IntroductionA tool used by individuals to conduct a quantitative analysis of information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company. Ratio analysis is predominately used by proponents of fundamental analysis.Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios.Ratio Analysis as a tool possesses several important features. The data, which are provided by financial statements, are readily available. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time.Because Ratio Analysis is based upon Accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick indication of a firm's performance and to identify areas which need to be investigated further.

AdvantagesFinancial ratio analysis is a useful tool for users of financial statement. It has following advantages:1. It simplifies the financial statements.2. It helps in comparing companies of different size with each other.3. It helps in trend analysis which involves comparing a single company over a period.4. It highlights important information in simple form quickly. A user can judge a company by just looking at few numbers instead of reading the whole financial statements.

LimitationsDespite usefulness, financial ratio analysis has some disadvantages. Some key demerits of financial ratio analysis are:1. Different companies operate in different industries each having different environmental conditions such as regulation, market structure, etc. Such factors are so significant that a comparison of two companies from different industries might be misleading.2. Financial accounting information is affected by estimates and assumptions. Accounting standards allow different accounting policies, which impairs comparability and hence ratio analysis is less useful in such situations.3. Ratio analysis explains relationships between past information while users are more concerned about current and future information.

Objectives of ratio analysis Ratios are worked out to analyse the following aspects of a business organization :a) Solvency: (i) long-term ; (ii) short-term ; (iii) immediately.b) Stability.c) Profitability.d) Operational efficiency.e) Credit standing.f) Structural analysis.g) Effective utilization of resources.h) Leverage or external financing.Nature of ratio analysisThough ratio analysis is al the range among the users of accounting information, it is better to understand the nature of ratios so, that they can be employed judicious under appropriate conditions.a) The relation between two or more financial data brought about by accounting ratio is not an end in itself. They are, means to get to know the financial position of an organization.b) An individual ratio may not be capable of providing the answers required for the various problems facing an executive. Industrial ratio may provide valuable information only when they are studies and compared with several other related ratios.c) Ratio analysis will tend to be more meaningful when certain standards and norms are laid down so that what the ratios indicate can be compared with the said standards. This provides base for decision-making assist in taking measures to rectify any drawback or deficiency.

CLASSIFICATIONS OF THE RATIOSThere is no dearth of financial ratios today. There are ratios for different purpose, for different types of users and for different types of analysis:Ratios can be grouped under the following heads :a) Traditional classificationb) Functional classificationc) Users angleThese ratios are explained below:Traditional classification of ratios Under this classification, the ratios readily suggest through their names, their respective sources. From this point of view ratios are classified as under :a) Balance sheet ratios or financial ratios : They deal with the relationship between two items, which are together found in the balance sheet. Ratios of current assets and current liabilities ratio of stock to working capital etc.b) Reserve statement ratios or Income statement ratios : These ratios deals with the relationship between two items, which are both found in the income statement.Examples : the ratio of net profit to sales, ratio of expenses to sale etc.These ratios are also known s Operating ratios as they deal with the operating results of an organization.c) Inter-statement ratios or combined ratios : These ratios indicate the relationship between two items or two groups of items, of which one is found in the balance sheet and the other in the income statement ( Profit and loss account ).

Functional classification of ratios The ratios may be grouped in accordance with the purposes they serve of the different users of accounting information. On this basis, the ratios are classified as follows : a) Liquidity Ratios : These ratios analyse short-term and immediate financial position of a business organization and indicate the ability of the firm to meet its short-term commitments (current liabilities) out of its short-term resources (current assets). They are also known as Solvency Ratios.b) Leverage Ratios : These ratios measure the relationship between proprietors funds and borrowed funds. They indicate the degree of debt-financing in a firm.c) Activity Ratios : These ratios are designed to indicate the effectiveness of the firm in utilizing its funds, its degree of efficiency, and its standards of performance. Hence, they are also known as Efficiency and Performance Ratios.d) Profitability Ratios : These ratios are intended to reflect the overall efficiency of the organization, its ability to earn a reasonable return on capital employed or on shares issued and the effectiveness of its investment policies.

Classification from the view point of usersRatios may also be classified from the view point of users of accounting information. Thus, we can have the following groups of ratios :a) from shareholders point of view : There are certain ratios which serve the purposes of shareholders. Shareholders, in general, expect a reasonable return on their capital and reasonable capital appreciation. They are also interested in the safety of their investments. The major point of interest to the shareholders is the profitability of the organization.Example : Earnings per share, Return on Proprietors funds, etc.b) from short-term creditors point of view : Short-term creditors of a company are basically interested in knowing the companys ability to pay its short-term liabilities as and when they become due. Hence, creditors place much importance+ on the liquidity aspect of the companys assets.Example : Current and Liquid ratios.c) from long-term creditors and the Management point of view :Leverage ratios provide useful information to long-term creditors. Long-term creditors include debenture holders, vendors of fixed assets and term-lending institutions. These creditors are primarily interested in the companys ability to repay the principal sum and make periodical interest payments as and when they become due. Besides, the management may use borrowed funds as a lever to improve earnings.BALANCE SHEET RATIOSThe Balance Sheet ratios which are discussed in the chapter are :a) Current Ratiob) Liquid Ratioc) Proprietary Ratiod) Stock-working Capital Ratioe) Capital Gearing Ratio andf) Debt Equity Ratio.Current RatioCurrent Ratio is also known as Working Capital Ratio, Solvency Ratio or 2 to 1 ratio. This ratio expresses the relationship between current assets and current liabilities.CalculationThe current ratio is calculated by dividing the current assets by current liabilities. This can be expressed as pure number or percentage ratio. Generally, it is expressed as a pure ratio.

Working CapitalWorking capital is the difference between current assets and current liabilities. Working capital is defined as the net current assets.Working capital = Current Assets less Current Liabilities.Since, current ratio indicates the working capital position of the business, it is also known as the Working Capital Ratio.Liquid ratio Liquid ratio is also known as Quick ratio or Quick asset ratio or Acid test ratio or Near money ratio, or 1 to 1 ratio.This ratio is design to indicate the financial position of an enterprise. Thus, the ratio shows the firms ability to meet its immediate obligations promptly. It measures the relationship between quick assets and quick liabilities.Calculation:The quick ratio or liquid ratio is calculated by dividing quick assets by quick liabilities. This is generally expressed as a pure ratio. Quick ratio = Quick assets Quick liabilitiesThis is also known as acid test ratio as there are possibilities of becoming cash insolvent in a very short time, if major part of the current assets is locked in inventories.Proprietary ratioProprietary Ratio is a test of the financial and credit strength of the business. It relates shareholders funds to total assets i.e. , total funds. This ratio determines the long term or ultimate solvency of the company.In other words, proprietary ratio determines as to what extent the owners interests and expectations are fulfilled from the total investments made in the business operations.

Trading on EquityThis phenomenon occurs when borrowed capital is employed in the business. The essence of Trading on Equity is to borrow and use external funds at an explicit cost and employ them efficiently so as to obtain a return higher than the cost of such funds.This results in higher returns on equity shareholders funds. Thus, the phenomenon of making higher rates of return available to the Equity shareholders of the company by means of greater utilisation of borrowed funds obtained at an explicit or lower cost is termed as Trading on Equity.Standard RatioIt is always desirable to have external and proprietors funds well-balanced. The proprietary ratio should neither be too high nor too low.What is a safe ratio is a matter to be decided only after due consideration of various other factors.Stock working capital ratioThe stock working ratio brings out the relationship between stock and working capital. It is alternatively known as inventory-working capital ratio or inventory net current assets ratio. Standard RatioIt is very difficult to lay down a standard stock-working capital ratio as the level of stock to be maintained differs from business to business.However, 1:1 may be considered as a reasonable standard.The difficulty in fixing a standard for the ratio is due to the fact that it is necessary to build up stock in the initial stages in case of a newly started business.

Capital Gearing RatioCapital Gearing Ratio brings out the relationship between two types of capital i.e., capital carrying fixed rate of interest or fixed dividend and capital that does not carry fixed rate of interest or fixed dividend. It is a modified counterpart of Debt Equity Ratio. In short, capital gearing ratio indicates the degree to which capital has been geared in the capital structure of a company.This ratio is also known as Leverage Ratio or Financial Leverage Ratio, or Capital Structure Ratio.Debt Equity RatioMeaningIt expresses the relation between the external equities and internal equities or the relationship between borrowed capital and owners capital.a) Debt Equity Ratio = Long Term Debts Shareholders Fundsb) Debt Equity Ratio = Long Term Debts Shareholders Funds +Long Term Debts

REVENUE STATEMENT RATIORevenue profit ratios are those ratios which highlight the relationship between two revenue statement items. The following five revenue statement ratios are discussed in this chapter.a) Gross Profit Ratiob) Operating Ratioc) Expenses Ratiod) Net Profit Ratioe) Stock Turnover Ratio andf) Net Operating Profit Ratio.Gross Profit RatioGross Profit ratio brings out the relationship between Gross Profit and Net Sales. It is also known as Turnover ratio or Margin or Gross margin ratio or Rate of gross profit. It is expressed as a percentage of net sales.Calculation Gross Profit 100 salesHigh and low ratiosA low gross profit ratio may indicate unfavorable purchase and mark policies, inability to increase sales volume and excessive competition. A high gross profit ratio may indicate efficiency of the sales department and effectiveness of cost control measures.Standard ratioit is very difficult to lay down the standard gross profit ratio as it refers from industry to industry and from year to year in a firm.In any case, the gross profit ratio must atleast be maintained at a consistent level if cannot be Improved. Steps should be taken to earn gross profit atleast sufficient to cover the operating expenses and fixed interest charges.Operating RatioOperating ratio is the relationship between cost of activities and net sales. This ratio brings out the relationship between total cost of goods sold and net sales.In other words, operating ratio shows at what percentage the operating expenses are comprised in net sales. This is expressed as a percentage.High and low operating ratiosLower the operating ratio, the better is the operational efficiency of the business. If the operating ratio is higher, it would lead to lower profits and therefore will be less favorable because what would be left out of operating profits for the shareholders will be meager. When more capital is needed, the operating ratio should be low.Standard ratioThough a standard operating ratio cannot be precisely laid down, the ratio in the case of manufacturing concerns is normally high, while in case of other firms, the ratio may be low.Expenses RatioThe ratio of each item of expenses or each group of expenses to net sales is known as an Expense Ratio and such ratios are collectively known as Expense Ratios. Thus, expense ratio brings out the relationship between various elements of operating costs and net sales.Expense ratios analyse each individual item of expense or group of expenses and express them as a percentage in relation to net sales.

Calculationa) Ratio of Administrative expenses:Administrative expenses 100 Net salesb) Ratio of Selling expenses:Selling expenses 100 Net sales c) Material consumed ratio:Material consumed 100Net sales d) Conversion cost ratio:Manufacturing expenses 100 Net salese) Ratio of non-operating expenses:Non-operating expenses 100 Net sales Net Profit RatioNet Profit ratio indicates the relationship between net profit and net sales. Net profit can be either operating net profit or net profit after tax or net profit before tax. This ratio is also known as Margin on Sales Ratio.CalculationNet profit ratio is calculated as under :a) Net profit 100 NAT 100 Net sales Net sales

b) NBT 100 Net sales This ratio is expressed as a percentage.Net Operating Profit RatioIt is a relationship between net operating profit and net sales which is expressed in percentageFormulaNet Operating Profit Ratio = Net Operating Profit 100 Net SalesStock Turnover RatioStock Turnover ratio is also known as Inventory ratio or Inventory Turnover ratio or Stock Turn ratio or Merchandise Turnover ratio or Stock Velocity ratio or simply Velocity of StockThis ratio measures the number of times stock turns or flows or rotates in an accounting period compared to the sales effected during that period. In other words, the ratio indicates the frequency of inventory replacement i.e., the number of times inventory has been sold and replaced during a given period of time.

CalculationStock Turnover ratio is the relationship between inventory and cost of goods sold and is calculated as under :Stock Turnover Ratio = Cost of goods sold Average Stock The ratio is expressed as a number, so many times in a year.

Average StockAverage stock on hand as at the end of a period is calculated by adding inventory in the beginning of the period to the inventory at the close of the period and the product is divided by two.Average Stock = Opening Stock + Closing Stock 2 When the opening stock figure is not available, closing stock can be considered as the average stock.For greater accuracy, average inventory for a year may be taken. This is calculated by adding inventory as at the beginning of the year and inventories as at the end of every month and dividing the total by 13.Standard RatioIt is difficult to establish a standard inventory ratio as inventory levels differ from industry to industry.Generally speaking, the rate of stock turnover will be much higher in food, provision and chain stores than in engineering concerns and firms dealing in capital goods or durable consumer goods.However, the following general guidelines may be considered as reasonable :a) inventory of raw material not to exceed 2 to 4 months consumption in a year.b) inventory of finished goods not to exceed 2 to 3 months sales.c) Work-in-progress not to exceed 15 to 30 days sales, depending upon the process time.However, both high and low turnover ratios are not conducive for profitability and a reasonable level of inventories has to be maintained based on past experience.High and Low Inventory RatiosA high inventory ratio may indicate any of the following :a) possibility of over-trading;b) effective inventory management;c) inadequate inventory resulting in loss of customer patronage;d) sales at lower prices resulting in lower profits;e) deflated inventory valuation;A low inventory turnover ratio may indicate any of the following :a) slackness in business activitiesb) over-investment in inventory;c) anticipation of rise in prices;d) accumulation of obsolete and dead stock;e) deflated inventory valuation;f) inflated inventory valuation;COMBINED RATIOSCombined ratios or Inter-Statement Ratios relate two items or two groups of items of which one is from Balance Sheet and one of the revenue statements.Return on Capital EmployedThis ratio explains the relationship between total profits earned by the business and total investments made or total assets employed. This ratio, thus measures the overall efficiency of the business operations.This ratio is alternatively known as Return of Total Resources.CalculationReturn on total resources is calculated by dividing Net Profit before preference dividend and interest on loans and debentures by total assets (fixed and current). This is always expressed as a percentage.= Net Profit before interest & tax 100 Capital Employed

Return on Proprietors FundsAlternatively known as Return on Proprietors Equity or Return on Shareholders Investment or Investors Ratio, the above ratio indicates the relationship between net profit earned and total Proprietors Funds.CalculationThe formula for calculating the Return on Proprietors Funds will be, NPAT 100 Proprietors FundsReturn on Equity Share CapitalThis ratio indicates the rate of earning on the Equity or ordinary share capital. This is expressed as a percentage or in absolute monetary terms. Alternatively, this may be expressed as an amount of return per equity share but as a percent of the equity capital it is easily understood. This ratio is also known as The Rate of Return on Equity Capital.CalculationThe formula for calculating the ratio is : = Net Profit after tax less Pref. dividend Equity Share CapitalAlternatively, the following formula may be employed for calculating the Return per equity share : Net Profit after Tax less Preference Dividend Number of Equity SharesEarning per shareMeaningEarning per share is calculated to find out overall profitability of the organization. Earning per share represents earning of the company whether or not dividends are declared. If there is only one class of shares, the earnings per share are determined by dividing net profit by the number of equity shares. If there are both equity and preference shares the net profit should be reduced by the amount necessary to pay preference dividend. It is calculated by the following formula.FormulaEarning per Share = Net Profit after Tax - Preference Dividend E.P.S Number of Equity Shares

Dividend Payout RatioMeaningThe purpose of this ratio is to find out the proportion of earning used for payment of dividend and the proportion of earning retained. The ratio is a relationship between earning per equity share and dividend per equity share. The ratio can be calculated as follows :Formula Dividend per Equity Share Earning per Equity ShareDividend Yield RatioMeaningIt is a relationship between dividend and market price.Formula Dividend Yield = Dividend per Share Market Price per SharePrice-Earning RatioMeaningIt is a proportion between market price and earning per share.

Formula P/E Ratio = Market Price per Equity Share Earning per ShareDebt Service RatioMeaningThis ratio is also called as interest coverage ratio. The purpose of this ratio is to find out the number of times the fixed financial charges are covered by income before interest and tax. The ratio is calculated by the following formula :Formula = Net Profit before interest and tax Fixed interest ChargesDebt Service Coverage RatioInterest coverage ratio tells about the ability of a company to pay interest regularly. It does not tell about the ability of a company to make payment of principal amount on time. For this purpose, debt service coverage ratio has to be calculated as follows : Debt Service = Net profit before Interest and Tax Coverage Ratio Interest + Principal Payment Instalment 1 - Tax RateCreditors Turnover RatioMeaningIt is similar to Debtors Turnover Ratio. It shows the speed with which payments are made to the suppliers for purchases made from them. It is a relationship between net credit purchases and average creditors.Formula Credit Purchases Average Accounts PayableAverage CreditorsFor the purpose of calculation of this ratio, average monthly balance of creditors and bills payable should be taken. If this information is not available average of opening and closing balances of creditors should be taken. If opening balance is not available, year end balance should be considered.Creditors turnover ratio may be further used to find out the average rate of payables by using the following formula : = Days in a Year OR Creditors Turnover Average Accounts Payable No. of days or months in a year. Credit Purchases in a YearDebtors Turnover Ratio (Debtors Velocity)Debtors Turnover Ratios is alternatively known as Turnover of Debtors Ratio or Accounts Receivable Turnover Ratio. Some analysts prefer to call this ratio as Debtors Turnover period or as Average collection period.This ratio attempts to measure the collectability of debtors and other accounts receivables. In other words, it shows the rate at which the trade debts are being collected.Sundry Debtors and Other Accounts ReceivableThese items represent the amount outstanding and receivable as on a particular date, usually as on the balance sheet date. The total receivables will be the total of Sundry Debtors and bills Receivable.Accounts Receivable should not include debtors or bills arising from non-operating transactions i.e., activities other than trading.Debtors Turnover ratio is calculated as under : = Credit Sales Average Accounts Receivables Debt Collection PeriodThe ratio indicated the extent to which the debts have been collected in time. It gives the average debt collection period. The ratio helps the lenders to known whether their borrowers are collecting money from debtors within a stipulated period.Formula Debtors + Bills Receivable Average daily or monthly Credit Sales Average daily sales is calculated as follows : = Net Credit Sales OR Months or days in a year No. of days in the year Debtors Turnover OR Average Accounts Receivable Months or days in a year Credit Sales for the yearAssets Turnover RatioFixed Assets Turnover RatioIt is a relationship between Sales and Fixed Assets.FormulaFixed Assets Turnover Ratio : Sales Fixed Assets Total Assets Turnover RatioMeaningIt shows the number of times total assets are being turned over in a year.FormulaTotal Assets Turnover Ratio = Sales Total Assets

Working Capital Turnover RatioFormula Sales Working Capital Capital Turnover RatioMeaningIt is a relationship between Sales and Capital employed.FormulaCapital Turnover Ratio = Sales Capital Employed

Illustration 1 :From the following financial statements of Sunshine Ltd., calculate the companys accounting ratios and offer brief comments on the companys :(1) Financial stability, (2) Financial management, and (3) Efficiency (profitability)Trading and Profit & Loss A/cFor the year ended 31st March, 2006Sales (Net)Opening StockPurchases

Less : Closing StockGross ProfitGeneral ExpensesDirectors EmolumentsDepreciationAudit FeesDebenture Interest

Income from InvestmentsProfit prior to TaxationTaxation @ 40%Profit after TaxationBalance brought forward from previous yearExcess Tax Provision of previous year written back

Transfer to General ReserveTransfer to Dividend Equalisation Reserve

Proposed Dividend :5% Preference Dividend30% Equity DividendBalance carried forwardRs.

65,0003,35,0004,00,00040,000

1,36,28010,0006,2005002,520

93,200

10,5801,000

10,0005,00015,000

50012,000Rs.6,00,000

3,60,0002,40,000

1,55,50084,5008,700

37,28055,920

11,58067,500

27,50040,000

Balance Sheet as on 31st March, 2006CostRs.DepreciationRs.NetRs.

Funds used in Fixed Assets : Land and Buildings Plant and Machinery Motor Vehicles Furnitures and Fittings

Investments (Market Value Rs. 99,000)

Current Assets : Prepaid Expenses Stock in Trade Debtors Bills Receivable Tax Credit Certificates Bank

Less Current Liabilities : Trade Creditors Accrued Expenses Provision for Taxation

Proposed Dividend Net Current Assets or Working Capital

Financed by : Share Capital 100, 5% Preference Shares of Rs. 100 each 40,000 Equity Shares of Rs. 1 each

Reserve and Surplus : Securities Premium General Reserve Dividend Equalisation Reserve Profit and Loss A/c Shareholders Funds Loan Capital : 7% Debentures (Decured on Land)50,00035,00015,0003,000

45,0005,50039,800

12,500

10,00040,000

4,000

90,0005,00040,000

21,0007,500600

20,00040,00050,0001,10016,00039,8001,66,900

1,02,800

50,000

1,39,00050,00014,0007,5002,40073,90087,000

64,1002,25,000

1,89,000

36,0002,25,000

Solution :Financial Management Ratios :1.Current Ratio= Current AssetsCurrent Liabilities= 1,66,900 = 1.62:1 1,02,8002.Liquid Ratio= Liquid AssetsCurrent Liabilities= 1,06,900 = 1.04:13.Proprietary Ratio=Proprietors Equity Total Assets= 1,89,000 = 0.58:1 3,27,800

4.Stock-Working= StockCapital Ratio Working Capital= 40,000 = 0.62:11,66,900 - 1,02,8005.Capital Gearing Ratio =Fixed Interest Bearing SecuritiesEquity Capital + Reserves= 46,000 = 0.27:1 1,79,000OR= Fixed Interest Bearing Securities Equity Capital= 46,000 = 1.15:1 40,000Profitability Ratio:Gross Profit Ratio=Gross Profit 100 Net Sales=2,40,000 100 = 40%6,00,000Operating Ratio=Operating Cost 100 Net Sales = Cost of Goods sold + Operating Exps. 100 Net Sales

=3,60,000 + (1,36,280,+ 16,700) 100 6,00,000=5,2,980 100 = 85.5% 6,00,000Net Profit Ratio=Net Operating Profit 100 Net Sales=Gross Profit - Operating Exps. 100 Sales=2,40,000 - 1,52,980 100 6,00,000=87,020 100 = 14.5% 6,00,000Stock Turnover Ratio=Cost of Goods Sold Average Inventory

= 3,60,000 = 6086 times 65,000 +40,000 2Return on Capital employed= Opening Net Profit (before Tax & Interest) Capital employed=87,020 100 = 38.68% 2,25,000

Return of Proprietors Equity=Net Profit after Tax Proprietors Equity= 55,920 100 = 29.59% 1,89,000Return on Equity Capital=Net Profit after tax & Pref. dividend 100 Equity Capital =55,920 - 500 100 = 138.55% 40,000Debtors Turnover Ratio/ Collection Period=Accounts Receivable 365 Net Sales=50,000 + 1,100 365 = 31 days 6,00,000

Comments :a)Financial Stability : Long-term : The long-term financial position of the company is indicated by the proprietary ratio. The proprietary ratio of the company is 0.58:1. This indicates that for every one rupee of the total assets, contribution of 58 paise has come from the proprietors. The contribution made by the proprietors to total assets is more than that of the outsiders. The ratio is satisfactory. Therefore, the firm can be considered financially stable in the long run.Short term : The short-term financial position of the company is indicated by the current and liquid ratios. The current ratio of the Company is 1.62:1 which is not favourable. Hence, the short-term financial position of the company is not strong, whereas the immediate solvency position as revealed by liquid ratio (1.04:1) seems to be satisfactory. The company is in a position to meet its current obligations out of its current assets as and when they fall due for payment.b)Financial Management : The proportion of fixed interest bearing securities to equity shareholders funds is 0.27:1. This indicates that the capital structure of the company is low-geared. Considering the proportion of fixed interest bearing securities to equity capital, the structure of capital seems to be slightly high geared. The gearing of capital structure of capital structure has profound influence+ on the quantum of profits available to the equity shareholders.The stock to Working Capital ratio is 62:1 which shows that out of every rupee of working capital, 62 paise are locked up in inventories. This has influence on the working capital position of the company and consequently on its liquid position. The collection period of debtors is not very long. The average collection period of 31 days is quite reasonable.c)Profitability : Gross Profit ratio is 40% and the net operating profit ratio is 14.5%. This indicates that out of every Rs. 100 worth of sales Rs. 14.50 is operating profit and Rs. 85.50 is the operating cost.The return on total resources is 36.14% and the return on equity capital is 138.55%. Equity shareholders earn Rs. 138.55 on every Rs. 100/- of capital subscribed and paid by them and Rs. 29.59 on every Rs. 100/- employed by them as resources.This shows that the profitability of the company seems to be satisfactory. However, whether there is an improvement in the profitability or not depends on the comparative study of figures of the previous accounting periods.

Illustration 2:The following are the summarised Profit & Loss Account of Siddhartha Product Limited for the years ending 31st December, 2005 and the balance sheet as on that date:Profit & Loss A/cTo Opening StockTo PurchasesTo Incidental ExpensesTo Gross Profit c/d

To Operating Expenses: Selling and Distribution Administration Finance

To Non-operating Expenses :Loss on Sale of Assets Net ProfitRs.99,0005,45,25014,2503,40,0009,99,000

30,0001,50,00015,0001,95,000

4,0001,50,0003,49,000By SalesBy Closing Stock

By Gross Profit b/dBy Non-operating Incomes :Interest 3,000 Profit on Sale Of Shares 6,000Rs.8,50,0001,49,000

9,99,000

3,40,000

9,000

3,49,000

Balance Sheet as at______LiabilitiesIssued Capital :2,000 Equity SharesOf Rs. 100 eachReservesCurrent LiabilitiesProfit & Loss A/cRs.

2,00,00090,0001,30,00060,0004,80,000AssetsLand & BuildingPlant & MachineryStock-in-TradeSundry DebtorsCash & Bank BalanceRs.1,50,00080,0001,49,00071,00030,000

4,80,000

From the above statements you are required to calculate the following ratios and state the purposes they serve :a) Current ratio,b) Operating ratioc) Stock turnoverd) Return on capital employed,e) Earning per equity share,f) Opening profit ratio.Solution :a) Current Ratio = Current Assets Current Liabilities = 1,49,000 + 71,000 + 30,000 1,30,000 = 2,50,000 1,30,000 = 1.92The purpose is to test the short-term financial position of the company.The ratio is near the standard ratio of 2:1. It appears that the short-term financial position of the company is not bad. However, the position is not satisfactory as a large portion of current assets is represented by stock-in-trade.b) Operating Ratio = Cost of Goods sold + Operating Expenses 100 Net Sales Cost of goods sold = Opening Stock + Purchases + Expenses chargeable to trading A/c - Closing Stock = (99,500 + 5,45,250 + 14,250) - 1,49,000 = 6,59 000 - 1,49,000 = 5,10,000 Operating Ratio = 5,10,000 + 1,95,000 100 8,50,000 = 7,05,000 100 8,50,000 = 83%. (approx)The purpose of the ratio is to test the operating efficiency of the company. This ratio is also used to find out what portion of sales is absorbed by operating costs. In this case, out of every Rs. 83 is the operating cost.c) Stock Turnover Ratio = Cost of goods sold Average Stock= 5,10,000 1,24,250= 4.1 times.

Calculation of Average Stock:Average Stock = Opening Stock + Closing Stock 2= 2,48,500 2= 1,24,250The purpose of this ratio is to measure the operating efficiency of the company and of inventory management. Higher the ratio, greater is the efficiency. In this example, the stock turnover is slightly more than 4 times on an average.d) Return on Capital Employed= Net Profit 100 Capital Employed= 1,50,000 100 4,80,000= 31% (approx)Sometimes, the ratio is calculated by considering the operating profit. If this approach is adopted, the ratio will be := 1,45,000 100 4,80,000= 30% (approx)Net Operating Profit is calculated as under : Net ProfitAdd : Non-operating Expenses

Less : Non- operating IncomeRs.1,50,0004,0001,54,0009,0001,45,000

The purpose of this ratio is to test the manner in which the resources are utilized. It is also used to test the overall profitability of the company.In this case, the ratio is 31%. It means, that the company has earned Rs.31 on every Rs. 100 employed as resources.e) Earning per Equity Share = Net Profit after tax & preference dividend No. of equity shares= 1,50,000 2,000= Rs. 75The purpose is to find out possibility of dividend.f) Net Operating Profit Ratio= Net Operating Profit 100 Net Sales= 1,45,000 100 8,50,000= 17.06%The purpose is to judge the operating efficiency of the management.

Illustration 3 :Shown below are the comparative balance sheets and operating data of Alpha Company for the years ended on 31st December, 2004, 2005 and 2006 :Comparative Balance Sheets2004Rs.

2005Rs2006Rs.

Current Assets :CashDebtorsStock [A]Fixed Assets (Net) :EquipmentsBuildingsLand [B]Total Assets [A + B]Current Liabilities :Bills PayableCreditorsAccrued Liabilities [A]Long term Loans : Debentures 6%) [B]Owners EquityEquity Capital (Rs. 100 each)Retained Earnings [C]Total Liabilities [A +B+C]

1,20014,80014,80030,800

9,80015,7005,00030,50061,300

7,5006,3001,20015,000

30,00016,30046,30061,3001,90012,40016,20030,500

12,00016,3005,00033,30063,800

3,00011,2001,60015,800

30,00018,00048,00063,800

40010,40019,80030,600

12,80018,0005,00035,80066,400

5,00013,4002,90021,300

30,0009,60039,60066,4000

Additional Information :2004Rs.2005Rs.2006Rs.

Total SalesNet Profit after TaxDividend paid1,00,0005,0003,0001,05,0005,70003,00093,0002,4001,000

You are required to :1. Compute the following for each of the three years :i) Current Ratio,ii) Acid Test Ratio,iii) Proprietary Ratio,iv) Return on Proprietors Equity.2. Discuss the financial condition of the company as on 31st December 2004, and the trends shown by the comparative data and the ratios.Solution :.Current Ratio= Current AssetsCurrent Liabilities 2004 : 30,800=2.05:1 15,000

2005 : 30,500=1.93:1 15,8002006 : 30,600 =1.44:1 21,3002.Acid Test Ratio= Quick AssetsCurrent Liabilities2004 : 16,000=1.07:1 15,0002005 : 14,300 =0.91:1 15,8002006: 10,800 =0.51:1 21,3003.Proprietary Ratio= Net Profit 100Proprietors Equity2004 : 5,000 100 =10.8% 46,3002005 : 5,700 100=11.88% 48,0002006 : 2,400 100=6.06% 39,600

Comments :a)Short-term financial position : Short-term financial position is reflected in the Current Ratio and Acid Test Ratio. The Current Ratio and Acid Test Ratio of the company for 2004 are favourable. The position of the company for 2004 seems to be satisfactory. In 2005 both the ratios have declined. The position of the company for 2006 has become worst as there is a drastic decline in the ability of the company to meet its current obligations out of its current assets.b)Long-term financial position : The proprietary ratio in 2004 was 1.76:1, in 2005, 0.75:1 and in 2006, 0.6:1.The financial position of the company seems to be satisfactory as the proprietors contribution to total assets is more than the contribution by outsiders.However, the ratio is showing a downward tendency. This means that the interest of the proprietors is decreasing. This should be checked.c)Profitability : The profitability position of the company showed improvement in 2005 as it is indicated by the increase in the return on proprietors equity and earnings per share as compared to the previous year. However, ratios of both the years have decreased in 2006. Return on proprietors equity has fallen from 11.88% in 2005 to 6.06% in 2006.The profitability position of the company is not satisfactory.

BIBLIOGRAPHYBook :-1. Advanced Financial management, L. N. Chopde, sheth publication, june, 2010.Websites:-1. http://accountingexplained.com/financial/ratios/advantages-limitations2. http://www.investopedia.com/terms/r/ratioanalysis.asp

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