Ratio Analysis
Classification of Accounting Ratios
1. Liquidity Ratios
2. Solvency Ratios
3. Activity (Turnover) Ratios
4. Profitability Ratios
1. Liquidity Ratios
Liquidity Ratios measure a company’s ability to meet its short-term obligations (usually within
one year).
They show how easily the firm can convert its current assets into cash to pay off current
liabilities.
These ratios reflect the short-term financial health and working capital management of the
business.
Purpose / Significance
To assess short-term solvency.
To check whether the company can pay creditors and suppliers on time.
To help management maintain an optimal working capital level.
To give assurance to investors and bankers about repayment capacity.
1.1 Current Ratio
Interpretation:
Indicates how many times current assets cover current liabilities.
A higher ratio means better liquidity, but too high may indicate idle or overstocked assets.
A very low ratio means liquidity risk — difficulty in paying short-term debts.
Ideal Ratio: 2 : 1 (i.e., Current Assets should be twice the Current Liabilities)
1.2 Quick Ratio (Acid-Test Ratio)
Formula:
Meaning:
Measures the ability to meet short-term liabilities immediately without selling inventory.
Focuses on most liquid assets — cash, bank, bills receivable, and debtors.
Interpretation:
Shows the company’s ability to pay its current debts even if inventory cannot be quickly sold.
A low quick ratio (<1) suggests poor immediate liquidity.
A very high ratio may indicate excess cash or inefficient asset use.
Ideal Ratio: 1 : 1
1.3 Absolute (Cash) Liquidity Ratio
Formula:
Meaning:
Measures immediate liquidity, i.e., ability to pay debts instantly using only cash and near-cash
items.
Excludes receivables and inventories.
Interpretation:
Indicates the firm’s instant payment capacity.
Should not be too high (idle cash) or too low (risk of non-payment).
Ideal Ratio: 0.5 : 1 (or 50%)
2. SOLVENCY RATIOS
Meaning
Solvency ratios measure the long-term financial stability of a business and its ability to meet long-term
obligations such as debentures, loans, or other non-current liabilities.
Definition:
“Solvency ratios indicate the relationship between a company’s debt and its equity or assets, showing how
safely it is financed for the long term.”
These ratios are important to creditors, investors, and lenders as they reflect the firm’s capacity to service
long-term debt and sustain growth.
Objectives
Assess the long-term financial position of the enterprise.
Evaluate the proportion of debt and equity financing.
Determine the firm’s ability to repay interest and principal.
Help in risk analysis for potential investors and lenders.
2.1 Debt-Equity Ratio
Formula:
Where:
Shareholders’ Funds = Share Capital + Reserves & Surplus − Fictitious Assets
Meaning:
It indicates the relationship between borrowed funds and owners’ funds. It shows the proportion of debt used
to finance the assets of the company compared to equity.
Interpretation:
A high ratio means heavy dependence on external debt → higher financial risk.
A low ratio indicates more reliance on equity → safer for long-term solvency.
Ideal Ratio: 1 : 1 (Generally acceptable standard; varies by industry.)
2.2 Debt to Total Assets Ratio
Formula:
Meaning:
Shows the proportion of total assets financed by debt. It measures the degree of financial leverage.
Interpretation:
Higher ratio: Larger portion of assets financed by debt → higher financial risk.
Lower ratio: Indicates more assets financed through equity → greater solvency.
Ideal Ratio: Below 0.5 (or 50%) is generally considered healthy.
2.3 Proprietary Ratio (Equity Ratio)
Formula:
Meaning:
It measures the proportion of total assets financed by owners’ equity. It is the inverse of the Debt to Total
Assets Ratio.
Interpretation:
Higher ratio: Indicates strong financial base and long-term stability.
Lower ratio: Indicates dependence on borrowed funds, weaker solvency.
Ideal Ratio: 0.5 : 1 or 50% (half of the assets financed by shareholders’ funds).
2.4 Interest Coverage Ratio
Formula:
Meaning:
Shows how many times a company’s earnings (before interest and tax) can cover its interest obligations.
Interpretation:
Higher ratio: Company easily meets interest obligations → strong solvency.
Lower ratio: Difficulty in paying interest → higher default risk.
Ideal Ratio: 3 times or above is generally considered satisfactory.
2.5 Total Assets to Equity Ratio
Formula:
Meaning:
Indicates how much of the company’s assets are financed by the shareholders’ funds.
It also shows the degree of leverage—how much debt is used relative to equity.
Interpretation:
Higher ratio: Indicates high use of debt → riskier structure.
Lower ratio: Indicates sound capital structure, low leverage.
Ideal Ratio: Around 2 : 1 (i.e., total assets are roughly twice the shareholders’ equity).
3. Activity (Turnover) Ratios
Explanation
Activity ratios, also called Turnover Ratios, measure how efficiently a business utilizes its assets
and resources to generate sales or revenue.
They indicate the speed and efficiency with which various assets (inventory, receivables, fixed
assets, etc.) are converted into sales or cash.
These ratios show how effectively management is using the firm’s working capital and fixed
assets.
A higher turnover ratio generally means better utilization and faster movement of assets, while a
lower ratio suggests inefficiency or underutilization.
3.1 Inventory Turnover Ratio (Stock Turnover Ratio)
Formula:
Meaning:
Shows how many times inventory is sold and replaced during a period.
Interpretation:
High ratio: Quick movement of stock; good sales and efficient inventory management.
Low ratio: Overstocking, slow sales, or obsolete inventory.
Ideal Ratio: Generally 5 to 6 times (varies by industry).
3.2 Debtors (Receivables) Turnover Ratio
Formula:
Meaning:
Indicates how efficiently the firm collects money from its credit customers.
Interpretation:
High ratio: Quick collection; better credit control.
Low ratio: Inefficient recovery or lenient credit policy.
Ideal Ratio: Around 6 to 8 times per year (depending on credit terms).
3.3 Creditors (Payables) Turnover Ratio
Formula:
Meaning:
Shows how quickly a business pays its suppliers.
Interpretation:
High ratio: Prompt payments; good credit standing.
Low ratio: Delay in payments or possible liquidity problems.
Ideal Ratio: Usually 4 to 6 times (depending on credit period allowed).
3.4 Working Capital Turnover Ratio
Formula:
Meaning:
Shows the efficiency of using working capital to generate sales.
Interpretation:
High ratio: Efficient utilization of short-term resources.
Low ratio: Idle working capital or inefficient operations.
Ideal Ratio: No fixed standard depends on business type; higher is generally better.
3.5 Fixed Assets Turnover Ratio
Formula:
Meaning:
Measures how efficiently fixed assets (like plant, machinery, etc.) are used to generate sales.
Interpretation:
High ratio: Effective use of fixed assets.
Low ratio: Underutilization or overinvestment in fixed assets.
Ideal Ratio: Around 2 to 5 times, depending on industry.
3.6 Total Assets Turnover Ratio
Formula:
Meaning:
Shows overall efficiency of the business in generating revenue from total assets.
Interpretation:
Higher ratio: Indicates efficient asset use.
Lower ratio: Suggests excessive assets or low sales volume.
Ideal Ratio: Generally 1 to 2 times, varies with nature of business.
4. Profitability Ratios
Meaning
Profitability ratios measure the ability of a business to generate earnings (profits) in relation to
sales, assets, or capital employed.
They help assess the overall efficiency and financial performance of a firm.
Compare profitability over years or with competitors.
Assist investors and creditors in assessing financial strength.
Guide decision-making for cost control and pricing.
4.1 Gross Profit Ratio
Formula:
Meaning:
It measures the profit margin after deducting cost of goods sold from net sales.
Indicates how efficiently a firm produces and sells its products.
Interpretation:
A high ratio means efficient production and good control over cost of goods sold.
A low ratio suggests higher costs or lower selling prices.
Ideal Ratio: Usually 25% to 40%, but it varies by industry.
4.2 Net Profit Ratio
Formula:
Meaning: Indicates the overall profitability after accounting for all operating and non-operating expenses,
interest, and taxes.
Interpretation:
Higher ratio = efficient cost control and good overall profitability.
Lower ratio = possible issues with pricing, high expenses, or poor sales mix.
Ideal Ratio: There’s no fixed standard, but 10% to 20% is generally considered healthy for many
manufacturing firms.
4.3 Operating Ratio
Formula:
Meaning: Shows the percentage of sales used to cover operating costs. Measures operating efficiency.
Interpretation
Lower ratio = Better efficiency
Higher ratio = Higher cost, lower profit
Ideal Ratio: Generally 70%–85%.
Below 80% = very efficient.
Above 90% = poor cost control.
4.4 Return on Equity (ROE)
Formula:
Meaning:
Indicates how effectively shareholders’ funds are being used to generate profit.
Interpretation:
A higher ROE means higher returns for investors.
Too high may also indicate high leverage (excessive borrowing).
Ideal Ratio: 15%–25% is considered good for most industries.
4.5 Return on Assets (ROA)
Formula:
Meaning:
Measures how efficiently assets are utilized to generate profit.
Interpretation:
High ROA = effective use of company’s resources.
Low ROA = poor asset utilization or high idle capacity.
Ideal Ratio: Generally >10% is desirable.
4.6 Earnings per Share (EPS)
Formula:
Meaning:
Shows the profit available to each equity share, indicating the firm’s earning power from shareholders’
perspective.
Interpretation:
Higher EPS = stronger profitability per share.
Used to assess market valuation and investor confidence.
Ideal Ratio: No universal standard higher than industry average is preferred.