RATIO ANALYSIS INTERPRETATION – means assigning reasons for the

behavior in respect of the data, presented in the

• Powerful technique used for analysis of
simplified form.
Financial Statements
• Ratios are used as a yardstick for evaluating the RATIO ANALYSIS – Analysis of ratios, without
financial condition and performance of a firm. interpretation, is meaningless and interpretation,
• In financial analysis, a ratio is compared against without analysis, is impossible.
a benchmark for evaluating the financial
DIFFERENT TERMS USED FOR COMPUTING FINANCIAL
position and performance of a firm.
RATIOS (Check on the ppt)
INTERESTED PARTIES IN THE INTERPRETATION OF FS:
LIQUIDITY RATIOS
creditors< investors, lenders, management, public
1. Current Ratio
Types of Financial Ratios
• Current ratio is defined as the
relationship between current assets and
current liabilities.
• It is also known as working capital ratio.
• This is calculated by dividing total
current assets by total current liabilities.

4 TYPES OF RATIO ANALYSIS

Interpretation of Current Ratio
PROFITABILITY RATIOS – How well does the company
generate profits? • As a conventional rule, a current ratio of 2:1 is
considered satisfactory.
LEVERAGE RATIOS – How extensively is the company • The rule is based on the logic that in the worst
using debt? situation, even if the value of current assets
LIQUIDITY RATIOS – Does the company have enough becomes half, the firm will be able to meet its
cash to pay the bills? obligations, fully.
• A ‘two to one ratio’ is referred to as ‘Rule of
EFFECIENCY RATIOS – How efficiently does the company thumb’ or arbitrary standard of the liquidity of
uses its assets and capital? the firm.
ANALYSIS – means methodical classification of data and • This current ratio represents a margin of safety
presentation in a simplified form for easy for creditors.
understanding. • Realization of assets may decline. However, all
the liabilities have to be paid, in full.
A high current ratio, due to the following causes, may Interpretation of Gross Profit Ratio
not be favorable for the following reasons:
Reasons for high gross profit ratio:
1. Slow-moving or dead stock/s, piled up due to poor
• High sales price, cost of goods remaining
sales.
constant
2. Figure of debtors may be high as debtors are not • Lower cost of goods sold, sales price remaining
capable of paying or debt collection system of the firm is constant
not satisfactory. (Accounts Receivable) • A combination of factors in sales price and costs
of different products, widening the margin
3. Cash or bank balances may be high, due to idle funds.
• An increase in proportion of volume of sales of
On the other hand, a low current ratio may be due to those products that carry a higher margin and
the following reasons: Overvaluation of closing stock due to misleading
factors.
1. Insufficiency of funds to pay creditors.
Reasons for fall in gross profit ratio: Reasons may be:

• Purchase of raw materials, at unfavorable rates

• Over investment and/ or inefficient utilization of
plant and machinery, resulting in higher cost of
production
• Excessive competition, compelling to sell at
reduced prices

The finance manager has to analyze the reasons for the

fall and initiate the action, necessary to improve the
situation.

Net Profit Ratio

PROFITABILITY RATIOS
• Net profit is obtained, after deducting operating
Gross Profit Ratio
expenses, interest and taxes from gross profit.
• Profit is a factor of sales. • The net profit ratio is calculated by
• Profit is earned, after meeting all expenses, as
and when sales are made.
• The Gross Profit ratio reflects the efficiency with
which a firm produces/sells its different
• Net Profit ratio indicates the overall efficiency of
products.
the management in manufacturing,
administering and selling the products.
• Net profit has a direct relationship with the
return on investment.
• If net profit is high, with no change in
investment, return on investment would be
• Gross Profit Ratio indicates the spread between high.
the cost of goods sold and revenue.
• If there is fall in profits, return on investment
• Analysis gives the clues to the management would also go down
how to improve the depressed profit margins.
• The ratio indicates the extent to which the Operating Expenses Ratio
selling price can decline, without resulting in
• To identify the cause of fall or rise in net profit,
losses on operations of a firm.
each operating expense ratio is to be calculated.
• High gross profit ratio is a sign of good
This can be calculated by
management
 • This ratio indicates the overall efficiency of
business, before tax.

OPERATING EXPENSES EXAMPLE:

• Advertising and Marketing expenses

• Office stationery and supplies
• Utility expenses
• Telephone expenses Interpretation of Return on Investment
• Property tax
• ROI (ROTA and RONA) measure the overall
• Legal expenses
efficiency of business.
• Repair and maintenance expense
• Insurance expenses • The owners are interested in knowing the
• Accounting fees expenses profitability of the firm, in relation to the total
• License fees assets and amount invested in the firm.
• Rent expense • A higher percentage of return on capital
• Payroll expense employed will satisfy the owners that their
• Vehicle expense funds are profitably utilized.
• Traveling expenses • It indicates the efficiency of the management of
• Research expenses various departments as funds are kept at its
disposal for making investment in assets.
Return on Investment
• If the firm increases its size, but is unable to
• Return on investment is the primary ratio that is increase its profits proportionately, then ROI
most popularly used to measure the overall (both ROTA and RONA) decreases. In such a
profitability and efficiency of business. case, increasing the size of the firm does not
• When return on investment is calculated on advance the welfare of the owners.
total assets, it is called ROTA. • Inter-firm comparison would be useful. Both the
• Total assets are related to operating profit. ratios of a particular firm should be compared
• EBIT is arrived at by adding interest and tax to with the industry average or its immediate
net operating profit. competitor to understand the efficiency of the
management in managing the assets, profitably.
• So, a higher rate of return on capital employed,
without comparison, does not imply that the
firm is managed, efficiently.
Return on Capital Employed • Once a comparison is made with other firms,
having similar characteristics, in the same
• Another way to calculate return on investment industry, a fair conclusion is possible.
is through capital employed or net assets.
• The ratios help in formulating the borrowing
• Net assets are equal to net fixed assets plus policy of the firm. The rate of interest on the
current assets minus current liabilities. borrowings should always be lower than the
• Net assets are equal to capital employed. return on capital employed. Then only, funds
• So, net assets and capital employed convey the are to be borrowed
same meaning, though called differently. • With both the ratios, the outsiders like bankers,
• Capital employed can be calculated in two ways: financial institutions and creditors know the
viability of the firm so that they can lend funds,
comfortably

Return on Equity
• Return on net assets is called RONA.
• As net assets are equal to capital employed, the • In the real sense, equity shareholders are the
terms RONA and ROCE indicate the same. real owners of the company.
 • They assume the risk in the firm. Preference
shareholders enjoy fixed rate of dividend and
preference for payment of dividend, before
dividend is distributed to equity shareholders.
• Similarly, in the event of the liquidation of the Interpretation of Debt-Equity Ratio
company, preference share capital
• has to be repaid first, before refunding to equity • Debt-Equity Ratio indicates the extent to which
shareholders debt financing has been used in business.
• Net profits after tax, after dividend is paid to • Total debt to net worth of 1:1 is considered
preference shareholders, entirely belong to the satisfactory, as a thumb rule.
equity shareholders. • This ratio shows the level of dependence on the
• Equity shareholders would be interested to outsiders.
know what their real return is on the funds • As a general rule, there should be a mix of debt
invested. and equity.
• The owners want to conduct business, with
maximum outsiders’ funds to take less risk for
their investment.
• At the same time, they want to maximize their
Interpretation of Return on Equity earnings, at the cost and risk of outsiders’ funds.

• ROE indicates how well the firm has used the Total Debt Ratio (TD Ratio)
resources of owners. • Total Debt Ratio compares the total debts (long-
• Earning a satisfactory return is the most term as well as short-term) with total assets.
desirable objective of a business.
• This ratio is of greatest interest to the
management as it is their responsibility to
maximize the owners’ welfare.
• This ratio is more meaningful to equity
shareholders as they are interested to know
Interpretation of Total Debt Ratio
their return. Interpretation of this ratio is similar
to return on investments. Higher the ratio, • This ratio depicts the proportion of total assets,
better it is to equity shareholders. financed by total liabilities.
Leverage Ratios • Impliedly, the remaining assets are financed by
the shareholders.
Debt-Equity Ratio • A higher DE ratio or TD ratio shows the firm is
trading on equity.
• Debt-Equity Ratio is also known as External-
• In case, the rate of return of the firm is more
Internal Equity Ratio.
than the cost of debt, it implies high return to
• This ratio is calculated to measure the relative
the shareholders.
claims of outsiders and owners against the
• On the other hand, a lower ratio implies low risk
firm’s assets.
to lenders and creditors of the firm and non-
• The ratio shows the relationship between the
existence of trading on equity. So, neither the
external equities (outsiders’ funds) and internal
higher nor the lower ratio is desirable from the
equities (shareholders’ funds).
point of view of the shareholders.
• A higher ratio is a threat to the solvency of the
firm.
• A lower ratio is an indication that the firm may
be missing the available opportunities to
improve profitability
 • A balanced proportion of debt and equity is Inventory Turnover Ratio / Inventory Velocity
required so as to take care of the interests of
• Inventory turnover ratio is also known as stock
lenders, the shareholders and the firm, as a
turnover ratio.
whole
• This is calculated by dividing cost of goods sold
Interest Coverage Ratio by average inventory.

• Debt ratios are static and fail to indicate the

ability of the firm to meet interest obligations.
• The interest coverage ratio is used to test the
firm’s debt-servicing capacity.
• The interest coverage ratio shows the number
of times the interest charges are covered by Interpretation of Inventory Turnover Ratio
funds that are ordinarily available to pay
interest charges. • Inventory turnover ratio shows the velocity of
stocks.
• A higher ratio is an indication that the firm is
moving the stocks better so profitability, in such
a situation, would be more.
Interpretation of Interest Coverage Ratio • However, a very high ratio may show that the
firm has been maintaining only fast-moving
• This ratio indicates the extent to which earnings can
stocks.
fall, without causing any embarrassment to the firm,
• The firm may not be maintaining the total range
regarding the payment of interest charges.
• The higher the IC ratio, better it is both for the firm
of inventory and so may be missing business
and lenders. opportunities, which may otherwise be
• For the firm, the probability of default in payment of available.
interest is reduced and for the lenders, the firm is • It is better to compare the turnover ratio, with
considered to be less risky. the industry or its immediate competitor.
• However, too high a ratio indicates the firm is very
conservative in not using the debt to its best No. of Days Inventory Holding
advantage of the shareholders.
• Inventory turnover ratio is also known as stock
• On the other hand, a lower coverage ratio indicates
turnover ratio.
the excessive use of debt.
• When the coverage ratio is low, compared to the
• This is calculated by dividing cost of goods sold
industry, it should improve its operational efficiency by average inventory
or retire the debt, early, to have a coverage ratio,
comparable to the industry.
• It is well said, a single soldier cannot afford to be
tipsy, while the whole army is sober!

Limitations:

1. IC ratio is based on the accrual concept of Interpretation of No. of Days Inventory Holding
accounting. In practice, the interest is to be paid in
cash. Therefore, it is better to compare the interest • Ideal Standard: There is no standard ratio.
liability with the cash profits (based on cash inflows • The ratio depends upon the nature of business.
and outflows, both for incomes and expenses) of • The ratio has to be compared with the ratio of
the firm. the industry, other firms or past ratio of the
same firm.
2. This ratio also ignores the repayment of • Every firm has to maintain certain level of
installment liability of the firm. inventory, be it raw materials or finished goods,
Activity Ratios to carry on the business, smoothly, without
 interruption of production and loss of business
opportunities.
• Inventory Turnover Ratio is a test of inventory
management.
Interpretation of Debtors’ (Receivables) Turnover Ratio
This level of inventory should be neither too high nor
too low. If the ratio is too • Debtors’ turnover ratio indicates the number of
times debtors are turned over, each year.
high, it is an indication of the following: • The higher the debtors’ turnover, more efficient
is the management of credit.
i. Blocking unnecessary funds that can be utilized
• If Bills Receivable is outstanding, they are to be
somewhere else, more profitably.
added to the debtors as bills receivable have
ii. Unnecessary payment for extra godown space
come into balance sheet, in place of debtors,
for piled stocks.
which are, still, outstanding.
iii. Chances of obsolescence and pilferage are
more. Debtors’ Collection Period
iv. Likely deterioration in quality and
v. Above all, slow movement of stocks means slow • The collection period is calculated by
recovery of cash, tied in stocks.

On the other hand, if the ratio is too low:

(i) Stoppage of production, in the absence of

Signals of Collection Period
continuous availability of raw materials and
(ii) Loss of business opportunities as range of • Debtors’ Turnover Ratio indicates the speed of
finished goods is not available, at all times. their collection.
• The shorter the period of collection, the better
To avoid the situation, the firm should know the
is the quality of debtors.
position, periodically, whether it is carrying excessive or
• A short collection period indicates the efficiency
inadequate stocks for necessary corrective action, in
of credit management.
time. It is always better to compare the ratios of the firm
• The average collection period should be
with the ratios of industry and other firms, in
compared with the credit terms and policy of
competition, for proper evaluation of the performance
the firm to judge the quality of collection
of the firm.
efficiency.
Debtors’ (Receivables) Turnover Ratio / Debtors’
Working Capital Turnover Ratio
Velocity
• The WCT Ratio indicates the velocity of
• Firms sell goods on cash and credit. As and
utilization of working capital of the firm, during
when goods are sold on credit, debtors
the year.
(receivables) appear in accounts. Debtors are
expected to be converted into cash, over a short • The working capital refers to net working
period, and they are included in current assets. capital, which is equal to total current assets
less current liabilities. The ratio is calculated as
• To judge the quality or liquidity of debtors,
follows:
financial analysts apply three ratios, which are:
a. debtors turnover ratio
b. collection period
c. aging schedule of debtors
• Debtors’ Turnover Ratio: Debtors turnover is Interpretation of Working Capital Turnover Ratio
found out by dividing credit sales by average
• This ratio measures the efficiency of working
debtors
capital management.
 • A higher ratio indicates efficient utilization of Dividend Pay-out Ratio or Pay-out Ratio
working capital and a low ratio shows
• Dividend pay-out ratio is calculated to find out
otherwise.
the proportion of dividend distributed out of
• A high working capital ratio indicates a lower
earnings per share.
investment in working capital has generated
• Dividend per equity share is calculated by
more volume of sales.
dividing the profits, after tax, by the number of
• Higher ratio improves the profitability of the
equity shares outstanding.
firm.
• For example, if the firm has an EPS and DPS of
• But, a very high ratio is also not desirable for
Rs. 5 and Rs. 3 respectively, DP ratio is 3/5 i.e.
any firm.
60%. So, the firm has distributed 60% of PAT
• This may also imply overtrading, as there may
(profits after tax) as dividend among its
be inadequacy of working capital to support the
shareholders
increasing volume of sales. This may be a risky
• Earnings not distributed are impliedly retained
proposition to the firm.
in the business for the purpose of expansion
Earnings per Share and growth of the firm.
• The proportion of retained earnings is equal to 1
• The profitability of the equity shareholders can
– DP ratio. So, in the above case, the retained
be measured, in other ways.
earnings ratio is 40%.
• One such measure is to calculate the earnings
per equity share.
• The earnings per equity share is calculated by

Dividend Yield Ratio

• Shareholders are the true owners, interested in

Interpretation of Earnings per Share the earnings distributed and paid to them as
• EPS simply shows the profitability of the firm dividend.
per equity share basis. • Therefore, dividend yield ratio is calculated to
• EPS calculation, over the years, indicates how evaluate the relationship between the dividends
the firm’s earning power, per share basis, has paid per share and the market value of the
changed over the years. share
• EPS of the firm is to be compared with the
industry and its immediate competing firm to
understand the relative performance of the
firm. Price Earnings Ratio
• As a profitability index, it is widely used ratio.
• This is the ratio that establishes the relationship
Bonus Issue Adjustment: between the market price of a share and its EPS.
• Adjustments for bonus issue should be made, • This ratio indicates the number of times the
while comparing EPS, over a period of time. earnings per share is covered by its market
price.
• Bonus shares are additional free shares issued
to the existing equity shareholders, out of the • The ratio is calculated as per the following
profits of the company. formula:
• Reserves and surplus profit is utilized for issue
of bonus shares, by transferring the amount to
the equity share capital account.
• In the process of issue of bonus shares, there is
no inflow or outflow of cash to the firm.
 • The price earnings ratio indicates investors’ than equity shareholders’ funds, capital gearing
judgement or expectations about the firm’s ratio is less than one, the firm is said to be “low
future performance. geared”.
• It signifies the number of years, in which the • In case the two are equal, the capital structure
earnings can equal to market price of share. is said to be “even geared”.
• This ratio is widely used by the security analysts • For computation of capital gearing ratio, funds
and investors to decide whether to buy or sell that belong to equity shareholders such as
the shares of a particular company, at that price. equity share capital, share premium and other
• Generally, higher the price-earnings ratio, the reserves are to be considered.
better it is for the management of that firm. • The capital-gearing ratio can be ascertained as
• If the P/E ratio falls, it is a cause of anxiety to under:
the management of the firm as the investor’s
perception about the future performance of the
company is not expected to be good.
• So, the management has to look into the causes
Interpretation of Capital Gearing Ratio
for the fall of the ratio.
• If the capital gearing ratio is high, the profits
For those who want to buy equity shares in a firm, if the
available to equity shareholders would be
P/E ratio of that company is low, compared to its
subject to wider fluctuations compared to a
competing firms, the equity shares of that company is a
company that has a low gearing ratio
‘good buy’, provided they anticipate the future
performance of the company would be brighter. Trading on Equity
Significance • Normally, assets of the firm are financed by
debt and equity. Suppliers of the debt would
• Price-earnings ratio helps the investor in
look to the equity as margin of safety.
deciding whether to buy the shares of a
• The use of debt in financing the assets has a
company, at a particular market price, or book
number of implications:
profit by selling at that rate.
Implications of Debt:
• The decision depends on the investor’s
✓ Firstly, debt is more risky to the firm,
perception about the future market.
compared to equity. Whether the firm
Capital Gearing Ratio makes profit or not, interest on debt has
to be paid. If interest and instalment are
• Capital gearing ratio refers to the proportion not paid, there may be a threat of
between fixed interest / dividend bearing funds insolvency, even
to non-fixed interest / dividend bearing funds. ✓ Secondly, debt is advantageous to the
• The fixed interest / dividend bearing funds equity shareholders. The equity
include funds provided by the debenture shareholders can retain control, with a
holders and preference shareholders. limited stake.
• Funds provided by equity shareholders do not ✓ They can find a way to magnify their
bear fixed commitment, unlike preference earnings. When the firm is able to earn
shareholders and debenture holders. on borrowed funds higher than the
• In case, the total amount of preference share interest rate paid, the return to owners
capital and other fixed interest bearing loans would be magnified. The process of
exceed the equity shareholders’ funds, the firm magnifying the earnings of equity
is said to be “high geared”. shareholders through the use of debt is
• In other words, if the capital-gearing ratio is called “financial leverage” or “financial
more than one, it is said to be high geared. gearing” or “Trading on Equity”.
• On the other hand, if preference share capital
and other fixed interest bearing loans are less STUDY THE REVIEWER ON CANVAS