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A ratio can be defined the relationship between two or more variables. In finance these variables are
taken from the balance sheet or profit or loss account. Ratio Analysis is one of the most widely used
tool for the analysis of financial statements of a business entity. Ratios are usually expressed in various
mathematical terms such as percentage, no. of times, or in numbers & compared with some standards.
Ration analysis does not merely mean the calculations of ratios. It actually refers to the comparing of
different numbers from the balance sheet, income statement and cash flow statements so as to arrrive
at certain conclusions. The comparison of such ratios can be of similar ratios of two or more different
companies or against the same ratios of the same entity. Ratios of a company may also be compared
with same ratios of the industry or economy. Such comparison gives us a meaningful idea as to how
the entity has performed in the past and what are its potential in the future. Thus, we can say that ratio
analysis helps in meaningful summerisation of large number of financial data to provide a qualitative
judgement about the financial performance of a business entity.
(a) Liquidity Ratios - These ratios indicate the ability of the entity to maintain the short term liquidty
for discharing the current liabiites. A company is expected to have sufficient short term liquidity so
that it can meet its current obligations. In case it fails to meet its current obligations, it loses creditors'
confidence and is always threatened by short term insolvency. Such a situation can even lead to
closure of the unit itself. Some of the frequently used ratios which fall under this category are (i)
Current Ratio (ii) Quick Ratio and (iii) Working Capital Turnover Ratio.
(b) Activity Ratios - These ratios indicate operational efficiency of the entity in utilising the available
resources. In other words, we can say that these ratios measure the efficiency of the entity in using the
available funds, especially the funds raised on short term basis. These ratios help banker to ascertain
the working capital need of the entity. Some of the important activity ratios are (i) Inventory turnover;
(ii) Debtor turnover; (iii) Fixed assets turnover; (iv) current assets / working capital turnover. Activity
ratios indicate the efficiency of a business organisation in utilisation of funds, particularly funds of
short term nature.
(c) Solvency Ratios / Leaverage Ratios - These ratios indicate proportion of debt vis-a-vis equity,
whcih in turn points towards the long term solvency of the entity. Some of the important solvency
ratios are (i) Debt-Equity ratio (ii) Debtor service coverage ratio
(d) Profitability Ratios - These ratios indicates the capacity and efficiency of the firm to generate
profit and surplus out of the main business. Some of the important profitability ratios are (i) Return on
Equity; (ii) Return on investment or capital employed etc.
LIQUDITY RATIOS :
Type of Ratio How to Calculate Remarks
Current ratio is calculated by dividing current
assets by current liabilities. Therefore, As per RBI stipulation, the
minimum current ratio of a firm
Current Ratio= Current Assets / Current should not be less than 1.33:1
liabilities
Here current assets refers to cash and those assets However, banks consider
Current Ratio which can be converted to cash within a period of current ratio of 2:1 as
one year, whereas current liabilities are liabilities satisfactory. Usually, higher
that are to be discharged within one year. current ratio is desirable but
unreasonable high current ratio
Current assets should be reasonably higher than is undesirable as it brings down
current liabilities to take care of the firm's short the profit of the unit due to
term liquidity. Current ratio represents margin of inefficient use of current assets.
safety for creditors.
Although current assets are
considered to be liquid in
nature, but certain assets like
The quick ratio is the ratio between quick current
inventory, prepaid expenses,
assets and current liabiliites. The quick assets
unquoted shares etc. may not be
include cash / bank balances + receivables upto 6
that liquid. Thus, such assets
months + quickly realisable securities such as
may not be available for paying
government securities or quickly marketable /
off liabilities of urgent nature
quoted shares and bank fixed deposits.
immediately. So to measure the
short term liquidity more
Thus, quick ratio = quick assets / current
Quick Ratio / accurately quick ratio is used
liabilities
Acid Test Ratio where the assets which are not
very liquid are deducted from
The other way to calculate quick ratio is to divide
current assets.
all liquid assets by current liabilities.
A ratio of 1:1 is considered to
Quick ratio = Current Assets - Inventory &
be satisfactory as cash yield
Prepaid expenses / current liabilities.
from most liquid assets can be
used for discharging current
liabilities.
ACTIVITY RATIOS :
PROFITABILITY RATIOS