Ratio

Ratio Analysis
MEANING
Ratios show the relationship between two numbers. Accounting ratio shows
the relationship between two accounting figure. Ratio analysis is the process of
computing and presenting the relationships between the items in the financial
statement. It is an important tool of financial analysis, because it helps to study
the financial performance and position of a concern.
FORMS
There are three different forms in which an accounting ratio can be expressed
1. Pure ratio: A pure ratio is a simple division of one number by another.
The relationship between current asset & current liabilities is expressed in
this way.
2. Percentage: Certain accounting ratio becomes more meaning full if
expressed as a percentage. The relationship between profit and sales is
expressed in this way
3. Rate: Sometimes ratios are expressed as rates i.e. ‘number of times’ over
a certain period .relationship between stock and sales is expressed in this
way.
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Ratio Analysis
CLASSIFICATION
1) Based on financial statement
According ratio express the relationship between figures taken from financial
statement. Figures may be taken from balance sheet, profit & loss account
or both. One way of classification of ratio is based upon the sources from
which figure are taken
A) Balance sheet ratios: If ratio are base on the figure of balance sheet they
are called balance sheet ratio E.g. ratio of current assets to current liabilities
or ratio of Debt to equity .while calculating these ratio, there is no need to
refer to the revenue statement .these ratio study the relationship between
the assets and the liabilities of the concern. These ratio help to judge the
liquidity, solvency and capital structure of the concern.
There are six type of balance sheet ratio as follow: Current ratio, Liquid
ratio, Proprietor ratio, Capital gearing ratio, Debt equity ratio a Stock
working capital ratio.
B) Revenue statement ratios: Ratio based on the figure from the revenue
statement are called revenue statement ratio. These ratios study the
relationship between the profitability and the sale of the concern.
There are six revenue statement ratios, viz Gross profit ratio, Operating
ratio, Expenses ratio, Net profit ratio & Net operating profit ratio &
Stock turn over ratio.
C) Composite ratios: This ratio indicates the relationship between two items,
of which one is found in the balance sheet and another in the revenue
statement. there are two types of composite ratios
i) Some composite ratio study the relation ship between the profit and the
investment of the concern E.g. Return on capital employed, Return
on proprietors fund, Return on equity capital etc.
ii) Other composite ratios that we are going to study are Debtors
turnover, Creditors turnover, Dividend payout and Debt services.
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Ratio Analysis
2) Based on function:
Accounting ratios can be classified according to their function (i.e. their purpose)
into Liquidity ratios, Leverage ratios, Activity ratios, Profitability ratios, and
Turnover ratios.
A) Liquidity ratios: show the relationship between the current assets and current
liabilities of the concern.
B) Leverage ratios: show the relationship between the proprietor fund and debt
used in financing the assets of the concern .Example are Capital gearing
ratio ,Debt equity ratio and Proprietary ratio .these ratio s are also known
as SOLVENCY RATIOS.
C) Activity ratios (also known as TURNOVER RATIOS or PRODICTIVITY
RATIOS) show the relationship between the sales and the assets .E.g. Stock
turnover ratio, Debtor turnover ratio etc.
D) Profitability ratios show the relationship between
i. Profit and sales ,for example – Operation ratio, Gross profit ratio,
Operating net profit ratio, Expenses ratios Etc, or
ii. Profit and investment, for Example-Return on investment, Return on
equity capital Etc.
E) Coverage ratios show the relationship between the profits on one hand and
the claims of outsiders (dividend, interest Etc) to be paid out of such profits.
Examples are Dividend payout ratio and debt service ratio.
3) Based on user
A) Ratios for short term creditors: current ratio, Liquid ratio & Stock
working capital.
B) Ratios for Share holder: Return on proprietors’ funds, Return on Equity
capital.
C) Ratios for Management: Return on capital employed, Turnover ratio,
Operating ratio, Expenses ratios.
D) Ratios for long term creditors: Debt equity ratio, Return on capital
employed, preparatory ratio.
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Ratio Analysis
1) CURRENT RATIO (CR) = CURRENT ASSETS (CA)
CURRENT LIABILITIES (CL)
2) QUICK / LIQUIDITY RATIO (QR) = QUICK ASSETS (QA)
QUICK LIABILITIES (QL)
3) STOCK WORKING CAPITAL (SWC) STOCK (CST) X 100
WORKING CAPITAL (WC)
4) PROPRIETORS RATIO (PR) = PROPRIETORS FUNDS (PF) X 100
TOTAL ASSETS (TA)
5) DEBT EQUITY RATIO (DER) = BF
PF
6) CAPITAL GEARING RATIO (CGR) = PC+BF
EF
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Ratio Analysis
1. CURRENT RATIO (CR)
MEANING : This ratio compares the current assets with the current liabilities.
It is expressed in the form of a pure ratio.
FORMULA : CURRENT RATIO (CR) = CURRENT ASSETS (CA)
CURRENT LIABILITIES (CL)
COMPONENTS :
Current assets: Sundry debtors(less Provision), loose tools, income accrued
/Due, Bill receivable, cash and Bank balance, Marketable
investment, closing stock of raw material, Working in progress,
finished goods, store and spares, Pre payments, short term loan
and advance tax..
Current liabilities: Sundry creditors, bill payable, outstanding expenses,
unclaimed dividend and proposed dividend, provision for
taxation, income received in advanced, bank overdraft.
FUNCTION/PURPOSE : Current ratio is a liquidity/solvency ratio which
indicates the ability of the concern to meet its short-term liabilities. It measure the
short term solvency of the concern .it is used by a creditors to judge the safety
margin available and to decide the amount and the term of the credit.
LIMITATION
 Ignore composition: Current ratio ignores the composition of working
capital. Two companies A & B may have the same current ratio; but if
company A has more stocks and company B has more cash, company B
has a better liquidity / solvency.
 Ignores Quality: current ratio also ignores the quality of working capital.
two companies A & B may have the same current ratio and the same
amount of stock and debtors ,but if company A has more absolute stock
and doubtful debts, company B has a better liquidity /solvency.
INTERACTION WITH OTHER RATIOS
This ratio should be studied with liquid and ratio and stock working capital ratio
for judging the short term solvency of the concern.
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Ratio Analysis
COMMENTS
Actual Ratio:-
Rs. XX of current assets available for each Re. of current liability.
Higher than Standard:-
1. Very good short term liquidity/solvency.
2. Excess stocks, bad debts, idle cash.
3. Under-trading.
Lower than Standard:-
1. Unsatisfactory short-term liquidity/solvency.
2. Shortage of stocks, bad debts, idle cash.
3. Over-trading.
2. QUICK/LIQUID RATIO (QR)
MEANING: Liquid ratio compares the quick assets with the quick liabilities .it is
expressed in the form of a pure ratio .it is also known as quick ratio or Acid test
ratio.
FORMULA: QUICK / LIQUIDITY RATIO (QR) = QUICK ASSETS (QA)
QUICK LIABILITIES (QL)
COMPONENTS
Quick assets (QA): Current assets (-) l closing stock (-) pre payment i.e.
Debtors, loose tools, income accrued, income accrued /Due,
Bill receivable, cash and Bank balance, Marketable
investment.
NOTE: stock is exclude because it is in certain as to when and how much ,it
will realise.Prepayment are exclude because ,they cannot be converted into cash.
QUICK LIABILITIES (QL): Sundry creditors, bill payable, outstanding
expenses, unclaimed dividend and proposed
dividend, provision for taxation
NOTE: bank overdraft is excluded ,because it is almost a permanent arrangement
with the bank and is not required to be paid in full as long as the concern existing.
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Ratio Analysis
FUNCTION/PURPOSE: Liquid ratio is a liquid/solvency ratio which indicates
the ability of the concern to meet its short term liabilities without selling stocks, it
measure the immediate solvency of the concern .it overcome the imitation of the
current ratio .it consider both the composition and the quality of the working
capital .it is qualitative test of solvency .it emphasizes the quality of the current
assets (i.e. their convertibility in to cash) rather than their quantum.
Liquid ratio should be studied with current ratio for commenting on short term
solvency
COMMENTS
Actual Ratio:-
Rs. XX of liquid assets available for each Re. of quick liability.
1. Very good day-to-day liquidity/solvency.
2. Idle cash balances.
3. Under-investment.
1. Unsatisfactory day-to-day liquidity/solvency.
2. Low cash balances.
3. Over-investment.
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Ratio Analysis
3. STOCK TO WORKING CAPITAL RATIO
MEANING: This ratio shows the relationship between the closing stock and the
working capital. It helps to judge the quantum of inventories in relation o the
working capital of the business. It is expressed as a percentage. It is also known
as Inventory Working Capital Ratio.
FORMULA:
STOCK TO WORKING CAPITAL RATIO =STOCK (CST) X 100
WORKING CAPITAL(WC)
COMPONENTS
Stock [CST] would mean closing stock.
Working Capital [WC] = Current Assets less Current Liabilities
FUNCTION/PURPOSE
Stock to working capital ratio is a liquidity ratio. It indicates the composition and
quality of the working capital. This ratio also helps to study the solvency of a
concern. It is qualitative test of solvency. It shows the extent of funds blocked in
stocks. If investment in stock is higher it means that the amount of liquid assets is
lower.
This ratio should be studied with stock-turnover ratio, current ratio and quick
ratio.
Best combination for short-term solvency would be:
(1)Current Ratio 2:1
(2)Quick ratio slightly greater than one.
(3)Good stock-turnover during the say 6 to 7 times, and
Stock to working capital ratio lower than 100%
COMMENTS
Actual Ratio:-
% of WC blocked in stocks.
1. More other current assets available to pay current liabilities.
1. Less other current assets available to pay current liabilities.
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Ratio Analysis
4. PROPRIETORY RATIO
MEANING:
Proprietary ratio compares proprietor’s funds with total liabilities (or total assets).
It is usually expressed in the form of percentage. It is also known as Net Worth to
Total Assets Ratio, Equity Ratio, and Net worth Ratio or Asset Backing Ratio.
FORMULA:
PROPRIETORY RATIO =
PROPRIETORS’ FUNDS OR SHAREHOLDER’S EQUITY (PF) X 100
TOTAL ASSETS OR TOTAL LIABILITIES (TA OR TL)
COMPONENTS:
Proprietors’ Funds [PF] will include:
1. Paid up Equity capital (EC)
2. Reserves & Surplus (RS) including capital reserves, revenue reserves, P&L
a/c Cr. Balance
Less: Accumulated losses (i.e. P & L a/c Dr. Balance)
Less: Fictitious Assets like Miscellaneous Expenditure not written off.
3. Paid up Preference Capital (PC)
Thus, PF = EC + RS + PC or EF + PC
Total Assets [TA] (Fixed Assets + Investments + Current Assets) = Total
Liabilities [TL] (Own Funds + Loans + Current Liabilities)
= Total of the (Horizontal) Balance Sheet excluding fictitious assets &
Accumulated losses (if any).
= Capital Employed + Current Liabilities
FUNCTION/PURPOSE:
Proprietary ratio is a solvency ratio which indicates
(i) The long term solvency; and
(ii) The extent of funds invested by the owners in relation to total
funds employed in the business (i.e. capitalization).
INTERACTION WITH OTHER RATIOS:
This ratio should be studied with Debt-Equity ratio to study the capital structure
and with Current and Liquid ratio to comment on the long term and short term
solvency of the business.
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Ratio Analysis
COMMENTS
Actual Ratio:-
% of total assets financed by owner’s funds.
1. Very good solvency position.
2. No trading on equity.
1. Unsatisfactory solvency position.
2. Trading on equity.
5. DEBT-EQUITY RATIO
MEANING: THIS ratio compares the long term debts with shareholders’ funds.
It is usually expressed as a pure ratio.
FORMULA: This ratio is calculated in two ways
(1) Debt = Borrowed Funds(BF)
Equity Proprietors’ Funds (PF)
(2) BF .
BF + PF
COMPONENTS
Borrowed Funds [BF] includes
1. Debentures, Loans, etc.
2. Interest accrued and due on such BF.
Proprietors’ Funds [PF] includes
1. Equity share capital (EC)
2. Reserves & Surplus (RS)
Less: (a) Profit & Loss A/c Dr. Balance (loss
(b) Miscellaneous Expenditure not written-off, if any.
3. Preference share capital (PC)
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Ratio Analysis
PURPOSE/FUNCTION
Debt-equity ratio is a solvency ratio which indicates the proportion of debt and
equity in financing of the assets of the concern. Debt-equity ratio shows the
(i) margin of safety for long term creditors; and
(ii) The balance between debt and equity (i.e. capitalization).
INTERACTION WITH CAPITAL GEARING RATIO
This ratio differs from Capital Gearing Ratio in one aspect. Preference share
capital is considered as a part of Equity in Debt-equity ratio whereas it is clubbed
with loans and debentures in Capital Gearing Ratio.
COMMENTS
Actual Ratio:-
Rs. X obtained from debt, for each Re. 1 from shareholders.
1. Low safety margin for lenders.
2. More interest payments.
3. Less scope for more loans.
4. Trading on equity.
1. High safety margin for lenders.
2. Less interest payments.
3. Scope for more loans.
4. No trading on equity.
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Ratio Analysis
6. CAPITAL GEARING RATIO
MEANING
‘Gearing’ means the process of increasing the equity shareholder’s return through
the use of debt. Equity Shareholders earn more when the rate of return on total
capital is more than the rate of interest on debts. This is also known as ‘leverage’
or ‘trading on equity’. The Capital Gearing Ratio shows the relationship between
two types of capital viz. (i) Equity capital including reserves and (ii) Preference
share capital and long term borrowings. It is usually expressed as a pure ratio.
This is also known as ‘Capital Structure Ratio’.
FORMULA
Capital Gearing Ratio =
Capital Entitled to fixed Rate of Interest or Dividend = PC + BF
Capital not so entitled to Fixed Rate of Interest or Dividend EF
COMPONENTS
Capital entitled to fixed rate of interest or dividend
1. Preference capital (PC)
2. Debentures, Long term loans, i.e. Borrowed Funds (BF)
Capital not entitled to fixed rate of interest or dividend (Equity holders’
Fund or EF)
1. Equity Capital (EC)
2. Reserves & Surplus (RS)
Less: Profit & Loss A/c Dr. Balance
Less: Fictitious Assets
Thus, CGR = PC + BF
EF
PURPOSE/FUNCTION
Capital Gearing Ratio is a leverage ratio which indicates the proportion of debt
and equity in the financing of assets of a concern. ‘Leverage’ means his process
of increasing the equity shareholders’ return through the use of debt also known
as ‘gearing’ or ‘trading on equity’. Capital Gearing Ratio shows the balance
between debt and equity.
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Ratio Analysis
COMMENTS
Actual Ratio:-
For every Rs. XX from funds with fixed returns, Re. 1 is from equity
shareholders.
Higher returns for equity shareholders if rate of fixed returns is less than ROI.
Low returns/loss to equity shareholders if rate of fixed returns is more than ROI.
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Ratio Analysis
1. Gross Profit Ratio:
GPR= GP/Sales x 100
2. Operating Ratio:
OR= COGS + OE/Sales x100
3. Expense Ratio:
ER= AE or SE or FE/Sales x100
4. Operating Profit Ratio:
OPR= OP/Sales x100
5. Net Profit Ratio:
NPR= NPBT/Sales x100
6. Stock Turnover Ratio:
STR= COGS/OST+CST/2
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Ratio Analysis
1. GROSS PROFIT RATIO
MEANING: THIS ratio compares gross profit with net sales. It is usually
expressed in the form of percentage.
FORMULA: GROSS PROFIT = GROSS PROFIT/NET SALES X 100
COMPONENTS
Gross Profit = Sales less Cost of Goods Sold
Cost of goods sold [COGS]
[In case of a Trading Concern]
1) Opening stock
2) Add: Purchases
3) Add: Direct expenses
4) Less: closing Stock
= COGS
[In case of a manufacturing concern]
1) Opening stock of finished goods
2) Add: Cost of goods produced
[Direct/Prime Cost (Material + Labour + Expenses)]
3) Less: Closing stock of finished goods
= COGS
Net sales [S]
= Sales less Sales returns less Allowances
FUNCTION/ PURPOSE
Gross profit ratio is a profitability ratio, which shows the relationship between
profits and sales. This ratio helps to judge (i) how efficient the concern is in
managing its production, purchase, selling and inventory; (ii) how good its
control is over the direct costs; (iii) how productive the concern is; and (iv) how
much amount is left to meet other expenses and earn net profits.
INTERACTION WITH OTHER RATIO: This ratio should be studied with net
profit ratio, operating ratio and return on investment ratio to know the over all
profitability of the concern.
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Ratio Analysis
COMMENTS
Actual Ratio:-
1. Margin of Rs. xx on sale of Rs. 100.
2. Rs. xx is available to meet other expenses.
1. High efficiency in managing purchases, production, labour, sales and
inventory.
2. High productivity.
3. Large amount available to meet other expenses.
1. Low efficiency in managing purchases, production, labour, sales and
inventory.
2. Low productivity.
Small amount available to meet other expenses
2. OPERATING RATIO
MEANING: Operating ratio expresses the relationship between total operating
costs and net sales. It is expressed by the way of a percentage.
FORMULA:
OPERATING RATIO =
COST OF GOODS SOLD + OPERATING EXPENSES X 100
NET SALES
COMPONENTS
Cost of Goods Sold [COGS]
Operating Expenses [OE]
1. Office and Administration Expenses
2. Selling and Distribution Expenses
3. Finance Expenses Excluding Interest on Loans and Debentures
Net Sales [S] = Sales less Sales returns less Allowances
FUNCTION/ PURPOSE
Operating ratio indicates cost of operations. Its purpose is to measure and
ascertain the efficiency of the management as regards operations. This ratio helps
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Ratio Analysis
to judge (i) how efficient the concern is in controlling its cost of production,
purchase, labour, administration, selling and inventory; and (ii) how much
amount out of sales revenue is used up in carrying the operations of the concern.
INTERACTION WITH OTHER RATIO : operating ratio show total of all
coast in all area such as administration, sale etc.it is advisable to break it up into
various expenses ratio so that we can know which expenditures in particulars is
increasing disproportionately. Operating ratio should always be studied with
expenses ratio and operating net profit ratio before commenting on the
profitability of the concern.
COMMENTS
Actual Ratio:-
1. Operating cost of Rs. xx on sale of Rs. 100.
2. Rs. (100 - xx) is the operating profit.
1. Low efficiency in managing purchases, production, labour, sales and
inventory.
3. Small amount available to meet other expenses.
1. High efficiency in managing purchases, production, labour, sales and
inventory.
3. Large amount available to meet other expenses.
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Ratio Analysis
3. EXPENSES RATIO
MEANING: THIS ratio expresses the relationship between each item of
expenditure and net sales. It is expressed as a percentage. Total of all expenses
will be equal to Operating ratio.
FORMULA
ANY EXPENSE RATIO = EXPENDITURE X 100
NET SALES
E.g.
Administrative Expenses Ratio = Administrative Expenses x 100
Net Sale
Selling Expenses Ratio = Selling Expenses / Net Sales x 100
FUNCTION/ PURPOSE
Expenses ratios are supplementary to the Operating ratio. Study of Expense ratios
helps us to know the cause behind overall change in the Operating ratio.
Management can take corrective action accordingly. Expense ratios indicate the
efficiency of management in controlling the expenses and thereby improving
profitability. Expenses ratios over a number of years should be studied to find out
trend. While interpreting these ratios, it must be kept in mind that if expenses are
fixed in nature, ratio would decrease as sales increase but if expenses are variable,
same percentage would be maintained.
COMMENTS
Actual Ratio:-
1. Expense of Rs. xx on sale of Rs. 100.
2. Rs. xx is available to meet other expenses.
1. Less control on that expenditure.
3. Small profit available to meet other expenses.
1. Very good control over that expenditure.
3. Large profit available to meet other expenses.
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Ratio Analysis
4. OPERATING PROFIT RATIO
MEANING: Operating profit ratio indicates the relationship between Operating
profit and the Sales. It is usually expressed in the form of a percentage. It is also
known as Net Operating Profit Ratio.
FORMULA
OPERATING PROFIT = OPERATING PROFIT X 100
NET SALES
COMPONENTS
Operating Profit [OP] =
1. Gross Profit
2. Less: Operating expenses [OE]
Net Sales [S] = Sales less Returns less Allowances.
FUNCTION/ PURPOSE
Operating profit ratio is a profitability ratio, which shows the relationship
between profits and sales. It indicates profits from operations. This ratio helps to
judge
(i) How efficient the concern is in managing all its operations of production,
purchase, inventory, administration, selling, distribution etc. and
(ii) How much amount is left to meet non-operating expenses and earn profits?
INTERACTION WITH OTHER RATIO: operating profit ratio should be
studied with return on capital employed and return on proprietors’ funds.
COMMENTS
Actual Ratio:-
1. Operating margin of Rs. xx on sale of Rs. 100.
2. Rs. xx is available to meet non-operating profit.
1. Good control over direct and indirect costs.
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Ratio Analysis
3. Large amount available to meet non-operating expenses/losses.
1. Less control over direct and indirect costs.
3. Small amount available to meet non-operating expenses/losses.
5. NET PROFIT RATIO
MEANING
Net Profit ratio indicates the relationship between net profit and sales. It is usually
expressed in the form of a percentage.
FORMULA
NET PROFIT = NET PROFIT (BEFORE TAX) X 100
NET SALES
COMPONENTS
Net Profit before Tax [NPBT] =
A) Operating net profit
B) Add: Non Operating Income
C) Less: Non Operating Expenses
= NPBT
Net Sales [S] =Sales less Returns less Allowances
FUNCTION / PURPOSE
Net profit ratio is a profitability ratio, which shows the relationship between
profits and sales. It indicates net profits from all types of activities of the entire
business. It measures the overall profitability from (a) operating activities of
buying/selling products; (b) financing activities of borrowing/lending; and (c)
buying/selling investments. This ratio helps to judge (i) how efficient the concern
is in managing all its activities of operations, financing and investment; and (ii)
how much amount is available for appropriations.
INTERACTION WITH OTHER RATIO: Net profit ratio should be studied
with return on capital employed and return on proprietors’ funds.
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Ratio Analysis
COMMENTS
Actual Ratio:-
1. Net margin of Rs. xx on sale of Rs. 100.
2. Rs. xx is available for appropriations.
1. Good control over all expenses.
2. Unusual gains.
3. Large amount available for appropriations.
4. High increase in net worth.
5. Strong capacity to face bad economic situation.
1. Less control over all expenses.
2. Unusual losses.
3. Small amount available for appropriations.
4. Less increase in net worth.
5. Weak capacity to face bad economic situation.
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Ratio Analysis
6. STOCK TURNOVER RATIO
MEANING
Stock turnover ratio shows the relationship between the cost of goods sold and
the average stock. This ratio is normally expressed as a ‘rate’.
FORMULA
A. Stock Turnover Ratio = Cost of Goods Sold (COGS)
Average stock (AS)
If stock is valued at sales price, formula will be
= Net Sales
Average Stock (at selling price)
Average Stock = Opening Stock + Closing Stock
2
Note: In the absence of information, closing stock can be used instead of average
stock in the above formula.
B. Stock Velocity [Stock Holding Period]
Stock velocity means the period (months or days) taken for converting average
stock into sales. It shows the Stock Holding Period.
12___________ = Number of months production on hand or Number of
Stock Turnover Ratio months it takes for converting stock into sales.
365________ = Number of days production on hand or Number of
Stock Turnover Ratio days it takes for converting stocks into sales.
COMPONENTS
Cost of Goods Sold [COGS]
= Sales less Gross Profit
Average Stock [AS] = Opening Stock + Closing Stock
2
FUNCTION / PURPOSE
Stock Turnover Ratio is an activity ratio, which shows the relationship
between sales and stock. Its purpose is to (i) calculate the speed at which stock
is being turned over into sales; (ii) calculate the stock velocity to indicate the
period taken by the average stock to be sold out; and (iii) judge how efficiently
the stocks are managed and utilized to generate sales.
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Ratio Analysis
INTERACTION WITH OTHER RATIO: THIS ratio should be studied with
the current ratio and liquid ratio while commenting on short term
liquid/solvency .if Company’s current ratio is 2:1 & liquid ratio is 0.5:1, it means
that the concern has larger stocks and low quick assets. This fact can be proved if
company’s stocks turnover ratio is very low say 1 or 2 which means low stocks –
turnover is the reason for good current ratio but bad quick ratio.
COMMENTS
Actual Ratio:-
Stock Holding Period is xx.
1. Stock sold out fast.
2. Same volume of sales from less stock.
3. More sales from less stock.
4. Working Capital requirement is less.
5. Too high ratio shows stock-outs or over-trading.
1. Stock sold out at a slow speed.
2. Same volume of sales from more stocks.
3. Less sales from less stock.
4. Working Capital requirement is more.
5. Too low ratio shows obsolete stocks or less trading.
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Ratio Analysis
1. Return on Investment/ Capital Employed
ROI = PBIT x 100
CE
2. Return on Proprietors Fund
RPF = NPAT X 100
PF
3. Return on Equity Capital
ROE = PAES x 100
EF
4. Dividend Pay Out
DP = _ _ED_ X 100
PAES
5. Debt Service / Interest Coverage Ratio
DSR = PBIT
INT
6. Debtors Turnover Ratio
DTR = CSR
DR+BR
7. Creditors Turnover Ratio
CTR = CRP
CD + BP
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Ratio Analysis
1. RETURN ON CAPITAL EMPLOYED
MEANING
The ratio measures the relationship between net profit (before interest and tax)
and the capital employed to earn it. It is expressed as a percentage. This ratio is
also known as ‘Return on Investment’ [ROI].
FORMULA
RETURN ON CAPITAL EMPLOYED =
PROFIT (BEFORE INTEREST, TAX) (PBIT) X 100
CAPITAL EMPLOYED X 100 (CE)
COMPONENTS
Profit (before Interest, Tax) [PBIT] =
1. Profit before interest on long-term borrowing, tax and dividends
2. Less abnormal, non-recurring items.
Capital Employed [CE] =
1. Equity capital
2. Add: Preference Capital + Reserves & Surplus
3. Add: Long term Borrowings (Term Loans + Debentures)
4. Less: Fictitious assets like Miscellaneous Expenses not written off
5. Less: Profit & loss A/c Dr. Balance (loss).
Note: Capital employed may be taken to mean Assets Employed, in which case,
Capital Employed [CE] can also be computed as
1. Fixed Assets (Less depreciation) (including investments)
2. Add: Current Assets
3. Less: Current Liabilities
4. Exclude Fictitious assets
FUNCTION/ PURPOSE Return on capital employed ratio is a profitability
ratio, which shows the relationship between profits and investments. Its purpose
is to measure the overall profitability from the total funds made available by the
owners and lenders. This ratio helps to judge how efficient the concern is in
managing the funds at its disposal.
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Ratio Analysis
COMMENTS
Actual Ratio:-
1. Return of Rs. xx on each Rs. 100 of capital.
2. Rs. xx is available for tax, interest and appropriations.
1. Good profit ratios (more profit on each rupee of sales).
2. Good turnover ratios (more sales on each rupee of asset used).
3. Large amount for appropriations.
5. Scope to attract fresh funds from owners or lenders.
1. Unsatisfactory profit ratios (less profit on each rupee of sales).
2. Unsatisfactory turnover ratios (less sales on each rupee of asset used).
3. Small amount for appropriations.
4. Low increase in net worth.
5. Less scope to attract fresh funds from owners or lenders.
2. RETURN ON PROPRITORS FUND
MEANING:
This ratio measures the relationship between profit (after interest rate and tax) and
the proprietor’s capital. It is usually expressed as a percentage. It is also known as
Return on Proprietor’s Equity or Return on Net Worth.
FORMULA
RETURN ON PROPRIETOR’S FUNDS =
NET PROFIT (AFTER TAX) (NPAT) X 100
PROPRIETOR’S FUNDS (PF)
COMPONENTS
Net profit [NPAT] =profit after interest and tax
Proprietors Funds [PF]
1. Equity capital[EC]
2. Add: Reserves & Surplus[RS]
Less: Fictious assets like miscellaneous Expresses not written off
Less: profit & loss A/C Dr. Balance (loss)
3. Add: preference capital [PC]
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Ratio Analysis
FUNCTION/ PURPOSE
Return on proprietor’s funds is a profitability ratio, which shows the relationship
between profits and investments by the proprietors in the concern. Its purpose is
to measure the rate of return on the total funds made available by the owners.
This ratio helps to judge how efficient the concern is in managing the owner’s
funds at its disposal.
INTERACTION WITH OTHER RATIOS: this ratio should be studied with
the debt equity ratio to know the effect of capital structure on earning of the
proprietors.
COMMENTS
Actual Ratio:-
1. Return of Rs. xx on each Rs. 100 of owner’s funds.
2. Scope to attract fresh funds from owners.
2. Less scope to attract fresh funds from owners.
3. RETURN ON EOUITY CAPITAL
MEANING
This ratio measures the relationship between net profit (after interest, tax and
preference dividend) and the equity shareholder’s funds. It is usually expressed as
a percentage.
FORMULA
RETURN ON EQUITY CAPITAL =
PROFIT AVAILABLE TO EQUITY SHAREHOLDERS (PAES) X 100
EQUITY SHAREHOLDER’S FUNDS (EF)
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Ratio Analysis
COMPONENTS
Profit for equity shareholders [PF] =profit after interest, tax and preference
dividend.
Equity shareholders Funds [EF] =
1. Equity capital[EC]
2. Add: Reserves & Surplus[RS]
Less: Fictious assets like miscellaneous Expresses not written off
Less: profit & loss A/C Dr. Balance (loss)
FUNCTION / PURPOSE
Return on equity capital is a profitability ratio, which shows the relationship
between profits and the equity shareholder’s funds in the concern. Its purpose is
to calculate the amount of profits available to take care of equity dividends,
transfer to reserves etc. it is used by the present or prospective investor for
deciding whether to purchase, keep or sell the equity shares.
This ratio should be studied with capital gearing ratio to know the effect of higher
or low gearing on earning per share.
COMMENTS
Actual Ratio:-
1. Return of Rs. xx on each Rs. 100 of equity shareholder’s funds.
3. Scope to attract fresh funds from equity shareholders.
4. High price for each equity share on stock exchange or in a merger.
2. Low increase in net worth.
3. Less scope to attract fresh funds from shareholders.
4. Low price for each equity share on stock exchange or in a merger.
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Ratio Analysis
4. DIVIDEND PAYOUT RATIO
MEANING:
Dividend Payout Ratio shows the relationship between the dividends paid to
equity shareholders out of the profits available to the equity shareholders.
FORMULA:
DP (TOTAL) =
DIVIDEND TO EQUITY SHAREHOLDERS(ED) X 100
PROFITS AVAILABLE TO EQUITY SHAREHOLDERS (PAES)
COMPONENTS
Dividend to Equity shareholders[ED] means the cash dividend paid to equity
shareholders
Profits Available to Equity SHAREHOLDERS (PAES) means net profit after
interest, income tax and preferences dividend i.e. NPAT-PD
FUNCTION / PURPOSE:
Dividend Payout Ratio is a type of coverage ratio. A coverage ratio shows the
relationship between the profits and the claims of outsiders to be paid out of such
profits. Its purpose is to measure the dividend-paying capacity of the company.
Comments
Actual Ratio:-
1. Rs. xx is paid as dividend out of each Rs. 100 available for distribution.
2. Balance (100 – xx) can be transferred to reserves.
1. Very high dividends make short term equity shareholders very happy.
2. Scope to issue fresh equity shares at high price.
3. High price on stock exchange or in merger for equity shares.
4. Less reserve may mean low growth in future and no bonus issue.
1. Very low dividends make short term equity shareholders very unhappy
2. Less scope to issue fresh equity shares.
3. Low price on stock exchange or in merger for equity shares.
4. If transfers to reserves are more, it may mean high growth in future or bonus
issue in future.
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Ratio Analysis
5. DEBT SERVICE RATIO
MEANING:
A Debt service ratio shows the relationship between net profits and interest
payable on loans. It expressed as a pure number. It is also known as Interest
Coverage Ratio.
FORMULA:
DEBT SERVICE RATIO =
PROFITS BEFORE INTEREST AND TAX (PBIT)
INTEREST (INT)
COMPONENTS
PBIT means the amount of net profit interest and tax. Interest means the interest
payable on loans.
INTERST means interest on long term loans.
FUNCTION/ PURPOSE:
Debt Service Ratio is a type of coverage ratio. A coverage ratio shows the
relationship between the profits and the claims of outsiders to be paid of such
profits. It purposes is to measure the interest-paying capacity of the company.
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Ratio Analysis
6. DEBT SERVICE COVERAGE RATIO
MEANING:
Debt Service Coverage Ratio shows the relationship between net profits and
interest + installments payable on loans. It is expressed as a pure number. Debt
Service means the payment of interest + installments on loans. Coverage means
the availability of profits for debt servicing.
FORMULA:
DEBT SERVICE COVERAGE RATIO =
CASH PROFITS AVAILABLE FOR DEBT SERVICING
INTEREST + INSTALLMENT DUE ON LOANS
COMPONENTS:
Cash profits available for debt servicing are computed as follows:
A. Net profits after interest and tax [NPAT]
B. Add:
1. Non-cash debits to P & L A/c
(Depreciation, goodwill w/o, deferred revenue expenses w/o, etc.)
2. Interest on loan
C. Cash profits for debt servicing
Interest means interest on long term loans during the year.
Installments mean installments due on long term loans during the year.
FUNCTION/PURPOSE:
Debt Service Coverage Ratio (DSCR) is a type or coverage ratio. A coverage
ratio shows the relationship between the profits and the claims of outsiders to be
paid out of such profits. The purpose of DSCR is to measure the debt-servicing
capacity of the company.
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Ratio Analysis
COMMENTS
Actual Ratio:-
Earnings are xx times the interest.
1. Strong capacity to pay interest as and when due.
2. Large balance profits left for tax, dividends.
3. Good scope to get more loans at a low rate of interest.
4. But less benefits of trading on equity, if assets are financed less by debt and
more by equity.
1. Weak capacity to pay interest as and when due.
2. Small balance profits left for tax, dividends.
3. Less scope to get more loans at a low rate of interest.
4. But more benefits of trading on equity, if assets are financed less by debt and
more by equity.
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Ratio Analysis
7. DEBTORS TURNOVER RATIO
MEANING
This ratio shows the relationship between net credit sales and average trade
debtors. It is expressed as a rate.
FORMULA
A. Debtors Turnover
Debtors Turnover = Credit Sales = Credit Sales = CRS .
Accounts Receivable Debtors + Bills Receivable DR + BR
Note: Debtors & Bills Receivable may be taken at the average of the opening and
closing amounts. If the details are not available, only the closing balance may be
considered.
B. Debtors Velocity (Debt Collection Period)
Debtors Velocity means the period (months or days) taken by the debtors for
settlement of their bills. It shows the number of days for which credit sales
remain outstanding.
= Debtors + Bills Receivable or 12 months or 365 days
Daily Credit Sales Debtors Turnover Ratio
COMPONENTS
Debtors = Net debtors arising out of sales less bad debts.
Note: Provision for doubtful debts against which there are no bad debts should
not be deducted from debtors.
Bills Receivable = Bills arising out of sales less bills receivable dishonored.
Credit Sales = Gross credit sales Less Allowances Less Returns.
FUNCTION/PURPOSE
Debtors Turnover Ratio is a turnover ratio, which shows the relationship between
credit sales and debtors. Its purpose is to (i) calculate the speed with which
debtors get settled on an average during the year; (ii) calculate the debtors
velocity to indicate the period of credit allowed to an average debtor; and (iii)
judge how efficiently the debtors are managed.
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Ratio Analysis
COMMENTS
Actual Ratio:-
Debt Collection Period is xx.
1. Debts are collected at a slow speed.
2. More credit is given to debtors.
3. More chances of bad-debts.
1. Debts are collected at a high speed.
2. Less credit is given to debtors.
3. Less chances of bad-debts.
8. CREDITORS TURNOVER RATIO
MEANING
Creditors’ turnover ratio shows the relationship between net credit purchases and
the average trade creditors. It is normally expressed as a ‘rate’.
FORMULA
A. Creditors Turnover
Creditors Turnover = Credit Purchases = Credit Purchases = CRP.
Accounts Payable Creditors + Bills Payable CD + BP
B. Creditors Velocity (Debt Payment Period)
Creditors Velocity means the period (months or days) taken by the concern to pay
off its creditors.
Credit Period Enjoyed = 365 days or 12 months or Creditors + BP .
Creditors Turnover Ratio Daily Credit Purchases
COMPONENTS
Credit Purchases = Gross Credit Purchases Less Returns.
Creditors may be taken at the average of the opening and closing amounts. If the
details are not available, only the closing balance may be considered.
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Ratio Analysis
PURPOSE/FUNCTION
Creditors Turnover Ratio is a turnover ratio, which shows the relationship
between credit purchases and creditors. Its purpose is to (i) calculate the speed
with which creditors are paid off on an average during the year; (ii) calculate the
creditors velocity to indicate the period taken by the average creditor to be paid
off; and (iii) judge how efficiently the creditors are managed.
INTERACTION WITH OTHER RATIO
This ratio should be studied along with the other two turnover ratio, viz stock
turnover and debtors’ turnover .the combined effect of turnover ratios show the
durations shows the duration of the operation cycle.
THUS,
Stock holding period 2 months
Add: Debtors collection period (+) 1 month
Less: Creditors payments period (-) 2 months
Net period 1 month
A short net period indicates fast operating cycle requiring less working capital
and hence strong liquidity and vice versa.
COMMENTS
Actual Ratio:-
Debt Payment Period is xx.
1. Creditors are paid late.
2. More credit is available from creditors.
3. Working Capital requirement is less.
1. Creditors are paid early.
2. Less credit is available from creditors.
3. Working Capital requirement is more.
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Ratio

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