UNIT XIV: RATIO ANALYSIS

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( MODULE C )

1. The P&L and Balance Sheet are interrelated and not independent statements.
2. P&L is useful to ascertain financial solvency and strength of an enterprise.
3. The P&L is based on Accrual Concept i.e. taking into account the income and
expenditure pertaining to accounting period irrespective of recovery.
4. The management uses the financial statements as tools for self appraisal and to
ascertain the efficiency of funds utilization & borrowings costs.
5. Investors need to know growth prospectus & assured return on investment.
6. Debenture holders & Creditors would like to know Solvency & Liquidity.
7. Employees are keen to know performance in their respective areas.
8. Ratio analysis serves as a tool for analyzing financial status.
9. The Ratio is simple one number expressed in terms of another & can be expressed in
terms of percentage or fractions or proportions.
10. Ratios reveal relationship in a more meaningful way & enables to interpret them
judiciously and intelligently to draw inferences or conclusions.
11. Comparison of present Ratios with past or future ratios of the same enterprise is
intra-firm comparison.
12. Comparison of ratios of one firm with those of others in the same line of business is
inter firm comparison.
13. Comparison with related facts is basis of ratio analysis.
14. Ratios indicating financial position are calculated on the basis of B. S.
15. Ratio indicating profitability, efficiency & control over expenses are calculated on the
basis of P&L Account.
16. Ratios throw light on the operating efficiency or effective use of resources .
17. Ratios are broadly classified into four groups 1) Liquidity Ratios 2) Leverage or Capital
Ratios 3) Profitability Ratios and 4) Activity Ratios.

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18. Inter Statement Ratios are called Composite Ratios.
19. Balance Sheet Ratios are also called Financial Ratios.
20. P&L Account Ratios are also called Operating Ratios.
21. The Liquidity Ratios reflect the ability to meet short term obligations.

22. Liquidity is a pre requisite for the very survival of an enterprise.

23. Liquidity Ratios are termed as Short Term Solvency Ratios.
24. Liquidity Ratios include Current Ratios, Quick Ratio, Net Working Capital Ratio and
Turn over Ratio.
25. Non-moving or slow moving book debts and provisions for bad debts should not be
taken as current assets.
26. Slow moving or Obsolete items of inventory are called Dead Inventory and do not
form a part of current asset.
27. Advance tax paid and provision for tax should be netted.
28. If provision is made for disputed excise duty and deposited with bank, such provisions
may be set off against relative deposit.
29. Provisions for disputed excise duty is Current Liability.
30. Spares upto 5% of total inventory or expected consumption within 12 months
whichever is less are current assets and rest are non-current assets.
31. Security deposits or tender deposits irrespective of maturity are treated as nonCurrent Assets.
32. Unsecured loans from directors where period is not mentioned should be treated as
Current Liability.
33. Disputed excise liability shown as contingent liability is not a Current Liability.
34. Deposits from Dealers, Selling Agents payable on termination are treated Term
Liabilities irrespective of their maturity.

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35. If preferential Shares are redeemable beyond 12 years, they are treated as part of Net
Worth.
36. A Current Ratio of 2:1 is considered to be a safe margin of Solvency.
37. An equal increase both in CA and CL would decrease Current Ratio.
38. The Current Ratio is susceptible to window dressing and can be maintained to cover
vital facts.
39. Net Working Capital represents the excess of Current Assets over Current Liabilities.
40. The greater the amount of Net Working Capital more would be the liquidity.
41. Stock-in-process has normally no instant sale value.

42. Quick Current Assets are those assets which can be converted into cash immediately
or at a shorter notice with out diminution of value.
43. Quick Assets excludes inventories and pre-paid expenses.
44. Quick Assets includes Cash, bank balance, Short-term Marketable securities, Debtors
and Receivables.
45. Normally Bank OD and CC facilities, which have become permanent mode of financing
are to be excluded from Current Liabilities.
46. If bank OD is payable on demand it is to be included in Current Liabilities.
47. Generally a Quick Ratio of 1:1 is considered to be satisfactory.
48. A good Current Ratio accompanied by a low Acid Test Ratio will indicate a
disproportionately high investment in stocks.
49.Cash & Marketable Securities are considered as Super Quick Current Assets.
50. Turnover Ratios enable us to know how quickly certain Current Assets are converted
into Cash.
51. Turnover Ratios are part of Activity Ratios & Supplement to Liquidity Ratios.
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52. If Inventory Turnover Ratio is 6, it means the enterprise holds an average stock of two
months.
53. Low Inventory Turnover Ratio indicates high building up of inventory.
54. The Inventory Ratio is to be calculated on the basis of finished goods stock.
55. An enterprise should have neither too high nor too low inventory turnover Ratio
56. For determining quality of debtors Two Ratios are used 1) Debtors Turnover Ratio and
2) Debt collection period Ratio.
57. The Defensive Interval Ratio denotes ability to meet projected daily cash expenditure
from its operations.
58. Defensive Interval Ratio is ratio between the Quick Assets and projected daily cash
requirements.
59. The long term solvency of an enterprise can be examined by using the Leverage Ratios
or Capital Structure Ratios.
60. Coverage Ratios are calculated from P&L Account.
61. Preferential shares redeemable with in one year are Current Liabilities and redeemable
from 1 year to 12 years are Long Term Liabilities.
62. Equity = Capital + Reserves + Preferential Share Capital redeemable after 12 years
( Accumulated losses + intangible assets + Bad debts not provided for + Discount on issue
of share)

63. Debt Equity Ratio is of two types i.e. Debt / Equity or TOL / TNW and an ideal Debt
Equity Ratio is 2:1.
64. High DE Ratio means creditors contribution is more than owners contribution.
65. A higher Debt Equity Ratio has greater risk for Creditors as well as Owners.
66. A higher D E Ratio is also allowed in case of capital intensive industries.
67. As interest is tax deductible DSCR uses concept of net profits before taxes.
68.Profitability Ratios can be determined on the basis of either sales or investment.
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69. Profitability Ratios are based on the premise that an enterprise should earn sufficient
profit on each rupee of sales.
70. Profit Margin Ratio indicates the efficiency in production as well as pricing.
71. Over valuation of closing stock or under valuation of opening stock will result in
increase in gross margin.
72. A high expenses Ratio should put the management on the alert and be diagnosed to
analyze the causes.
73. E P S is a measure of profitability from the share holders point of view.
74. Dividend payment Ratio is also called Pay Out Ratio.
75. Dividend Pay Out Ratio indicates the relationship between the dividends distributed
and net earnings of a company.
76. The relation of equity capital to preference share capital and other fixed interest
bearing loans is known as Leverage or Capital gearing .
77. The technique of raising finance for a company by resorting to fixed interest or
dividend carrying securities is called Gearing the Capital.
78. The Price Earning Ratio is useful in forecasting whether the shares of a company are
over valued or under valued.
79. Activity Ratios measure the efficiency with which an enterprise is utilizing its Assets.
80. Activity Ratios are also called Efficiency Ratios or Asset Utilization Ratios or Turnover
Ratios.
81. The Asset Turnover Ratio is also called Investment Turnover Ratio.
82. DSCR helps in deciding the repayment schedule of Loans.
83. Expansion of production & sales without adequate financial support is Over Trading.
84. Cash shortage, high inventory turn over and low Current Ratio are effects of Over
Trading.

85. Trading below the level at which resources can permit is Under Trading.
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86. Low inventory turn over with high Current Ratio and high fixed unit cost are the
symptoms of under trading.
87. If the owned capital is much less than total borrowed capital it is under capitalization.
88. Under capitalization may be the result of over trading.
89. Long Term Solvency is measured by Leverage Ratios & Profitability Ratios.
90.Process of analysis depends on objective or purpose that analyst has in mind.
RATIOS
1. Raw material Turnover Ratio = Cost of RM used / Average stock of R M
2. SIP Turnover = Cost of Goods manufactured / Average stock of SIP
3. Debt Collection period = No. days or months or Weeks in a year
Debt Turnover Ratio.
4. Average Payment Period = No. days or months or Weeks in a year
Creditors Turnover Ratio.
5. Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory.
6. Debtors Turnover Ratio = Net Credit Sales / Average Debtors.
7. Creditors Turnover Ratio = Net Credit Purchases / Average Credits.
8. Defensive Interval Ratio = Liquid Assets / Projected Daily Cash Requirement
9. Projected daily cash requirement = Projected operating cash expenses / 365.
10. Debt Equity Ratio = Long Term Debt / Equity.
11. Debt Equity Ratio = Total outside Liability / Tangible Net Worth.
12. Debt to Total Capital Ratio = Total Debts or Total Assets
Permanent Capital + Current Liabilities
13. Interest Coverage Ratio = EBIT / Interest.
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14.Dividend Coverage Ratio = N. P. after Interest & Tax / Preferential dividend
15. Gross Profit Margin = Gross Profit / Net Sales * 100
16. Net Profit Margin = Net Profit / Net Sales * 100
17. Cost of Goods Sold Ratio = Cost of Goods Sold / Net Sales * 100.

18. Operating Profit Ratio = Earnings Before Interest Tax / Net Sales * 100
19. Expenses Ratio or Operating Ratio = Expenses / Net Sales * 100
20. Net Profit Ratio = Net Profit After interest and Tax / Net Sales * 100
23. Operating Expenses Ratio = Administrative + Selling expenses * 100
Net Sales
24. Administrative Expenses Ratio =(Administrative Expenses / Net Sales ) * 100
25.

Selling

Expenses

Ratio

=(Selling

Expenses

Net

Sales

26. Financial Expenses Ratio = ( Financial Expenses / Net Sales ) * 100

27. Return on Assets = Net Profit After Tax / Total Assets.
28. Total Assets = Net Fixed Assets + Net Working Capital.
29. Net Fixed Assets = Total Fixed Assets Accumulated Depreciation.
30. Net Working Capital = ( CA CL ) ( Intangible Assets + Fictitious Assets +
Idle Stock + Bad Debts )
31. Return on Capital Employed = Net Profit Before Interest and Tax
Average Capital Employed.
32. Average Capital employed = Equity Capital + Long Term Funds provided by
Owners & Creditors at the beginning & at the
end of the accounting period divided by two.
34. Return on Ordinary Share Holders Equity = (NPAT Preferential Dividends)
Average Ordinary Share Holders
Equity or Net Worth.
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35. Earnings Per Share = Net Profit After Taxes and Preferential dividends
Number of Equity Share.
36. Dividend per Share = Net Profit After Taxes and distributable dividend
Number of Equity Shares.
37. Dividend Pay Out Ratio = Dividend per Equity Share
Earnings per Equity Share.
38. Dividend Pay Out Ratio = Dividend paid to Equity Share holders
Net Profit available for Equity Share Holders.
39. Price Earning Ratio = Market Price per equity Share / Earning per Share.
40. Total Asset Turnover = Cost of Goods Sold / Average Total Assets.
41. Fixed Asset Turnover = Cost of Goods Sold / Average Fixed Assets.

100

42. Capital Turnover = Cost of Goods Sold / Average Capital employed.

43. Current Asset Turnover = Cost of Goods Sold / Average Current Assets.
44. Working Capital Turnover = Cost of Goods Sold / Net Working Capital.
45. Return on Net Worth = ( Net Profit / Net Worth ) * 100
46. DSCR = Profit after Tax & Depreciation + Int. on T L & Differed Credit +
Lease Rentals if any divided by Repayment of Interest &
Installments on T L & Differed Credits + Lease Rentals if any.
UNIT XV : STATEMENT OF SOURCES AND APPLICATION OF FUNDS
1. The banker examines the published accounts of a company which approaches for
funds with a view to assess its profitability & Financial strength.
2. Balance Sheet shows the status of sources & uses of funds as on give date.
3. To find out the movement in sources and uses of funds, compare the Balance Sheet as
at the commencement and end of the period.
4. The comparative statement of funds flow is also known as Balance Sheet variation
statement.
5. Increase in liabilities and decrease in assets are sources of Funds.
6. Decrease in liabilities and increase in assets are uses of funds.
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UNIT XIV: RATIO ANALYSIS SHORT NOTES
1. Ratio analysis means the process of computing, determining and presenting the
relationship of inter connected accounting figures or groups of accounting figures of the
financial statements.
2. As per traditional classification Ratios are classified as 1) Balance Sheet Ratios 2) P&L
Account Ratios and 3) B/S and P&L Account ratios.
3. Bills discounted with banks if shown as foot note in the Balance Sheet this should be
added to borrowings from banks under C L & Receivables under C A.
4. The Current Liabilities are settled by making payment of due where as Current Assets
are subject to shrinkage for reasons like bad debts, inventory becoming obsolete or un
salable etc. therefore a reasonable satisfactory margin of Current Assets over Current
Liabilities are required so that the Current Ratio could act as a short term liquidity buffer.
5. Inadequate NWC or decline in NWC compared to earlier years or other enterprises
engaged in similar lines of activities is the first sign of financial problems being faced by
the enterprise & serves as a wrong signal for analysts.
6. Projected cash operating expenses are calculated on the past experience and future
plans.
7. Projected cash operating expenses include cost of goods sold + Selling, Administrative
and other expenses payable in cash.

8. The consequences of high Debt Equity Ratio are 1) High pressure on earnings to pay
interest 2) Possibility of creditors loosing heavily incase of failure of the enterprise 3)
Interference of creditors may become more in day to day activities. 4) Further borrowings
may become difficult.
9. While making payment of dividends on Equity Shares a company has to strike a
balance i.e. take care so that neither the market value of its shares comes down nor its
future growth prospectus suffer.
10. Incase the rate of return on long term debts is less than the return on total Equity
Capital, thus the Surplus earned on funds can be utilized for paying dividend to the equity
share holders at a higher rate such situation is called , Trading on Equity.
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11. In the interest of prudential financial management, it is imperative that a proper
balance between owned capital and debit capital be maintained. Any imbalance will be
termed as Under Capitalization or over capitalization.
12. Ratio analysis is relevant in assessing the performance of an enterprise in respect of
1) Liquidity position 2) Long Term solvency 3) Operating efficiency
4) Overall profitability 5) Inter firm comparison 6) Trend Analysis.
13. Limitations of Ratios Analysis are 1) Ratios are only tools 2) Ratio Analysis
communicates only relative picture 3) Ratio Analysis may mislead due to window
dressing 4) Ratio Analysis may not give correct picture due to effect of inflation
5) Inter firm comparison may mislead 6) Ratio Analysis gives only symptoms.
14. Analysis is a process of breaking down a complete set of facts and figures into simple
elements, while interpretation means critically examining and drawing conclusions from
the simplified elements.
15. An analysis of a single set of financial statements has a very limited value. The
comparison with other units or industry figures are useful for judging the relative
efficiency of an enterprise.
UNIT XV : STATEMENT OF SOURCES AND APPLICATION OF FUNDS
1. While preparing funds flow statement if the profit on sale of assets is given as
additional information , it should be deducted from net profit and should be shown as
sources on account of sale of assets at full rate for which sold.
2. If F. A. are given at the commencement & close of years to arrive at sources / uses of
funds due to changes in FA. depreciation should be taken into account.
3. To arrive at tax liability tax provision at the commencement of the year + tax paid during
the year tax provisioning at the end of the year.
4. Funds flow statement can also be made basing on changes in WC/Cash flow
5. If the funds flow statement is prepared on the basis of WC then the net reduction in WC
or net increase in WC should be taken into account.
6.Cash flow statement is basically a summary of all the entries that are normally recorded
in the cash book. Incase the cash flow statement shows a negative balance, it means the
required cash have to be arranged to meet the gap.
7. The accrual concept is ignored in cash flow statement but it is considered in funds flow
statement.
8. Cash Flow statement is a tool for monitoring cash balance to ensure timely receipt &
payment of cash.