RATIO ANALYSIS

MEANING
 The term ‘ratio’ refers to the numerical or
quantitative relationship between two
items/ variables.
 Thus a ‘ratio’ is a simple arithmetical
expression of the relationship of one
number to another and is obtained by
dividing the former by the later.
 When this ratio is expressed with
reference to the items shown in financial
statement, then it is called ‘accounting
ratio’.
The ratio is calculated by dividing
one item of the relationship by the
other. The dividing number is known
as the base or base number. The
other number is expressed in relation
to this base number. In ratio analysis
base is always taken as 1 or 100 &
the other number is expressed in its
comparison.
For example:
If sales are four times the average
stock then in terms of ratio we
express it as 4:1 & not 1:0.25.
 EXPRESSION OF RATIO
Pure Ratio:
In this, the relationship between two items
is expressed in proportionate form. In other
words, the relationship between two figures
is expressed in a common denominator.
For example – if current assets & current
liabilities of an enterprise are Rs.20,000 &
Rs.10,000. The pure ratio between current
assets & current liabilities will be
20,000 = 2:1
10,000
Rate or So Many Times /
Ratio as Turnover:
In this, rate is calculated between
two numerical variables. In other
words, a ratio is calculated between
two numerical facts for which one
item is divided by another and the
quotient so obtained is taken as unit
of expression. When the ratio is
expressed in this form, it is called as
‘turnover’ and is written in ‘times’.
For example – sales for the year are
Rs.80,000 and fixed assets are
Rs.20,000; it indicates that sales are
4 (80,000/20,000) times of fixed
assets.
Ratio as Percentage:
In this form, the relationship between
two items is expressed in the form of a
part of 100. In other words, a quotient
obtained by dividing one item by
another is multiplied by 100 and thus it
become the percentage form of
expression.
For example – if gross profit is Rs.30,000
and sales is Rs.1,00,000, we can say
that ratio of gross profit to sales is 30%
(30,000/1,00,000 x 100)
OBJECTIVES, UTILITY or ROLE
OF RATIO ANALYSIS
 Helping in Financial Statement Analysis
 Helping in Financial Forecasting
 Helping in Co-ordination
 Helping in Control
 Helping in Communication
 Helping in Efficiency Appraisal
 Helping in Financial Strength Appraisal
 Trend Analysis
LIMITATIONS RATIO ANALYSIS
 Limited use of a Single Ratio
 Lack of Qualitative Analysis of the Problem
 Effect of Inherent limitations of Accounting
 Arithmetical Window Dressing
 Future Estimates on the Basis of the Past
 Background is Overhead
 Different Accounting Procedures
 Contd…
No Allowance for Price Level Changes
Lack of Proper Standards
Calculating Ratios between Unrelated
items
Effect of Personal Ability and Bias of
Analyst
 PRECAUTIONS IN RATIO
ANALYSIS
Nature of Data
Dispatch
Presentation
Reliability
Determination of proper Standards
Revision and Alteration
Price Level Changes
Cost-Benefit
 Contd…
Comparison
Use of Other methods
Proper Record
STEPS FOR RATIO ANALYSIS
Arrangement of Data
Calculation of appropriate ratios from
the above data.
Comparison of the calculated ratios
with the predetermined standards or
norms set for the purpose.
Interpretation of Ratios
 INTERPRETATION OF RATIOS
On the basis of the single ratio
On the basis of group of related ratios
On the basis of historical trends
On the basis of projected ratios (or
future expectations)
On the basis of inter-firm comparison
 On the basis of similar firms
On the basis of common sense
 Classification of Ratios
Statement-wise Classification Classification accor- Functional
Classification by Users ding to importance Classification

A. Balance Sheet A. Ratios for 1.Primary Ratios A. Liquidity/

Ratios Management Solvency ratio
B. Profit & Loss A/c B.Ratio for 2.Secondary Ratios B. Leverage/Capital
Ratios Shareholders (a) Supporting Structure Ratios
C. Composite or C. Ratios for (b) Explanatory C. Profitability Ratio
Mixed Ratios Creditors D. Activity Ratios
E. Investment
Analysis Ratio
 EXPLANATION OF CHART
o Statement-wise Classification:
It is the most traditional classification
of financial ratios. This is based on
accounting statements providing
information necessary for the
calculation of various ratios. There are
3 types of ratios on the basis of
statements:
 Balance Sheet Ratios
When both figures for ratio
computation are extracted from the
balance sheet of the business, the
ratio is called Balance Sheet Ratio or
Financial Ratios. Important balance
sheet ratios are as follows:
Current Ratio
Proprietary Ratio
Capital Gearing Ratio
Liquidity Ratio
Fixed Assets Ratio
Book Value Per Share
 Profit & Loss Account Ratio
When both figures for ratio
calculation are taken from profit and
loss account, the ratio is called profit
and loss ratio. Major Profit and Loss
Ratios are as follows:
Operating Ratio
Net Profit Ratio
Stock Turnover Ratio
Expense Ratio
Gross Profit Ratio
 Composite or Mixed Ratios
In such ratios, one item or a group of
items is taken from Balance Sheet
and the other from Profit & Loss
Account. For example –
Return on Capital Employed
Return on Shareholders’ Funds
Current Assets Turnover Ratio
Ratio of Net Sales to Fixed Assets
o Classification of Ratios by
Users
 Ratios for Management:
Operating Ratio
Return on Capital Employed
Stock Turnover
Debtors’ Turnover
Solvency Ratio
 Ratios for Creditors:
Current Ratio
Solvency Ratio
Creditors’ Turnover
Fixed Assets Ratio
Asset Coverage Ratio
Debt-Service Ratio
 Ratios for Shareholders:
Return on Shareholders’ Funds
Capital Gearing ratio
Dividend Cover
Yield Rate
Proprietary ratio
Dividend rate
Assets Cover of Shares
o Classification by Relative Importance
This classification is being adopted by the British
Institute of Management for inter-firm
comparisons. In this, all the ratios are classified
into two groups:
 Primary Ratios (return on capital employed, assets
turnover, profit ratio etc.)
 Secondary Ratios (working capital turnover, stock to
current assets ratio, current assets to fixed
assets ratio, fixed assets to total assets ratio etc.)
• Purpose-wise or Functional
Classification
It is the modern approach of classifying
financial ratios. This classification is based
on needs of different parties interested in
financial analysis. Various ratios are
classified into the following groups:
 Liquidity Ratios – These ratios are used to
measure the ability of the firm to meet its
short-term obligations out of its shot-term
resources. Egs.
 Current Ratio
 Liquid or Quick Ratio
 Absolute Liquidity Ratio
 Activity or Efficiency Ratio – These ratios
enables the management to measure the
effectiveness of the resources at the
command of the firm. Ratios includes,
 Stock Turnover Ratio
 Debtors Turnover Ratio
 Creditors Turnover Ratio
 Total Assets Turnover Ratio
 Fixed Assets Turnover Ratio
 Current Assets Turnover Ratio
 Working Capital Turnover Ratio
 Capital Turnover Ratio
 Profitability Ratios – These ratios are
intended to measure the end result of
business operations i.e. profitability.
The following ratios are computed in this
category:
 Based on Sales
(i) Gross Profit Ratio
(ii) Operating Ratio
(iii) Expenses Ratio
(iv) Operating Profit Ratio
(v) Net Profit Ratio
Based on Capital or Investment
(i) Return on Capital Employed
(ii) Return on Net Worth or
Shareholders’ Funds
(iii) Return on Equity Shareholders’
Fund
(iv) Return on Total Assets
o Capital Structure or Leverage
Ratio
These ratios help in measuring the
financial contribution of the owners as
compared to that of creditors and also
the risk in debt financing. Following
are such important ratios:
(i) Debt-Equity Ratio
(ii) Proprietary Ratio
(iii) Solvency or Debt to Total Assets
Ratio
(iv) Fixed Assets to Net Worth Ratio
(v) Capital Gearing Ratio
(vi) Interest Coverage or Debt-Service
Ratio
(vii) Dividend Coverage Ratio
o Investment Analysis Ratios
These ratios are helpful to the
shareholders in analyzing the
perspective investment in the
company. Following ratios are included
in this category:
(i) Earnings per Share
(ii) Price-Earnings Ratio
(iii) Dividend per Share
(iv) Dividend Yield Ratio
(v) Dividend Payment Ratio
(vi) Book Value per Share
Note –
Thus, ratios are classified with different point of
view, but from analytical point of view, the
functional classification is more appropriate
as it highlights the utility of different ratios.
 LIQUIDITY OR SHORT-TERM
SOLVENCY RATIOS
It refers to a firm’s ability to meet its current
financial obligations as they arise.
The importance of adequate liquidity in
the sense of the ability of a firm to
meet its current/short-term obligations
when they become due for payment
can hardly be over-stressed.
It reflects the short-term financial strength of
the firm.
 The object of liquidity analysis is to
examine the firm’s ability to meet its
current obligations out of short-term
resources.
Three types of ratios can be
calculated for assessing the short-
term solvency of a firm:
Current ratio
Liquid or Quick ratio
Absolute Liquid ratio
Current Ratio or Working
Capital Ratio
Current ratio may be defined as the
relationship between current assets and
current liabilities. It is also known as working
capital ratio or 2:1 ratio.
Formula –
Current ratio = Current Assets
Current Liabilities
 The following items are included in current assets and
current liabilities:

Current Liabilities Current Assets

Creditors Cash and Bank
Bills Payable Balance
Bank Over Draft Debtors
Short-term Loans Bills receivable
Outstanding Stock/Inventory
Expenses Short-term
Income Tax Payable Investments or
Unclaimed Dividend Marketable securities*
Provision for Tax Prepaid expenses
Proposed Dividend Advanced Payment
*Marketable Securities – also known as ‘short-
term investment’.
Marketable Securities are those which can be
easily convertible into cash.
example:
shares, bonds, government securities, Kissan
Vikas Patra etc.
Interpretation and Significance
Current ratio of a firm measures its short-term
solvency and reflects its ability to meet short-term
obligations when they are due.
For example,
if the current ratio will be 2.5:1. It implies that for
every Re.1 worth of current liabilities, there are
current assets worth Rs.2.5 i.e current assets are
two and a half times of current liabilities. This also
implies that the firm will be able to pay off its
current liabilities in full, even if it realises its
current obligations the margin of safely of
funds to short-term creditors.
If the current ratio is higher, it is good from
the creditors’ point of view but extremely high
current ratio is not good from the
management’s point of view.
In such a case, (i) more funds of the firm
would be employed in unproductive uses (like
inventory) which do not fetch any return;
(ii) it is the indicator of a firm’s poor investment
policy, and (iii) poor credit management due to
over extended accounts receivable.
Similarly, a low and declining current
ratio would indicate :
(i) an inadequate margin of safety to the
creditors, i.e. firm has no sufficient cash to pay
its liabilities; (ii) shortage of working capital
in the business i.e firm is trading out of its
resources.
Ideal Current Ratio: 2:1
It was reasoned that if the firm was to go out
of business, it might not be possible to sell off
the current assets at their book value, but a
current ratio of 2:1 would leave enough money
to pay off the short-term creditors.
 Current ratio suffers from the
following weaknesses
 It is a crude measure of financial liquidity as it
does not take into account the liquidity of the
individual components of current assets.
 The greatest weakness of current ratio is the
possibility of window dressing &
manipulation.
 The current ratio is largely affected by the
seasonal fluctuations.
Illustration 1:

Liabilities Amt. Assets Amount

Share Capital 2,00,000 Fixed Assets 1,50,000

Reserve 40,000 Stock 80,600
15%Debentures 30,000 Debtors 22,400
Profit and Loss Bills Receivable
A/c 20,000 Prepaid 20,000
Bank Overdraft 30,000 Expenses
Bills Payable 29,000 Cash 4,000
Creditors 21,000 Bank 43,000
50,000
3,70,000 3,70,000
Solution:
Current Ratio = Current Assets
Current Liabilities
= 2,20,000
80,000
= 2.75:1
Comment: The current ratio is much satisfactory
because (2.75) is much higher than the accepted
standard of 2:1. hence, the liquidity position of the
firm is sound.
Liquidity or Quick Ratio or
Acid Test Ratio
This ratio is used as a complement of current
ratio. This ratio is calculated for assessing the
capacity of the firm to make immediate
payment of its liabilities. This ratio establishes
the relationship between quick/liquid current
assets and current liabilities.
 The formula used is :
Liquid Ratio = Liquid or Quick Assets
Current liabilities
Or
= Current Assets – (Stock+ Prepaid Exp.)
Current Liabilities
Liquid assets consist of cash, short-term bills
receivable, marketable securities and good debtors.
Some authorities advocate for the use of the term
liquid or quick liabilities in place of current liabilities
for calculating this ratio. Liquid liabilities include all
current liabilities except bank overdraft. The
argument for excluding bank overdraft from liquid
liabilities
 is that it is usually a permanent source of
financing because this facility is not
withdrawn by the banks all of a sudden. If this
view is accepted, the quick ratio should be
calculated as:
Quick Assets
Quick Liabilities
Note: If the bank overdraft is to be withdrawn
on demand, it should be a part of liquid
liabilities.
Payment in advance & advance income tax can
not be converted into cash.
 INTERPRETATION &
SIGNIFICANCE
Liquid ratio is considered to be superior to
current ratio in evaluating the liquidity
position of the firm. Thus, liquidity ratio is an
indication of a firm’s ability to meet
unexpected demand for working capital.

Ideal Quick Ratio: A quick ratio of 1:1 is

considered as an ideal ratio.
COMPARISON WITH CURRENT
RATIO
A high liquidity ratio compared to current
ratio may indicate under-stocking while a low
liquid ratio indicate overstocking.
Ques.

Liabilities Rs. Assets Rs.

Sundry Creditors 20,287 Goodwill 80,000
Bills payable 900 Land & Building 60,000
Bank Overdraft 2,600 Stock 13,640
Provision for Sundry Debtors 26,150
Taxation 6,200 Bills Receivable 1,130
Proposed Dividend Cash 2,430
Provision for 4,313 Payment in
Deferred Taxation Advance
7,000 3,100
Advance Income
Tax
5,000
Current Ratio = Current Assets
Current Liabilities
= 51,450
34,300
= 1.5:1
Acid Test Ratio = Quick Assets
Current liabilities
= Current Assets – Stock – Payment in Advance – Advance income tax
Current Liabilities
= 51,450 – 13,640 – 3,100 – 5,000 = 29,710 = 0.87:1
34,300 34,200
Note: It is assumed that bank overdraft is payable on demand.
 Absolute Liquid Ratio or
Cash Position Ratio or
Super-Quick Ratio
The absolute liquid ratio is the relationship
between the absolute liquid or super quick
assets to liquid or quick liabilities. It is a more
rigorous test of liquidity of a firm. This is a
variation of quick ratio and is even called
‘super quick ratio’.
formula:
Absolute Liquidity Ratio= Absolute Liquid Assets
Quick/Liquid Liabilities
 Components:
Absolute liquid assets refers to cash, bank and
marketable securities. Liquid liabilities
includes all current liabilities except bank
overdraft as it is not to be paid immediately.
Interpretation and Significance
This ratio pays more significance to liquidity
when used in conjunction with current and
quick ratio. A standard of 0.5:1 in absolute
liquidity ratio is an acceptable norm. This
ratio is recommended to ensure liquidity. It is
considered to be a conservative test and is not
widely used in practice.
Ques.

Liabilities Amoun Assets Amoun

t t
Equity share capital 5,00,000 Fixed Assets 10,00,000
Preference share cap. 1,00,000 Investments 3,00,000
Reserves & surplus 4,00,000 Cash 50,000
Debentures 7,00,000 Debtors 1,50,000
Sundry creditors 60,000 Marketable Securities 2,00,000
Bills Payable 1,00,000 Stock 3,00,000
Outstanding Expenses 10,000
Bank Overdraft 1,30,000
20,00,000 20,00,000
Absolute Liquid Ratio = Cash + Marketable Securities
Current Liabilities
= 2,50,000
3,00,000
= 0.83
Comments: Absolute liquid ratio 0.83 are also quite higher than
the accepted standards of 1 and 0.5 respectively. In all, liquid
position of the company is sound.
 Activity or Efficiency Ratios or
Current Assets Movement Ratios
Also called Turnover Ratios or Performance
Ratios or Assets management ratio. In the
discussion on the liquidity ratios, it has been
pointed out that more and more on the
composition of current assets and current
liabilities should be known if the analyst really
wants to know about the liquidity position of
the firm. It is in reference that the analyst
should also look beyond the measures of the
liquidity in order to assess the activity of a
specific current assets or a current liability.
 An activity ratio is the relationship between
sales or cost of goods sold and investment in
various assets of the firm. And calculated in
turnover or in number of times.
Ques. Why Activity Ratio is calculated?
Ans. A turnover ratio is a measure of movement
and thus indicates as to how frequently an
account has moved/turned over during a period.
It shows as to how efficiently and effectively the
assets of the firm are being utilized. In simple
words, for measuring the efficiency of the firm.
Inventory Turnover Ratio or
Stock Turnover Ratio
This ratio is calculated to consider the
justification of amount of capital employed in
stock. Under it, rate of conversion of stock into
sales (i.e., stock velocity) is known by
establishing relationship of investment in
inventory. It is calculated as follows:

Inventory Turnover ratio = Cost of goods sold or Net sales

Average Inventory at cost
where,
Average inventory = Opening Stock + Closing stock
2

Cost of goods sold = Opening stock + Purchase – Closing Stock

= Net Sales – Gross Profit

Note: Inventory, here will mean inventory of finished

goods only because it only is capable of being sold. In
departmental stores, where inventory is usually valued
at sale price, this ratio is calculated on this basis :
Net Sales
Average Inventory at Selling Price
 In case of a manufacturing concern inventory
turnover may be known separately for raw
material and finished goods both b applying
the following formulae:
(1) Raw material Turnover =
Raw material Consumed
Average Inventory of Raw Material
(2) Finished Goods Turnover =
Cost of Goods Sold
Average Inventory of Finished Goods
This ratio is an indicator of velocity of flow of
inventory in business. Hence, this ratio
should be compared with the firm’s own past
ratio or ratios of other similar firms or with
industry average.
Stock Velocity = No. of days/months in a year/weeks
Stock Turnover ratio
= Average Stock
x No. of days/months
Cost of goods sold
Average Age of Inventory: Some
people calculate average age of inventory also
together with inventory turnover. This
represents the number of days, on an average,
an item remains in the firm’s inventory. It is
calculated as follows:
Average Age of Inventory = 365
Inventory Turnover
The shorter the average age of firm’s inventory, the more
liquid or active it may be considered.
Ques. Compute the stock turnover of a certain
company for each of the three years shown
below and give your interpretation of the results:
2001 2000 1999
Rs. Rs. Rs.
Cost of goods sold 516378 453740 641425
Average Inventory 236420 301231 539850
Solution:
Stock Turnover = Cost of goods sold
Average Inventory
2001: 5,16,378 = 2.19 times
2,36,420
 2000: 4,53,740 = 1.15 times
3,01,231
1999: 6,48,425 = 1.20 times
5,39,850
Interpretation: As is clear from the above calculation
stock turnover has shown in increasing trend during
the years under review. It implies that sales level per
rupee invested in stock has been increasing
continuously. An analysis of absolute amounts of
stock shows that the company is following the policy
of reducing investment in stock each year. This shows
that company’s efficient inventory control policy and
sales capability.
 Some Important Terms
• A contingent liability is defined as an obligation
relating to a past transaction or event that may be payable in
the future. The distinction between a real liability and a
contingent liability depends on the certainty of the payment
to be made. A real liability exists when it is probable that
the payment will be made. A contingent liability exists
when it is only possible that the payment will be made.
• Real liabilities payable from an existing appropriation
must be recognized at year-end even though the amount
may be estimated in whole or part. Real liabilities not
properly payable from an existing appropriation will be
reported as payable from a future appropriation.
 Contingent liabilities
Contingent liabilities are possible future
liabilities that will only become certain on the
occurrence of some future event. A contingent
liability is less certain than a provision: the
latter is expected to occur, a contingent
liability might occur.
Contingent liabilities are not shown in the
balance sheet, but must be disclosed in the
notes.
 Common types of contingent liabilities include
guarantees and the results of legal disputes.
Guarantees may be given on behalf of an associate
company, or as part of a larger deal (banks frequently
give guarantees of various sorts as part of their
business).
Contingent liabilities often do not ever become actual
liabilities. If they are large they may nonetheless be
enough of a risk to have a significant impact on
valuation.
Investors should look out for large, unusual or
potentially problematic contingent liabilities such as:
 guarantees given without apparent or sufficient
reason
 contingent liabilities that do not fit in with the
usual course of the business.
 Accounting Values versus
Economic Values
 Use of the Historical cost Principle For
purposes of valuation, accountants use the
historical cost as the basis. The value of an
asset is shown at its historical cost less
accumulated depreciation. Likewise, the value
of a liability reflects a historical number.
Hence accounting values differ significantly
from current economic values.
 Exclusion of Intangible Assets Intangible
assets like technical know-how, brand equity,
managerial capability, and goodwill with
suppliers often have substantial economic
value. Yet they are ignored in financial
accounting because it is difficult to objectively
value them.
 Understatement or Omission of Certain
Liabilities Firms usually understate or even
wholly omit certain liabilities that are of a
contingent nature. They may be mentioned by
way of a footnote to the balance sheet but they
are not recorded on the main balance sheet.
Sometimes such liabilities are substantial.
 Debtors or Receivable
Turnover Ratio or
Receivable Turnover Ratio
This ratio is a qualitative analysis of a firm’s
marketing and credit policy and debtors
realisations. In other words, if the firm sells
goods on credit, the realisation of sells revenue
is delayed and the receivables ( both debtors
and/or bills) are created. It is calculated to
know the uncollected portion of credit sales in
the form of debtors by establishing
relationship between trade debtors & net credit
sales of the business.
Formula:
Debtors/Receivable Turnover Ratio =
Net credit Sales
Average (Debtors+B/R)

Note: Higher the value of debtors turnover, the

more efficient is the management of debtors.
An increase in this ratio is an indication of
firm’s marketing superiority and efficiency
in credit realization.
 Some Notable Points
 Average trade receivable implies a simple
average of opening and closing trade receivables.
 Trade receivables is the sum of trade debtors and
bills receivable but debtors and bills receivable
arising from irregular or non-trading activities
(such as bills receivable received on sale of a
fixed assets) are not included in this calculation.
 The amount of provision for bad and doubtful
debts is not deducted from debtors in the
calculation of trade receivables.
 Net credit sales consist of gross credit sales
minus sales returns.
 If cash sales are negligible, then calculations
may be made from net total sales figure in
place of net credit sales.
 Average collection period or Average Age of
Receivables
Trade Receivables = Trade Receivables
x No. of Working Days
Sales per day Net credit Sales

Or = No. of working Days

Debtors Turnover
Or = Trade Receivables
x No. of Working Days
Net credit Sales
Creditors/Payable Turnover
Ratio or P/T Ratio
The shot-term creditors (i.e., suppliers of goods
and bankers) are very much interested in this
ratio, as it shows the firm’s trend of payment
to its short-term creditors. This ratio shows the
velocity of the debt payment by the firm. This
ratio shows the relationship of credit purchases
and the average payables (creditors & bills) as
follows:
Creditors Turnover Ratio = Net Credit Purchases
Average (Creditors+ B/P)
Note: Lower the ratio, the better is the liquidity position
of the firm. Higher creditors turnover ratio indicates
weak liquid position. A continuous increase in this
ratio shows delay in payments.

Average Payment Period = No. of Days/Months

Creditors Turnover Ratio

Note: Higher the creditors velocity, better it is.

Total Assets Turnover Ratio =
Net Sales/ Cost of goods Sold
Total Assets
This ratio measures the per rupee sales generated by per
rupee of tangible assets being maintained by the firm.
It may be noted that (i) intangible assets such as
goodwill etc. are not considered and (ii) that the
tangible assets are taken at their written down values.
In time series analysis of ratios, if the Total Assets
Turnover ratio increases over a period, it means that
more sales have been generated per rupee of tangible
assets. This ratio must be analysed together with
some other ratio/information.
Fixed Assets Turnover Ratio =
Net Sales/Cost of goods sold
Fixed Assets (less Dep.)
Where the average fixed assets is equal to the
average of the opening and closing balances of
the fixed assets.
High Good
Current Assets Turnover ratio =
Net Sales/Cost of goods sold
Current Assets

Capital Turnover Ratio =

Sales/Cost of goods sold
Capital employed
*capital employed = Fixed Assets + Current
Assets – Current Liabilities
The higher the current ratio, the greater is the
sales made per rupee of capital employed in
the firm & hence higher is the profit.
 Working Capital Turnover Ratio =
Net Sales/ Cost of Goods Sold
Working Capital
The higher the working capital turnover ratio,
the lower is the investment in the working
capital and higher would be the profitability. A
high working capital turnover ratio reflects the
better utilization of the working capital of the
firm. However, a working capital turnover
ratio also implies a low net working capital in
relation to its net working capital. This may be
a risky proposition for the firm.
 Profitability Ratio
(A) Based on Sales/General Profitability Ratio:-

Gross Profit Ratio/Average mark up ratio =

Gross Profit
x 100
Net Sales
Operating Ratio = Operating cost x 100
Net Sales
lower Good

*operating cost = Cost of goods sold +operating

expenses
**operating expenses includes administrative,
selling and distribution expenses.
Operating Profit Ratio :- The operating profit
refers to the pure operating profit of the firm
i.e. the profit generated by the operation of the
firm and hence is calculated before
considering any financial charge (such as
interest payment), non-operating income/loss
and tax liability etc. The operating profit is
also termed as the Earnings Before Interest
and Taxes (EBIT).
OP Ratio = Operating Profit x 100
Net Sales
*operating profit = Gross Profit – Operating
Expenses
High Good

** Operating Profit Ratio = 100 – Operating

Ratio
Expenses Ratio:- The expenses ratios are the
measure of cost control and are computed by
establishing the relationship between
difference expense items and the sales. In
other words, it is calculated to show
relationship of each item of manufacturing
cost and operating expenses to net sales. These
ratios help in analysing the causes of variation
of the operating ratio.
Expenses Ratio = Different Expenses x 100
Net Sales
Lower the ratio, the greater is the profitability.
Net Profit ratio :- It measures the efficiency of the
management in generating additional revenue over
and above the total cost of operations. The net profit
ratio shows the overall efficiency in manufacturing,
administrative, selling and distributing the product.
This ratio also shows the net contributions made by
every 1 rupee of sales to the owner funds. The NP
Ratio indicates the proportion of sales revenue
available to the owners of the firm and the extent to
which the sales revenue can decrease or the cost can
increase without inflicting a loss on the owners. So,
the NP Ratio shows the firm’s capacity to face the
adverse economic situations.
NP Ratio = NP ( after tax) x 100
Net Sales
Or = NP ( before tax) x 100
Net Sales
The higher the ratio, the better is the
profitability of the firm.
 (B) Based on capital :-
Return on Capital Employed:- The
profitability of the firm can also be analyzed
from the point of view of the total funds
employed in the firm. The term funds
employed or the capital employed refers to the
total long term sources of funds. It means that
the capital employed comprises of
shareholders funds plus long term debts.
Alternatively, it can also be defined as fixed
assets plus net working capital.
Return on Capital Employed =
Net Profit (PBIT) x 100
Capital Employed
Some Equations:
Gross capital employed = Total Assets –
Fictitious Assets
Net Capital Employed = Total Assets – Fictitious
Assets – Current Liabilities
Average Capital Employed =
Opening Capital Employed + Closing Capital Employed

2
Return on Net Worth/Shareholder’s Funds/
Shareholders Investment/Proprietors’ Funds/
Equity : This ratio measures the profitability
of a concern in relation to total investments
made by the shareholders or proprietors in the
business.
The excess of total assets over total outside
liabilities of an enterprise is known as
shareholders’ funds or proprietors’ funds or
net worth.
Return on Net Worth = Net Profit (PAIT) x 100
Shareholder’s fund
Return on Equity Shareholder’s Fund :-
It examines profitability from the perspective of
the equity investors by relating profits
available for the equity shareholders with the
book value of the equity investment. The
return from the point of view of equity
shareholders may be calculated by comparing
the net profit less preference dividend with
their total contribution in the firm.
Return on Equity Shareholder’s Fund =
Net Profit after Tax – Preference Dividend x 100
Equity Shareholder’s Funds
*Equity Shareholder’s Funds = Share Capital+Reserves Credit balance of P/l

Return on Equity Shareholder’s Funds =

Net Profit after Tax – Preference Dividend x 100
Equity Share Capital (Paid up)
Return on Total Assets =
Net profit after tax x 100
Total Assets

Or Net profit after tax + Interest x 100

Total Assets
 Capital
Structure/Leverage/Long
Term Solvency/Debt
Management
A firm’s capital structure is theRatios:
relation of debt
to equity as sources of firm’s asset.
Debt Equity Ratio = Total Debts
Shareholder’s fund
Or Long Term Debts
Shareholder’s Funds
Low Good
i.e more safety
Proprietary Ratio = Proprietors’/shareholders fund
Total Assets
(a) Liability Approach :- Equity share Capital +
Preference share capital + all reserves & surplus –
Preliminary Expenses
(b) Asset Approach :- Total assets – misc. expenses –
Total Debts

Ratio above 50% is generally safe for the creditors.

* Proprietors’ Fund = Share capital ( Equity &
Preference) + all Reserves & Surplus +
undistributed profit (after Deducting accumulated
losses)
- Fixed Assets to proprietors Fund Ratio =
Fixed Assets ( after dep.)
Proprietors’ Funds
- Current Assets to proprietors’ fund ratio =
Current Assets
Proprietors’ Funds
Solvency or Debt to Total Asset Ratio =
Total Liabilities
Total Assets
Fixed Assets Ratio = Fixed Asset
Long term funds
or = Fixed Asset
Capital employed
Idle Ratio is 0.67:1
Capital Gearing Ratio/Capitalisation Ratio
= Variable cost bearing capital
Fixed cost bearing capital
or = Equity to shareholders’ funds
Debenture + preference shares
or = Equity share capital
Fixed cost bearing capital

Dividend coverage ratio = NPAIT

Preference Dividend