Ratio Analysis — Study Notes

1. Introduction

Ratio analysis is a quantitative technique of financial analysis that expresses the relationship between two related items of the financial statements. A ratio is simply the arithmetical relationship between two numbers, and in accounting it helps to evaluate the liquidity, solvency, activity, and profitability of a business. Ratios make financial statements more meaningful by removing the scale effect, allowing comparisons over time and between firms.

Ratios are classified into four main categories. Liquidity ratios measure the ability of the firm to meet its short-term obligations. Solvency ratios measure the ability to meet long-term obligations. Activity ratios measure the efficiency of the use of resources. Profitability ratios measure the earning capacity of the firm. Each category answers a specific question about the health of the business.

The usefulness of ratios depends on the quality of the underlying data and the basis of comparison. A single ratio in isolation conveys little; ratios are meaningful only when compared with the firm's own past ratios, the industry averages, or the ratios of similar firms. This chapter presents the formulas, interpretation, and accounting treatment of the most important ratios.

2. Classification of Ratios

2.1 Liquidity Ratios

These ratios measure the short-term paying capacity of the firm.

$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

The ideal current ratio is 2:1. It measures whether the firm can meet its current obligations.

$$\text{Quick Ratio (Acid Test Ratio)} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$$

$$\text{Quick Assets} = \text{Current Assets} - \text{Inventories} - \text{Prepaid Expenses}$$

The ideal quick ratio is 1:1. It is a more stringent test of liquidity than the current ratio.

$$\text{Cash Ratio} = \frac{\text{Cash and Cash Equivalents}}{\text{Current Liabilities}}$$

2.2 Solvency Ratios

These ratios measure the long-term solvency and the relationship of borrowed funds to owned funds.

$$\text{Debt to Equity Ratio} = \frac{\text{Total Debt}}{\text{Shareholders' Funds}}$$

$$\text{Total Assets to Debt Ratio} = \frac{\text{Total Assets}}{\text{Total Debt}}$$

$$\text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}}$$

$$\text{Interest Coverage Ratio} = \frac{\text{Net Profit before Interest and Tax}}{\text{Interest on Long-term Debt}}$$

$$\text{Debt Service Coverage Ratio} = \frac{\text{Net Profit before Interest and Tax + Depreciation}}{\text{Interest + Principal Repayment}}$$

2.3 Activity Ratios (Turnover Ratios)

These ratios measure how efficiently the firm utilises its resources.

$$\text{Inventory Turnover Ratio} = \frac{\text{Cost of Revenue from Operations}}{\text{Average Inventory}}$$

$$\text{Trade Receivables Turnover Ratio} = \frac{\text{Credit Revenue from Operations}}{\text{Average Trade Receivables}}$$

$$\text{Average Collection Period} = \frac{365}{\text{Trade Receivables Turnover Ratio}}$$

$$\text{Trade Payables Turnover Ratio} = \frac{\text{Credit Purchases}}{\text{Average Trade Payables}}$$

$$\text{Working Capital Turnover Ratio} = \frac{\text{Revenue from Operations}}{\text{Working Capital}}$$

2.4 Profitability Ratios

These ratios measure the earning capacity of the firm.

$$\text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Revenue from Operations}} \times 100$$

$$\text{Net Profit Ratio} = \frac{\text{Net Profit}}{\text{Revenue from Operations}} \times 100$$

$$\text{Operating Ratio} = \frac{\text{Cost of Revenue from Operations + Operating Expenses}}{\text{Revenue from Operations}} \times 100$$

$$\text{Operating Profit Ratio} = 100 - \text{Operating Ratio}$$

$$\text{Return on Investment (ROI)} = \frac{\text{Net Profit before Interest, Tax and Dividend}}{\text{Capital Employed}} \times 100$$

$$\text{Return on Equity (ROE)} = \frac{\text{Net Profit after Tax}}{\text{Shareholders' Funds}} \times 100$$

3. Interpreting the Ratios

• A high current ratio indicates strong liquidity, but an excessively high ratio may mean inefficient use of resources.
• A low debt-equity ratio indicates a conservative capital structure with less financial risk.
• A high inventory turnover ratio indicates efficient management of inventory.
• A high gross profit ratio indicates efficient production and pricing.
• The return on investment indicates the overall efficiency of the capital employed.

4. Advantages and Limitations

4.1 Advantages

• Simplifies and summarises financial data.
• Facilitates comparison between firms and over time.
• Helps in decision making on credit, investment, and dividends.
• Identifies the strengths and weaknesses of the firm.
• Aids in forecasting and planning.

4.2 Limitations

• Ratios are based on historical cost data.
• Different accounting policies affect comparability.
• Window dressing can distort ratios.
• A single ratio is meaningless without comparison.
• Ratios ignore qualitative factors such as management quality.
• Price-level changes are not accounted for.

Quick Revision Tables

Table 1: Key Ratios and Formulas

Table 2: Ideal Benchmarks

Table 3: Classification of Ratios

Mind Map

Important Diagrams (SVG)

Diagram 1: Classification of Ratios

Diagram 2: Liquidity Ratio Computation Flow

Common Mistakes

1. Including inventories and prepaid expenses in quick assets; they must be excluded to compute the quick ratio.
2. Using total assets in place of capital employed while computing return on investment.
3. Using net profit after tax instead of profit before interest and tax in the interest coverage ratio.
4. Taking the total debt as only the long-term debt without considering short-term borrowings in certain ratios.
5. Computing the inventory turnover ratio with revenue instead of the cost of revenue from operations.
6. Comparing ratios across firms with different accounting policies without adjustment.
7. Forgetting to consider the average of opening and closing balances while computing turnover ratios.

Exam Tips

1. Write the formula first and then substitute the values to secure method marks.
2. Use average figures (opening + closing divided by 2) for turnover ratios whenever both are available.
3. Compute capital employed as Shareholders' Funds + Long-term Debt for ROI calculations.
4. Remember that gross profit ratio uses revenue from operations, and net profit ratio uses net profit after tax or before tax as stated.
5. Practise the calculation of operating and operating profit ratios together since they are complements.
6. Present the answer with the correct sign and unit, and state whether the result is favourable.
7. When a ratio is compared with an ideal benchmark, interpret the deviation logically.

Conclusion

Ratio analysis is a powerful tool that summarises the financial statements into comparable and interpretable measures. The four categories of liquidity, solvency, activity, and profitability ratios each answer a distinct question about the firm's financial health. Correct computation requires attention to the definitions of the components, such as quick assets, capital employed, and cost of revenue from operations. While ratios have limitations arising from historical cost, window dressing, and differing accounting policies, they remain indispensable for decision-making. Together with the cash flow statement, ratio analysis completes the toolkit for the analysis of financial statements.