Ratio Analysis and Interpretation

Published on November 25, 2017
Ratio Analysis and Interpretation
A ratio shows relationship between two numbers . The ‘’accounting ratio’’is used to describe significant relationships which exist between figures shown in balance sheet ,in profit and loss account , in budgetary control system or in many parts of accounting ratios.It is necessary to to ascertain financial strengths and weaknesses of an enterprise so Ratio analysis is a very powerful analytical tool useful in this picture.


Ratios normally pinpoint a business firm strengths and weakness in two ways;
  • Ratios provide much easier way out than any other method to compare past performance and present
  • Ratios depict the areas in which a particular business is competitively advantaged or disadvantaged through comparing ratios to those of other businesses of the same size within same industry.
It helps to speculate and help decisions in relation to the firm.

Classification of Ratio Basic Function

Classification of Ratio Basic Function

Classification of Ratio on The Basics of The Financial Statement 

Classification of Ratio on The Basics of The Financial Statement

Ratio based on user

  • Ratio for short term creditors
  • Ratios for shareholders
  • Ratio for management
  • Ratio for long term creditors 
Current ratio Current ratio =current assets/
Current liabilities
A current ratio of2:1 indicates highly solvent position.where,
Cureent assets =Inventories+sundry debtors+cash and bank bal.+receivables+loans+any othercurrent assets
Current liabilities=creditors+short term loans+cash credit+outstanding expenses+provision for taxation+proposed dividend+unclaimed dividend+any other current liabilities
a. Quick ratio /liquid/acid test ratio Current assets,loans,advances-inventories/Current liabilities &provisions This ratio best measures of liquidity.an acid test of 1111111:1 is considered satisfactory.
b. Absolute liquid/super quick ratio Absolute liquid assets/current liabilties The ideal absolute liuquid ratio is considered as 1:2
c. Defensive interval ratio Liquid assets/projected daily cash requirement The higher the ratio more safety of short term liquidity
d. Net working capital ratio Current assets- current liabilities It depicts ability of business to survive financial crisis.
e. Cash ratio Cash and bank balances+marketable securities/current liabilties It measures absolute liquidity of the business.


This ratio will also be found under another name ’’capital structure ratio’’ .it has much greater significance. The ratio indicates the proportion of owners stake in the business.
Solvency ratio
a. Debt ratio Total outside liabilities/total debt + net worth It is an indicator of use of outside fund
b. Debt service coverage ratio Cash flow from operating activities/loan instalments + finance charge A ratio of 2 is considered to be ideal be financial institution.

Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio

This ratio may also be found under name of ;’’asset management ‘’ratio. This ratio Indicate Efficiency in Asset Use.

A. TOTAL ASSET TURNOVER RATIO Sales or cost of goods sold/average total assets this ratio helps to ensure that level of of stock is kept consistent to fulfill customers requirement at time.
a. Fixed assets turnover ratio sales or cost of goods sold/fixed assets This indicates of the average age of assets ,particularly when depreciation rates are noted in the accounts.
b. Capital turnover ratio Sales or cost of goods sold /net assets This indicates the firm ability to generate sales per rupee of long term investment.
Working capital turnover ratio Sales or cost of goods sold/working capital This ratio indicates extent of working capital turned over in achieving sales of the firm.
Inventory turnover ratio Sales or cost of goods sold /average inventory It measures the efficiency of the firmto manage inventory.
Creditors turnover ratio Credit purchases/average creditors This includes balances of trade creditors and bills payable
Debtors turnover ratio Credit sales/average debtors Higher the ratio the better position.
Payables turnover ratio Annul net credit purchases/average accounts payables It measures the velocity of payables payment.

Profitability Ratio

THIS ratio helps assessing the adequacy of profits earned by the company and to discover whether profitability is increasing or decreasing.

Revenue based profitability;

a. Net profit margin Net profit/total revenue including non operating income multiply 100 It measures the relationship between net profit and sales of the business.
b. Operating profit ratio Operating profit /sales multiply by 100 It measures operating performance of business.
c. Gross profit margin Gross profit /revenue from sales of goods and services multiply by 100 It measures the gross profit margin on the total sales made by the company.

Capital based profitability business

a. Return on capital employed Net profit + interest(1-effectivetax rate)/average capital employed multiply 100 It measures overall earnings (either pre tax or post tax )on capital employed.
b. Return on equity Net profit/ average equity multiply by 100 This ratio expresses the net profit in terms of equity shareholders fund.

Asset based profitability of ratio

a. Return on total assets Net profit /average assets multiply by 100 This ratio indicates the efficiency of utilization of assets in generating revenue.
b. Return on operating assets Operating profit /average operating assets multiply by 100. It measures net profit per rupee of average operating assets.

Lets sum up
Ratio are important tools for financial analysis and are used by owners ,investors, bankers, creditors,
Rating agencies and other interested persons.
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