Ratio Analysis — Notes

An accounting ratio expresses the relationship between two related figures in the financial statements, for example current assets and current liabilities. Ratio analysis means computing such ratios, comparing them (with past years, other firms or accepted standards) and interpreting them.

Forms: pure ratio (2 : 1); times (10 times); percentage (25%); rupees per share (₹3.00).

The ISC syllabus lists four groups:

• Liquidity: current ratio; quick (liquid or acid-test) ratio.
• Solvency: debt to equity; proprietary; debt to total assets; interest coverage.
• Activity: trade receivables, trade payables, inventory and working capital turnover.
• Profitability: gross profit, net profit, operating and operating profit ratios; earnings per share; price-earnings ratio; return on investment.

Ratios are read by comparison: with a convention (2 : 1, 1 : 1), with the same firm last year, or with similar firms.

Definitions. The first table fixes every base used in the chapter; the second lists all seventeen formulas. Points to note:

• Current assets and current liabilities follow the Schedule III heads of the balance sheet.
• Debt means non-current liabilities only; current liabilities never enter the solvency ratios.
• Capital employed can be reached three ways (liabilities side, assets side, total assets − current liabilities); the answers must agree.
• Inventory, receivables and payables turnover use averages of opening and closing figures; working capital turnover uses the year-end working capital. If only closing figures are given, use them; if credit figures are not given, use the totals.
• The net profit ratio is on profit after tax unless a question asks for profit before tax.

Rounding rule. Work every ratio to two decimal places, rounded half up (0.9625 → 0.96; 10.125 → 10.13); an exact result is written as it is (2.5 : 1, 25%). Earnings per share is written in rupees and paise (₹2.30).

Current ratio = current assets ÷ current liabilities. Conventional level 2 : 1. Below 1 : 1, current liabilities exceed current assets and dues may not be met; a very high ratio suggests idle cash, excess stock or slow collection.

Quick (liquid or acid-test) ratio = quick assets ÷ current liabilities, where quick assets = current assets − inventories − prepaid expenses. Conventional level 1 : 1. It tests whether short-term dues can be paid without selling stock, which is why a banker often prefers it when much of the current assets is slow-moving inventory.

Watch the items: bills receivable belong to trade receivables; a bank overdraft is a short-term borrowing (current liability); debentures, long-term loans and long-term provisions are non-current.

Debt to equity ratio = debt ÷ equity (debt = long-term borrowings + long-term provisions; equity = shareholders' funds). Lower means a larger safety margin for lenders and a smaller fixed interest burden.

Proprietary ratio = shareholders' funds ÷ total assets. The share of the assets financed by owners; higher is safer for outsiders.

Debt to total assets ratio = debt ÷ total assets. The share of the assets financed by long-term debt; lower is safer.

Interest coverage ratio = profit before interest and tax ÷ interest on long-term debt (times). How many times the interest is earned; a high figure means interest will be paid even if profit falls. Work back to profit before interest and tax: profit after tax → add tax → add interest.

Method. For each transaction (taken separately): (1) write the change in the numerator and the denominator; (2) recompute the ratio; (3) compare with the original and state increase, decrease or no change.

Rules that follow from the arithmetic (see the table):

• an equal rise in both parts lowers a ratio above 1; an equal fall raises it (the opposite for a ratio below 1);
• a change in one part only moves the ratio in that direction;
• a swap inside one part changes nothing (collecting a debtor: current ratio unchanged).

Typical cases. Buying inventory for cash: current ratio unchanged, quick ratio falls. Buying inventory on credit: both fall (when above 1). Issuing shares for cash: liquidity ratios rise, debt-equity falls. Redeeming debentures in cash: debt-equity falls. Bonus shares from reserves: debt-equity unchanged. Paying a dividend: debt-equity rises.

Not in the ISC 2027 syllabus: effect-of-transaction problems on ratios other than the current, quick and debt-equity ratios.

• Trade receivables turnover = credit revenue from operations ÷ average trade receivables (debtors + bills receivable). Higher means faster collection.
• Trade payables turnover = net credit purchases ÷ average trade payables (creditors + bills payable). Lower means the firm takes longer to pay; a sudden fall may signal a cash strain.
• Inventory turnover = cost of revenue from operations ÷ average inventory. Higher means faster-moving stock; very high may mean too little stock.
• Working capital turnover = revenue from operations ÷ working capital.

Finding cost of revenue: opening inventory + net purchases + direct expenses (wages, carriage inwards) − closing inventory; or revenue − gross profit. If gross profit is a percentage on cost, cost = revenue × 100 ÷ (100 + rate). Revenue from operations is net of sales returns; purchases are net of purchases returns.

• Gross profit ratio = gross profit ÷ revenue from operations × 100.
• Net profit ratio = profit after tax ÷ revenue from operations × 100.
• Operating ratio = (cost of revenue from operations + operating expenses) ÷ revenue from operations × 100.
• Operating profit ratio = operating profit ÷ revenue from operations × 100 = 100 − operating ratio.
• Earnings per share = (profit after tax − preference dividend) ÷ number of equity shares. Number of shares = equity share capital ÷ face value.
• Price-earnings ratio = market price per equity share ÷ earnings per share (times).
• Return on investment = profit before interest and tax ÷ capital employed × 100.

Operating ratios ignore non-operating items (interest or dividend received, profit or loss on sale of assets, loss by fire) and finance costs; the net profit ratio includes them. Return on investment uses profit before interest because capital employed includes the lenders’ money; compare it with the rate of interest the company pays.

Missing figures. Turn each given ratio into a statement about one unknown and solve in a chain:

• working capital and the current ratio give current liabilities (working capital ÷ (current ratio − 1)) and current assets;
• the quick ratio gives quick assets, and the gap to current assets gives inventories (after prepaid expenses);
• inventory turnover × average inventory gives cost of revenue; a gross profit rate then gives revenue;
• a net profit ratio gives profit after tax; less preference dividend, ÷ shares, gives earnings per share; × price-earnings ratio gives the market price.

Always finish by recomputing every given ratio from your answers.

Reading ratios together. Compare each ratio with a benchmark, last year and similar firms, and read the groups together (for example, receivables turnover against payables turnover; return on investment against the interest rate).