Ratio Analysis describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm. Ratios provide clues to the financial position of a concern. It enables to assess the profitability, solvency and efficiency of an enterprise.
Types of Ratios:
There is a two way classification of ratios:
- Traditional classification.
- Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as statement of profit and loss ratio
- Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios
- Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another variable from the balance sheet, it is called composite ratio
- Functional classification.
- Liquidity Ratios
- Solvency Ratios
- Activity (or Turnover) Ratios
- Profitability Ratios
- Leverage Ratios
Liquidity ratios are calculated to measure the short-term solvency of the business, i.e. the firm’s ability to meet its current obligations.
Current ratio is the proportion of current assets to current liabilities. It is expressed as follows:
- Current Ratio = Current Assets ÷ Current Liabilities
Examples of Current assets
- current investments,
- trade receivables (debtors and bills receivables),
- cash and cash equivalents,
- short-term loans and advances
- prepaid expenses,
- advance tax
- accrued income
Examples of Current liabilities:
- short-term borrowings,
- trade payables (creditors and bills payables),
- other current liabilities and short-term provisions
Significance of Current Ratio:
- It provides a measure of degree to which current assets cover current liabilities.
- The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds.
- The ratio should be reasonable. It should neither be very high or very low. Both the situations have their inherent disadvantages.
- A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects under utilisation or improper utilisation of resources.
- A low ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its short-term debt on time.
It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as :
- Quick ratio = Quick Assets ÷ Current Liabilities
Quick Assets: Those assets which are quickly convertible into cash. Example:cash and cash equivalents
- current investments
- trade receivables (debtors and bills receivables),
- Marketable securities
Solvency ratios are calculated to determine the ability of the business to service(ability to pay) its debt in the long run.
- Debt-Equity Ratio = Long term ÷ Debts Shareholders’ Funds
- Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus + Money received against share warrants
- Share Capital = Equity share capital + Preference share capital
- Shareholders’ Funds (Equity) = Non-current Assets + Working capital – Non-current liabilities
- Working Capital = Current Assets – Current Liabilities
Debt to Capital Employed Ratio
- Debt to Capital Employed Ratio = Total Debt ÷ Total Asset
- Proprietary Ratio = Shareholder’s Funds ÷ Capital employed (or net assets)
Total Assets to Debt Ratio
- Total assets to Debt Ratio = Total assets ÷ Long-term debts
Interest Coverage Ratio
- Interest Coverage Ratio = Net Profit before Interest and Tax ÷ Interest on long-term debts
Activity (or Turnover) Ratios
The activity ratios express the number of times assets employed is turned into sales during an accounting period. Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability, and so are also known as efficiency ratios.
- Inventory Turnover Ratio = Cost of Revenue from Operations ÷ Average Inventory
Trade receivable Turnover
- Trade Receivable Turnover ratio = Net Credit Revenue from Operations ÷ Average Trade Receivable
- Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable)/2
Trade payable Turnover
- Trade Payables Turnover ratio = Net Credit purchases ÷ Average trade payable
- Average Trade Payable = (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable) ÷ 2
- Average Payment Period = No. of days/month in a year ÷ Trade Payables Turnover Ratio
Investment (Net assets) Turnover
- Net Assets or Capital Employed Turnover ratio = Revenue from Operation ÷ Capital Employed
Fixed assets Turnover
- Fixed asset turnover Ratio = Net Revenue from Operation ÷ Net Fixed Assets
Working capital Turnover
- Working Capital Turnover Ratio = Net Revenue from Operation ÷ Working Capital
Profitability ratios are calculated to analyse the earning capacity of the business which is the outcome of utilisation of resources employed in the business.
Gross profit ratio
- Gross Profit Ratio = (Gross Profit Net÷ Revenue of Operations) × 100
- Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)÷ Net Revenue from Operations ×100
Operating profit ratio
- Operating Profit Ratio = 100 – Operating Ratio
Alternatively, it is calculated as under:
- Operating Profit Ratio = (Operating Profit ÷ Revenue from Operations )× 100
Where Operating Profit = Revenue from Operations – Operating Cost
Net profit ratio
- Net Profit Ratio = (Net profit ÷ Revenue from Operations) × 100
Generally, Net Profit = Profit after tax (PAT)
Return on Investment (ROI) or Return on Capital Employed (ROCE)
- Return on Investment (or Capital Employed) = (Profit before Interest and Tax ÷ Capital Employed) × 100
Return on Net Worth (RONW)
Return on Shareholders’ Funds is also called as Return on Net Worth.
- RONW = (Profit After Tax ÷ Shareholders’ Funds) × 100
Earnings per share (EPS)
- EPS = Profit available for equity shareholders ÷ Number of Equity Shares
Where, Profit available for equity share holders = Profit after Tax – Dividend on Preference Shares
Book value per share
- Book Value per share = Equity shareholders’ funds ÷ Number of Equity Shares
Where, Equity shareholder fund = Shareholders’ Funds – Preference Share Capital
Dividend payout ratio
Dividend payout ratio refers to the proportion of earning that are distributed to the shareholders. This reflects company’s dividend policy and growth in owner’s equityIt is calculated as:
- Dividend Payout Ratio = Dividend per share ÷ Earnings per share
Price / Earning ratio (P/E Ratio)
P/E Ratio reflects investors expectation about the growth in the firm’s earnings and reasonableness of the market price of its shares. P/E Ratio varies from industry to industry and company to company in the same industry depending upon investors perception of their future. It is computed as:
- P/E Ratio = Market Price of a share ÷ Earnings per share
Leverage or capital structure ratios are calculated to test the long term financial position of a firm.
Capital Gearing Ratio
The capital gearing ratio is described as the relationship between equity share capital including reserves and surpluses to preference share capital and other fixed interest bearing loans.
- Less than one means highly geared
- More than one means low geared
- Gearing should be kept in such a way that the company is able to maintain a steady rate of dividend.
Advantages of Ratio Analysis
- Helps in Identification of problem areas.
- Simplifies complex figures and establish relationships.
- Helps to understand efficacy of decisions.
Limitations of Ratio Analysis
- They can identify the problem but do not provide any solution.
- Lack of standardised definitions
- Lack of universally accepted standard levels
- Ignores Qualitative or Non-monetary Aspects
- Forecasting is not feasible.
- This also suffers from reliability and limitations of Accounting Data
- Few ratios based on unrelated figures