BEFA UNIT V

BEFA – UNIT V
UNIT - V: Financial Ratios Analysis: Concept of Ratio Analysis, Importance and Types of Ratios, Liquidity Ratios,
Turnover Ratios, Profitability Ratios, Proprietary Ratios, Solvency, Leverage Ratios – Analysis and Interpretation (simple
problems).
******************************************************************************************
RATIOS
What is a Ratio?
Ratio is a mathematical relationship between two accounting figures. They show the relationship between two
items in a more meaningful way which help us to draw certain conclusions. Ratios may be used to compare the
previous data with current data, to compare one firm with another firm etc. the ratios can be expressed as
percentage or proportion or times based on the nature of ratio.
Ratio Analysis:
Ratio analysis is the analysis of financial information found in the financial statements of a Business. Such
analysis can shed light on financial aspects that include risk, reward (profitability), solvency, and how well the
Business operates. As a tool for investors, ratio analysis can simplify the process of comparing the financial
information of multiple organisations.

USES OR ADVANTAGES OR IMPORTANCE OF RATIO ANALYSIS

Ratio Analysis stands for the process of determining and presenting the relationshipof items and groups of items
in the financial statements. It is an importanttechnique of financial analysis. It is a way by which financial
stability and health ofa concern can be judged. The following are the main uses of Ratio analysis:
a) Useful in financial position analysis: Accounting reveals the financial positionof the concern. This helps
banks, insurance companies and other financial institution in lending and making investment decisions.
b) Useful in simplifying accounting figures: Accounting ratios simplify, summaries and systematic the a
accounting figures in order to make them more understandable and in lucid form.

c) Useful in assessing the operational efficiency: Accounting ratios helps to have an idea of the working of a
concern. The efficiency of the firm becomes evident when analysis is based on accounting ratio. This helps the
management to assess financial requirements and the capabilities of various business units.
d) Useful in forecasting purposes: If accounting ratios are calculated for number of years, then a trend is
established. This trend helps in setting up future plans and forecasting.
e) Useful in locating the weak spots of the business: Accounting ratios are of great assistance in locating the
weak spots in the business even through the overall performance may be efficient.
f) Useful in comparison of performance: Managers are usually interested to know which department
performance is good and for that he compare one department with the another department of the same firm.
Ratios also help him to make any change in the organisation structure.

LIMITATIONS OF RATIO ANALYSIS

a) False results if based on incorrect accounting data: Accounting ratioscan be correct only if the data
(on which they are based) is correct. Sometimes, the information given in the financial statements is affected by
window dressing, i. e. showing position better than what actually is.
b) No idea of probable happenings in future: Ratios are an attempt to makean analysis of the past financial
statements; so they are historical documents.Now-a-days keeping in view the complexities of the business,
it is important to have an idea of the probable happenings in future.
 BEFA UNIT V

c) Variation in accounting methods: The two firms’ results are comparable with the help of accounting ratios
only if they follow the some accounting methods or bases. Comparison will become difficult if the two concerns
follow the different methods of providing depreciation or valuing stock.
d) Price level change: Change in price levels make comparison for various years difficult.
e) Only one method of analysis: Ratio analysis is only a beginning and gives justa fraction of information
needed for decision-making so, to have a comprehensive analysis of financial statements, ratios should be used
along with other methods of analysis.
f) No common standards: It is very difficult to by down a common standard for comparison because
circumstances differ from concern to concern and the nature of each industry is different.
g) Different meanings assigned to the some term: Different firms, in order to calculate ratio may assign
different meanings. This may affect the calculation of ratio in different firms and such ratio when used for
comparison may lead to wrong conclusions.
h) Ignores qualitative factors: Accounting ratios are tools of quantitative analysis only. However, sometimes-
qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under
such circumstances may be distorted.
i) No use if ratios are worked out for insignificant and unrelated figure: Accounting ratios should be
calculated on the basis of cause and effectrelationship. One should be clear as to what cause is and what effect is
beforecalculating a ratio between two figures.

Types of Ratios:
LIQUIDITY RATIOS
Liquidity ratios express the ability of the firm to meet its short-term Obligations as when they become due.
Creditors are interested to know whether the firms is in a position to meet its commitments on time or not.
These ratios help in identifyingthe danger signals for the firm in advance. The important liquidity ratios are
given below.
A) Current Ratio:- It is also called as working capital ratio. It is the ratio between current assets and current
liabilities. The firm is in comfortable position if its currentratio is 2:1.
It can be calculated by the following formula:
Current Ratio = Current Assets / Current Liabilities.
Current assets = Cash in Hand + Cash in Bank + Marketable (short term ie. < 1 year duration) Securities +
short term investments + bills receivables + debtors + inventory + stock + work-in-progress + pre-paid expenses
+ incomes receivable (accrued income) etc.
Current liabilities = Expenses payable (Outstanding) + bills payable + creditors + short term loans taken +
income tax to be paid + dividend payable + bank overdraft + long term loans and debentures whose repayable
date is within coming one year + provision for tax + short term advances etc.

B) Quick Ratio:- It is also called as Acid test ratio or liquid ratio. It is the ratio between quick assets and current
liabilities. The firm is in comfortable positionif its current ratio is 1:1. It means for every rupee of current liability,
there should be one rupee worth of quick assets. Quick assets can be converted into cash quickly. It
can be calculated by the following formula:
Quick Ratio = Quick Assets / Current Liabilities
Quick Assets = Current Assets – (Stock or inventory and Prepaid Expenses)
 BEFA UNIT V
Example 1: From the Balance Sheet of XYZ Co. Ltd., calculate liquidity ratios.
(Rs. in thousands)

Capital & Liabilities Amount Assets Amount

Preference share capital 100 Land and Buildings 225

Equity share capital 150 Plant and machinery 250

General reserve 250 Furniture andFixtures 100

Debentures 400 Stock 250

Creditors 200 Debtors 125
Bills payable 50 Cash at Bank 250
Outstanding expenses 50 Cash in hand 125
Profit and loss account 100 Prepaid expenses 50
Bank loan(Long term) 200 Marketablesecurities 125

1500 1500

Ans: Current Ratio is 3.08:1 or 3.08 Quick Ratio is 2.08:1 or 2.08

2. ACTIVITY RATIOS/TURNOVER RATIOS
Activity ratios are classed as Turnover ratios. These ratios tell how active the firm isin selling stocks, collecting
money from debtors and paying to creditors. They are given below.
A) Inventory Turnover Ratio:- It is also called as Stock turnover ratio. It indicates the number of times the
average stock is being sold during a given accounting period. The higher the ratio, the better is the performance
of the firm in selling its stock. It is the rate at which inventories are converted into sales and then to cash. It is
calculated by the following formula:
Inventory Turnover Ratio = Cost of Goods Sold / Average Stock.
Cost of Goods Sold = Opening Stock + Purchases + Manufacturing Expenses – Closing Stock
OR
Sales – Gross Profit
Average Stock = (Opening Stock + Closing Stock) / 2
* If information about Opening Stock is not given then in the place of Average Stock, We can take
Closing Stock directly in the formula.
**When cost of goods sold is not given, sales amount should be taken in its place in the formula.
𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐇𝐨𝐥𝐝𝐢𝐧𝐠 𝐏𝐞𝐫𝐢𝐨𝐝 = 365 Days / Inventory Turnover Ratio
 BEFA UNIT V

Example 1: A firm sold goods worth Rs. 500000 and its gross profit is 20% of sales value. The inventory at
the beginning of the year was Rs. 16000 and at end of the year was 14000. Compute inventory turnover ratio
and the inventory-holding period. (Ans is: Inventory Turnover Ratio is 26.66, Holding Period is 14 days)
2. Debtors Turnover Ratio:- It reveals the number of times the average debtors are collected during a given
accounting period. The firms usually prepare the aged list of debtors showing the details of when to collect and
how much to collect from debtors. The higher the ratio, the better is the performance of the firm in collecting
money from debtors.
Debtors Turnover Ratio = Net Credit Sales / Average Debtors.
Net Credit Sales = Credit Sales – Sales Returns.
Average Debtors = (Opening Debtors + Closing Debtors) / 2
If Opening Debtors are not available the only Closing Debtors should be taken in the formula.

* Debtors include Sundry Debtors and Bills Receivable

Debt Collection Period = 365 days / Debtors turnover Ratio
Example: A firm’s sales during the year was Rs. 400000 of which 60% were credit sales. The balance of
debtors at the beginning and ending year were 25000 and 15000 respectively. Calculate debtors turnover ratio
of the firm. Also, find out debt collection period. (Ans: Debtors turnover Ratio = 12 ,
Debt Collection Period = 30.41 days)
3) Creditors Turnover Ratio:- It reveals the number of times the average creditors are paid during a given
accounting period. The firms usually prepare the aged list of creditors showing the details of when to pay and
how much to pay to itscreditors. It shows how promptly the firm is in a position to pay its creditors.
Creditors Turnover Ratio = Net Credit Purchases / Average Creditors
* Net Credit Purchases = Total Credit Purchases – Purchase Returns
** Average Creditors = (Opening Creditors + Closing Creditors) / 2
If Opening creditors information is not available, the take closing creditors directly in the place of average
creditors.
Creditors include Sundry Creditors and Bills Payable.
Creditors Payment Period = 365 / Creditors Turnover Ratio
Example: A firm’s purchases during the year was Rs. 400000 of which 50% were credit purchases. The balance
of creditors at the beginning and ending year were 30000 and 10000 respectively. Calculate Creditors turnover
ratio of the firm. Also, find out creditors payment period. (Ans: 10 times; 36.5 days)

CAPITAL STRUCTURE RATIOS:

Capital structure ratios are also called as leverage ratios. These ratios focus on the long term solvency of the
firm. The long term solvency of the firm always reflected in its ability to meet its long term commitments such
as payment of interest periodically without fail, repayment of principal as and when the become due. The below
are the most commonly used capital structure ratios:
 BEFA UNIT V

1) Debt-Equity Ratio:- It is the ratio between outsider’s funds(Debt) and insider’s funds (Equity). It is a
measure of solvency. This ratio is used to measure the firm’s obligations to creditors in relation to the owners’
funds. The standard ratio is 1:1. This means for every rupee of debt, there should be one rupee worth internal
funds. A high D/E ratio implies that the creditors’ stake is more as compared to that of owners.
Debt-Equity Ratio = Long Term Loans / Shareholders Funds or Net worth.
Debt = Debentures + bonds + mortgage loan + other long term loans.
Equity = Equity share capital + preference share capital + capital reserve + revenue reserve + sinking fund +
contingent reserve – artificial assets.
Note: Artificial assets = preliminary expenses + deferred revenue expenses + discount on issue of
shares/ debentures + profit and loss A/C debit balance + underwriting commission
Example 1: Calculate Debt – Equity ratio from the following data:
Debentures Rs. 400000, Long term loans Rs. 200000, Preference share capital Rs. 100000, Equity share
capital Rs. 150000, General reserve Rs. 250000, Profit &Loss account Rs. 100000. (Ans: 1:1)
2) Interest Coverage Ratio:- This ratio judges the firm’s capacity to pay the interest on debt it borrows.
The higher the ratio, better it is. A ratio implies that the Company has no problems in paying interest.
Interest Coverage Ratio = PBIT / Interest
Example: EBIT of a company is Rs. 560000. Its fixed commitments include payment of 10 percent on 7000
debentures of Rs. 100 each. It is subject to tax of 30 percent per annum. Calculate interest coverage ratio.
(Ans: 8 times)
3) Proprietor’s Funds to Total Assets Ratio:
𝐏𝐫𝐨𝐩𝐢𝐞𝐭𝐨𝐫𝐬′𝐅𝐮𝐧𝐝𝐬 𝐭𝐨 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 𝐑𝐚𝐭𝐢𝐨 = Proprietors Funds / Total Assets
Proprietors’ Funds = Equity share capital + Preference share capital + General reserve + Employee Provident
Fund + profit and loss account.
Total Assets = Tangible assets and Current assets
Example: From the Balance Sheet of XYZ Co. Ltd., calculate Proprietor’s Funds to Total Assets Ratio. Also
find the Liquidity Ratios. Rs. In thousands
Capital & Liabilities Amount Assets Amount

Preference share capital 100 Land and Buildings 225

Equity share capital 150 Plant and machinery 250

General reserve 250 Furniture and 100

Fixtures
Debentures 400 Stock 250

Creditors 200 Debtors 125

Bills payable 50 Cash at Bank 250

Outstanding expenses 50 Cash in hand 125

Profit and loss account 100 Prepaid expenses 50

Bank loan(Long term) 200 Marketable securities 125

1500 1500

(Ans: 0.4 or 40%)

 BEFA UNIT V
PROFITABILITY RATIOS
Profitability ratios indicate how well the firm is operating its Activities in a profitability manner. Owners want a
reasonable rate of return on their investment. So, the firm has to generate profits to meet the expectations of
shareholders and also for further expansion of the business. The following are the common profitability ratios.
1) Gross Profit Ratio:- It is the ratio between gross profit and net sales. It is expressed in percentage.
Gross Profit Ratio = (Gross Profit / Net Sales) x 100
Example: Net sales is Rs. 50000 for a firm and cost of goods sold is Rs. 20000. Calculate Gross Profit Ratio.
(Ans: 60%)
2) Net Profit Ratio:- It is the ratio between net profit after tax and net sales. It is also expressed in percentage.
Net Profit Ratio = (Net Profit / Net Sales) x 100
Example : Calculate net profit ratio from the following data.
Net sales Rs. 50000; Cost of goods sold Rs. 20000; Administration Expenses Rs. 3000;
Selling and Distribution expenses Rs. 4000; Loss on sale of fixed asset Rs. 3000; Interest on investment
received Rs. 2000; Tax 20% (Ans: 35.2%)
3) Operating Ratio:- It is the ratio between cost of goods sold plus operating expenses and net sales. It is
expressed as percentage to sales.
Operating Ratio = (Operating Costs / Net Sales) x 100
Operation Profit Ratio = 100 – Operating Ratio
Example: Calculate operating ratio and Operating Profit Ratio from the following data.
Net sales Rs. 50000; Cost of goods sold Rs. 20000; Administration Expenses Rs. 3000;
Selling and Distribution expenses Rs. 4000; Loss on sale of fixed asset Rs. 3000;
Interest on investment received Rs. 2000; Tax 20% (Ans: Operating Ratio = 54%)
4) Return On Investment (ROI):- This ratio is also called as Return on Capital Employed (ROCE). The firm is
interested to assess the return on capital employed.
ROI = (PBIT / Capital Employed) x 100
Profit Before Interest and Tax (PBIT) = Gross profit – All expenses and losses + All incomes
Capital employed = Equity share capital + Preference share capital + Reserves + Long term loans +
Debentures – Intangible assets.

5) Return On Equity (ROE):- The equity shareholders are interested to assess the return on equity capital
employed.
ROE = (Net Profit – Preference Dividend / Equity Shareholders Funds) x 100

*Net Profit is also called as Profit After Tax(PAT) = PBIT – Interest paid – Tax
**Equity Shareholders Funds = Equity Share capital + Reserves and Surplus
 BEFA UNIT V

6) Earnings per Share (EPS):- EPS is the relationship between net profit and thenumber of equity shares
outstanding at eth end of the given period.
EPS = Net Profit – Preference Dividend / number of Equity Shares
Example 1: Given that the number of share is 10000 and the net profit after taxesfor a given period is
Rs. 450000, Find the EPS (Ans: Rs. 45)

7) Dividend Yield Ratio (D/Y Ratio):- Yield means the amount of total return the investor will receive for a
given period of time for the amount of his investment. Dividend yield refers to the percentage return on the price
paid for shares. It is calculated as follows:
Dividend Yield Ratio = (Dividend per Share / Market Price per Share) x 100
Example: Given that current market price of a share Rs. 300; face value of the share is Rs. 100;
percentage of dividend declared is 20%. Calculate the Dividend Yield Ratio. (Ans: 6.667%)
* Dividend per Share = Face value of share x 20/100 = 100 x 20/100 = Rs. 20
8) Price Earnings Ratio (P/E Ratio):- This is the ratio of the market value of a share to Earnings per Share
𝐏𝐫𝐢𝐜𝐞 − 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐑𝐚𝐭𝐢𝐨 = Market Value of each Equity Share / Earnings per Equity Share
Example: Given that market price of a share is Rs. 340 and EPS is 10, calculate the P/E Ratio. (Ans: 34)

Practice Questions:
1. The following is an extract of a balance sheet of a company during the last year. Compute current ratio and
quick ratio.
Land and buildings 50000 Plant and machinery 100000

Furniture and fixtures 25000 Closing stock 25000

Sundry debtors 12500 Wages prepaid 2500

Sundry creditors 8000 Rent outstanding 2000

(Ans: Current Ratio = 4:1 or 4 Quick Ratio = 1.25:1 or 1.25)
Problem 2:- Calculate inventory turnover ratio and Average period of holding the stocks.

Sundry debtors 45000 Closing stock 30000

Sales 400000 Sales returns 20000

Stock as on 1-1-2014 40000 Stock as on 31-12-2014 60000

(Ans: Inventory Turnover Ratio = 8 times inventory holding period = 46 Days)

 BEFA UNIT V

Problem 3:- Given the following data, calculate Debtors and Creditors Turnover Ratios.

Debtors as on 1-1-2014 8000 Debtors as on 31-12-2014 16000

Creditors as on 1-1-2014 32000 Purchases (60% credit) 150000
Furniture and fixtures 25000 Cash 5000
Creditors as on 31-12-2015 26000
Sales (75% credit) 250000

Ans: DTR = 15.6 times Debt Collection Period = 23.36 days

CTR = 31. Times Creditors Payment Period = 117.74 days
Problem 4:- Given the following data, calculate current ratio and quickratio

Capital 360000 Debentures 420000

Reserve fund 240000 Creditors 36000
Bank over draft 60000 Rent outstanding 6000
Provision for taxation 78000 Land and buildings 440000
Plant and machinery 235000 Furniture and fixtures 140000

Motor vehicles 105000 Stock 60000

Sundry debtors 90000 Short term investments 75000
Cash at bank 30000 Cash in hand 25000
 BEFA UNIT V

Problem 5:- Given the following data, calculate Debt-equity ratio, Interestcoverage ratio and Proprietary funds to
total assets ratio.
Liabilities and Capital Rs Assets Rs
Share Capital: Motor vehicles 105000
10% Preference Capital 60000 Plant and machinery 235000
Equity shares Capital 300000 Sundry debtors 90000
Reserve fund 240000 Land and buildings 440000
Bank over draft 60000 Furniture and 140000
fixtures
Provision for taxation 78000 Stock 60000
15% Debentures 420000 Short term investments 75000
Creditors 36000 Cash in hand 25000
Rent outstanding 6000 Cash at bank 30000
1200000 1200000

EBIT = Rs. 204000

 BEFA UNIT V

Example 6: Calculate Gross Profit Margin, Net Operating Margin and Operating Ratio from the given
following information.
Sales Rs. 10,00,000; Cost of Goods Sold Rs. 6,00,000; Depreciation Rs. 1,00,000
Selling and Administrative Costs Rs. 2,00,000.
 BEFA UNIT V

Example 7: Prepare a balance sheet from the following particulars.

Stock velocity :6
Gross profit margin : 20%
Capital turnover ratio :2
Fixed assets turnover :4
Debt collection period : 2 months
Creditors payment period : 73 days
Gross profit : Rs. 60000
Excess of closing stock over opening stock was: Rs. 5000
Solution:
BEFA UNIT V
BEFA UNIT V
 BEFA UNIT V

Important Questions
Essay Questions
1. What is a Ratio? Explain the different ratios used in Ratio Analysis.
2. What is Ratio Analysis? Explain the various advantages and disadvantages of Ratio
Analysis.

Short Answer Questions

1. Liquid Ratio/Quick Ratio
2. Concept of ratio analysis
3. Current assets.
4. Disadvantages of Ratio Analysis