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(Specially prepared for RBI GR B Phase-II 2016 Finance Paper)

RATIO ANALYSIS

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FINANCIAL STATEMENTS

Financial Statements generally consists of

the following two types :
Profit & Loss Account which summarises
the expenses incurred and revenues
received during the period covered by it ; and
Balance Sheet which lists out the Assets
and Properties owned by the Unit and the
Liabilities it owes to outsiders and also to its
owners.
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WHO ARE INTERESTED IN FINANCIAL STATEMENTS ?

Creditors , Bankers & Financial

Institutions :

General financial position to determine if the concern is

worth lending to.

Whether the sales, production, profitability are increasing

or decreasing?

The liquidity position of the concern i.e. meeting the

liabilities in time.

The assets that are available to secure their advances.

The stake of the owners of the concern as compared to

the amount lent.

How the amount lent to the concern has been utilised, and
so on? 3
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MAJOR COMPONENTS OF BALANCE SHEET

Balance Sheet is a statement of Assets & Liabilities as on a
given date. It reflects the Financial Position of a concern as
on a date. The Balance Sheet can be looked at from two
angles:

1. ASSETS as USES and LIABILITIES as SOURCES OF

FUNDS
2. ASSETS as what the Business Owns and LIABILITIES as
what the Business Owes.

LIABILITIES ASSETS
NET WORTH FIXED ASSETS
TERM LIABILITIES CURRENT ASSETS
CURRENT LIABILITIES OTHER NON CURRENT
ASSETS 4
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MAJOR COMPONENTS OF BALANCE SHEET

1. Net Worth : It is the total investment of the owners in

the Business.
For a Limited Company it comprises of a sum of Share
Capital + Reserves
Share Capital is the direct investment of the owners in the
business. This includes Equity Share Capital and
Preference Share Capital.
Reserves : Profits of the business which have been reinvested
in the business. In Proprietorship and Partnership Firms
they are added to Capital and not shown separately.

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MAJOR COMPONENTS OF BALANCE SHEET

2. TERM LIABILITIES : All those borrowings made

by the concern which are repayable after One Year of the
Balance Sheet date are called Term Liabilities. These
include

TERM LOANS
DEBENTURE
TERM DEPOSITS
REDEEMABLE PREFERENCE SHARE CAPITAL
(Maturing with 12 years of Balance Sheet Date)

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MAJOR COMPONENTS OF BALANCE SHEET

3. CURRENT LIABILITIES : All those borrowings

made by the concern which are expected to be repaid within
12 months of the date of the Balance Sheet. These include
CREDITORS
PROVISIONS FOR EXPENSES
BANK BORROWING FOR WORKING CAPITAL
DEPOSITS MATURING WITHIN 12 MONTHS
INSTALLMENTS OF TERM LOANS
DEBENTURES/REDEEMABLE PREFERENCE SHARES MATURING
WITHIN ONE YEAR

Total of Term Liabilities + Current Liabilities is called Outside Liabilities

and is the Total Borrowings of the Firm

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MAJOR COMPONENTS OF BALANCE SHEET

4. FIXED ASSETS: These are the assets which help in

the production of goods & services of the concern. They are
tangible in nature and have a long life. The examples of
Fixed Assets are :

Land
Building
Plant & Machineries
Furniture & Fixtures etc.

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MAJOR COMPONENTS OF BALANCE SHEET

5. CURRENT ASSETS: These are the assets which

are expected to be consumed or converted into cash
through the normal business operations and usually within
one year. Such as:
Cash & Bank Balances
FDs with Banks
Short Term Govt .Securities
Stocks of R.M., Semi F.G and F.G
Stores, Spares
Advance Payment for Suppliers
Prepaid Insurance
Debtors & Bills Receivables
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MAJOR COMPONENTS OF BALANCE SHEET

6. NON CURRENT ASSETS: These are the assets

which do not fall in the above two categories of assets. They
are:

Corporate Investments
Loans not recoverable within 1 year
Non Consumable Spares
Deferred Receivables
Advance for Capital Expenditure
Intangible Assets [ Goodwill, Patent, Trade Mark]
Preliminary & Pre-operative Expenses
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RATIO ANALYSIS
Its a tool which enables the banker or lender to
arrive at the following factors :
Liquidity position
Profitability
Solvency
Financial Stability
Quality of the Management
Safety & Security of the loans & advances to be
or already been provided

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FORMAT OF BALANCE SHEET FOR RATIO ANALYSIS
LIABILITIES ASSETS
NET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS : LAND & BUILDING, PLANT &
Share Capital/Partners Capital/Paid up Capital/ MACHINERIES
Owners Funds Original Value Less Depreciation
Reserves ( General, Capital, Revaluation & [Net Value or Book Value or Written down value]
Other Reserves)
Credit Balance in P&L A/c
LONG TERM LIABILITIES/BORROWED NON CURRENT ASSETS
FUNDS : Term Loans (Banks & Institutions) Investments in quoted shares & securities
Debentures/Bonds, Unsecured Loans, Fixed Old stocks or old/disputed book debts
Deposits, Other Long Term Liabilities Long Term Security Deposits
Other Misc. assets which are not current or fixed
in nature
CURRENT LIABILTIES CURRENT ASSETS : Cash & Bank Balance,
Bank Working Capital Limits such as Marketable/quoted Govt. or other securities,
CC/OD/Bills/Export Credit Book Debts/Sundry Debtors, Bills Receivables,
Sundry /Trade Creditors/Creditors/Bills Payable, Stocks & Inventory (RM,SIP,FG) Stores &
Short duration loans or deposits Spares, Advance Payment of Taxes, Prepaid
Expenses payable & provisions against various expenses, Loans and Advances recoverable
items within 12 months
INTANGIBLE ASSETS
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Patent, Goodwill, Debit balance in P&L A/c,
 CLASSIFICATION OF RATIOS

Balance Sheet P&L Ratio or Balance Sheet

Ratio Income/Revenue and Profit & Loss
Statement Ratio Ratio
Financial Ratio Operating Ratio Composite Ratio
Current Ratio Gross Profit Ratio Fixed Asset
Quick Asset Ratio Operating Ratio Turnover Ratio,
Proprietary Ratio Expense Ratio Return on Total
Debt Equity Ratio Net profit Ratio Resources Ratio,
Stock Turnover Ratio Return on Own
Funds Ratio,
Earning per Share
Ratio, Debtors
Turnover Ratio,
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SOME IMPORTANT NOTES
Liabilities have Credit balances and Assets have Debit
balances
Current Liabilities are those which have either become due
for payment or shall fall due for payment within 12 months
from the date of Balance Sheet
Current Assets are those which undergo change in their
shape/form within 12 months. These are also called
Working Capital or Gross Working Capital
Net Worth & Long Term Liabilities are also called Long
Term Sources of Funds
Current Liabilities are known as Short Term Sources of
Funds
Long Term Liabilities & Short Term Liabilities are also called
Outside Liabilities
Current Assets are Short Term Use of Funds 14
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SOME IMPORTANT NOTES

Assets other than Current Assets are Long Term Use of Funds
Installments of Term Loan Payable in 12 months are to be taken
as Current Liability, only for Calculation of Current Ratio & Quick
Ratio.
If there is profit it shall become part of Net Worth under the head
Reserves and if there is loss it will become part of Intangible
Assets
Investments in Govt. Securities to be treated current only if these
are marketable and due. Investments in other securities are to be
treated Current if they are quoted. Investments in
allied/associate/sister units or firms to be treated as Non-current.
Bonus Shares as issued by capitalization of General Reserves
and as such do not affect the Net Worth. But with Rights Issue,
change takes place in Net Worth and Current Ratio.
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1. Current Ratio : It is the relationship between the

current assets and current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
The ideal Current Ratio preferred by Banks is 1.33 : 1
Current Assets : Cash & those assets which can be
converted into cash within 1 year. For example,
Marketable securities, Debtors, Inventories, Prepaid
Expenses.
Current Liabilities : Creditors, Bills Payable,
Accrued Expenses, Short Term Bank Loans, Income
Tax Liabilities and long Term Liabilities maturing in
the current year.

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Current Ratio measures the firms short term
solvency. A ratio greater than 1 means that
the firm has more current assets than
current claims against them.
As a conventional rule a Current Ratio of 2 is
considered most satisfactory. This rule is
based on the logic that in a worse situation,
even if the value of current assets become
half, the firm will be able to meet its current
obligations. It represents the Margin of
Safety i.e. a cushion of protection for
creditors. Higher the ratio greater the margin
of safety.
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2. Net Working Capital : This is worked out

as surplus of Long Term Sources over Long
Term Uses, alternatively it is the difference
of Current Assets and Current Liabilities. It
measures the firms potential reservoir of
funds.
NWC = Current Assets Current
Liabilities

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3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current

Assets and Current Liabilities.

Quick Current Assets : Quick assets are those which can be immediately
converted into cash without a loss of value. Cash & Bank balances are the most liquid
assets. Examples of quick Assets are : Cash/Bank Balances, Receivables upto 6
months, Quickly realizable securities such as Govt. Securities or quickly
marketable/quoted shares and Bank Fixed Deposits. Inventories are less liquid hence
the same is deducted from the Current Assets to arrive at Quick Assets.
Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example :
Cash 50,000
Debtors 1,00,000
Inventories 1,50,000 Current Liabilities 1,00,000
Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3:1

Quick Ratio => 1,50,000/1,00,000 = 1.5 : 1
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4. DEBT EQUITY RATIO : It is the relationship between

borrowers fund (Debt) and Owners Capital (Equity). It
represents the lenders contribution for each Rupee of owners
contribution.

Long Term Outside Liabilities / Tangible Net Worth

Liabilities of Long Term Nature

Total of Capital and Reserves & Surplus Less Intangible Assets

For instance, if the Firm is having the following :

Capital = Rs. 200 Lacs

Free Reserves & Surplus = Rs. 300 Lacs
Long Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 = 1.6 : 1

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Composite Ratio

17. RETRUN ON EQUITY CAPITAL (ROE) :

Net Profit after Taxes / Tangible Net Worth

18. EARNING PER SHARE : EPS indicates the quantum of net profit
of the year that would be ranking for dividend for each share of
the company being held by the equity share holders.

Net profit after Taxes and Preference Dividend/ No. of Equity

Shares

19. PRICE EARNING RATIO : PE Ratio indicates the number of times

the Earning Per Share is covered by its market price.

Market Price Per Equity Share/Earning Per Share

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20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most
important one which indicates the ability of an enterprise to
meet its liabilities by way of payment of installments of Term
Loans and Interest thereon from out of the cash accruals and
forms the basis for fixation of the repayment schedule in
respect of the Term Loans raised for a project. (The Ideal DSCR
Ratio is considered to be 2 )

PAT + Depr. + Annual Interest on Long Term Loans & Liabilities

---------------------------------------------------------------------------------
Annual interest on Long Term Loans & Liabilities + Annual
Installments payable on Long Term Loans & Liabilities

( Where PAT is Profit after Tax and Depr. is Depreciation)

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LIQUIDITY RATIOS :
1. CURRENT RATIO = C.A / C.L
2. QUICK RATIO = (C.A
INVENTORY)/C.L
ACTIVITY RATIOS :
1. INVENTORY TURNOVER RATIO =
(COST OF GOODS SOLD OR
SALES)/INVENTORY
2. DEBTORS TURNOVER RATIO =
(CREDIT SALES OR
SALES)/AVERAGE DEBTORS
3. INVENTORY PERIOD =
360/INVENTORY TURNOVER
4. COLLECTION PERIOD =
360/DEBTORS TURNOVER
5. ASSETS TURNOVER =
SALES/NET ASSETS OR CAPITAL
EMPLOYED
6. WORKING CAPITAL TURNOVER
= SALES/NET WORKING CAPITAL
PROFITABILITY RATIOS :
1. GROSS MARGIN = GROSS
PROFIT/SALES
2. NET MARGIN = PAT/SALES,
EBIT/SALES
3. PAT TO EBIT RATIO = PAT/EBIT
4. RETRUN ON INVESTMENT RATIO
= EBIT/NET ASSETS OR CAPITAL
EMPLOYED
5. RETRUN ON EQUITY = PAT/NET
WROTH
LEVERAGE RATIOS :
1. TOTAL DEBT RATIO = TOTAL
DEBT/CAPITAL EMPLOYED
2. DEBT EQUITY RATIO = NET
WORTH/TOTAL DEBT
3. CAPITAL EQUITY RATIO = C.E
OR NET ASSETS / NET WORTH
4. INTEREST COVERAGE RATIO =
(EBIT+Depr.)/INTEREST 23