Meaning of Ratio

According to Accountants Handbook by Wixon, Kell and Bedford, a ratio is an expression of the quantitative relationship between two numbers

Nature of Ratio Analysis

The ratios may be used as a symptom like blood pressure, the pulse rate or the body temperature and their interpretation depends upon the caliber and competence of the analyst. The following are the four steps involved in the ration analysis: 1. 2. 3. Selection of relevant data from the financial statements depending upon the objective of the analysis. Calculation of appropriate ratios from the above data. Comparison of the calculated ratios of the same firm in the past, or the ratios developed from projected financial statements or the ratios of some other firms or the comparison with the ratios of the industry to which the firm belongs. Interpretation of the ratios.

4.

Interpretation of the Ratios

The interpretation of ratios is an important factor. Though calculation of ratios is also important but it is only a clerical task whereas interpretation needs skill intelligence and foresightedness. The interpretation of the ratios can be made in the following ways: 1. 2. 3. 4. 5. Single absolute ratio Group of ratios Historical comparison Projected ratios Inter-firm comparison

Guidelines or precautions for use of Ratios

Following guidelines or factors may be kept in mind while interpreting various ratios: 1. 2. 3. 4. 5. 6. Accuracy of Financial Statements Objective or purpose of Analysis Selection of Ratios Use of Standards Calibre of the Analyst Ratios Provide only a base

Use and Significance of Ratio Analysis

The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyze and interpret the financial health of enterprise. The use of ratios is not confined to financial managers only. The supplier of goods on credit, banks financial institutions, investors, shareholders and management all make use of ratio analysis as a tool in evaluating the financial position and performance of a firm for granting credit, providing loans or making investments in the firm.

A. Managerial Uses of Ratio Analysis

1. 2. 3. 4.

Helps in decision-making Helps in financial forecasting and planning Helps in communicating Helps in control

B. Utility to Shareholders/Investors
An investor in the company will like to assess the financial position of the concern where he is going to invest. His first interest will be the security of his investment and then a return in the form of dividend or interest.

C. Utility to Creditors
The creditors or suppliers extend short-term credit to the concern. They are interested to know whether financial position of the concern warrants their payments at a specified time or not.

D. Utility to Employees
The employees are also interested in the financial position of the concern especially profitability. Their wage increases and amount of fringe benefits are related to the volume of profits earned by the concern.

Utility to Government
Government may base its future policies on the basis of industrial information available from various units. The ratios may be used as indicators of overall financial strength of public as well as private sector. In the absence of the reliable economic information, governmental plans and policies may not prove successful.

Limitations of Ratio Analysis

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Limited use of a single ratio Lack of adequate standards Inherent limitations of accounting Change of accounting procedure Window dressing Personal bias Incomparable Absolute figures distortive Price level changes Ratios no substitutes

Analysis of short term financial position or test of liquidity

Two types of ratios can be calculated for measuring short-term financial position or short term solvency of a firm. Liquidity ratios Current assets movement or efficiency ratios

1. 2.

Liquidity Ratios: Liquidity refers to the ability of a concern to meet its current obligations as and when these become due. To measure the liquidity of a firm, the following ratios can be calculated: 1. Current Ratio 2. Quick or Acid Test or Liquid Ratio 3. Absolute Liquid Ratio or Cash Position Ratio

Current Ratio: Current ration may be defined as the relationship between current assets and current liabilities. This ratio, also known as working capital ratio. Thus, Current Ratio = Current Assets/Current Liabilities Or Current Assets : Current Liabilities.
Current Assets Cash in hand. Cash at bank Marketable securities (short term) Short term investment Bills receivable Sundry debtors Inventories (stocks) Work-in-process Current Liabilities Outstanding expenses / Accrued expenses Bills payable Sundry creditors Short term advances Income tax payable Dividends payable Bank overdraft (if not permanent arrangement) a

Prepaid expenses

Interpretation of Current Ratio

A relatively high current ratio is as indication that the firm is liquid and has the ability to pay its current obligations in time as and when they become due. On the other hand a relatively low current ration represents that the liquidity position of the firm not good and the firm shall not be able to pay its current liabilities in time without facing difficulties. As a convention the minimum of two to one ratio is referred to as a bankers rule of thumb or arbitrary standard of liquidity for a firm.

1. 2. 3.

A high current ration may not be favourable due to the following reasons: There may be slow moving stocks. The stocks will pile up due to poor sale. The figures of debtors may go up because debt collection is not satisfactory. The cash or bank balances may be lying idle because of insufficient investment opportunities.

On the other hand a low current ratio may be to the following reasons: 1. There may not be sufficient funds to pay off liabilities. 2. The business may be trading beyond its capacity. The resources may not warrant the activities.

Important factors for reaching a conclusion

1. 2. 3. 4. 5. Type of Business Types of products Reputation of the concern Seasonal influence Type of assets available

All the above mentioned factors should be taken into mind while interpreting current ratio.

Significance and Limitations of Current Ratio

One has to be careful while using current ratio as a measure of liquidity because it suffers from the following limitations: 1. Crude Ratio 2. Window dressing
a. Over-valuation of closing stock b. Obsolete worthless stocks are shown in the closing inventory at their cost instead of writing them off. c. Recording in advance cash receipts applicable to the next years sales. d. Omission of a liability for merchandise included in inventory. e. Treating a short term obligation as a long liability. f. Inadequate provision for bad and doubtful debts. g. Inclusion in debtors advance payment for purchase of fixed assets.

Quick/Liquid or Acid Test Ratio= Quick or Liquid Assets/Current Liabilities Quick/Liquid Assets Cash in hand Cash at bank Marketable securities Temporary investments Bills receivable Sundry debtors Current Liabilities Outstanding expenses / Accrued expenses Bills payable Sundry creditors Short term advances (payable shortly) Income tax payable Dividends payable Bank overdraft

Quick assets can also be calculated as:

Current assets (inventories + prepaid expenses). Investment here will mean all types of stocks i.e. finished, work-in-process, and raw materials.

Interpretation of Quick Ratio

Usually, a high acid test ratio is an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand a low quick ration represents that the firms liquidity position is not good. As a rule of thumb or as a convention quick ratio of 1:1 is considered satisfactory.

Significance of Quick Ratio

It measures the firms capacity to pay off current obligations immediately and is a more rigorous test of liquidity than the current ratio. It is used a complementary ratio to the current ratio.

Absolute Ratio
Absolute ratio: although receivables, debtors and bills receivables are generally more liquid than inventories, yet there may be doubts regarding their realization into cash immediately or in time. Hence, some authorities are of the opinion that the absolute liquid ratio should also be calculated together with current ratio and acid test ratio so as to exclude even receivables from the current assets and find out the absolute liquid assets.
Absolute Liquid Ratio = Absolute liquid assets/Current Liabilities

Absolute liquid assets include cash in hand and the bank and marketable securities or temporary investments. The acceptable norm for this ratio is 50% or 0.5 : 1 or 1:2 i.e. Rs. 1 worth absolute liquid assets are considered adequate to pay Rs. 2 worth current liabilities in time as all the creditors are no expected to demand cash at the same time and then cash may also be realized from debtors and inventories.

Current assets movement or efficiency/activity ratios

Activity ratios measure the efficiency or effectiveness with which a firm manages its resources or assets. These ratios are also called turnover ratios because they indicate the speed with which assets are converted or turned over into sales.
Liquidity Ratios Current Assets Movement or Efficiency Ratios Inventory/stock turnover ratio

Current ratio

Quick or acid test or liquid ratio

Debtors turnover ratio

Absolute liquid ratio

Creditors/payable turnover ratio

Working capital turnover ratio

Inventory Turnover Ratio (I.T.R.) indicated the number of times the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory. Inventory Turnover Ratio = Cost of goods sold/Average inventory at cost Inventory Turnover Ratio = Net Sales/Average inventory at cost] Inventory Turnover Ratio = Net Sales/Average inventory at selling price Inventory Turnover Ratio = Net Sales/Inventory

Inventory Conversion Period

It may also be interest to see average time taken for clearing the stocks. Inventory Conversion Period = Days in a year/Inventory turnover ratio.

Interpretation of Inventory Turnover Ratio

Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually a high inventory turnover/Stock velocity indicates efficient management of inventory because more frequently the stocks are sold, the lesser amount of money is required to finance the inventory. A very high turnover of inventory does not necessarily imply higher profits. The profits may be low due to excessive cot incurred in replacing stocks in small lots, stock-out situations, selling inventories at very low prices, etc. Hence, in cases of too high or too low inventory turnover further investigation should be made before interpreting the final results. It may also be mentioned here that there are no rules of thumb or standard inventory turnover ratio (generally acceptable norms) for interpreting the inventory turnover ratio. The norms may be different for different firms depending upon the nature of industry and business conditions.

Debtors or Receivable Turnover Ratio and Average Collection Period

Two kinds of ratios can be computed to evaluate the quality of debtors: Debtors/Receivable turnover or debtors velocity: Debtors turnover ratio indicated the velocity of debt collection of firm. In simple words, it indicates the number of times average debtors (receivables) are turned over during a year, thus Debtors (receivables) turnover/velocity = Net credit annual sales/Average trade debtors = No. of times Trade debtors = Sundry debtors + Bills receivables and accounts receivables Average Trade Debtors = (Opening trade debtors + Closing trade debtors)/2 Note: Debtors should always be taken at gross value. No provision for bad and doubtful debts be deducted from them.

Interpretation of Debtors Turnover/Velocity

Debtors velocity indicated the number of times the debtors are turned over during a year. Generally the higher the value of debtors turnover the more efficient is the management of debtors/sales or more liquid are the debtors. But a precaution is needed while interpreting a very high debtors turnover ratio because a very high ratio may imply a firms inability due to lack of resources to sell on credit thereby losing sales and profits. There is no rule of thumb which may be used as a norm to interpret the ratio as it may be different from firm to firm, depending upon the nature of business.

Average Collection Period Ratio

The average collection period represents the average number of days for which a firm has to wait before its receivables are converted into cash. 1. 2. Average Collection Period = Average trade debtors (Drs + B/R)/Sales per day Sales per day = Net sales/No. of working days.

Interpretation of Average Collection Period Ratio

Interpretation of Average Collection Period Ratio represents the average number of days for which a firm has to wait before its receivables are converted into cash. It measures the quality of debtors. Generally the shorter the average collection period the better is the quality of debtors as a short collection period implies quick payment by debtors. There is no rule of thumb or standard which may be used as a norm which interpreting this ratio as the ratio may be different from firm to firm depending upon the credit policy, nature of business and business conditions.

Creditors/Payables Turnover Ratio

In the course of business operations a firm has to make net purchases and incur short term liabilities. A supplier of goods, i.e. creditor, is naturally interested in finding out how much them the firm is likely to take in repaying its trade creditors. a) Creditors/Payable Turnover Ratio = Net Credit Annual Purchases/Average Trade Creditors b) Average payment period ratio = [Average trade creditors (Creditors + Bills Payable)]/Average daily purchases Average Daily Purchases = Annual Purchases/No. of working days in a year Or Average payment period = Trade creditors x No. of working days/Net annual purchases Or Average payment period = No. of Working Days/Creditors turnover ratio

Interpretation of Average Payment Period Ratio

The average payment period ration represents the average number of days taken by the firm to pay its creditors. Generally lower the ration the better is the liquidity position of the firm and higher the ratio, less liquid is the position of the firm. But higher payment period also implies greater credit period enjoyed by the firm and consequently larger the benefit reaped from credit suppliers.

Working Capital Turnover Ratio

Working capital = Current assets Current Liabilities Working capital turnover ratio indicates the velocity of the utilization of net working capital. This ratio indicates the number of times the working capital is turned over in the course of a year. Working Capital Turnover Ratio = Cost of sales/Average working capital Average working capital = (Opening working capital + Closing working capital)/2

Analysis of Long-Term Financial Position or test of solvency: The term Solvency refers to ability of a concern to meet its long term obligations. The following ratios serve the purpose of determining the solvency of the concern:
1. 2. 3. 4. 5. 6. 7. 8. 9. Debt-Equity Ratio Funded debt to total capitalization ratio Proprietary ratio or equity ratio Solvency ratio or Ratio of total liabilities to total assets Fixed Assets to net worth or proprietors funds ratio Fixed assets to long term funds or fixed assets ratio Ration of current assets to proprietors funds debt service ratio or interest coverage ratio Cash to debt-service ratio.

Debt-Equity Ratio
Debt-Equity ratio also know as External-Internal equity ratio is calculated to measure the relative claims of outsiders and the owners (i.e., shareholders) against the firms assets. Debt Equity Ratio = Outsiders Funds/Shareholders Funds Or Debt to Equity Ratio = External Equities/Internal Equities The outsiders funds included all debts/liabilities to outsiders, whether longterm or short-term or whether in the form of debentures bonds, mortgages or bills. The shareholders funds consist of equity share capital preference share capital, capital reserves, revenues reserves and reserves representing accumulated profits and surpluses like reserves for contingencies sinking fund etc. The accumulated losses and deferred expenses, if any, should be deducted from the total to find out shareholders funds. When the accumulated losses and deferred expenses are deducted from the shareholders funds, it is called net worth and the ratio may be termed as debt to net worth ratio.

Interpretation of Debt-equity Ratio

A ratio of 1 : 1 may be usually considered to be a satisfactory ratio although there cannot be any rule of thumb or standard norm for all types of businesses. In some business a high ratio 2 : 1 or even more may even be considered satisfactory, say, for example in the case of contractors business. Generally speaking a low ratio (debt being low in comparison to shareholders funds) is considered as favourable from the long-term creditors point of view because a high proportion of owners funds provide a larger margin of safety for them.

Funded debt to total capitalization ratio

The ratio establishes a link between the long-term funds raised from outsiders and total long-term funds available in the business. The two words used in this ration are (i) Funded Debt and (ii) Total Capitalization Funded Debt = Debentures + Mortgage loans + Bonds + Other long-term loans Total Capitalization = Equity Share Capital + Preference Share Capital + Reserves and Surplus + Other Undistributed Reserves + Debentures + Mortgage Loans + Bonds +Other long-term loans. Funded debt is that part of Total Capitalization which is financed by outsiders. Funded debt to Total Capitalization Ratio = (Funded Debt/Total Capitalization) x 100 Though there is no rule of thumb but still the lesser the reliance on outsiders the better it will be. If this ratio is smaller, better it will be up to 50% or 55% this ratio may be to tolerable and not beyond.

Proprietary Ratio or Equity Ratio

A variant to the debt-equity ratio is the proprietary ratio which is also known as Equity Ratio or Shareholders to Total Equities Ratio or Net worth to Total Assets Ratio. This ratio establishes the relationship between shareholders funds to assets of the firm. Proprietary Ratio or Equity Ratio = Shareholders Funds/Total Assets

Interpretation of Equity Ratio

As equity ratio represents the relationship of owners funds to total assets, higher the ratio or the share of the shareholders in the total capital of the company better is the long-term solvency position of the company. This ratio indicated the extent to which the assets of the company can be lost without affecting the interest of creditors of the company.

Solvency ratio or the ratio of total liabilities to total assets

This ratio is a small variant of equity ratio and can be simply calculated as 100 equity ratio. The ration indicated the relationship between the total liabilities to outsiders to total assets of a firm and can be calculated as follows: Solvency Ratio = Total Liabilities to Outsiders/Total Assets

Fixed assets to net worth ratio or ratio of fixed assets to proprietors funds
The ratio establishes the relationship between fixed assets and shareholders funds i.e. share capital plus reserves, surpluses and retained earnings. The ration can be calculated as follows: Fixed assets to net worth ratio = Fixed assets (After depreciation)/Shareholders funds.

Fixed assets to total long term funds or fixed asset ratio

A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to total long-term funds which is calculated as:

Calculation of RATIOS
By: Prof. (Dr.) N.N.Sengupta

Ratio
1. Current Ratio/Working Capital Ratio . 2. Liquid Ratio/ Quick Assets Ratio/Acid Test Ratio 3. Stock to Working Capital Ratio.

Components
Current Assets Liabilities Liquid (Quick) Assets Quick Liabilities Stock on Hand Working Capital Proprietors Equity Total Assets Current Assets . Proprietors Equity Fixed Assets . Proprietors Equity External Liabilities Proprietors Equity (b) Current Liabilities Proprietors Equity (c) Long-term Liabilities Proprietors Equity (a) Current

4. Proprietary Ratio 5. Assets-Proprietorship Ratio

6. Debt Equity Ratio/LiabilitiesProprietorship Ratio

7. Capital Gearing Ratio 8. Equity capital Ratio 9. Preference Capital Ratio 10. Gross Profit Ratio/Margin Ratio/ Turnover Ratio 11. Stock Turnover/Stock Velocity 12. Net Profit Ratio 13. Return on Investment/ ROI 14. Interest Coverage Ratio 15. Dividend Yield

Pref. Share Hldr Equity +Debt Hldr Equity Ordinary Shareholders Equity Equity Capital and Reserves Net Worth And Debentures Preference Capital Net Worth And Debentures Gross Profit Net Sales Cost of Sales Avg Stock Carried Net Profit Net Sales Net Profit . Capital Employed EBIT . Annual Fixed Interest Charges Dividend Per Equity Share . Market value Per Equity Share

A. Solvency and Liquidity Position (i) Current Ratio (ii) Liquid Ratio (iii) Stock to working Capital Ratio (iv) Turnover of Debtors (v) Turnover of Creditors, etc. B. profitability Position (i) Gross Profit Ratio, (ii) Operating Ratio, (iii) Net Profit Ratio,. (iv) ROI (v) Return on Proprietors Equity, (vi) Return on Ordinary Share Capital, (vii) Fixed Assets Turnover and (viii) Turnover of Total Assets.

C. Coverage Position Total Coverage Ratio=

Net Profit Before Interest and Taxes Principal Payments Interest + 1- t

Where, t= tax rate. D. Stability Position (i) Proprietary Ratio (ii) Assets Proprietorship Ratio (iii) Debt Equity Ratio E. Capital Structure (i) Capital Gearing Ratio (ii) Equity Capital Ratio (iii) Long-term Loan to Net Worth and Debentures, etc.

F. Measure of Sickness Profitability Indicators

a) b) c)

Cash from operatios Sales

Net Generated Cash NetWorth

Net Gererated Cash Gross Fixed Assets + Goss Current Assets

Some Questions for Practice

Q1. From the following Balance Sheet of Utopia Ltd., Calculatea.Current Ratio b.Liquid Ratio c.Proprietary Ratio d.Debt Equity Ratio e.Gearing Ratio Balance Sheet Of Utopia Ltd. Liabilities Eq. Share Capital Pref. Share Capital Reserves and Surplus 6% Debentures Bank Overdraft Sundry Creditors Bills Payable Rs.Assets Land & Building & Rs.

50,000

90000 155000 100000 60000 10000 5000

70,000 Plant Machinery 25,000Stock Sundry Debtors Bills Receivable Cash

1,00,000 80,000 70,000 25,000

Q2. Based on the above information you are required to prepare the Balance Sheet of the Company as on 31.12.1992.

Current ratio Acid test ratio Net Working Capital Stock turnover ratio (Cost of sales closing stock ) Gross Profit ratio Average debt collection period Fixed Assets Shareholders / Net to

2.5 1.5 Rs.3,00,000 6 times 20% ---2 months 0.80

Q3. From the following information of Punjab Traders Ltd. prepare the Statement of Proprietary Fund of the Company. (i) Capital Turnover Ratio 2, (ii) Fixed Assets Turnover Ratio 3, (iii) Gross Profit Ratio 25 %, (iv) Stock Velocity 6, (v) Debtors Velocity 4 months, and (vi) Creditors Velocity 2 months. The Gross Profit is Rs. 60,000 Reserves and Surplus are Rs. 20,000. Closing stock is Rs. 6,000 less than the Opening Debtors. Make necessary assumptions that you think appropriate.

4. From the following particulars prepare a summarized Balance eet in details as at 31st December, 2006.
Fixed Assets to Net Worth Current Ratio Reserve included in Proprietors Fund Fixed Assts Cash and Bank Balances Current Liabilities The firm has no Bank Overdraft. 0.8:1 3:1 25% Rs. 8,00,000 Rs. 15,000 Rs. 1,50,000

Q 5. From the following particulars prepare the balance sheet of the firm concerned: Stock Velocity Capital turnover ratio Fixed assets turnover ratio Gross profit ratio Debt collection period 6 2 4 20% 2 months

Creditors payment 73 days The periodprofit was Rs. 60,000 Closing stock was gross Rs. 5,000 in excess of the opening stock