RATIO ANALYSIS

INTRODUCTION

Ratio analysis is the process of determining and interpreting numerical relationship based on
financial statements. It is the technique of interpretation of financial statements with the help
of accounting ratios derived from the balance sheet and profit & loss account. It involves the
comparison of existing ratios against standards established. The standards may be set by
management as goals expressed in the budgets (i.e., budgetary standard) or may be historical
figures showing the performance of the same concern in the past (i.e. historical standard) or
may be figures reflecting the performance of other companies (i.e. industrial or market
standard.)

Mode of Expressing Accounting Ratios

Accounting ratios can be expressed in various ways, such as:

a) Pure ratio, say ratio of current assets to current liabilities is 2:1, or

b) A rate, say current assets are 2 times current liabilities.
c) A percentage, say, current assets are 200% of current liabilities

Each method of expression has a distinct advantage over the other. The analyst will select that
method which bests suits his convenience and purpose. There are certain accounting ratios
which can be best expressed if stated as a pure ratio, e.g., debt-equity ratio. While some others
can most advantageously be expressed as a percentage only e.g. gross profit percentage. Ratios
are expressed in such a way that the first variable appears as the numerator and the second as
the denominator.

(I) ANALYSIS OF SHORT-TERM FINANCIAL POSITION OR TESTS OF LIQUIDITY

The liquidity ratios are used to test the short term solvency or liquidity position of the business.
It enables to know whether short-term liabilities can be paid out of short-term assets. This ratio
also indicates whether a firm has adequate working capital to carry out routine business
activity. Though commercial Banks and other short-term creditors are primarily concerned with
the analysis of short-term financial position or test of liquidity, it is a valuable aid to
management in checking the efficiency with which working capital is being employed in the
business. It is also of importance to shareholders and long-term creditors in determining to
some extent the prospects of dividend and interest payment. The questions involved in
connection with the ratio analysis of short-term financial position are:

(a) Will the company be able to pay its current debts promptly?
(b) Is the management utilizing capital effectively?
(c) Is the current financial position improving?

The important ratios which fall under this category are as follows:

(a) Current ratio – Current ratio, also called as working capital ratio, is the most widely used
of all analytical devices based on the balance sheet. It establishes the relationship between
total current assets and current liabilities. It is the barometer of general measure of liquidity
and state of trading. The following formula is used to calculate current ratio:

Current ratio = Current Assets

Current Liabilities

Components of Current Assets

Current assets include the following:
(a) Cash in hand
(b) Cash at bank
(c) Bills receivable
(d) Sundry debtors
(e) Stock of raw materials, work-in-progress and finished goods
(f) Short-term investment, i.e., readily realizable investments
(g) Prepaid expense
(h) Accrued Income or revenues
Loose tools are not treated as current assets. Instead it is treated as fixed assets
Components of current liabilities
(a) Sundry creditors
(b) Bills payable
(c) Bank overdraft
(d) Outstanding expenses
(e) Income or revenues received in advance
(f) Provision for taxation
(g) Short-term borrowing
(h) Unclaimed dividend
(i) Proposed dividend
Current assets are those assets which are expected to be converted into cash within a year.
Current liabilities are those liabilities which are payable within one year.
Standard current ratio
A current ratio of 2:1 is considered ideal as a rule of thumb. It means the current assets must
not only be equal to current liabilities but should leave a comfortable margin of working capital
after paying off the current debts. But in actual practice 1:1 ratio is found acceptable than 2:1. A
high ratio, i.e., more than 2:1, say 3:1 indicates under trading and the same also indicates one
of the signs of over capitalization. Conversely, a low ratio indicates over trading or under
capitalization of business.
(b) Quick ratio or acid test ratio or liquid ratio: it is a refinement of the current ratio and a
second testing device for the working capital position. It is concerned with the relationship
between liquid assets and liquid liabilities. The following formula is used:

Quick ratio = Quick Assets

Quick Liabilities

Components of quick assets: The assets which are converted into cash without loss within a
short period of time say 1 year is known as quick assets. Quick assets include all current assets
except stock and prepaid expenses.
Components of quick liabilities: The liabilities which become payable within a short period of
time, say 1 year is known as quick liabilities. It includes all current liabilities except bank
overdraft and cash credit as they more or less constitute a permanent arrangement and are
renewed periodically.
Interpretation of quick ratio: A quick ratio of 1:1 is usually considered to be ideal. This ratio is a
more rigorous test of liquidity than the current ratio and when used in conjunction with it, gives
a better picture of the firm’s ability to meet its short-term debts out of short-term assets.
However, care must be exercised in placing too much reliance on 100% acid test ratio without
further investigation. This is because the interpretation of the acid-test ratio depends on
circumstances. For example, a seasonal business which seeks to stabilize production will tend to
have a weak acid-test ratio during its period of slack sales, and probably a powerful one during
the period of heavy selling.

(II) ANALYSIS OF LONG-TERM FINANCIAL POSITION OR TESTS OF SOLVENCY

When an organization’s assets are more than its liabilities it is known as a solvent organization.
Solvency indicates that position of an enterprise where it is capable of meeting long term
obligations. The long-term debt is contributed by debenture holders, financial institutions,
other suppliers selling goods on installments basis.
(a) Debt-equity ratio or external-internal equity ratio: Debt-equity ratio expresses the
relationship between debt and equity. Debt here is taken to mean long-term and short-term
debt and equity means owners or shareholders’ funds. In other words, this ratio indicates
the relationship between external equities, i.e., outsiders’ funds and internal equities i.e.,
shareholders’ funds. The following formula is used:

Debt-equity ratio = Debt

Equity

OR
External equities
Internal equities
Components of Debt: It comprises of long-term as well as short term debt.
Components of Equity: It consists of shareholders’ funds, reserves and accumulated profit.
However, if there are any accumulated losses or fictitious assets, they are deducted from
shareholders’ funds (fictitious assets are assets that cannot be realized in cash or no further
benefits can be derived from these assets e.g. preliminary expenses)
If preference shares are redeemable it can be treated as external equity and irredeemable
preference share is treated as internal equity.
It is suggested that current liability is to be included in the long-term liabilities.
Interpretation
The standard debt-equity ratio is 1:2. It means for every value of 2 shares there is 1 of debt. If
the debt is less than 2 times the equity, it means that creditors are relatively less and the
financial structure of the business is sound. If the debt is more than 2 times the equity, the
state of long-term creditors is more and indicates a weak financial structure. It indicates a high
level of financial gearing or leverage.
Problem 1: The comparative figures of X Ltd and Y Ltd are given below:
X Y
Total assets 200,000 300,000
Total liabilities 40,000 100,000
Owner’s equity 160,000 200,000
Calculate Debt-equity ratio for each company and comment
Solution: Debt-equity Ratio = Debt
Equity

X Ltd = 40,000 = 0.25

160,000

Y Ltd = 100,000 = 0.50

200,000
Interpretation:
In the case of X Ltd, it is less dependent on debt (as its borrowed capital is 25%) and dependent
more on equity. In the case of Y Ltd. Borrowed capital is 50% of the equity fund. X Ltd is
considered to be more satisfactory in terms of capital structure.
(b) Capital gearing ratio: It expresses the relationship between equity capital and fixed
interest bearing securities and fixed dividend bearing shares. The following formula is used:

Capital Gearing Ratio = Equity Shareholders funds

Fixed Interest-bearing securities + Fixed Dividend bearing Shares

Components of fixed interest-bearing securities:

1. Debentures
2. Long-term loans
Components of equity shareholders’ funds:
1. Equity share capital
2. Accumulated reserves and profits
3. Deduction of losses (example loss on the issue of debentures) and fictitious assets from
the total of (1) and (2)

Interpretations
When fixed interest-bearing and fixed dividend-bearing shares are higher than equity
shareholders’ funds, the company is said to be ‘highly geared’. Where the fixed Interest-bearing
securities and fixed dividend bearing shares are equal to equity share capital, the company is
said to be “evenly geared”. Where the fixed interest-bearing securities and fixed dividend
bearing shares are lower than equity share capital it is said to be “low geared”. If capital gearing
is high, further raising of long-term loans may be difficult and issue of equity shares may be
attractive and vice-versa.

(c) Fixed Assets Ratio: it establishes the relation between fixed assets and capital
employed. The following formula is used.
Fixed Assets Ratio = Fixed Assets
Capital employed

Components of capital employed:

1. Owners funds
 2. Long-term loans
3. Long-term deposits
4. Debentures
Interpretation
This ratio enables to know how fixed assets are financed, i.e., by use of long-term funds or by
short-term funds. The ideal ratio is 0.67. This ratio should not be more than 1.

(d) Dividend cover ratio: It is the ratio between disposable profit and dividend. Disposable
profit refers to profit left over after paying interest on long-term borrowing and income tax.
This ratio is expressed as a rate and is calculated using the following formula.
Dividend Cover Ratio = Net Profit after interest and Tax
Dividend Declared
Interpretation
This ratio indicates the ability of the business to maintain the dividend on shares in future. If
this ratio is higher it indicates that there is sufficient amount of retained profit. Even if there is
slight decrease in profit in the future it will not affect payment of dividend in future.

(III) ACTIVITY RATIOS OR PERFORMANCE RATIOS

Activity ratios indicate the performance of an organization. This indicates the effective
utilization of the various assets of the organization. Most of the ratios falling under this
category are based on turnover and hence these ratios are called turnover ratios. The various
activity ratios are as follows:
(a) Stock turnover ratio: this ratio establishes the relationship between the cost of goods
sold during a given period and the average stock holding during that period. It tells us as
how many times stock has turned (sold) over the period. This ratio indicates the operational
and marketing efficiency of the business. It not only helps in determining the liquidity of the
firm but also assists in evaluating inventory policy so as to protect the firm from any danger
of over-stocking.
Normally, inventory turnover ratio is best expressed through the relationship between cost
of goods sold and average inventory at cost, but ratio of sales to inventory may also be used
 as a substitute for the rate of cost of goods sold to average inventory, in case, cost of goods
sold is not available. The average inventory for a year is the sum of inventory at the
beginning of the year and inventory at the end of the year and the total is divided by 2. The
following formula is used to calculate the inventory turnover ratios.
Inventory Turnover Ratio = Cost of goods sold
Average stock

Interpretation
The ideal stock turnover ratio is 8 times a year. A low inventory turnover may reflect dull
business, over investment in inventory, accumulation of stock at the end of the period in
anticipation of higher prices or of greater sales volume, incorrect inventory resulting from
the inclusion of obsolete and unsaleable items and excessive quantities of certain inventory
items in relation to immediate requirements.
A high turnover of inventory may not be accompanied by a high net income as profits may
be sacrificed in obtaining a large sale volume with the result that a higher rate of turnover is
likely to prove less profitable than a lower turnover unless accompanied by a larger total
gross profit. Similarly, a relatively high turnover ratio may not really be an indicator of
favorable results as it may indicate serious under-investment in inventories and this may in
turn result in loss of customer patronage on account of failure to make prompt deliveries.
But, generally, a high stock turnover ratio means that the concern is efficient and hence it
sells its goods quickly.

(IV) PROFITABILITY RATIOS

Profitability ratios indicate the profit earning capacity of a business.
(a) Gross Profit Ratio: It expresses the relationship of gross profit to net sales and is
expressed in terms of a percentage. Sales for this purpose mean net sales, i.e., sales after
deducting the value of goods returned by the customers. Gross profit results from the
difference between net sales and cost of goods sold without considering expenses generally
charged to profit and loss a/c. Cost of goods sold in the case of a trading concern is the
purchase of goods and all expenses directly connected with the purchases of goods, while in
 the case of a manufacturing concern, it consists of the purchase price of raw materials and
all manufacturing expenses. The following formula is used to calculate this ratio:
Gross profit ratio = Gross Profit x 100
Net Sales

This ratio is a measure of general profitability of the business and a tool that indicates the
degree to which selling price of goods per unit may decline without resulting in losses on
operations for the firm. The gross profit should be adequate to cover the operating expenses
and to provide for fixed charges, dividends and building up of reserves.
Normally 25% to 30% margin is anticipated.
(b) Net Profit Ratio: It expresses the relationship between net profits after taxes to sales. The
following formula is used.
Net Profit Ratio = Net profit after Tax x 100
Net Sales

This ratio is widely used as a measure of over-all profitability and is very useful to proprietors,
as it gives an idea of the efficiency as well as profitability of the business to a limited extent. A
percentage of 15% to 20% is ideal, especially for going concerns.
(c) Earnings per share: This ratio indicates the earnings per equity share. It establishes
the relationship between net profit available for equity shareholders and the number of equity
shares. The following formula is used:
Earnings per Share = Net Profit available for equity shareholders
Number of equity shares

This value is normally reported as so many shillings earned per share (or whatever other
currency one may be using).