CHAPTER FOUR

RATIO ANALYSIS

Learning Objectives:
After completing this chapter you will be able to:
1. Identify the various ways of Classifying ratios.
2. Attempt to identify ratios which are appropriate for control of different
types of activities.
3. Understand how ratios are to be computed and compared against what
norms is explained.
4. Discuss the managerial uses of primary ratio.

4.1 Introduction
Financial ratios provide basic relationships about several aspects of a
business. You might have observed that the financial media presents many of
these rations to analyze the strengths and weaknesses of individual
business firms. An internationally cited use of rations comes in the ranking of
the 500 largest corporations by a financial bi-monthly, namely, “Fortune
International”. This exercise is based on five basic parameters, viz., Sales,
Assets, Net Income, Stockholders Equity, and Number of Employees.
The nine rating measures derived from these parameters are: (i) Sales change,
(ii) Profit change, (iii) Net Income as a percentage of Sales, (iv) Net Income as a
percentage of Assets, (v) Net Income as a percentage of stockholders equity, (vi)
10 Years Growth in EPS, (vii) Total Return to Investors (latest year and 10
years average), (viii) Assets per Employee, (ix) and Sales per Employee.

4.2 Classification
Financial ratios have been classified in a variety of ways. You must find the
following broad bases having been employed in current literature.
(1) Primary Criterion: this distinguishes a measure which could be
considered useful for all kinds and sizes of business enterprises, from
many other measures which are not so universal in usage. The first one
has been called the Primary Ration (Viz., the Return on Investment or
ROI) and the other category called “Secondary Measures” includes all
other ratios. Such measures will essentially vary among firms, and they
will select only such of those measures as are relevant for their needs.

1
 The British Institution of Management uses this classification for inter-
firm comparisons.
(2) Ratios tagged to needs of Interest Groups: the major interest groups
identified for this purpose are:
(a) Management
(b) Owners
(c) Lenders
This classification assumes that “management group” is different from
“owners group”.
Management and Operational Control: Cost of Goods Sold and Gross Margin
Analysis, Profit (Net Income) Analysis, Operating Expense Analysis,
Contribution Analysis, and Analysis of Working Capital.
Owners’ Viewpoint: Net Profit to Net Worth, Net Profit available to Equity
Shareholders (or to equity share capital), Earnings Per Share (EPS), cash Flow
Per Share, and Dividend Per Share.
Lenders’ Evaluation: Current Assets to Current Liabilities, Quick Assets (i.e.,
Current Assets minus Inventories) to Current Liabilities, Total Debt to Total
Assets, Long-term Debt to Net Assets, Total Debt to Net Worth, Long-term Debt
to Net Worth, Long-term Debt to Net Assets, and Net Profit Before Interest and
Taxes (i.e., NBIT) to Interest.
(3) Fundamental Classification: ratios under this classification are
grouped according to a basic function relevant to financial analysis. Four
such functional groups have been generally recognized.
(a) Liquidity Ratios: are rations which measure a firm’s ability to meet
its maturing short-term obligations. Examples include the Current
Ratio and the Quick Ratio.
(b) Leverage Ratios: re ratios which measure the extent to which a
firm has been financed by debt. Suppliers’ of debt look to equity as
a margin of safety, but owners would borrow to maintain control
with limited investment. And if they are able to earn on borrowed
funds more than the interest that has to be paid, the return to owners
is magnified. Examples include Dent to Total Assets, Times Interest
Earned, and Fixed Charge Coverage Ratio.
(c) Activity Ratios: are ratios which measure the effectiveness with
which a firm is using its resources. Examples include Inventory
Turnover, Average Collection period, Fixed Assets Turnover, and Total
Assets Turnover.

2
 (d) Profitability Ratios: are ratios which measure managements overall
effectiveness a shown by the returns generated on sales and
investment. Examples include Profit (Net or Gross) margin, Net Profit
to Total Assets or ROI, Net Profit After Tax to Net Worth.
One more class of ratios is sometimes added to the four groups specified above.
This is called the “Market Value” group of ratios, which relate investors’
expectations about the company’s future to its present performance and
financial conditions. Examples would cover Price-Earnings (PR) and
Market/Book- Value Ratios.
The fundamental classification is probably the most extensively used mode of
presenting Financial Statement Analysis.
Which ratios are relevant for controlling business activities and the ratios in
which top management would be particularly interested? Obviously, they are
activity ratios which we have classified as “Management Oriented” ratios. The
primary ratio which is of universal relevance to management will be specifically
explained regarding its rationale and construction in this unit.
You have noticed that the basic flow of activities of a business firm follows a
certain sequence:
“Investment Decision Financing of Investment Acquisitions of
Resources Deployment of Resources Disposal of Output
Reinvestment of Surplus.”
This sequence needs some explanation. A typical firm would take a decision
to invest after an analysis of the projected inflows and outflows of the project.
This will be followed by a plan to finance the project which may be debt
finance and/or proprietors’ own funds. Finances will then be utilized to build
facilities and commercial output will be obtained as per the project schedule
(assuming there are no over-runs and delays). Sales revenue will follow the
disposal of the output and after meeting all costs and expenses (including tax
and financial charges), a decision will be taken to compensate the owners
(dividend decision) and reinvest the balance if any.
You will appreciate that the cycle of business activities commences with the
deployment of resources and terminate in the disposal of output. A
business would like to have as many such cycles as possible during a time
period, say a year. Apart from increasing the number of such cycles during a
time period the management would be interested to reduce costs and
expenses to the minimum at each stage of the cycle.

3
Accounting ratios which belong to the category of “Management Oriented
Activity ratios” enable business firms to exercise control over operations.
The next part of this chapter focuses attention on these ratios.

4.3 The Norm for Evaluation

You may be just wondering as to how we control activities through ratios. The
answer is not difficult to seek. Ratios that we have identified for control of
activities measure relationships between key elements at any point of time.
Such a measure is then compared with some “norm” and the causes for
deviation investigated. An action plan is then prepared and implemented to
remove the cause(s).
The following appear to be the ways for evaluating the figures.
(a) Against a trend over time.
(b) Against an average of some past period
(c) Against an industry average
(d) Against an average of a cross=section sample.

4.4 Computation and Purpose

A summary of management oriented activity ratios is given below. This
describes the ratios and also their main purpose.
I. Cost of Goods Sold & Gross Margin Analysis
(1) Cost of Goods Sold = Cost of Goods Sold
Net Sales
(2) Gross Margin = Net Sales - Cost of Goods Sold
Net Sales

- Provide an idea of “gross Margin” which in turn would depend on

relationship between prices, volume and costs.

II. Profit Analysis

(3) Net Margin = Net Profit
Net Sales
- Reflects management’s ability to operate business to recoup all
costs and expenses (including depreciation, interest and taxes)
and also to provide a compensation to owners.

(4) Operating Margin = Net Operating Income Before Interest & Taxes
Net Sales

- Provide a view of operating efficiency.

4
(5) Post-Tax Margin = Net Profit after Taxes but before Interest
Net Sales

- Shows after tax margin to both owners and leaders. The

numerator for post tax margin may be obtained by adding back to
net profit the after tax cost of interest on debt which is Pretax
interest times (1minus Tax rate).

III. Expense Analysis

(6) Operating Ratio = Operating Expenses
Net Sales
- Reflects the incidence of operating expenses (which are defined
variously for different costing purposes).

IV. Contribution Analysis

(7) Total Contribution = Net Sales – Variable Costs
Net Sales

- Indicates the total margin provided by operations towards fixed

costs and profit of the period.

V. Management of Capital
(8) Gross Assets Turnover = Net Sales
Total Assets

- Indicates effectiveness of the use of all assets, viz., current and

non-current.

(9) Net Assets Turnover = Net Sales

Total Assets – Current Liabilities

- Indicates effectiveness of assets employed on the assumption

that current liabilities are available to the business as a matter of
course, and will effectively reduce the assets required to be
employed.

(10) Inventory Turnover = Net Sales or Cost of Goods Sold

Average Inventories

- Shows the number of times inventory replenishment is required

during an accounting period to achieve a given level of sales.

(11) Receivables Turnover = Net Sales

Average Receivables

- Indicates the amount of trade credit allowed and revolved during

a year to achieve a level of sales.

5
 (12) Average Collection Period = Average Receivables X 365 days
Net Sales

- Evaluates the effectiveness of the credit period granted to

customers.

Illustration:
Compute the twelve activity ratios for the two years with the help of the
following information which has been extracted from the annual accounts of
Orient Paper & Industries Private Limited. On the basis of the limited
information available with you, what areas would you identify for control?

Orient Paper & Industries Private Limited

Balance Sheet as at Year Ending on December 31
(Amounts in Dollars of Thousands)
Assets: 3013 2014 2015
Cash 64 78
Debtors 58 60 65
Inventories 62 84 117
Fixed Assets (net) 360 340
Investments 32 43
Other Assets 10 7
Total 600 650
Liabilities and Equity:
Current Liabilities 82 58
Long-term Loans 182 170
Equity Share capita ($100 each) 240 240
General Reserves 96 182
Total 600 650
Income Statement for the Year Ended December 31
Gross Sales 370 480
Less: Returns 20 30
Net Sales 350 450
Less: Cost of Goods Sold (includes $70 fixed per year) 190 215
Gross Profit 160 235
Less: Operating Expenses (includes $10 fixed a year) 50 72
Operating Profit (EBIT) 110 163
Less: Interest Expenses 20 18
Earnings Before taxes 90 145
Less: Taxes (40%) 36 58
Net Income (Earnings After taxes) 54 87

6
 Solution:
2014 2015 Remark (+/-)
(1) Cost of Goods Sold to Sales Percentage:
Cost of Goods Sold x 100 = $190 X 100 = 44.3% $215 X 100 = 47.8% +
Net Sales $350 $450

(2) Gross Margin Percentage

Net Sales - CGS x 100 = $350 - $190 X 100 = 45.7% $450 - 215 X 100 = 52.2% +
Net Sales $350 $450

(3) Net Margin Percentage:

Net Profit x 100 = $54 X 100 = 15.4% $87 X 100 = 19.3% +
Net Sales $350 $450

(4) Operating Margin Percentage:

EBIT x 100 = $110 X 100 = 31.4% $163 X 100 = 36.2% +
Net Sales $350 $450

(5) Post Tax Margin Percentage:

NI after tax but before Interest x 100 = $66 X 100 = 18.9% $97.8 X 100 = 21.7% +
Net Sales $350 $450

Note: NI after tax but before Interest= Net Income + I (1-T)

For 2014 = $54 + $20 (1 – 0.40) = $66
For 2015 = $87 + $18 (1 – 0.40) = $97.8

(6) Operating Ratio

Operating Expenses x 100 = $50 X 100 = 14.3% $72 X 100 = 16.0% +
Net Sales $350 $450

(7) Contribution Analysis

Net Sales – Variable Costs x100 = 350 – 160* x100 = 54.3% 450 – 207* x100 = 54% -
Net Sales 350 450

Note:
2014, Variable CGS $120 + variable operating expenses $40 = $160*
2015, Variable CGS $145 + variable operating expenses $62 = $207*

(8) Gross Assets Turnover

Net Sales x 100 = $350 X 100 = 58.3% $450 X 100 = 69.2% +
Total Assets $600 $650

7
 (9) Net Assets Turnover
Net Sales = $350 = 0.68 $450 = 0.76 +
TA - CL ($600 - $82) ($650 - $58)

(10) Inventory Turnover

Net Sales/CGS = $190 = 2.60 $215 = 2.14 -
Average Inventories ($62+$84)/2 ($84+$117)/2

(11) Receivables Turnover

Net Sales = $350 = 5.93 $450 = 7.20 +
Average Receivables ($58+$60)/2 ($60+$65)/2

(12) Average Collection Period

Average Receivables x 360 days = $59 X 360 = 60 days $62.5 X 360 = 50 days -
Net Sales $350 $450
(or)

360 days = 360 days = 60 days 360 days = 50 days -

Receivables Turnover 5.93 7.20

(13*) Return on Investment (ROI)

Net Income x 100 = $54 X 100 = 9.0% $87 X 100 = 13.38% +
Total Assets $600 $650

(or)

Net Income = Net Margin X Gross Assets Turnover

Total Assets
= Net Income X Net Sales
Net Sales Total Assets
= $54 X $350 X 100 = 9.0% $87 X $450 X 100 = 13.38% +
$350 X $600 $450 X $650

(14*) Return on Equity (ROE)

Net Income x 100 = $54 X 100 = 16.07% $87 X 100 = 20.62% +
Owners’ Equity $336 $422

(or)
ROE = ROI X Equity Multiplier (Total Assets/Owners’ Equity)

9 X $600/$336 = 16.07% 13.38 X $650/$422 = 20.62% +

8
Managerial Uses of the Primary Ratio
The return on investment (ROI) has been aptly regarded as a primary ratio
because it specifies the relative profit earned on the capital employed. This is
one single measure where the final outcome of all business activities gets
recorded. It provides not only a vehicle for measuring relative business
efficiency but also focuses attention on whether an adequate return has been
earned in accordance with the expectations of the investors on the capital
contributed by them.
In many cases it becomes necessary to disaggregate an organization into
divisions and the return on divisional investment can be employed to gauge
the divisional performance.
However, it may be stated that the concept of ROI (Return on Investment) is not
free from ambiguity. This is primary due to the fact that numerator and
denominator of this ratio, i.e., “return” and “capital” are subject to differing
interpretations. As standing definition of these two basic terms do not exist as
yet, the firms define the terms according to their own thinking. While some
firms may define “investment” quite broadly, others may define it narrowly. As
a consequence of this variations of ROI are found in “practice”, e.g., ROA (i.e.,
Return on Assets).
You may not that the use of ROI which in fact is a combination of some other
ratios was pioneered by Du Pont. That is why it is sometimes known as the Du
Pont system of financial control.
The return on investment (Assets) may be expressed as a relationship in the
following formula:
ROI = Net Margin X Total Assets Turnover
(or)
= Net Income X Net Sales
Net Sales Total Assets

You may further notice that total assets may be financed partly by owners’
fund (known as equity) and partly by borrowed funds (recognized as debt).
Given the proportion of assets financed by equity, an appropriate measure on
return on equity (ROE) may also be derived from the ROI. This will be given by:

ROE = ROI/proportion of total assets financed by equity

= ROI ÷ Equity
Total Assets

ROE = ROI X Total Assets

Equity
9
The term “Total Assets/Equity” may be recognized as “Equity Multiplier”
and then ROE will be equal to ROI times the equity multiplier.
The Du Pont chart is presented in Figure 4.1 and it may be of interest to you
to note the manner in which the various key elements converge into a single
measure, viz., the Return on Investment (ROI).

Return on
Investment

Profit Margin: Total Assets

Earnings as a percent multiplied by utilization
of sales

Sales divided Net Income Total divided Sales

into Assets into

Total subtracted Sales Fixed added Current

Costs from Assets to Assets

Other Marketable
Operating Interest Cash Securities
Expenses

Depreciation Taxes Accounts Inventories

Receivable

10