Ratio Analysis
Ratio analysis evaluates financial statements by computing mathematical relationships between financial figures. Ratios make data meaningful by enabling comparison across time, companies, and industry benchmarks.
Profitability Ratios
Gross Profit Ratio = (GP/Net Sales) × 100. Measures trading efficiency. Net Profit Ratio = (NP/Net Sales) × 100. Overall profitability. ROA = (NP/Total Assets) × 100. Asset efficiency. ROE = (NP/Shareholders’ Equity) × 100. Return for owners — most important for investors.
Liquidity Ratios
Current Ratio = Current Assets/Current Liabilities. Ideal: 2:1. Ability to pay short-term debts. Quick Ratio = (CA − Stock)/CL. Ideal: 1:1. Excludes stock (least liquid). Cash Ratio = Cash/CL. Most conservative.
Solvency Ratios
Debt-to-Equity = Total Debt/Shareholders’ Equity. Financial leverage. Interest Coverage = EBIT/Interest Expense. Ability to pay interest — below 1.5 is concerning. Debt Ratio = Total Liabilities/Total Assets.
Efficiency Ratios
Stock Turnover = COGS/Average Stock. How quickly stock sells. Debtors Turnover = Credit Sales/Average Debtors. Collection speed. Average Collection Period = 365/Debtors Turnover. Days to collect. Asset Turnover = Sales/Total Assets.
Interpretation
Compare against: previous years (trend), industry averages (benchmark), competitors, and targets. A single ratio alone is meaningless — always compare and analyse trends. Consider business context.
Limitations
Based on historical data. Accounting policies differ across companies. Window dressing possible. Inflation distorts. Qualitative factors not captured.
Summary
Ratio analysis — profitability, liquidity, solvency, efficiency — transforms raw financial data into meaningful insights for analysis and decision-making.
Worked Example: Ratio Analysis of Himalaya Traders
From the financial statements of Himalaya Traders for FY 2080/81:
| Item | Amount (Rs) |
|---|---|
| Net Sales | 2,000,000 |
| Cost of Goods Sold | 1,400,000 |
| Gross Profit | 600,000 |
| Operating Expenses | 350,000 |
| Net Profit | 250,000 |
| Current Assets | 500,000 |
| Stock | 200,000 |
| Current Liabilities | 300,000 |
| Total Assets | 1,500,000 |
| Total Debt | 600,000 |
| Shareholders’ Equity | 900,000 |
| Debtors | 150,000 |
| Credit Sales | 1,800,000 |
Calculations:
| Ratio | Formula | Calculation | Result | Interpretation |
|---|---|---|---|---|
| GP Ratio | GP/Sales × 100 | 600,000/2,000,000 × 100 | 30% | Good — Rs 30 gross profit per Rs 100 sales |
| NP Ratio | NP/Sales × 100 | 250,000/2,000,000 × 100 | 12.5% | Healthy — operating expenses well controlled |
| Current Ratio | CA/CL | 500,000/300,000 | 1.67:1 | Below ideal 2:1 but adequate — monitor closely |
| Quick Ratio | (CA−Stock)/CL | (500,000−200,000)/300,000 | 1:1 | Exactly at ideal — can meet immediate obligations |
| Debt-Equity | Debt/Equity | 600,000/900,000 | 0.67:1 | Low leverage — conservative financing, low risk |
| ROE | NP/Equity × 100 | 250,000/900,000 × 100 | 27.8% | Excellent return for owners |
| Debtors Turnover | Credit Sales/Debtors | 1,800,000/150,000 | 12 times | Debtors pay every 30 days (365/12) — efficient collection |
| Stock Turnover | COGS/Stock | 1,400,000/200,000 | 7 times | Stock sells every 52 days (365/7) — reasonable |
Overall Assessment: Himalaya Traders is a well-managed business with good profitability (30% GP, 12.5% NP, 27.8% ROE), adequate liquidity (quick ratio 1:1), low financial risk (debt-equity 0.67), and efficient operations (debtors collected monthly, stock turns 7 times/year). The only concern is the current ratio slightly below the 2:1 benchmark.
Exam Tips
Tip 1: Always show the formula, substitution, AND interpretation — three marks for three steps. Tip 2: Memorise ideal benchmarks: Current Ratio 2:1, Quick Ratio 1:1, Debt-Equity below 1. Tip 3: When comparing two companies, calculate ratios for both and comment on which is better and why. Tip 4: ROE is the most important ratio for investors — always calculate and interpret it. Tip 5: State limitations when concluding — ratios are historical, affected by accounting policies, and don’t capture qualitative factors.