for full text article go to : www.accountingchimp.com/ratio-analysis/ In this article of Ratio Analysis, you will learn how they can be used to analyze a company. Understand the meaning and formulas associated with Liquidity ratios, Profitability ratios, Turnover ratios, and Debt ratios

1. Ratio Analysis
~ By edu CBA

2. • Ratio analysis is a tool that aid us to
interpret the financial statements in
terms of the operating performance and
financial position of a firm.
• It comprises comparison for a meaningful
interpretation of the financial statements
which in turn plays a vital role in business
planning process.
• It involves comparing the ratios with
similar firms in the industry or analyzing
the trend in the same company over a
period of time.
• It is a very important and most basic
part of fundamental analysis process.

3. There are several financial ratios available we are going to discuss the most
widely used and categorized into the following broad areas.
Liquidity ratios
It quantifies if the
company would be
able to meet its
short term debt
obligations
Turnover ratios
Profitability ratios
It measures firms
operating
competence i.e. how
well it utilized the
available resources in
order to generate
profit.
It indicates the firm’s
efficiency with
respect to its asset
management.
Debt ratios
A financial ratio
that measures
the extent of a
company’s or
consumer’s
leverage

4. Liquidity Ratios
Current Ratio
• This measures the short
term solvency of the
company using the
balance sheet.
• Also known as the
working capital ratio, it
tells if a firm has
sufficient funds to pay its
liabilities over the period
of next 12 months.
Quick Ratio
Cash Ratio
• It measures the current
short term solvency of
the company.
• It considers if the very
liquid assets (can be
converted into cash
immediately) are
available to meet the
obligations.
• It considers only the
most liquid short-term
assets of the company,
which are those that
can be most easily
used to pay off existing
commitments
• Most stringent measure
among the three
liquidity ratios.
Current ratio =
Current Assets
Current liabilities
Quick ratio =
Quick assets (Current
assets- Inventory)
Current liabilities
Cash ratio =
Cash and cash
equivalents
Current liabilities

5. Profitability Ratios ~ In relation to sales
Gross profit margin/ratio
It is measure to show by how much gross profit exceed production costs.
Gross profit margin = Gross profit / Net sales*100
Net profit margin/ratio
It shows management’s efficiency in manufacturing, administrating, and selling the products
and the costs it incurs there.
Net profit margin = Earnings after tax/Net sales*100
Operating profit margin/ratio
This ratio specifies how much profit a firm makes after paying for variable costs of
production such as wages, raw materials, etc. but before interest and tax.
Operating profit margin =EBIT/ Net sales*100

6. Profitability Ratios ~ In relation to investment
Return on investment (ROI)
It is a performance measure which evaluates the efficiency of an investment.
Return on investment = Net profit after interest and tax / Total Assets
Return on Equity (ROE)
Return on equity (ROE) discloses the amount of profit a firm made compared to the total
amount of shareholders equity.
ROE = Net profit after tax / Shareholder's equity
Return on capital employed (ROCE)
This ratio measures the returns a firm gets out of the total capital employed by them.
ROCE = EBIT / (Total Assets - Current Liabilities)

7. Turnover Ratios
Inventory Turnover Ratio
Debtor Turnover Ratio
It indicates the number of times inventory
has been converted into sales in a
particular period of time
Inventory turnover ratio =
Cost of goods sold / Average Inventory
It shows how quickly a firm collects
outstanding cash from its
customers/debtors in an accounting period
Debtors turnover ratio =
Net receivable sales/ Average debtors
Creditor Turnover Ratio
Assets Turnover Ratio
It evaluates how quickly the business pays
off its creditors/suppliers in a particular
period.
Creditors turnover ratio = Total purchases
/ Average creditors
This ratio compares the sales revenue of
a company to its assets.
Asset Turnover Ratio = Sales Revenue /
Total Assets

8. Debt Ratios
Debt to equity ratio =
Liabilities / Equity
Debt to equity ratio
•
•
It indicates the relative portion of entity's
equity and debt used to fund the assets.
Financial lenders prefer a low debt to equity
ratio before considering to give any debt.
Debt ratio
•
Debt ratio = Liabilities /
Assets
•
This ratio indicates the amount of debt to
the total amount of assets.
Higher the ratio greater is the risk related
with the firm's operation.
Debt service coverage ratio
DSCR = Net Operating
Income/Total debt service
•
•
It depicts the ability of the firm to pay back its
principal loan amount and interest amount.
A debt service coverage ratio which is below 1
indicates a negative cash flow

9. Other ratios
This ratio helps in measuring the profit that is available to the
equity shareholders on a per share basis.
EPS = Earnings after tax – Preferred dividends/Equity shares
outstanding
Dividend
per share
Earnings
per share
It is the dividends that have been paid to the shareholders on a
per share basis.
Dividend per share = Earnings paid to the ordinary shareholders/
Number of ordinary shares outstanding
It signifies the expectations of the investors for the stock. A P/E
ratio greater than 15 has historically been considered high.
(P/E) ratio = Market price of share/Earnings per share
Earnings per
share

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