RATIOS

MEANING

A ratio shows the relationship between two numbers. Accounting ratio shows the relationship between

two accounting figures. Ratio analysis is the process of computing and presenting the relationships

between the items in the financial statement. It is an important tool of financial analysis, because it helps

to study the financial performance and position of a concern.

Classification of ratios based on function

1. Liquidity Ratios: show the relationship between the current assets and current liabilities of the concern.

Examples are Liquid ratio and Current ratio.

2. Leverage Ratios: show the relationship between proprietor’s funds and debts used in financing the

assets of the concern. Examples are Capital gearing ratio, Debt-Equity ratio and Proprietary ratio. These

are also known as Solvency ratios.

3. Activity Ratios (also known as Turnover ratios or Productivity ratios) show the relationship between

the sales and the assets. Examples are Stock turnover ratio, Debtors turnover ratio etc.

4. Profitability ratio show the relationship between Profits and sales; for example, Operating ratio, gross

profit ratio, Operating net profit ratio, Expenses ratios etc.; or Profits and investments; for example,

Return Return on capital employed., Return on investments, Return on equity capital etc.

5. Coverage ratios show the relationship between the profit on one hand and the claims of outsiders

(dividend, interest etc.) to be paid out of such profits. Examples are Dividend payout ratio and Debt

services ratio.

Profit and loss account Ratio:

GROSS PROFIT RATIO

Meaning

This ratio compares gross profit with net sales. It is usually expressed in the form of percentage.

Formula

Gross profit = Gross Profit x 100

Net Sales

Function/Purpose

Gross profit is a profitability ratio, which shows the relationship between profits and sales. This ratio

helps to judge (i) how efficient the concern is in managing its production, purchase, selling and

inventory; (ii) how good its control is over the direct costs; (iii) how productive the concern is; and (iv)

how much amount is left to meet other expenses and earn net profit.

OPERATING RATIO

Meaning

Operating ratio expresses the relationship between total operating costs and net sales. It is expressed by

way of percentage .

Formula

Operating Ratio = Cost of Goods Sold + Operating Expenses x 100 Net Sales

Function/Purpose

Operating ratio indicates cost of operations. Its purpose is to measure and to ascertain the efficiency of

the management as regards operations. This ratio helps to judge (i) how efficient the concern is in

controlling its costs of production, administration, selling expenses; and (iv) how much amount out of

sales revenue is used up in carrying out the operations of the concern.

EXPENSES RATIO

Meaning

This ratio expresses the relationship between each item of expenditure and sales. It is expressed as a

percentage. Total of all Expenses ratios will be equal to operating ratio.

Formula

Expense Ratio = Expenditure x 100 Net Sales

e.g.

Cost of goods Sold ( Factory cost) = COGS × 100 Net sales

Administrative Expenses Ratio = Administrative Expenses x 100 Net Sales

Finance expenses= Finance expenses *100 Net sales

Selling Expenses Ratio = Selling Expenses x 100 Net Sales

OPERATING PROFIT RATIO

Meaning Operating profit ratio indicates the relationship between Operating profit and the sales.Formula

Operating Profit = Operating Profit x 100 = Net Sales

Components

Operating profit [OP] =

1. Gross Profit

2. Less: Operating expense [OE]

Function/Purpose

Operating profit ratio is a profitability ratio, which shows the relationship between profits and sales.

It indicates profits from operations. This ratio helps to judge (i) how efficient the concern is in

managing

all its operations of production, purchase, inventory, administration, selling, distribution etc.; and (ii)

how much amount is left to meet non-operating expenses and earn net profits.

NET PROFIT RATIO

MeaningNet profit ratio indicates the relationship between net profit and the sales. It is usually expressed in the form of a percentage.

Net Profit = Net Profit x 100 Net Sales

Balance Sheet Ratio

CURRENT RATIO

Meaning

This ratio compares the current assets with the current liabilities. It is expressed in the form of a pure

ratio e.g. 2:1

Formula

Current Ratio = Current Assets = CA Current Liabilities CL

Function/Purpose

Current ratio is a liquidity/solvency ratio which indicates the ability of the concern to meet its short-term

liabilities. It measures the short term solvency of the concern. It is used by a creditor to judge the safely

margin available and to decide the amount and the terms of the credit. The standard ratio is 2: 1.

LIQUID RATIO

Meaning

Liquid ratio compares the quick assets with the quick liabilities. It is measures the immediate

solvency position of the company. It is also known as Quick ratio or Acid test ratio.

Formula

Liquid ratio = Quick Assets = QA

Quick Liabilities QL

Note: QA=Current Assets less Closing Stock less Prepayment

QL=Current Liabilities less Bank Overdraft less income received in advance

Note 1: Stock is excluded because it is uncertain as to when and how much it will realize.

Prepayment (pre-paid expenses, advances etc) are excluded because they cannot be converted into

cash.

Note 2: Bank overdraft is excluded because it is almost with bank and not required to be paid back

is full as long as the concern exists.

STOCK TO WORKING CAPITAL RATIO

Meaning

Formula:

Stock *100

Working capital

This ratio shows the relationship between the closing stock and the working capital. It helps to judge the

quantum of inventories in relation to the working capital of the business. It is expressed as a percentage.

It is also known as Inventory Working Capital Ratio.

If the stock to working capital is 70%. It means 70% of the working capital is blocked in assets and 30%

is blocked in other current assets.

PROPRIETORY RATIO

Meaning

Proprietory ratio compares proprietor’s funds with total assets. It is usually expressed in the form of

percentage.

Formula

Proprietory Ratio = Proprietors’ Funds or Shareholder’s Equity X 100 = PF X 100

Total Assets TA Components

Proprietor’s Funds [PF] will include

1. Paid up Equity capital (EC)

2. Reserves & Surplus (RS) including capital reserves, revenue reserves, P & L a/c Cr.

Balance.

Less: Accumulated losses (i.e. P & L a/c Dr. Balance)

Less: Fictitious Assets like Miscellaneous Expenditure not written off.

3. Paid up Preference Capital (PC)

Thus, PF = EC + RS + PC –Misc Exp

Function/Purpose

Proprietory ratio is a solvency ratio which indicates (i) the long term solvency; and (ii) the extent

of funds invested by the owners in relation to total funds employed in the business (i.e.

capitalization).

DEBT – EQUITY RATIO

Meaning

This ratio compares the long-term debt with shareholders’ funds. It is usually expressed as a pure

ratio.

Formula

Debt = Borrowed Funds = BFEquity Proprietors’ Funds PF

Purpose/Function

Debt –equity ratio is a solvency ratio which indicates the proportion of debt and equity in financing of

the assets of the concern. Debt-equity ratio shows the (i) margin of safety for long term creditors; and

(ii) the balance between debt and equity (i.e. capitalization). If the debt equity ratio is 2.5: 1, it indicates

that for every 2.5 obtained from debt, the company has obtained Re 1 from the shareholder

CAPITAL GEARING RATIO

Meaning

The Capital Gearing ratio shows the relationship between two types of capital viz (i) Funds not bearing

fixed rate of interest and dividend- Equity capital including reserves less fictitious asset . and (ii) . Funds

and dividend bearing fixed rate of interest Preference capital and Long Term Borrowing. This is also

known as ‘Capital Structure ratio’. When the ratio is more than 1, the company is said to highly geared

and when the ratio is less than 1 the company lowly geared.

Formula= Funds bearing fixed rate of interest and dividend

Funds not bearing fixed rate of interest and dividend

Preference Share capital + Debenture + Long term Bank loan + Public deposit

Equity share capital + Reserves and Surplus – Misc expenditure

Combined Ratio:

RETURN ON CAPITAL EMPLOYEDMeaning

This ratio measures the relationship between net profit (before interest and tax) and the capital employed to earn it. It is expressed as a percentage . This ratio is also known as ‘Return on Investment’ [ROI]

Formula Return on Capital Employed = Profit (before Interest, Tax) x 100

Capital Employed ComponentsProfit (before Interest, Tax) [PBIT] =1. Profit before interest on long term borrowing tax & dividends.2. Less abnormal, non-recurring items.

Capital Employed (CE) =1 Equity capital2. Add. Preference capital + Reserves & Surplus3. Add. Long term Borrowings (Terms loans + Debentures)4. Less : Fictitious assets like Miscellaneous Expenses not written off5. Less : Profit & loss A/c. Dr. Balance (loss).Note : Capital employed may be taken to mean Assets Employed, in which case,

Capital Employed [CE] can also be computed as1. Fixed Assets (Less depreciation) ( including investments)2. Add : Current Assets3. Less : Current Liabilities 4. Exclude Fictitious assets.

Function / PurposeReturn on capital employed ratio is a profitability ratio, which shows the relationship between profits and investments. Its purpose is to measure the overall profitability from the total funds made available by the owners and lenders. This ratio helps to judge how efficient the concern is in managing the funds at its disposal.

RETURN ON PROPRIETORS’ FUNDSMeaningThis ratio measures the relationship between net profit (after interest and tax) and the proprietors’ capital. It is usually expressed as a percentage. It is also known as Return on Proprietor’s Equity or Return on Net Worth

Formula

Return on Proprietor’s Funds = Net Profit (after Tax) x 100 = NPAT x 100 Proprietor’s Funds PF

RETURN ON EQUITY SHAREHOLDER FUNDMeaning

This ratio measures the relationship between net profit (after interest, tax and preference dividend) and the equity shareholders funds. It is usually expressed as a percentage.

Formula

Return on Equity Capital = NPAT – Prefrence dividend X 100 = Equity Shareholder’s Funds

Components :

Equity shareholders’ Funds [EF] =Equity capital [EC]Reserves and Surplus [RS]Less: Fictitious assets like Miscellaneous Expenses not written offLess: Profit& Loss A/c Dr. Balance(loss)

DEBTORS TURNOVER

Meaning

This ratio shows the relationship between net credit sales and average trade debtors .It is expressed as a times. Actual debtors turnover ratio of 6 times indicates that debtors turnover 6 times during the year

Formula

Debtors Turnover = Net Credit SalesAvg Accounts Receivable + Avg Bills receivable

Debtors Velocity (Debt Collection Period)

Debtors velocity means the period (months or days) taken by the debtors for settlement of their bills. It shows the number of days for which credit sales remain outstanding = 365 days/ 12 months Debtors Turnover Ratio

Function / PurposeDebtors turnover ratio is a turnover ratio, which shows the relationship between credit sales and debtors. Its purpose is to (I) calculate the speed with which debtors get settled on an average during the year; (ii) calculate the debtors velocity to indicate the period of credit allowed to average debtor; and (iii) judge how efficiently the debtors are managed.

CREDITORS TURNOVER RATIO

MeaningCreditors turnover ratio shows the relationship between the net credit purchases and the average trade creditors. Actual debtors turnover ratio of 6 times indicates that debtors turnover 6 times during the year

Formula

Creditors Turnover = Credit Purchases = Net Credit Purchases Accounts Payable Avg Creditors + Avg Bills Payable

Creditors Velocity (Debt Payment Period)

Creditors velocity means the period (months or days) taken by the concern to pay off its creditors. Credit Period Enjoyed = 365 days or 12 months Creditors Turnover

Function / Purpose

Creditors turnover ratio is a turnover ratio, which shows the relationship between credit purchases and creditors. Its purpose is to (i) calculate the speed with which creditors are paid off on an average during the year; (ii) calculate the creditors velocity to indicate he period taken by the average creditor to be paid off; and (iii) judge how efficiently the creditors are managed.

STOCK TURNOVER RATIOStock turnover ratio shows the relationship between the cost of goods sold and the average stock. This ratio is normally expressed as a ‘rate’

Formula

A. Stock Turnover Ratio = Cost of Goods Sold Average Stock

Function/ PurposeStock turnover ratio is an activity ratio, which shows the relationship between sales and stock. Its purpose is to (i) calculate the speed at which stock is being turned over into sales; (ii) calculate the stock velocity to indicate he period taken by the average stock to be sold out; and (iii) judge how efficiently the stocks are managed and utilized to generate sales.

Actual RatioFor example, a Stock turnover ratio of 8, indicates that the stock is being turned into sales 8 times during the year. The Inventory cycle makes 8 rounds during the year. It also helps to work out the Stock Holding Period (stock velocity). If the Stock turnover is 8 times, the Stock Holding Period is 1.5 months (12 months / Stock turnover ratio = 12 / 8). This indicates that it takes 1.5 months for the stock to be sold out. Stock velocity shows the duration of the inventory cycle.

Interest Coverage Ratio:

This ratio indicates sufficiency or deficiency of earnings to pay interest falling due within the period covered under profits.

Interest coverage Ratio= NPBIT Interest

DEBT SERVICE COVERAGE RATIO

Note : Debt Service Coverage Ratio (which deals with the capacity to pay interest as well as loan installment) is different from Debt Service Ratio

MeaningDebt Service Coverage Ratio shows the relationship between net profits and interest + installments payable on loans. It is expressed as a pure number. Debt Service means the payment of interest + installments on loans. Coverage means the availability of profits for debt servicing.

FormulaDebt Service Coverage Ratio = Net profit + Depreciation + Interest on Term loan

Interest + Installment due on loans

Function / PurposeDebt Service Coverage Ratio (DSCR) is a type of coverage ratio. A coverage ratio shows the relationship between the profit and the claims of outsiders to be paid out of such profits. The purpose of DSCR is to measure the debt-servicing capacity of the company.

DIVIDEND PAYOUT RATIO

MeaningDividend Payout Ratio shows the relationship between the dividend paid to equity shareholders out of the profits available to the equity shareholders. It shows how much percentage of earnings are given as dividend

FormulaDividend payout ratio = Dividend per share x 100

Earning per share

EARNING PER SHARE:

EPS= NPAT- Preference dividend No of Equity shares

Earning per share is most widely used financial data. Higher the ratio indicates that the company may pay dividend at a higher rate. It shows how much percentage of earnings are given as dividend

Price –Earning ratio (P/E ratio) : This ratio is the market price of shares expressed as multiple of Earning per share:

P/E ratio: Market price per share Earnings per share

This ratio indicates the market price is how many times as the earning, A higher P/E ratio is good. Investor should invest in the company having low P/E ratio

Dividend yield ratio Market price per share Earning per share

It means the dividend is how percentage of market price per share

ADVANTAGES OF RATIO ANALYSIS

Advantages :

Useful in analysis of financial statements. Ratio analysis is the most important tool available for analysing the financial statements i.e. Profit and Loss Account and Balance Sheet. Such analysis is made not only by the management but also by outside parties like bankers, creditors, investors etc.

Useful in improving future performance. Ratio analysis indicates the weak spots of the business. This helps management in overcoming such weaknesses and improving the overall performance of the business in future.

Useful in inter-firm comparison. Comparison of the performance of one firm with another can be made only when absolute data is converted into comparable ratios. If A firm is earning a net profit of Rs. 50,000 while another firm B is earning Rs. 1.00,000, it does not necessarily mean that firm B is better off unless this profit figure is converted into a ratio and then compared.

Useful in judging the efficiency of a business. As stated earlier, accounting ratios help in judging the efficiency of a business. Liquidity, solvency, profitability etc. of a business can be easily evaluated with the help of various accounting ratios like current ratio, liquid ratio, debt-equity ratio, net profit ratio, etc. Such an evaluation enables the management to judge the operating efficiency of the various aspects of the business.

Useful in simplifying accounting figures. Complex accounting data presented in Profit and Loss Account and Balance Sheet is simplified,

summarised and systematised with the help of ratio analysis so as to make it easily understandable. For example, gross profit ratio, net profit ratio, operating ratio etc. give a more easily understandable picture of the profitability of a business than the

Absolute figures.

Limitations of Ratio Analysis

Ratio analysis is a very useful technique. But one should be aware of its limitations as well. The following limitations should be kept in mind white making use of ratio analysis in interpreting the financial statements.

1. Reliability of ratios depends upon the correctness of the basic data. Ratios obviously will be only as reliable as the basic data on which they are based. If the balance sheet or profit and loss account figures are themselves unreliable, it will be a mistake to put any reliance on the ratios worked out on the basis of that Balance Sheet or Profit and Loss Account.

1. An individual ratio may by itself be meaningless. Except in a few cases, an accounting ratio may by itself be meaningless and acquires significance only when compared with relevant ratios of other firms or of the previous years. In fact, ratios yield their best advantage on comparison with other similar firms; also if ratios for a year are compared with ratios in the previous years, it will be a useful exercise. Comparison is the essential requirement for using ratios for interpreting a given situation in a firm or industry.

2. Ratios are not always comparable. When the ratios of two firms are being compared, it should be remembered that different firms may follow different accounting practices. For example, one firm may charge depreciation on straight line basis and the other on diminishing value. Similarly, different firms may adopt different methods of stock valuation. Such differences will not make some of the accounting ratios strictly comparable. However, use of accounting standards makes ratio comparable.

1.Ratios sometimes give a misleading picture. One company produces 500 units in one year and 1,000 units the next year; the progress is 100%. Another firm produces 4,000 units in one year and 5,000 in the next year, the progress is 25%. The second firm will appear to be less active than the first firm, if only the rate of increase or ratio is compared. It will be much more useful if absolute figures are also compared along with rate of increase—unless the firms being compared are equal in all respects. In fact, one should be extremely careful while comparing the results of one firm with those of another firm if the two figures differ in any significant manner, say in size, location, degree of automation or mechanisation.

2.Ratios ignore qualitative factors. Ratios are as a matter of fact, tools of quantitative analysis. It ignores qualitative factors which sometimes are equally or rather more important than the quantitative factors. As a result of this, conclusions from ratio analysis may be distorted. For example, despite the fact that credit may be granted to a customer on the basis of information regarding the financial position of business as disclosed by certain ratios, but the grant of credit ultimately depends upon the credit standing,

reputation and managerial ability of the customer, which cannot be expressed in the form of ratios.

3.Change in price levels makes ratio analysis ineffective. Changes in price levels often make comparison of figures for a number of years difficult. For example, the ratio of sales to fixed assets in 2003 would be much higher than in 1995 due to rising prices because fixed assets are stilt being expressed on the basis of cost incurred a number of years ago while sates are being expressed at their current prices.

2. There is no single standard for comparison. Ratios of a company have meaning only when they are compared with some standard ratios. Circumstances differ from firm to firm and the nature of each industry is different. Therefore, the standards will differ for each industry and the circumstances of each firm will have to be kept in mind. It is difficult to find out a proper basis of comparison. Therefore, the performance of one industry may not be properly comparable with that of another. Usually it is recommended that ratios should be compared with the average of the industry. But the industry averages are not easily available.

3. Ratios based on past financial statements are no indicators of future. Accounting ratios are calculated on the basis of financial statements of past years. Ratios thus indicate what has happened in the past. Since past is quite different from what is likely to happen in future, it is difficult to use ratios for forecasting purposes. The financial analyst is more interested in what will happen in future. The management of a company has information about the company's future plans and, policies and is, therefore, able to predict future to a certain extent. But an outsider analyst has to rely only on the past ratios which may not necessarily reflect the firms future financial position and performance.

COMPUTATION OF RATIOS

Q1) Following is the Balance Sheet of Ranbaxy ltd. as on 31st March 2007. You are required to convert the same in Vertical formats and. calculate the following ratios: 1) Current Ratio 2) Liquid Ratio, 3) Stock to Working Capital Ratio, 4) Proprietory Ratio, 5) Capital Gearing Ratio, 6) Debt Equity RatioLiabilities Rs. Assets Rs.Equity Share Capital (Rs. 10 each)10% Preference Share CapitalGeneral Reserve12% DebenturesAccounts PayableBank OverdraftAcceptances givenIncome received in AdvanceProvision for Taxation

2,00,000

1,00,0002,00,0001,00,0001,60,0001,00,00075,00025,00040,000

Land & Bldg at WDVPlant & Mach at WDVLong Term InvestmentsCapital WIPInventoriesBook Debts (last year Rs. 1,80,000)Current InvestmentsPrepaid ExpCash at Bank

1,00,0001,20,00090,00075,0002,00,0002,00,000

50,00010,00040,000

Advance TaxBills ReceivableUnderwriting Commission( To the extent not w/off)

30,00075,00010,000

10,00,000 10,00,000

Q.2) The following is the Profit & Loss A/c. of Reliance ltd. for the year ended 31st March 2007. You are required to convert the same in a suitable form for analysis and calculate the following ratios:1) Gross Profit Ratio, 2) Operating Ratio, 3) Operating Expense Ratio, 4) Operating Profit Ratio; 5) Net Profit Ratio.Particulars Rs. Particulars Rs.To Opening StockTo PurchasesTo Factory ExpensesTo Gross Profit

1,50,00010,50,0004,50,0003,50,000

By Sales (10% cash)Less: Returns

By Closing Stock

20,00,0002,00,00018,00,0002,00,000

20,00,000 20,00,000

To Administrative ExpensesTo RentTo Interest paid on DebenturesTo Selling ExpensesTo Bad debtsTo DepreciationTo Loss by fireTo Provision for TaxTo Net Profit

1,20,00030,00012,00015,00010,00030,00040,0001,21,5001,21,500

By Gross ProfitBy Bad Debts RecoveryBy Dividend/ Int. receivedBy Miscellaneous Income

3,50,00050,00025,00075,000

5,00,000 5,00,000To Proposed Equity DividendTo Dividend on Preference ShareTo Transfer to General Reserve

50,00010,000

61,500

By Net Profit 1,21,500

1,21,500 1,21,500The Companies shares are quoted on stock exchange at Rs 44.60

From the financial statements given above (Q.1 & Q.2) you are required to calculate the following ratios:

Overall Profitability Ratios: 1) Return on Capital Employed, 2) Return on Shareholders fund, 3) Return on Equity Shareholders fund.

Turnover Ratios: 1) Stock Turnover ratio, 2) Debtors Turnover ratio & Debtors Velocity, 3) Creditors Turnover ratio & Creditors Velocity, 4) Fixed Asset Turnover Ratio, 5) Total Asset Turnover ratio .6) Working Capital Turnover ratio.

Ratios related to Equity Shares: 1) Earning Per Share (EPS), 2) Price Earning Ratio (P/E ratio), 3) Dividend Per Share (DPS), 4) Dividend Payout Ratio (D/P ratio), 5) Dividend Yield Ratio.

Coverage Ratio: 1) Interest Coverage Ratio, 2) Dividend Coverage Ratio