Objective of Project Report : The main objective of the Project Report is Find the Ratio Analysis of company. And sub objectives of this report is understand the Meaning of Ratio, Pure Ratio or Simple Ratio, Advantages of Ratio Analysis, Limitations of Ratio Analysis, classification of Ratio, Liquidity Ratio, Profitability Ratio or Income Ratio, Activity & Turnover Ratio, Return on Capital Employed
Meaning of Ratio:-
A ratio is simple arithmetical expression of the relationship of one number
to another. It may be defined as the indicated quotient of two mathematical
According to Accountant’s Handbook by Wixon,
Kell and Bedford, “a ratio is an expression of the quantitative relationship
between two numbers”.
Ratio analysis is the process of determining and presenting the relationship
of items and group of items in the statements. According to Batty J.
Management Accounting “Ratio can assist management in its basic functions of
forecasting, planning coordination, control and communication”.
It is helpful to know about the liquidity,
solvency, capital structure and profitability of an organization. It is
helpful tool to aid in applying judgement, otherwise complex situations.
Ratio analysis can represent following three
Ratio may be expressed in the following
three ways :
Pure Ratio or Simple
It is expressed by the simple division of one number by another. For example
, if the current assets of a business are Rs. 200000 and its current
liabilities are Rs. 100000, the ratio of ‘Current assets to current
liabilities’ will be 2:1.
‘Rate’ or ‘So Many
In this type , it is calculated how many times a figure is, in comparison to
another figure. For example , if a firm’s credit sales during the year are
Rs. 200000 and its debtors at the end of the year are Rs. 40000 , its
Debtors Turnover Ratio is 200000/40000 = 5 times. It shows that the credit
sales are 5 times in comparison to debtors.
In this type, the relation between two figures is expressed in hundredth.
For example, if a firm’s capital is Rs.1000000 and its profit is Rs.200000
the ratio of profit capital, in term of percentage, is 200000/1000000*100 =
ADVANTAGE OF RATIO ANALYSIS
1. Helpful in analysis of
2. Helpful in comparative
3. Helpful in locating
the weak spots of the business.
4. Helpful in
5. Estimate about the
trend of the business.
6. Fixation of ideal
7. Effective Control.
8. Study of Financial
LIMITATIONS OF RATIO
Comparison not possible if different firms adopt different accounting
Ratio analysis becomes less effective due to price level changes.
Ratio may be misleading in the absence of absolute data.
Limited use of a single data.
Lack of proper standards.
False accounting data gives false ratio.
Ratios alone are not adequate for proper conclusions.
Effect of personal ability and bias of the analyst.
CLASSIFICATION OF RATIO
Ratio may be classified into the four
categories as follows:
Quick Ratio or Acid Test Ratio
Leverage or Capital
Debt Equity Ratio
Debt to Total Fund Ratio
Fixed Assets to Proprietor’s Fund Ratio
Capital Gearing Ratio
Interest Coverage Ratio
Activity Ratio or Turnover
Stock Turnover Ratio
Debtors or Receivables Turnover Ratio
Average Collection Period
Creditors or Payables Turnover Ratio
Average Payment Period
Fixed Assets Turnover Ratio
Working Capital Turnover Ratio
Profitability Ratio or
(A) Profitability Ratio based on Sales :
a. Gross Profit Ratio
b. Net Profit Ratio
c. Operating Ratio
d. Expenses Ratio
(B) Profitability Ratio
Based on Investment :
Return on Shareholder’s
Return on Total Shareholder’s Funds
Return on Equity Shareholder’s Funds
Earning Per Share
Dividend Per Share
Dividend Payout Ratio
Earning and Dividend Yield
Price Earning Ratio
(A) Liquidity Ratio:-
It refers to the ability of the
firm to meet its current liabilities. The liquidity ratio, therefore, are
also called ‘Short-term Solvency Ratio’. These ratio are used to assess the
short-term financial position of the concern. They indicate the firm’s
ability to meet its current obligation out of current resources.
In the words of Saloman J. Flink,
“Liquidity is the ability of the firms to meet its current obligations as
they fall due”.
Liquidity ratio include two ratio :-
Quick Ratio or Acid Test Ratio
a. Current Ratio:- This
ratio explains the relationship between current assets and current
liabilities of a business.
assets’ includes those assets which can be converted into cash with in a
Current Assets = Cash in Hand + Cash at Bank
+ B/R + Short Term Investment + Debtors(Debtors – Provision) + Stock(Stock
of Finished Goods + Stock of Raw Material + Work in Progress) + Prepaid
Current Liabilities :-
‘Current liabilities’ include those liabilities which are repayable in a
Current Liabilities = Bank Overdraft + B/P +
Creditors + Provision for Taxation + Proposed Dividend + Unclaimed Dividends
+ Outstanding Expenses + Loans Payable with in a Year.
According to accounting principles, a current ratio of 2:1 is supposed to be
an ideal ratio.
It means that current assets of a business
should, at least , be twice of its current liabilities. The higher ratio
indicates the better liquidity position, the firm will be able to pay its
current liabilities more easily. If the ratio is less than 2:1, it indicate
lack of liquidity and shortage of working capital.
The biggest drawback of the current ratio is
that it is susceptible to “window dressing”. This ratio can be improved by
an equal decrease in both current assets and current liabilities.
b. Quick Ratio:-
Quick ratio indicates whether the firm is in a position to pay its current
liabilities with in a month or immediately.
‘Liquid Assets’ means those assets, which
will yield cash very shortly.
Liquid Assets = Current Assets – Stock –
An ideal quick ratio is said to
be 1:1. If it is more, it is considered to be better. This ratio is a better
test of short-term financial position of the company.
LEVERAGE OR CAPITAL STRUCTURE RATIO
(B) Leverage or Capital Structure Ratio
This ratio disclose the firm’s ability to
meet the interest costs regularly and Long term indebtedness at maturity.
These ratio include the following ratios :
Debt Equity Ratio:-
This ratio can be expressed in two ways:
First Approach : According to this approach,
this ratio expresses the relationship between long term debts and
Debt Equity Ratio=Long term Loans/Shareholder’s Funds
or Net Worth
Long Term Loans:-
These refer to long term liabilities which mature after one year. These
include Debentures, Mortgage Loan, Bank Loan, Loan from Financial
institutions and Public Deposits etc.
Shareholder’s Funds :-
These include Equity Share Capital, Preference Share Capital, Share Premium,
General Reserve, Capital Reserve, Other Reserve and Credit Balance of Profit
& Loss Account.
Second Approach :
According to this approach the ratio is calculated as follows:-
Ratio=External Equities/internal Equities
Debt equity ratio is calculated for using
This Ratio is calculated to assess the ability of the firm to meet its long
term liabilities. Generally, debt equity ratio of is considered safe.
If the debt equity ratio is more than that,
it shows a rather risky financial position from the long-term point of view,
as it indicates that more and more funds invested in the business are
provided by long-term lenders.
The lower this ratio, the better it is for
long-term lenders because they are more secure in that case. Lower than 2:1
debt equity ratio provides sufficient protection to long-term lenders.
b. Debt to Total Funds Ratio :
This Ratio is a variation of the debt equity ratio and gives the same
indication as the debt equity ratio. In the ratio, debt is expressed in
relation to total funds, i.e., both equity and debt.
Debt to Total Funds Ratio = Long-term Loans/Shareholder’s funds + Long-term Loans
Generally, debt to total funds ratio of 0.67:1 (or
67%) is considered satisfactory. In other
words, the proportion of long term loans should not be more than 67% of
A higher ratio indicates a burden of payment
of large amount of interest charges periodically and the repayment of large
amount of loans at maturity. Payment of interest may become difficult if
profit is reduced. Hence, good concerns keep the debt to total funds ratio
below 67%. The lower ratio is better from the long-term solvency point of
c. Proprietary Ratio:-
This ratio indicates the proportion of total funds provide by owners or
Proprietary Ratio = Shareholder’s Funds/Shareholder’s Funds
+ Long term loans
This ratio should be 33% or more
than that. In other words, the proportion of shareholders funds to total
funds should be 33% or more.
A higher proprietary ratio is generally
treated an indicator of sound financial position from long-term point of
view, because it means that the firm is less dependent on external sources
If the ratio is low it indicates that
long-term loans are less secured and they face the risk of losing their
d. Fixed Assets to Proprietor’s Fund
Ratio :- This ratio is
also know as fixed assets to net worth ratio.
Fixed Asset to
Proprietor’s Fund Ratio = Fixed Assets/Proprietor’s Funds
(i.e., Net Worth)
The ratio indicates the extent to which proprietor’s (Shareholder’s) funds
are sunk into fixed assets. Normally , the purchase of fixed assets should
be financed by proprietor’s funds. If this ratio is less than 100%, it would
mean that proprietor’s fund are more than fixed assets and a part of working
capital is provided by the proprietors. This will indicate the long-term
financial soundness of business.
Capital Gearing Ratio:-
This ratio establishes a relationship between equity capital (including all
reserves and undistributed profits) and fixed cost bearing capital.
Capital Gearing Ratio = Equity Share Capital+ Reserves +
P&L Balance/ Fixed cost Bearing Capital
Whereas, Fixed Cost Bearing Capital =
Preference Share Capital + Debentures + Long Term Loan
If the amount of fixed cost bearing capital is more than the equity share
capital including reserves an undistributed profits), it will be called high
capital gearing and if it is less, it will be called low capital gearing.
The high gearing will be beneficial to
equity shareholders when the rate of interest/dividend payable on fixed cost
bearing capital is lower than the rate of return on investment in business.
Thus, the main objective of using fixed cost
bearing capital is to maximize the profits available to equity shareholders.
f. Interest Coverage Ratio:-
This ratio is also termed as ‘Debt Service Ratio’. This ratio is calculated
Interest Coverage Ratio = Net Profit before charging
interest and tax / Fixed Interest Charges
This ratio indicates how many
times the interest charges are covered by the profits available to pay
This ratio measures the margin of safety for
This higher the ratio, more secure the
lenders is in respect of payment of interest regularly. If profit just
equals interest, it is an unsafe position for the lender as well as for the
company also , as nothing will be left for shareholders.
An interest coverage ratio of 6 or 7 times
is considered appropriate.
ACTIVITY RATIO OR TURNOVER RATIO
(C) Activity Ratio or Turnover Ratio :-
These ratio are calculated on the bases of ‘cost
of sales’ or sales, therefore, these ratio are also called as ‘Turnover
Ratio’. Turnover indicates the speed or number of times the capital
employed has been rotated in the process of doing business. Higher turnover
ratio indicates the better use of capital or resources and in turn lead to
It includes the following :
Stock Turnover Ratio:-
This ratio indicates the relationship between the cost of goods during the
year and average stock kept during that year.
Stock Turnover Ratio = Cost of Goods Sold / Average
Here, Cost of goods sold = Net Sales –
Average Stock = Opening Stock + Closing
This ratio indicates whether
stock has been used or not. It shows the speed with which the stock is
rotated into sales or the number of times the stock is turned into sales
during the year.
The higher the ratio, the better it is,
since it indicates that stock is selling quickly. In a business where stock
turnover ratio is high, goods can be sold at a low margin of profit and even
than the profitability may be quit high.
Debtors Turnover Ratio
:- This ratio indicates the
relationship between credit sales and average debtors during the year :
Debtor Turnover Ratio = Net Credit Sales / Average Debtors
+ Average B/R
While calculating this ratio, provision for
bad and doubtful debts is not deducted from the debtors, so that it may not
give a false impression that debtors are collected quickly.
:- This ratio indicates the
speed with which the amount is collected from debtors. The higher the ratio,
the better it is, since it indicates that amount from debtors is being
collected more quickly. The more quickly the debtors pay, the less the risk
from bad- debts, and so the lower the expenses of collection and increase in
the liquidity of the firm.
By comparing the debtors turnover ratio of
the current year with the previous year, it may be assessed whether the
sales policy of the management is efficient or not.
Average Collection Period
:- This ratio indicates the
time with in which the amount is collected from debtors and bills
Period = Debtors + Bills Receivable / Credit
Sales per day
Here, Credit Sales per day = Net Credit
Sales of the year / 365
Second Formula :-
Average Collection Period = Average Debtors *365 /
Net Credit Sales
Average collection period can also be
calculated on the bases of ‘Debtors Turnover Ratio’. The formula will be:
Average Collection Period = 12 months or 365 days /
Debtors Turnover Ratio
This ratio shows the time in
which the customers are paying for credit sales. A higher debt collection
period is thus, an indicates of the inefficiency and negligency on the part
of management. On the other hand, if there is decrease in debt collection
period, it indicates prompt payment by debtors which reduces the chance of
d. Creditors Turnover Ratio :-
This ratio indicates the relationship between credit purchases and average
creditors during the year .
Creditors Turnover Ratio = Net credit Purchases /
Average Creditors + Average B/P
If the amount of credit purchase is not given in the question, the ratio may
be calculated on the bases of total purchase.
This ratio indicates the speed with which the amount is being paid to
creditors. The higher the ratio, the better it is, since it will indicate
that the creditors are being paid more quickly which increases the credit
worthiness of the firm.
Average Payment Period :- This ratio indicates the
period which is normally taken by the firm to make payment to its creditors.
Average Payment Period = Creditors + B/P/ Credit Purchase
This ratio may also be calculated as follows
Period = 12 months or 365 days / Creditors
The lower the ratio, the better it is, because a shorter payment period
implies that the creditors are being paid rapidly.
Fixed Assets Turnover Ratio
This ratio reveals how efficiently the fixed assets are being utilized.
Turnover Ratio = Cost of Goods Sold/ Net
Here, Net Fixed Assets = Fixed Assets –
This ratio is particular importance in manufacturing concerns where the
investment in fixed asset is quit high. Compared with the previous year, if
there is increase in this ratio, it will indicate that there is better
utilization of fixed assets. If there is a fall in this ratio, it will show
that fixed assets have not been used as efficiently, as they had been used
in the previous year.
Working Capital Turnover
This ratio reveals how efficiently working
capital has been utilized in making sales.
Turnover Ratio = Cost of Goods Sold / Working
Here, Cost of Goods Sold = Opening Stock +
Purchases + Carriage + Wages + Other Direct Expenses - Closing Stock
Working Capital = Current Assets – Current
This ratio is of particular
importance in non-manufacturing concerns where current assets play a major
role in generating sales. It shows the number of times working capital has
been rotated in producing sales.
A high working capital turnover ratio shows
efficient use of working capital and quick turnover of current assets like
stock and debtors.
A low working capital turnover ratio
indicates under-utilisation of working capital.
Profitability Ratios or Income Ratios
(D) Profitability Ratios or Income Ratios:-
The main object of
every business concern is to earn profits. A business must be able to earn
adequate profits in relation to the risk and capital invested in it. The
efficiency and the success of a business can be measured with the help of
Profitability ratios are calculated to
provide answers to the following questions:
Is the firm earning adequate profits?
What is the rate of gross profit and net profit on sales?
What is the rate of return on capital employed in the firm?
What is the rate of return on proprietor’s (shareholder’s) funds?
What is the earning per share?
Profitability ratio can be determined on
the basis of either sales or investment into business.
Profitability Ratio Based
on Sales :
a) Gross Profit Ratio :
This ratio shows the relationship between gross profit and sales.
Gross Profit Ratio
= Gross Profit / Net Sales *100
Here, Net Sales = Sales – Sales Return
This ratio measures the margin of
profit available on sales. The higher the gross profit ratio, the better it
is. No ideal standard is fixed for this ratio, but the gross profit ratio
should be adequate enough not only to cover the operating expenses but also
to provide for deprecation, interest on loans, dividends and creation of
b) Net Profit Ratio:-
This ratio shows the relationship between
net profit and sales. It may be calculated by two methods:
Net Profit Ratio = Net Profit / Net
Operating Net Profit = Operating Net
Profit / Net
Here, Operating Net Profit = Gross Profit –
Operating Expenses such as Office and Administrative Expenses, Selling and
Distribution Expenses, Discount, Bad Debts, Interest on short-term debts
This ratio measures the rate of
net profit earned on sales. It helps in determining the overall efficiency
of the business operations. An increase in the ratio over the previous year
shows improvement in the overall efficiency and profitability of the
(c) Operating Ratio:-
This ratio measures the proportion of an enterprise cost of sales and
operating expenses in comparison to its sales.
Operating Ratio =
Cost of Goods Sold + Operating Expenses/
Net Sales *100
Where, Cost of Goods Sold = Opening Stock +
Purchases + Carriage + Wages + Other Direct Expenses - Closing Stock
Operating Expenses = Office and
Administration Exp. + Selling and Distribution Exp. + Discount + Bad Debts +
Interest on Short- term loans.
Ratio’ and ‘Operating Net Profit Ratio’ are inter-related. Total of both
these ratios will be 100.
Operating Ratio is a measurement of the efficiency and profitability of the
business enterprise. The ratio indicates the extent of sales that is
absorbed by the cost of goods sold and operating expenses. Lower the
operating ratio is better, because it will leave higher margin of profit on
(d) Expenses Ratio:-
These ratio indicate the relationship between expenses and sales. Although
the operating ratio reveals the ratio of total operating expenses in
relation to sales but some of the expenses include in operating ratio may be
increasing while some may be decreasing. Hence, specific expenses ratio are
computed by dividing each type of expense with the net sales to analyse the
causes of variation in each type of expense.
The ratio may be calculated as :
(a) Material Consumed Ratio = Material
(b) Direct Labour cost Ratio = Direct labour
cost / Net sales*100
(c) Factory Expenses Ratio = Factory
Expenses / Net Sales *100
(a), (b) and (c) mentioned above will be
jointly called cost of goods sold ratio.
It may be calculated as:
Cost of Goods Sold Ratio = Cost of Goods
Sold / Net Sales*100
(d) Office and Administrative Expenses
Ratio = Office and Administrative Exp./
(e) Selling Expenses Ratio = Selling
Expenses / Net Sales *100
(f) Non- Operating Expenses Ratio =
Non-Operating Exp./Net sales*100
Various expenses ratio when
compared with the same ratios of the previous year give a very important
indication whether these expenses in relation to sales are increasing,
decreasing or remain stationary. If the expenses ratio is lower, the
profitability will be greater and if the expenses ratio is higher, the
profitability will be lower.
(B) Profitability Ratio Based on
Investment in the Business:-
These ratio reflect the true capacity of the
resources employed in the enterprise. Sometimes the profitability ratio
based on sales are high whereas profitability ratio based on investment are
low. Since the capital is employed to earn profit, these ratios are the real
measure of the success of the business and managerial efficiency.
These ratio may be calculated into two
I. Return on Capital Employed
II. Return on Shareholder’s funds
Return on Capital
This ratio reflects the overall profitability of the business. It is
calculated by comparing the profit earned and the capital employed to earn
it. This ratio is usually in percentage and is also known as ‘Rate of
Return’ or ‘Yield on Capital’.
Capital Employed = Profit before interest, tax and
Where, Capital Employed = Equity Share
Capital + Preference Share Capital + All Reserves + P&L Balance +Long-Term
Loans- Fictitious Assets (Such as Preliminary Expenses OR etc.) –
Non-Operating Assets like Investment made outside the business.
Capital Employed = Fixed Assets + Working
Advantages of ‘Return on Capital Employed’:-
Since profit is the overall
objective of a business enterprise, this ratio is a barometer of the overall
performance of the enterprise. It measures how efficiently the capital
employed in the business is being used.
Even the performance of two
dissimilar firms may be compared with the help of this ratio.
The ratio can be used to judge
the borrowing policy of the enterprise.
This ratio helps in taking
decisions regarding capital investment in new projects. The new projects
will be commenced only if the rate of return on capital employed in such
projects is expected to be more than the rate of borrowing.
This ratio helps in affecting
the necessary changes in the financial policies of the firm.
Lenders like bankers and
financial institution will be determine whether the enterprise is viable for
giving credit or extending loans or not.
With the help of this ratio,
shareholders can also find out whether they will receive regular and higher
dividend or not.
Return on Shareholder’s Funds :-
Return on Capital Employed Shows the overall
profitability of the funds supplied by long term lenders and shareholders
taken together. Whereas, Return on shareholders funds measures only the
profitability of the funds invested by shareholders.
These are several measures to calculate the
return on shareholder’s funds:
(a) Return on total Shareholder’s Funds
For calculating this ratio ‘Net Profit after
Interest and Tax’ is divided by total shareholder’s funds.
Return on Total Shareholder’s Funds = Net Profit after
Interest and Tax / Total Shareholder’s Funds
Where, Total Shareholder’s Funds = Equity
Share Capital + Preference Share Capital + All Reserves + P&L A/c Balance
This ratio reveals how profitably
the proprietor’s funds have been utilized by the firm. A comparison of this
ratio with that of similar firms will throw light on the relative
profitability and strength of the firm.
(b) Return on Equity Shareholder’s
Equity Shareholders of a company are more
interested in knowing the earning capacity of their funds in the business.
As such, this ratio measures the profitability of the funds belonging to the
Return on Equity
Shareholder’s Funds = Net Profit (after int., tax & preference
dividend) / Equity
Shareholder’s Funds *100
Where, Equity Shareholder’s Funds = Equity
Share Capital + All Reserves + P&L A/c
Balance – Fictitious Assets
ratio measures how efficiently the equity shareholder’s funds are being used
in the business. It is a true measure of the efficiency of the management
since it shows what the earning capacity of the equity shareholders funds.
If the ratio is high, it is better, because in such a case equity
shareholders may be given a higher dividend.
(c) Earning Per Share (E.P.S.) :-
This ratio measure the profit available to the equity shareholders on a per
share basis. All profit left after payment of tax and preference dividend
are available to equity shareholders.
Earning Per Share = Net Profit – Dividend on
Preference Shares / No. of Equity
This ratio helpful in the determining of the market price of the equity
share of the company. The ratio is also helpful in estimating the capacity
of the company to declare dividends on equity shares.
(d) Dividend Per Share (D.P.S.):-
Profits remaining after payment of tax and preference dividend are available
to equity shareholders.
But of these are not distributed among them
as dividend . Out of these profits is retained in the business and the
remaining is distributed among equity shareholders as dividend. D.P.S. is
the dividend distributed to equity shareholders divided by the number of
D.P.S. = Dividend paid to Equity Shareholder’s / No. of Equity
(e) Dividend Payout Ratio or D.P. :-
It measures the relationship between the earning available to equity
shareholders and the dividend distributed among them.
D.P. = Dividend paid to Equity Shareholders/ Total
Profit belonging to Equity Shareholders*100
D.P. = D.P.S. / E.P.S. *100
(f) Earning and Dividend Yield :-
This ratio is closely related to E.P.S. and D.P.S. While the E.P.S. and
D.P.S. are calculated on the basis of the book value of shares, this ratio
is calculated on the basis of the market value of share
Price Earning (P.E.) Ratio:-
Price earning ratio is the ratio between market price per equity share &
earnings per share. The ratio is calculated to make an estimate of
appreciation in the value of a share of a company & is widely used by
investors to decide whether or not to buy shares in a particular company.
This ratio shows how much is to be invested in the market in this company’s
shares to get each rupee of earning on its shares. This ratio is used to
measure whether the market price of a share is high or low.