Unit 3: Ratio Analysis

Ratio analysis is the technique of expressing one financial figure as a proportion of another to interpret the liquidity, solvency, profitability and operational efficiency of a business. It converts the raw numbers of the Balance Sheet and Statement of Profit and Loss into comparable indicators, and is a core tool of financial statement analysis alongside common-size and trend analysis.

Defining properties and conventions:

• Nature of a ratio: an arithmetical relationship between two accounting figures, expressed as a pure number (2:1), a percentage (25%), or a rate/times (5 times).
• Source data: figures are drawn from the Balance Sheet (position, a point in time) and the Statement of Profit and Loss (performance, a period).
• Average vs. closing figures: where a flow (sales, COGS) is compared with a stock (inventory, debtors), the stock item is usually averaged as (Opening + Closing) / 2.
• Bases of comparison: a ratio is meaningful only against a benchmark — the firm's own past (trend), a budget/standard, or industry peers (cross-section).
• Classification used here: liquidity, solvency, profitability and activity (turnover) ratios, with Du-Pont linking profitability to turnover and leverage.

II. Liquidity Ratios — Short-Term Solvency

Liquidity ratios measure the firm's ability to meet current obligations falling due within one operating cycle or a year, using its short-term assets.

A. Current Ratio

Tests the cushion of current assets available to cover current liabilities.

• Formula:
  
  TEXT

  Current Ratio = Current Assets / Current Liabilities

• Components: current assets = inventories + trade receivables + cash + marketable securities + prepaid expenses; current liabilities = trade payables + short-term borrowings + outstanding expenses.
• Ideal norm: 2:1 is conventional; too high signals idle funds, too low signals strain.
• Example: CA ₹4,00,000 and CL ₹2,00,000 give a ratio of 2:1.

B. Quick (Liquid / Acid-Test) Ratio

Refines the current ratio by dropping the least liquid current assets.

• Formula:
  
  TEXT

  Quick Ratio = (Current Assets − Inventory − Prepaid Expenses) / Current Liabilities

• Rationale: inventory must first be sold and collected, so excluding it gives a sterner test of immediate payability.
• Ideal norm: 1:1.
• Reading it: a current ratio of 3:1 with a quick ratio of 0.8:1 warns that liquidity depends heavily on unsold stock.

III. Solvency Ratios — Long-Term Financial Stability

Solvency ratios assess the firm's capacity to meet long-term obligations and the balance between owners' and outsiders' funds.

A. Debt-Equity Ratio

Shows the proportion of borrowed funds to shareholders' funds.

• Formula:
  
  TEXT

  Debt-Equity Ratio = Long-term Debt / Shareholders' Funds

• Components: long-term debt = debentures + long-term loans; shareholders' funds = equity + preference capital + reserves − fictitious assets.
• Norm: 2:1 is broadly acceptable; a high ratio means aggressive gearing and higher financial risk.

B. Debt to Total Assets / Proprietary Ratio

Measures how much of total assets is financed by owners.

• Proprietary Ratio:
  
  TEXT

  Proprietary Ratio = Shareholders' Funds / Total Assets

• Interpretation: a higher proprietary ratio (say 0.6) indicates a strong, less leveraged asset base and greater protection for creditors.

C. Interest Coverage Ratio

Tests how comfortably operating profit covers fixed interest charges.

• Formula:
  
  TEXT

  Interest Coverage = Profit before Interest and Tax (EBIT) / Interest on Long-term Debt

• Reading it: a ratio of 6 times means EBIT is six times the interest bill; a figure near 1 signals default risk.

IV. Profitability Ratios — Earning Capacity

Profitability ratios evaluate the firm's ability to generate returns relative to sales, assets or capital employed.

A. Ratios based on Sales

Express profit as a percentage of revenue.

• Gross Profit Ratio:
  
  TEXT

  Gross Profit Ratio = (Gross Profit / Net Sales) × 100

  • Use: reflects production/trading efficiency and mark-up.
• Net Profit Ratio:
  
  TEXT

  Net Profit Ratio = (Net Profit after Tax / Net Sales) × 100

  • Use: overall efficiency after all expenses.
• Operating Ratio:
  
  TEXT

  Operating Ratio = ((COGS + Operating Expenses) / Net Sales) × 100

  • Link: operating ratio + operating profit ratio = 100%.

B. Ratios based on Investment

Relate profit to the funds invested.

• Return on Capital Employed (ROCE):
  
  TEXT

  ROCE = (EBIT / Capital Employed) × 100

  • Capital employed = shareholders' funds + long-term debt (or total assets − current liabilities).
• Return on Equity (ROE):
  
  TEXT

  ROE = (Net Profit after Tax − Preference Dividend) / Equity Shareholders' Funds × 100

  • Focus: return earned for the residual owners.
• Earnings Per Share (EPS):
  
  TEXT

  EPS = (Net Profit after Tax − Preference Dividend) / No. of Equity Shares

V. Turnover (Activity) Ratios — Operational Efficiency

Turnover ratios measure how efficiently the firm uses its assets to generate sales; they express activity as a rate (times) or a period (days).

A. Inventory Turnover Ratio

How many times stock is sold and replaced in a period.

• Formula:
  
  TEXT

  Inventory Turnover = Cost of Goods Sold / Average Inventory

• Days: Inventory Holding Period = 365 / Inventory Turnover.
• Reading it: a high turnover means fast-moving stock and low holding cost; a low one warns of obsolescence.

B. Trade Receivables (Debtors) Turnover Ratio

Speed of converting credit sales into cash.

• Formula:
  
  TEXT

  Debtors Turnover = Net Credit Sales / Average Trade Receivables

• Collection period: Average Collection Period = 365 / Debtors Turnover, e.g. a turnover of 6 gives roughly a 61-day collection period.

C. Trade Payables (Creditors) Turnover Ratio

Speed at which the firm pays its suppliers.

• Formula:
  
  TEXT

  Creditors Turnover = Net Credit Purchases / Average Trade Payables

• Payment period: Average Payment Period = 365 / Creditors Turnover; a longer period conserves cash but may strain supplier relations.

D. Working Capital & Fixed Asset Turnover

Relate sales to the assets that support them.

• Working Capital Turnover:
  
  TEXT

  Working Capital Turnover = Net Sales / Working Capital

• Fixed Asset Turnover:
  
  TEXT

  Fixed Asset Turnover = Net Sales / Net Fixed Assets

  • Use: measures how productively long-term assets generate revenue.

VI. Du-Pont Analysis — Decomposing Return

Du-Pont analysis, developed at the DuPont Corporation in the 1920s, breaks a single return figure into its driving components so managers can see whether performance stems from margins, asset use or leverage.

A. The Three-Factor Model

Explains ROE as the product of profitability, efficiency and gearing.

• Formula:
  
  TEXT

  ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
  
       = (Net Profit / Sales) × (Sales / Total Assets) × (Total Assets / Equity)

• Component meanings:
  • Net Profit Margin: operating and cost efficiency per rupee of sales.
  • Asset Turnover: how hard assets are worked to produce sales.
  • Equity Multiplier: financial leverage; higher debt raises the multiplier and magnifies ROE and risk.
• Insight: two firms with the same ROE can differ sharply — one high-margin low-turnover (jeweller), the other low-margin high-turnover (supermarket).

B. Extended Du-Pont and ROI Version

Adds tax and interest burden and links to return on investment.

• ROI form:
  
  TEXT

  Return on Investment = Net Profit Margin × Asset Turnover

• Five-step ROE: multiplies tax burden × interest burden × operating margin × asset turnover × equity multiplier, isolating the drag of tax and financing.
• Worked example: margin 10%, asset turnover 2, equity multiplier 1.5 →
  ROE = 0.10 × 2 × 1.5 = 0.30 = 30%.

VII. Importance and Objectives of Ratio Analysis

Ratio analysis serves as the interpretive bridge between raw statements and decision-making by diverse users.

A. Importance

Highlights why the technique is central to financial appraisal.

• Simplification: condenses voluminous data into a single meaningful indicator, e.g. a 2:1 current ratio.
• Comparability: enables inter-firm and intra-firm comparison by removing the effect of scale.
• Trend analysis: ratios plotted over years reveal improving or deteriorating patterns.
• Forecasting and budgeting: stable historical ratios feed projected statements.
• Communication: gives shareholders, lenders and management a common vocabulary of performance.

B. Objectives

States what the analyst seeks to achieve.

• Assess liquidity: confirm capacity to pay short-term dues.
• Judge solvency: evaluate long-term stability and gearing.
• Measure profitability and efficiency: gauge earning power and asset utilisation.
• Aid control and decisions: locate weak areas for corrective action and support credit, investment and lending choices.

C. Limitations

Notes the analytical cautions the technique demands.

• Historical basis: built on past figures, so it ignores current price levels and inflation.
• Window dressing: manipulated year-end figures distort ratios.
• No absolute standard: an "ideal" ratio varies by industry and season.
• Qualitative blindness: ignores non-financial factors like management quality and market reputation.
• Isolated ratios mislead: a single ratio must be read alongside others and its benchmark.