1. CHAPTER – III

Theoretical Frame Work

2. RATIO ANALYSIS
INTRODUCTION
Defination: According to Myers “Study of relationship among the various financial factors of
the enterprise.”
Ratio analysis is one of the popular tools of financial statement analysis. In simple words, ratio
is the quotient formed when magnitude is divided by another measure in the same unit. A ratio is
defined as “The indicated quotient of two mathematical expressions” and as the relation between
two or more things. Usually the ratio is stated as percentage that is distribution expenses might
be stated as 20% of scales.
A financial ratio is defined as relationship between two variables taken
from the financial
statements of the concern. Financial ratios expedite the analysts by reducing the large number of
items involved in a relatively small set of readily comprehended and economically meaningful
indicators.
INTERPRETATION OF RATIO
One of the most difficult problems confronting the analyst is the interpretation and analysis of
financial ratios. An adequate financial analysis involves more than an understanding and
interpretation of each of the individual ratios. Further analysts requires an insight into the
meaning of inter-relations among the ratios and the financial data in the statements.
The followings factors must be considered while analyzing the financial ratios.
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General economic conditions of the firm.
Risk acceptance.
Future expectations.
Accounting system of the industry.
Analyzing and interpreting the system used by the other industry.

3. The interpretation of ratios can be made by comparing them with:
 Previous figures
 Similar firms-inter firm comparisons.
 Targets-individuals ratio set to meet the objectives.
Purposes of the Ratio Analysis are:


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To study the short term solvency of the firm – liquidity of the firm
To study the long term solvency of the firm – leverage position of the firm
To interpret the profitability of the firm – Profit earning capacity of the firm
To identify the operating efficiency of the firm. – turnover of the ratios
Utilities of the Ratio Analysis are:
i. Easy to understand the financial position of the firm: The ratio analysis facilitates the parties
to read the changes taken place in the financial performance of the firm from one time period to
another.
ii. Measure of expressing the financial performance and position: It acts as a measure of
financial position through Liquidity ratios and Leverage ratios and also a measure of financial
performance through Profitability ratios and Turnover Ratios.
iii. Intra-firm analysis on the financial information over many number of years:
The financial performance and position of the firm can be analyzed and interpreted within the
firm in between the available financial information of many number of years; which portrays
either increase or decrease in the financial performance.
iv. Inter-firm analysis on the financial information within the industry: The
Financial performance of the firm is studied and interpreted along with the similar
firms in the industry to identify the presence and status of the respective firm among others.
v. Possibility for Financial planning and control: It not only guides the firm to earn in
accordance with the financial forecasting but also facilitates the firm to identify the major source
of expense which drastically has greater influence on the earnings

4. ADVANTAGES OF RATIO ANALYSIS:
Ratio analysis helps management pinpoint specific deterioration, as well as detects any
trouble spot that may prevent the attainment of objectives. The interested parties undertake
frequent examination of different areas of business to evaluate managements ability to maintain a
satisfactory balance of operations.
The following are the advantages claimed by the ratio analysis:
1. It guides management in formulating future financial planning policies.
2. It throws light on efficiency of the business organization.
3. It permits comparison of the firms figures with data for similar firms, and possibility with
industry wise date
4. It also permits the data to be measured against yard sticks of performance or of sound
financial condition.
5. It ensure effective cost control it provides greater clarity, perspective, or meaning to the
data, and it brings out information.
6. It measures profitability of the concerns and its solvency.
7. It permits monitory figures of many digits to be condensed two or three digits which
enhances the managerial efficiency.
LIMITATIONS OF RATIO ANALYSIS
1.It is dependant tool of analysis: The perfection and effectiveness of the analysis mainly
depends upon the preparation of accurate and effectiveness of the financial
2. Statements: It is subject to the availability of fair presentation of data in the financial
statements.
3. Ambiguity in the handling of terms: If the tool of analysis taken for the study of inter firm
analysis on the profitability of the firms lead to various complications. To study the profitability
among the firms, most required financial information are profits of the enterprise. The profit of
one enterprise is taken for analysis is Profit After Taxes (PAT) and another is considering Profit
Before Interest and Taxes (PBIT) and third one is taking Net profit for study consideration. The
term profit among the firms for the inter firm analysis is getting complicated due to ambiguity or
poor clarity on the terminology.

5. 4. Qualitative factors are not considered: Under the ratio analysis, the quantitative factors only
taken into consideration rather than qualitative factors of the enterprise. The qualitative aspects
of the customers and consumers are not considered at the moment of preparing the financial
statements but while granting credit on sales is normally considered.
5. Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of historical
transactions known as Postmortem Analysis. The analysis is mainly based on the yester
performance which influences directly on the future planning and forecasting ; it means that the
analysis is mainly constructed on the past information which will also resemble the same during
the future analysis.
6. Time value of money is not considered: It does not give any room for time value of money
for future planning or forecasting of financial performance; the main reason is that the
fundamental base for forecasting is taken from the yester periods which never denominate the
timing of the benefits.
CLASSIFICATION OF RATIOS:
From the financial data we can calculate several ratios which are grouped in to various
classes as per the financial activities or function of firm these ratios help the management of the
firm to assess the financial performance.
These ratios are classified into four categories they are
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Liquidity ratios
Leverage ratios
Activity ratios
Profitability ratios
LIQUIDITY RATIO:
These are the ratios which measures the firm’s ability to meet its current obligations. A firm
should see that it does not suffer from lack of liquidity and also that it does not have excess
liquidity if the firm cannot meet its obligation because of insufficient liquidity, which will lead to
poor credit worthiness, loss of creditors confidence and even in legal terms which could result in
closing of the company. And a very higher degree of liquidity is also not good for the company,
because there are no earnings. Therefore, it is necessary to make a proper balance between high
liquidity and insufficient liquidity.
The most common ratios which indicate the extent of liquidity or lack of it are:

6. 1.
2.
3.
4.
CURRENT RATIO.
QUICK RATIO (ACID TEST RATIO).
CASH RATIO.
NET WORKING CAPITAL RATIO.
1.CURRENT RATIO:
The current ratio is the ratio of the total current assets to total current liabilities. It is calculated
as.
Current ratio = current assets / current liabilities
 Standard norm:
The ideal norm is that 2:1; which means that every one rupee of current liability is
appropriately covered by Two rupees of current assets.
 Objective:
The objective of computing this ratio is to measure the ability of the firm to meet its short
term obligations and to reflect the short term financial strength/solvency of the firms.
Current assets
Marketable securities
Debtors & inventories
Prepaid expenses
Bills receivables, accrued incomes
Current liabilities
Creditors
Bills payable
Accrued expenses
Short term bank loan, income tax liability
2.QUICK RATIO OR ACID TEST RATIO:
Quick ratio establishes a relationship between quick assets and current liabilities. It is calculated
as
QUICK RATIO = QUICK ASSETS / CURRENT LIABILITIES
 Standard norm :
It indicates amount of quick assets available for meeting current liquidity. Traditionally,
a quick ratio of 1:1 is considered to be satisfactory deal.
 Objective :
The objective of computing this ratio is to measure the ability of the firm to meet its short
term obligations as and when due without relying upon the realization of the stock

7. Quick assets
Marketable Securities
Debtors
Bill Receivable
Cash at Bank
Cash in Hand
3.
CASH RATIO:
cash ratio establishes a relationship between cash and cash equilants
and current
liabilities. To get the cash ratio only absolute liquid assets readily realizable securities are taken
into consideration as satisfactory.
CASH RATIO = (CASH IN HAND+CASH AT BANK+MARKETABLE
SECURITIES) / CURRENT LIABILITIES
 Standard norm:
Higher the ratio is the better the position of the firm
 Objective:
The objective of computing this ratio is to stringently test on and ability of the firm
to meet its short term obligations.
4. NET WORKING CAPITAL RATIO:
Working capital ratio is the difference between the current assets and current
liabilities. The amount of working capital is sometimes used as a measure of the firm’s
liquidity. It is considered that if a firm has more working capital ratios has the greater
ability to meet its current obligations.
WORKING CAPITAL RATIO = CURRENT ASSETS - CURRENT
LIABILITIES
 Standard norm :
Standard ratio should be 1:1, the long term debt should not be more than the net
working capital

8.  Objective:
The ratio computes the total long term debt financed by external sources.
LEVERAGE RATIOS:
The long term creditors like debenture holder like financial institutions etc. are more concerned
with the long term financial strength on the other side the short term creditors like bankers
suppliers of raw materials are more concerned with the firm’s current debt paying ability.
Financial leverage of capital structure ratios are calculated to judge the long term position of the
firm the ratios indicate the funds provide by owners and creditors.
Creditors consider mostly the owner’s equity as a safety margin, if it is less than the creditors
risk will be high. Thus, leverage ratios are calculated to measure the financial risk and the firm’s
ability of using debt for the benefit of share holders.
The important leverage ratios which are calculated from balance sheet items to determine the
proportion of debt in total financing are:
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DEBT EQUITY RATIO
PROPRIETORY RATIO
FIXED ASSETS RATIO
CAPITAL EMPLOYED TO NETWORTH
DEBT-EQUITY RATIO:
It reflects the relative claims of creditors and share holders against the assets of the business.
Debt, usually, refers to long term liabilities. Equity includes equity and preference share capital
and reserves.
This ratio establishes a relationship between long term debts and share holders funds.
DEBT EQUITY RATIO = LONGTERM LIABILITIES/
SHARE HOLDERS FUNDS
 Standard norm:
A Debt Equity ratio of 2:1 is considered ideal. A firm with a debt equity ratio of 2or
less exposes its creditors to relatively lesser risk

9.  Objective:
The objective of computing this ratio is to measure the relative proportion of debt and
equity in financing the assets of the firm.
PROPRIETORY RATIO:
It expresses the relationship between net worth and total assets.
PROPRIETORY RATIO = NETWORTH / TOTAL ASSETS
NET WORTH = EQUITY SHARE
CAPITAL+RESERVES- FICITIOUSASSETS.
CAPITAL
+
PREFERENCE
SHARE
TOTALASSETS = FIXED ASSETS + CURRENT ASSETS (excluding fictitious assets)
 Objective:
The objective of computing this ratio is to find out how proprietors have financed the
assets.
 Standard norm:
A high proprietary ratio is indicator of strong financial position of the business. The
higher the ratio, the better it is
FIXED ASSETS RATIO:
It establishes the a relation between fixed assets to capital employed
FIXED ASSETS = FIXED ASSETS / CAPITAL EMPLOYED
CAPITAL
EMPLOYED
=
EQUITY
SHARE
CAPITAL
+
PREFERANCE
SHARECAPITAL + RESERVE + LONG TERM LIABILITIES- FICTITIOUSASSETS

10.  Standard norm:
Fixed assets ratio should not be more than 1. A ratio of 0.67 is
Considered to be ideal.
 Objective:
This ratio indicates the proportion of fixed assets financed by
long term funds of the firm
CAPITAL EMPLOYED TO NETWORTH:
The ratio can be calculated by dividing capital employed or net assets by net worth. Net
worth includes share capital and reserves and surplus. Generally, capital employed net assets to
net worth ratio should be more than one.
NET ASSETS
-------------------NET WORTH
ACTIVITY RATIOS OR TURNOVER RATIO:
Activity ratio measures the effectiveness with which a firm uses its available resources or assets.
They are also called as “TURNOVER RATIOS”, since they indicate the speed with which the
resources are being converted into sales.
The better management of assets, larger the amount of sales. Hence the funds of creditors and
owners are invested in various kinds of assets to generate sales and profits.
Several activity ratios can computed to for evaluating the effective utilization of assets. Some of
them are given below:
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INVENTORY TURNOVER RATIO
DEBTORS TURN OVER RATIO
FIXED ASSETS TURN OVER RATIO
AVERAGE PAYMENT PERIOD RATIO
CREDITORS TURNOVER RATIO
CAPITAL EMPLOYED TUR OVER RATIO
WORKING CAPITAL TURNOVER RATIO

11. INVENTORY TURNOVER RATIO:
It indicates the number of items average stock has turned over during the period. It indicates the
efficiency of the firm’s inventory management.
This ratio is usually expressed as time.
 The cost of goods is an expenditure including operating , administration, project
establishment, interest on loans, and depreciation on fixed assets, provision for
bad debts.
 The average inventory used in the determination, in the average of opening and
closing inventories. It is calculated by dividing the cost of goods sold by average
inventory.
INVENTORY
TURNOVER
AVERAGE INVENTORY
RATIO
=
COST
OF
GOODS
SOLD/
 But in VPT it is calculated by dividing the average inventory by stores
consumed.
INVENTORY TURN OVER RATIO = AVERAGE
INVENTORY/STORES CONSUMED.
{AVERAGE INVENTORY=(OP.INVENTORY+CL.INVENTORY)/2}
{CGS=OP.INV+NET PURCHASES+DIRECT EXPENSES-CL.INV}
DEBTORS TURN OVER RATIO:
Debtors turnover ratio is calculated by dividing credit sales by average debtors. When the
information regarding credit sales and opening and closing balance of debtors may not be
available, then debtor turnover ratio can be calculated by dividing total sales by the yearend
balance of the debtors.
DEBTORS TURN OVER RATIO = NETCREDITSALES/AVERAGE DEBTORS
AVERAGE DEBTORS = (OPENING DEBTORS + CLOSING DEBTORS)/2
 OBJECTIVE:
The objective of computing this ratio is to determine the efficiency with which
trade debtors is trade debtors are managed.

12.  STANDARD NORM:
Higher the value of debtors turnover , the more efficient is the
management of credit. High ratio indicates the shorter collection period
which implies prompt payment by debtors and low ratio indicates a
longer collection period which indicates longer collection period which
implies delayed payments by debtors.
FIXED ASSETS TURNOVER RATIO:
Fixed assets turnover ratio establishes a relationship between net sales and fixed assets. This
ratio measures the efficiency of the firm utilizing its investments in fixed assets, and also the
adequacy of sales relation to the investment in fixed assets.
FIXED ASSETS TURN OVER RATIO = NET SALES/ NET FIXED
ASSETS
NET SALES means Gross Sales – Sales Returns.
NET FIXED ASSETS which means Gross fixed assets – Depreciation.
 STANDARD NORM:
Generally a high fixed assets turnover ratio indicates efficient utilization of
fixed assets by the management
 OBJECTIVE:
Objective of computing this ratio is to determinethe efficiency with which fixed
assets are utilized.
AVERAGE PAYMENTS PERIOD:
This period shows an average period for which the credit purchases remain outstanding
Average payment period = average trade creditors / avg.net credit purchases per day
AVERAGE NET CREDITORS = NET CREDIT PURCHASES FOR THE YEAR/ NO OF
WORKING DAYS PER YEAR

13. CREDITORS TURNOVER RATIO:
Creditors turnover ratio express the relation between creditors and purchases. It calculated as
CREDITORS TURN
CREDITORS.
OVER
RATIO =
NET CREDIT PURCHASES/
AVERAGE
NET CREDIT PURCHASES = CREDIT PURCHASES-PURCHASE RETURNS.
The creditors turnover ratio indicates the speed with which the creditors turnover on an average
each year. In general, a high ratio indicates the shorter payment period which implies either the
availability of less credit or earlier payments, and a low rate indicates a larger payment period
which implies either the availability of more credit or delayed payme
 STANDARED NORM:
Credit turnover rate can also be expressed in terms of number of days taken by
the business to pay off its debts. It is termed as debt payment period
 NUMBER OF DAYS IN YEAR/CREDITORS TURNOVER RATIO.
WORKING CAPITAL TURNOVER RATIO:
This ratio show the firm able to generate sales by using its
limited recourses of working capital. The firm may also take the ratio relating to
net current assets to sales.
Working capital turnover ratio establishes the relationship between net sales and
working capital.
WORKINGCAPITAL TURNOVERRATIO =
NETSALES/WORKING CAPITAL
CAPITAL EMPLOYED TURNOVER RATIO:
A firm’s ability to generate a large volume of sales for a given amount of net assets is
most important aspect of the operating performance. The unutilized of underutilized assets
increase the firm need for costly financing as well as expenses for maintenance and upkeep. This
net assets turnover ratio should be interpreted cautiously.
The net assets turnover ratio can be calculated as sales divided by net assets where net
assets includes net fixed assets, net current assets.

14. PROFITABILITY RATIOS:
A Company should earn profits to survive and grow over a long period of time. Profit is the
ultimate output of a company and it will have no future if it fails to make sufficient profits.
Profit is the difference revenues and expenses over a period of time.
Therefore, the finance manager should continuously evaluate the efficiency of its company in
terms of profits. So the profitability ratio are calculated to measure the operating efficiency of
the company.
Apart from management of the company, creditors and owners are also interested in the financial
soundness of the firm. The management is eager to measure the operating efficiency to show
how good it has been in managing the financial resources.
On the other and owners or shareholders who invest their funds in the company want to get a fair
return on their investments. Creditors want to get interest and repayment of principal regularly.
This is possible only when the company earns enough profits.
Profitability ratios can be determined on the basis of sales and investments.
1) The profitability ratios in relation to sales are:
Gross profit ratio
Net profit ratio
Operating expenses ratio
Operating profit ratio.
2) The profitability ratios in relation to investments are:
Return of capital
Return of shareholder equity
Return of total assets.
Earnings per share

15. I . The profitability ratios in relation to sales are:
1) GROSS PROFIT RATIO
It is the first profitability ratio calculated in relation to sales. This ratio can be called as
gross profit margin or gross margin ratio. This ratio establishes a relationship between gross
profit and sales to measure the efficiency of the firm and it reflects it pricing policy.
The ratio is calculated by dividing the gross profit by sales. A high gross profit margin
indicates that the firm is able to produce at relatively lower cost and it is also a sign of good
management.
Whereas, a low gross profit margin reflects a higher cost of goods sold due to the firm’s
inefficient management.
GROSS PROFIT
GROSS PROFIT RATIO = ------------------------- x 100
NET SALES
This ratio indicates on an average gross margin earned on a scale of rupees 100.
Higher the ratio better will be the performance
Gross profit which is excess of net sales over cost of goods sold
The main objective of computing this ratio is to determine the efficiency with which production /
purchase operations are carried on.
2).NET PROFIT RATIO:
Net profit ratio measures the relationship between the net profit & net sales. It indicates the result
of overall operation of the firm.
This ratio is computed by dividing the net profit by the net sales
This expressed as a percentage. Its formula is as follows.
NET PROFIT RATIO=
NET PROFIT AFTER TAX
------------------------------------------- x 100
NET SALES

16. This ratio indicates on an average net margin earned on a scale of 100/-.
Higher is the ratio greater is the capacity of the firm to with stand adverse economic
conditions
3) OPERATING PROFIT RATIO:
Operating profit ratio measures the relationship between operating profit and net sales this
ratio is computed by dividing the operating profit by the net sales, and expressed as percentage.
OPERATING PROFIT
OPERATING PROFIT RATIO = ---------------------------- x 100
NET SALES
Operating profit is the excess of gross profit over other operating expenses. The main
objective of computing this ratio is to determine the operating efficiency of the management.
4) OPERATING EXPENSES RATIO:
This ratio measures the relation between operating expenses and sales. It also explains the
changes in profit margins (EBIT to sales) ratio.
This operating expenses ratio is a yardstick of operating efficiency but it should be used
continuously. Further, the operating ratio cannot be used as a test of financial conditions in case
of those firms where non operating revenues and expenses form a substantial part of the total
income.
This ratio can be calculated by dividing by sales.
Operating expenses include cost of goods sold plus selling expenses, general and administrative
expenses (excluding interest, taxes etc)
A higher operating expenses ratio is unfavorable since it leaves a small amount of operating
income to meet interest dividends etc.
A lower operating expenses ratio is favorable because it will have large amount to meet
necessary needs of the firm.

17. CGS + OPERATING EXPENSES
OPERATING EXPENSES RATIO = ------------------------------- x 100
SALES
II) The profitability ratios in relation to investments are:
 RETURN ON CAPITAL EMPLIOYED RATIO:
The ratio illustrates that how much return is earned in the form of Net profit after taxes out of
the total capital employed. The capital employed is nothing but the combination of both
noncurrent liabilities and owners’ equity.
The ratio expresses the relationship in between the total earnings after taxation and the total
volume of capital employed
Return on total capital employed
Net profit after taxes × 100=Total capital employed
 Standard norm of the ratio:
Higher the ratio is better the utilization of the long term funds raised under the capital structure
means that greater profits are earned out of the total capital employed.
 RETURN ON SHARE HOLDERS EQUITY:
Return on share holders equity is calculated to see the profits earned by the firms or owners
investments. The share holder equity will include the paid up share capital, share premiums and
reserves and surplus less accumulated losses. In other words share holders equity is some called
as net worth and it can also be found by subtracting total liabilities from total assets. But the net
worth refers to the market value of the owners equity is recorded at book value in the balance
sheet.
The return on share holder equity is calculated by net profit after tax divided by share holders
equity or net worth.
PROFIT AFTER TAX
RETURN ON SHARE HOLDERS EQUITY =
--------------------------------- x 100
SHARE HOLDERS EQUTY

18.  EARNINGS PER SHARE:
Earnings per share is the net profit after tax and preferences dividend which is earned on
capital representative of one equity share. It is calculated as.
Profit After Tax –Preference Dividend Number Of Equity Shares
The EPS, the better is the performance of the company. The EPS is one of the driving
factors in investment analysis and perhaps the most widely calculated ratio amongst all ratios
used for financial analysis.
 RETURN ON TOTAL ASSETS RATIO:
It is calculated as
PROFIT AFTER TAX
---------------------------TOTAL ASSETS
Total assets do not include fictitious assets. The higher ratio the better it is.