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What is Ratio Analysis ?

ratio analysisImage

A ratio analysis is a quantitative analysis of information contained in a company's financial statements.

It assist in measuring the efficiency and profitability of a company based on its financial reports.

Objectives of Ratio-Analysis

The importance of ratio analysis lies in the fact that it presents data on a comparative basis and enables the drawing of inferences regarding the performance of the firm. Ratio analysis helps in concluding the following aspects:

  • Liquidity Position :

    What is liquidity 1Image

    Ratio analysis helps in determining the liquidity position of the firm. A firm can be said to have the ability to meet its current obligations when they become due. It is measured with the help of liquidity ratios.

    In accounting, liquidity (or accounting liquidity) is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities. Liquidity is the ability to pay short-term obligations.

  • Long- Term Solvency :


    Ratio analysis helps in assessing the long term financial viability of a firm. Long- term solvency measured by leverage/capital structure and profitability ratios.

    Long- Term solvency is the ability of a company to meet long-term debts as they become due.

  • Operating Efficiency :


    Percentage measure of a management’s ability to generate sales revenue and to control costs.

    Ratio analysis determines the degree of efficiency of management and utilization of assets. It is measured by the activity ratios.

  • Overall Profitability :

    overall profitabilityImage

    Profitability is simply the capacity to make a profit.

    The management of the firm is concerned about the overall profitability of the firm which ensures a reasonable return to its owners and optimum utilization of its assets. This is possible if an integrated view is taken and all the ratios are considered together.

Liquidity ratios :


The liquidity ratio, is a computation that is used to measure a company's ability to pay its short-term debts.

Liquidity ratios

Category Types of Ratio Interpretation
Liquidity ratios Net Working Capital =
Current assets-current liabilities
It measures the liquidity of a firm.
Current ratio =
Current Assets/ Current Liabilities
It measures the short term liquidity of a firm.
A firm with a higher ratio has better liquidity.
A ratio of 2:1 is considered safe.
Acid test or Quick ratio =
Quick assets/ Current Liabilities
It measures the liquidity position of a firm.
A ratio of 1:1 is considered safe.

Turnover ratios :


It shows how many times an inventory was turned into cash during an accounting period.

Turnover ratios

Category Types of Ratio Interpretation
Turnover ratios Inventory Turnover ratio =
Costs of goods sold/ Average inventory.
This ratio indicates how fast inventory is sold.
A firm with a higher ratio has better liquidity.
Debtor Turnover ratio=
Net credit sales/ Average debtors
This ratio measures how fast debts are collected.
A high ratio indicates shorter time lag between credit sales and cash collection.
Creditor’s Turnover ratio =
Net credit purchases/ Average Creditors
A high ratio shows that Accounts are to be settled rapidly.

4. Capital Structure Ratios :


This ratio indicates the relative proportions of debt and equity in financing the assets of a firm.

Capital Structure Ratios

Category Types of Ratio Interpretation
Capital Structure Ratios Debt-Equity ratio =
Long term debt/Shareholder's Equity
This ratio indicates the relative proportions of debt and equity in financing the assets of a firm.
A ratio of 2:1 is considered as ideal, although it depends upon industry.
Debt to Total capital ratio =
Short term debt + long-term debt/Shareholder's Equity + Total Debt
It indicates what proportion of the permanent capital of a firm consists of debt.
It measures the share of the total assets financed by outside funds.
A low ratio is desirable for creditors.
A firm should neither have a high ratio nor a low ratio.

Coverage ratios :

A coverage ratio divides a company's income or cash flow by a certain expense in order to determine financial solvency.

Coverage ratios

Category Types of Ratio Interpretation
Coverage ratios Interest Coverage =
Earning before Interests and Tax/ interest
A ratio used to determine how easily a company can pay the outstanding interest on debt.
A ratio of more than 3 times is satisfactory.
Dividend Coverage =
(i)  Earning after tax/ Preference Dividend

(ii)  Earnings after tax- Preference Dividend/ Equity Dividend
It measures the ability of firm to pay dividend on preference shares, and equity shares. A high ratio is better for creditors.
Total Coverage ratio =
Earning before interests and tax/ Total fixed charges
It shows the overall ability of the firm to fulfill the liabilities. A high ratio indicates better ability.

Profitability ratios:

A profitability ratio is a measure of profitability, which is a way to measure a company's performance.

Profitability ratios

Category Types of Ratio Interpretation
Profitability ratios Gross Profit margin = Gross profit ×100/Sales It measures the profit in relation to sales.
Net Profit margin = Net Profit before interest and tax/ Sales


Net Profit after Tax and Interest/Sales
It measures the net profit of a firm with respect to sale.

This ratio is used to measure the efficiency of the firm.

Expenses ratios


Expense ratio is the fee charged by the investment company to manage the funds of investors.

Expenses ratios

Category Types of Ratio Interpretation
Expenses ratios Operating ratio =
Cost of Goods sold + other operating expenses/ Sales
Operating ratio shows the operational efficiency of the business.
Lower operating ratio shows higher operating profit and vice versa.
Cost of Goods sold ratio =
Cost of Goods sold/ Sales
It measures the cost of goods sold in relation to sales.
Specific Expenses ratio =
Specific Expenses/ Sales
It measures the specific expenses in relation to sales.

Return on Investments


Return on investment (ROI) measures the gain or loss generated on an investment relative to the amount of money invested.

Return on Investments

Category Types of Ratio Interpretation
Return on Investments Return on Assets (ROA) =
Net Profit after Taxes×100/ Total Assets
It measures the profitability of the total funds per investment of a firm.
Return on Capital Employed (ROCE) =
Net Profit*100/ Capital employed.


Net Profit/sales* sales/ Capital Employed
It measures profitability of the firm with respect to the capital employed.

The higher the ratio, the more efficient use of capital employed.
Return on Total Shareholders’ Equity =
Net Profit after Taxes×100/ Total shareholders' equity
It reveals how profitably the owner’s fund has been utilized by the firm.
Return on Ordinary shareholders equity =
Net Profit after taxes and Preference dividend/ Ordinary Shareholder's Equity * 100
It determines whether the firm has earned satisfactory return for its equity holders or not.

Shareholder’s ratios :

Share holders ratioImage

Shareholder’s ratios are used in order to assess the worth of a particular company and their shares.

Shareholder’s ratios

Category Types of Ratio Interpretation
Shareholder’s ratios Earnings per Share (EPS) =
Net Profit after tax and Preference dividend/ Number of Ordinary Shares
It measures the profit available to the equity holders on a per share basis.
Dividend per Share (DPS) =
Total dividends over a period/ Number of Ordinary Shares outstanding
It is the net distributed profit belonging to the shareholders divided by the number of ordinary shares.
Dividend Payout ratio (D/P) =
Total Dividend to Equity holders/ Total net profit of equity holders.


Dividend per Share/ Earnings per Share
It shows what percentage share of the net profit after taxes and preference dividend is paid to the equity holders.

A high D/P ratio is preferred from investor’s point of view.
Earnings Yield = Earnings per Share/ Market Value per Share It shows the percentage of each rupee invested in the stock that was earned by the company.
Dividend Yield =
Dividend per Share/ Market Value per Share
It shows how much a company pays out in dividends each year relative to its share price.
Price- Earnings ratio (P/E) =
Market Value per Share/ Earnings per Share
It reflects the price currently paid by the market for each rupee of EPS.

Higher the ratio better it is for owners.
Earning Power =
Net profit after Taxes/ Total Assets
It measures the overall profitability and operational efficiency of a firm.

Activity ratios :

Activity ratios measure a firm's ability to convert different accounts within its balance sheets into cash or sales.

Activity ratios

Category Types of Ratio Interpretation
Activity Ratios Inventory turnover =
Cost of goods sold / Average Inventory
It measures how quickly inventory is sold.

A firm should ensure to keep the stock as low as possible.
Raw Material turnover =
Cost of Raw Material used/ Average Raw Material Inventory
It shows the velocity at which raw material converted into goods ready for sale. If this ratio is high then the company is efficiently converting raw materials into finished goods.
Debtors turnover =
Net credit sales/ Average trade debtors
It shows how quickly current assets i.e. receivables or debtors are converted to cash.

Assets turnover ratios :

Asset turnover ratio measures the value of a company's sales or revenues generated relative to the value of its assets.

Assets turnover ratios

Category Types of Ratio Interpretation
Assets Turnover Ratios Total Assets turnover =
Net sales / Total Assets
It measures the efficiency of a firm in managing and utilizing its assets.
Fixed Assets turnover =
Net sales/ Fixed Assets
Higher the ratio, more efficient is the firm in utilizing its assets.
Capital turnover =
Net sales/ Capital Employed
Current Assets turnover =
Net sales/ Current Assets

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