for weeks & 12 for months)
15. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets

16. RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share

capital and long term funds provided by the owners and the
creditors of the firm at the beginning and end of the accounting
period.
 Composite Ratio

17. RETRUN ON EQUITY CAPITAL (ROE) :

Net Profit after Taxes / Tangible Net Worth

18. EARNING PER SHARE : EPS indicates the quantum of net profit
of the year that would be ranking for dividend for each share of
the company being held by the equity share holders.

Net profit after Taxes and Preference Dividend/ No. of Equity

Shares

19. PRICE EARNING RATIO : PE Ratio indicates the number of times

the Earning Per Share is covered by its market price.

Market Price Per Equity Share/Earning Per Share

20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most
important one which indicates the ability of an enterprise to
meet its liabilities by way of payment of installments of Term
Loans and Interest thereon from out of the cash accruals and
forms the basis for fixation of the repayment schedule in
respect of the Term Loans raised for a project. (The Ideal DSCR
Ratio is considered to be 2 )

PAT + Depr. + Annual Interest on Long Term Loans & Liabilities

---------------------------------------------------------------------------------
Annual interest on Long Term Loans & Liabilities + Annual
Installments payable on Long Term Loans & Liabilities

( Where PAT is Profit after Tax and Depr. is Depreciation)

EXERCISE 1

LIABILITES ASSETS
Capital 180 Net Fixed Assets 400
Reserves 20 Inventories 150
Term Loan 300 Cash 50
Bank C/C 200 Receivables 150
Trade Creditors 50 Goodwill 50
Provisions 50
800 800

a. What is the Net Worth : Capital + Reserve = 200

b. Tangible Net Worth is : Net Worth - Goodwill = 150
c. Outside Liabilities : TL + CC + Creditors + Provisions = 600
d. Net Working Capital : C A - C L = 350 - 250 = 50
e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1
f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1
 EXERCISE 2

LIABILITIES 2005-06 2006-07 2005-06 2006-07

Capital 300 350 Net Fixed Assets 730 750
Reserves 140 160 Security Electricity 30 30
Bank Term Loan 320 280 Investments 110 110
Bank CC (Hyp) 490 580 Raw Materials 150 170
Unsec. Long T L 150 170 S I P 20 30
Creditors (RM) 120 70 Finished Goods 140 170
Bills Payable 40 80 Cash 30 20
Expenses Payable 20 30 Receivables 310 240
Provisions 20 40 Loans/Advances 30 190
Goodwill 50 50
Total 1600 1760 1600 1760

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70)
820 /800 = 1.02
3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
Exercise 3.

LIABIITIES ASSETS
Equity Capital 200 Net Fixed Assets 800
Preference Capital 100 Inventory 300
Term Loan 600 Receivables 150
Bank CC (Hyp) 400 Investment In Govt. Secu. 50
Sundry Creditors 100 Preliminary Expenses 100
Total 1400 1400

1. Debt Equity Ratio will be : 600 / (200+100) = 2:1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200

= 11 : 2

4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

 Exercise 4.

LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15)

: 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW

= 100 / ( 362 30)
= 100 / 332 = 0.30 : 1
 Exercise 4. contd

LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100

[ (362 - 30 ) / (550 30)] x 100
(332 / 520) x 100 = 64%
Q . What is the Net Working Capital ?
Ans : C. A - C L. = 255 - 88 = 167

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover
Ratio in Times ? Ans : Net Sales / Average Inventories/Stock
1500 / 128 = 12 times approximately
 Exercise 4. contd
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12

= 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?

Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
Exercise 5. : Profit to sales is 2% and amount of profit is say
Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100

2 = (5 x100) /Sales
Therefore Sales = 500/2 = Rs.250 Lac
Exercise 6. A Company has Net Worth of Rs.5 Lac, Term
Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and
Current Assets are Rs.25 Lac. There is no intangible Assets
or other Non Current Assets. Calculate its Net Working
Capital.
Answer
Total Assets = 16 + 25 = Rs. 41 Lac
Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac
Current Liabilities = 41 15 = 26 Lac

Therefore Net Working Capital = C. A C.L

= 25 26 = (- )1 Lac
Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net
Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities

hence the NWC would be NIL ( since NWC = C.A - C.L )

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What

is the amount of Current Assets ?

Answer : 4a - 1a = 30,000
Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000
Hence Current Assets would be 4a = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per

month, monthly average interest on TL is Rs.5000/-. If the amount
of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What
would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment

= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2
Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio
is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune
of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long
Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac
i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current
Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net
Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity
Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs.
Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being

Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10
Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 10
i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure
which should be Rs. 10 Lac
EXERCISE 12. A firm sold its stocks in CASH, in order to meet its liquidity
needs. Which of the following Ratio would be affected by this?

1. Debt Equity Ratio

2. Current Ratio
3. Debt Service Coverage Ratio
4. Quick Ratio

EXERCISE 13. A company is found to be carrying a high DEBT EQUITY

Ratio. To improve this, a bank may suggest the company to :

1. Raise long term interest free loans from friends and relatives
2. Raise long term loans from Institutions
3. Increase the Equity by way of Bonus Issue
4. Issue Rights share to existing share holders.

EXERCISE 14. Which of the following is a fictitious Asset?

1. Goodwill
2. Preliminary Expenses
3. Pre-operative expenses
4. Book Debts which have become doubtful of recovery
EXERCISE 15. Under which of the following methods of depreciation on
Fixed Assets, the annual amount of depreciation decreases?

1. Written Down Value method

2. Straight Line method
3. Annuity method
4. Insurance policy method

EXERCISE 16 Debt Service Coverage Ratio (DSCR) shows :

1. Excess of current assets over current liabilities

2. Number of times the value of fixed assets covers the amount of loan
3. Number of times the companys earnings cover the payment of
interest and repayment of principal of long term debt
4. Effective utilisation of assets

EXERCISE 17. Which of the following is not considered a Quick Asset?

1. Cash and Bank balances

2. Bank Fixed Deposits
3. Current Book Debts
4. Loans and Advances
Exercise 18. From the following financial statement calculate (i) Current Ratio (ii)
Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v)
Average Creditors payment period.
C.Assets
Sales 1500 Inventories 125
Cost of sales 1000 Debtors 250
Gross profit 500 Cash 225
C. Liabilities
Trade Creditors 200

(i) Current Ratio : 600/200 = 3 : 1

(ii) Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1
(iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times
(iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 =
61 days
(v) Average Creditors payment period : (Trade Creditors/Cost of sales) x 365
(200/100) x 365 = 73 days
 Questions on Fund Flow Statement

Q . Fund Flow Statement is prepared from the Balance sheet :

1. Of three balance sheets

2. Of a single year
3. Of two consecutive years
4. None of the above.

Q. Why this Fund Flow Statement is studied for ?

1. It indicates the quantum of finance required

2. It is the indicator of utilisation of Bank funds by the concern
3. It shows the money available for repayment of loan
4. It will indicate the provisions against various expenses

Q . In a Fund Flow Statement , the assets are represented by ?

1. Application of Funds
2. Sources of Funds
3. Surplus of sources over application
4. Deficit of sources over application
Q . In Fund Flow Statements the Liabilities are represented by ?

1. Sources of Funds
2. Use of Funds
3. Deficit of sources over application
4. All of the above.

Q . When the long term sources are more than long term uses, in the
fund flow statement, it would suggest ?

1. Increase in Current Liabilities

2. Decrease in Working Capital
3. Increase in NWC
4. Decrease in NWC

Q . When the long term uses in a fund flow statement are more than the
long term sources, then it would mean ?

1. Reduction in the NWC

2. Reduction in the Working Capital Gap
3. Reduction in Working Capital
4. All of the above
 Q. How many broader categories are there for the Sources of funds, in
the Fund Flow Statement ?

1. Only One, Source of Funds

2. Two, Long Term and Short Term Sources
3. Three , Long, Medium and Short term sources
4. None of the above.

R K MOHANTY
email ID : rajendra2411@gmail.com,
rajendra2411@hotmail.com