Introduction
Types of Ratios
There is a two way classification of ratios
(1) Traditional classification
(2) Functional classification
Traditional classification
1. ‘Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as statement of profit and loss ratio. For example, ratio of gross profit to revenue from operations is known as gross profit ratio. It is calculated using both figures from the statement of profit and loss.
2. Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios. For example, ratio of current assets to current liabilities known as current ratio. It is calculated using both figures from balance sheet.
3. Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another variable from the balance sheet, it is called composite ratio. For example, ratio of credit revenue from operations to trade receivables (known as trade receivables turnover ratio) is calculated using one figure from the statement of profit and loss (credit revenue from operations) and another figure (trade receivables) from the balance sheet.
Functional classification
1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to measure it are known as ‘Liquidity Ratios’. These are essentially short-term in nature.
2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations towards stakeholders, particularly towards external stakeholders, and the ratios calculated to measure solvency position are known as ‘Solvency Ratios’. These are essentially long-term in nature.
3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the efficiency of operations of business based on effective utilisation of resources. Hence, these are also known as ‘Efficiency Ratios’.
4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from operations or funds (or assets) employed in the business and the ratios calculated to meet this objective are known as ‘Profitability Ratios
I- Liquidity Ratios
Liquidity ratios are calculated to measure the short-term solvency of the business, i.e. the firm’s ability to meet its current obligations. These are analysed by looking at the amounts of current assets and current liabilities in the balance sheet. The two ratios included in this category are current ratio and liquidity ratio.
a. Current Ratio
b. Quick Ratio
II- Solvency Ratios
a. Debt-Equity Ratio;
b. Debt to Capital Employed Ratio;
c. Proprietary Ratio;
d. Total Assets to Debt Ratio;
e. Interest Coverage Ratio.
III- Activity (or Turnover) Ratio
These ratios indicate the speed at which, activities of the business are being performed. The activity ratios express the number of times assets employed, or, for that matter, any constituent of assets, is turned into sales during an accounting period. Higher turnover ratios means better utilisation of assets and signify improved efficiency and profitability, and as such are known as efficiency ratios. The important activity ratios calculated under this category are
a) Inventory Turnover;
b) Trade receivable Turnover;
c) Trade payable Turnover;
d) Investment (Net assets) Turnover
e) Fixed assets Turnover; and
f) Working capital Turnover.
IV- Profitability Ratios
The profitability or financial performance is mainly summarised in the statement of profit and loss. Profitability ratios are calculated to analyse the earning capacity of the business which is the outcome of utilisation of resources employed in the business. There is a close relationship between the profit and the efficiency with which the resources employed in the business are utilised. The various ratios which are commonly used to analyse the profitability of the business are:
a) Gross profit ratio
b) Operating ratio
c) Operating profit ratio
d) Net profit ratio
e) Return on Investment (ROI) or Return on Capital Employed (ROCE)
f) Return on Net Worth (RONW)
g) Earnings per share
h) Book value per share
i) Dividend pay-out ratio
j) Price earning ratio.
Advantages of Ratio Analysis:
Ratio analysis offers many advantages including enabling financial statement analysis, helping understand efficacy of decisions, simplifying complex figures and establish relationships, being helpful in comparative analysis, identification of problem areas, enables SWOT analysis, and allows various comparisons.
Limitations of Ratio Analysis:
There are many limitations of ratio analysis. Few are based because of the basic limitations of the accounting data on which it is based. In the first set are included factors like Historical Analysis, Ignores Price-level Changes, Ignore Qualitative or Non-monetary Aspects, Limitations of Accounting Data, Variations in Accounting Practices, and Forecasting. In the second set are included factor like means and not the end, lack of ability to resolve problems, lack of standardised definitions, lack of universally accepted standard levels, and ratios based on unrelated figures.
01 : Current Ratio
Current ratio is the proportion of current assets to current liabilities. It is expressed as follows:
Current Ratio = Current Assets : Current Liabilities or
Current Assets / Current Liabilities
Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and cash equivalents, short-term loans and advances and other current assets such as prepaid expenses, advance tax and accrued income, etc.
Current liabilities include short-term borrowings, trade payable (creditors and bills payable), other current liabilities and short-term provisions.
Importance:
It provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. The ratio should be reasonable. It should neither be very high or very low. Both the situations have their inherent disadvantages. A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects under utilisation or improper utilisation of resources. A low ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its short-term debt on time. If this problem persists, it may affect firm’s credit worthiness adversely. Normally, it is safe to have this ratio within the range of 2:1.
02: Liquid ratio or Quick ratio
It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as
Quick ratio = Quick Assets : Current Liabilities or Quick Assets/Current Liabilities
The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we exclude the inventories at the end and other current assets such as prepaid expenses, advance tax, etc., from the current assets. Because of exclusion of non-liquid current assets it is considered better than current ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary check on liquidity position of the business and is therefore, also known as ‘Acid-Test Ratio’.
Importance:
The ratio provides a measure of the capacity of the business to meet its short-term obligations without any flaw. Normally, it is advocated to be safe to have a ratio of 1:1 as unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in otherwise less profitable short-term investments.
03: Stock Turnover ratio
Determines the number of times inventory is converted into revenue from operations during the accounting period under consideration. It expresses the relationship between the cost of revenue from operations and average inventory. The formula for its calculation is as follows:
Inventory Turnover Ratio = Cost of Revenue from Operations sales / Average Inventory
Where average inventory refers to arithmetic average of opening and closing inventory, and the cost of revenue from operations means revenue from operations less gross profit.
Importance :
It studies the frequency of conversion of inventory of finished goods into revenue from operations. It is also a measure of liquidity. It determines how many times inventory is purchased or replaced during a year. Low turnover of inventory may be due to bad buying, obsolete inventory, etc., and is a danger signal. High turnover is good but it must be carefully interpreted as it may be due to buying in small lots or selling quickly at low margin to realise cash. Thus, it throws light on utilisation of inventory of goods.
04: Debtor turnover ratio
It expresses the relationship between credit revenue from operations and trade receivable. It is calculated as follows :
Trade Receivable (Debtor) Turnover ratio = Net Credit sales or Revenue from Operations/Average Trade Receivable
Where Average Trade Receivable = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable)/2
It needs to be noted that debtors should be taken before making any provision for doubtful debts.
Importance : The liquidity position of the firm depends upon the speed with which trade receivables are realised. This ratio indicates the number of times the receivables are turned over and converted into cash in an accounting period. Higher turnover means speedy collection from trade receivable. This ratio also helps in working out the average collection period. The ratio is calculated by dividing the days or months in a year by trade receivables turnover ratio.
i.e., Number of days or Months
Trade receivables turnover ratio
05: Creditor turnover ratio
Trade payables turnover ratio indicates the pattern of payment of trade payable. As trade payable arise on account of credit purchases, it expresses relationship between credit purchases and trade payable. It is calculated as follows:
Trade Payables Turnover ratio = Net Credit purchases/ Average trade payable
Where Average Trade Payable = (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable)/2
Average Payment Period = No. of days/month in a year
Trade Payable Turnover Ratio
Significance : It reveals average payment period. Lower ratio means credit allowed by the supplier is for a long period or it may reflect delayed payment to suppliers which is not a very good policy as it may affect the reputation of the business. The average period of payment can be worked out by days/months in a year by the Trade Payable Turnover Ratio.
06: Operating ratio
It is computed to analyse cost of operation in relation to revenue from operations. It is calculated as follows:
Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Net Revenue from Operations ×100
= cost of goods sold + operating expenses / sales x 100
Operating expenses include office expenses, administrative expenses, selling expenses, distribution expenses, depreciation and employee benefit expenses etc.
Cost of operation is determined by excluding non-operating incomes and expenses such as loss on sale of assets, interest paid, dividend received, loss by fire, speculation gain and so on.
Operating Profit Ratio
It is calculated to reveal operating margin. It may be computed directly or as a residual of operating ratio.
Operating Profit Ratio = 100 – Operating Ratio
Alternatively, it is calculated as under:
Operating Profit Ratio = Operating Profit/Sales, Revenue from Operations × 100
Where ,
Operating Profit = Revenue from Operations – Operating Cost
Importance:
Operating ratio is computed to express cost of operations excluding financial charges in relation to revenue from operations. A corollary of it is ‘Operating Profit Ratio’. It helps to analyse the performance of business and throws light on the operational efficiency of the business. It is very useful for inter-firm as well as intra-firm comparisons. Lower operating ratio is a very healthy sign.
07: Gross Profit ratio
Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin. It is computed as follows:
Gross Profit Ratio = Gross Profit/Sales, Net Revenue of Operations × 100
Importance:
It indicates gross margin on products sold. It also indicates the margin available to cover operating expenses, non-operating expenses, etc. Change in gross profit ratio may be due to change in selling price or cost of revenue from operations or a combination of both. A low ratio may indicate unfavourable purchase and sales policy. Higher gross profit ratio is always a good sign.
Net Profit Ratio
Net profit ratio is based on all inclusive concept of profit. It relates revenue from operations to net profit after operational as well as non-operational expenses and incomes. It is calculated as under:
Net Profit Ratio = Net profit/Revenue from Operations,Sales × 100
Generally, net profit refers to profit after tax (PAT).
Importance:
It is a measure of net profit margin in relation to revenue from operations. Besides revealing profitability, it is the main variable in computation of Return on Investment. It reflects the overall efficiency of the business, assumes great significance from the point of view of investors.
08: Proprietary ratio
Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets and is calculated as follows :
Proprietary Ratio = Shareholders’, proprietary Funds/Capital employed (or net assets)
Importance:
Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors. This ratio can also be computed in relation to total assets instead of net assets (capital employed). It may be noted that the total of debt to capital employed ratio and proprietory ratio is equal to 1. The higher ratio indicates that assets have been mainly financed by owners funds and the long-term loans is adequately covered by assets.It is better to take the net assets (capital employed) instead of total assets for computing this ratio also. It is observed that in that case, the ratio is the reciprocal of the debt to capital employed ratio.
This ratio primarily indicates the rate of external funds in financing the assets and the extent of coverage of their debts are covered by assets.
09: Fixed Asset turnover ratio
It is computed as follows:
Fixed asset turnover Ratio = Net Revenue from Operation/sales or cost of goods sold / Net Fixed Assets
Net Assets or Capital Employed Turnover Ratio
It reflects relationship between revenue from operations and net assets (capital employed) in the business. Higher turnover means better activity and profitability. It is calculated as follows :
Net Assets or Capital Employed Turnover ratio = Revenue from Operation /Capital Employed
Capital employed turnover ratio which studies turnover of capital employed
(or Net Assets) is analysed further by following two turnover ratios :
(a) Fixed Assets Turnover Ratio : It is computed as follows:
Fixed asset turnover Ratio = Net Revenue from Operation/Net Fixed Assets
(b) Working Capital Turnover Ratio : It is calculated as follows :
Working Capital Turnover Ratio = Net Revenue from Operation/ Working Capital
Importance : High turnover of capital employed, working capital and fixed assets is a good sign and implies efficient utilisation of resources. Utilisation of capital employed or, for that matter, any of its components is revealed by the turnover ratios. Higher turnover reflects efficient utilisation resulting in higher liquidity and profitability in the business.
10: Debt equity ratio
Debt-Equity Ratio measures the relationship between long-term debt and equity. If debt component of the total long-term funds employed is small, outsiders feel more secure. From security point of view, capital structure with less debt and more equity is considered favourable as it reduces the chances of bankruptcy. Normally, it is considered to be safe if debt equity ratio is 2 : 1. However, it may vary from industry to industry. It is computed as follows:
Debt-Equity Ratio = Long − term Debts / Shareholders’ Funds
where:
Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus + Money received against share warrants + Share application money pending allotment
Share Capital = Equity share capital + Preference share capital
or
Shareholders’ Funds (Equity) = Non-current assets + Working capital – Non-current liabilities
Working Capital = Current Assets – Current Liabilities
Importance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-term lender regarding extent of security of the debt. As indicated earlier, a low debt equity ratio reflects more security. A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in meeting its obligations to outsiders. However, from the perspective of the owners, greater use of debt (trading on equity) may help in ensuring higher returns for them if the rate of earnings on capital employed is higher than the rate of interest payable.
11: Return to capital employed ratio
It explains the overall utilisation of funds by a business enterprise. Capital employed means the long-term funds employed in the business and includes shareholders’ funds, debentures and long-term loans. Alternatively, capital employed may be taken as the total of non-current assets and working capital. Profit refers to the Profit Before Interest and Tax (PBIT) for computation of this ratio. Thus, it is computed as follows:
Return on Investment (or Capital Employed) = Profit before Interest and Tax/ Capital Employed × 100
Importance:
It measures return on capital employed in the business. It reveals the efficiency of the business in utilisation of funds entrusted to it by shareholders, debenture-holders and long-term loans. For inter-firm comparison, return on capital employed funds is considered a good measure of profitability. It also helps in assessing whether the firm is earning a higher return on capital employed as compared to the interest rate paid.
12: Capital Gearing ratio
What is the Capital Gearing ratio?
It tells us about companies’ capital structure. Broadly, Capital Gearing is nothing but the ratio of Equity to Total Debt. This critical information about capital structure makes this ratio as one of the most significant ratios to look at before investing.
Through this ratio, investors can understand how geared the capital of the firm is. The firm’s capital can either be low geared or high geared. When a firm’s capital is composed of more common stocks rather than other fixed interest or dividend-bearing funds, it’s said to have been low geared. On the other hand, when the firm’s capital consists of less common stocks and more of interest or dividend-bearing funds, it’s said to be highly geared.
Now why it matters to know whether the firm’s capital is high geared or low geared? Here’s why. Companies that are low geared tend to pay less interest or dividends, ensuring the interest of common stockholders. On the other hand, high geared companies need to give more interest increasing the risk of investors. For this reason, banks and financial institutions don’t want to lend money to the companies which are already highly geared. it is calculated as follows:
Capital Gearing Ratio = Fixed Interest bearing funds/ Common Shareholders’ Equity
common shareholders equity Include : Total of Shareholders equity - Preference share
Fixed Interest bearing fund : The all items on which the company has to pay interest are appear here which include long term loans/debts, debentures, bonds, and Preference share