Ratio Analysis
(The Banker’s X-Ray Machine — Read ANY Company’s Health in Minutes!)
₹10 crore profit sounds great — but is it 10% of sales or 0.1%? Is the company liquid enough to pay next month’s EMI? Are debtors paying on time? Ratios answer ALL these questions by comparing one number with another. Ratios are a banker’s MOST used tool — every loan proposal, every credit review, every NPA decision uses ratios.
Banky Gets His X-Ray Vision! 🔬📊
A borrower’s Balance Sheet has 50 numbers. P&L has 30 more. How does Banky quickly tell if the company is healthy? By using RATIOS — comparing key numbers to reveal profitability, liquidity, solvency, and efficiency in seconds!
The Full Chapter — All Ratios Explained
📈 Part 1 — Profitability Ratios (How Much Does the Company EARN?)
1. Return on Investment (ROI) / Return on Capital Employed:
Capital Employed = Share Capital + Reserves + Long-term Loans − Non-business assets − Fictitious assets. Operating Profit = Profit before Interest & Tax (interest on SHORT-term borrowings is deducted). If ROI < cost of borrowing → borrowing was NOT wise. Business survives ONLY when ROI > Cost of Capital.
2. Earnings Per Share (EPS):
Tells earning per equity share. Helps determine market price. Compare EPS across companies. EPS does NOT change with market price (only numerator matters).
3. Price-Earnings (P/E) Ratio:
How many times the EPS is covered by market price. High P/E = investors expect GROWTH. P/E DOES change with market price. Helps investor decide if share is overvalued or undervalued.
4. Gross Profit Ratio:
Shows how much selling price can decline before losses start. Should cover operating expenses + fixed charges + dividends + reserves.
5. Net Profit Ratio:
Net margin on every ₹100 of sales. Increasing NP ratio year-on-year = improving efficiency.
🏦 Part 2 — Solvency Ratios (Can the Company PAY Its Debts?)
LONG-TERM Solvency:
1. Fixed Assets Ratio:
Should be ≤ 1. Ratio < 1 = good (part of WC financed by LT funds = "core working capital"). Ratio > 1 = BAD (short-term funds diverted for fixed assets!). Ideal: 0.67 or below.
2. Debt-Equity Ratio:
Ideal: 1 (equal debt and equity). Higher D/E = more leveraged = more risky. Fixed deposits from shareholders = part of DEBT (not equity!). Redeemable preference shares (within 12 years) = also DEBT.
SHORT-TERM Solvency:
3. Current Ratio:
Satisfactory: 1.2 to 2. Too low = can’t pay bills. Too HIGH = funds sitting idle. Book debts > 6 months = exclude. Prepaid expenses = include in CA. Pay current liability when CR is 2 → CR IMPROVES! Collect from debtors → NO change (one CA becomes another).
4. Quick / Acid Test / Liquidity Ratio:
Liquid Assets = Current Assets − Stock − Prepaid Expenses. Satisfactory: above 1. Quick ratio < Current ratio always (because stock excluded). Comparing the two reveals inventory buildup.
5. DSCR (Debt Service Coverage Ratio):
Used by BANKERS for term loans. Shows margin of safety before default. Higher = better. DSCR of 1.5+ is generally acceptable.
🔄 Part 3 — Turnover / Activity Ratios (How FAST Is Money Moving?)
1. Stock Turnover Ratio:
High ratio = brisk sales. Low ratio = overstocking, obsolescence risk. Average inventory = (Opening + Closing) ÷ 2. “Stock position = graveyard of the balance sheet” — if inventory piles up, trouble ahead!
2. Debtors’ Turnover Ratio:
Higher = better (debts collected faster). Accounts Receivable = Trade Debtors + Bills Receivable.
3. Debt Collection Period:
Shorter = better. Receivables should not exceed 3–4 months’ credit sales. Too long = bad debts risk. Too short = lost sales (overly restrictive credit policy).
⚠️ Part 4 — Uses, Limitations & Special Effects on Current Ratio
4 Uses: (1) Simplify financial statements, (2) Inter-firm comparison, (3) Intra-firm comparison (division-wise), (4) Planning & forecasting.
4 Limitations: (1) Need comparative study — alone not enough, (2) Depend on financial statement quality (different accounting policies = misleading), (3) Ratios are only INDICATORS — not proof, (4) Window dressing can distort ratios.
Effect on Current Ratio (when CR = 2:1):
Pay a current liability → CR IMPROVES (from 2 to 3). Buy fixed asset for cash → CR DECLINES. Collect from debtors → NO CHANGE (one CA to another). Bill receivable dishonoured (debtor solvent) → NO CHANGE. Issue new shares for cash → CR IMPROVES. Issue shares for fixed assets → NO CHANGE.
Exam-Ready Points
🎯 Must Remember!
- 3 Categories: Profitability (ROI, EPS, P/E, GP, NP), Solvency (Fixed Assets, D/E, Current, Quick, DSCR), Turnover (Stock, Debtors).
- ROI: Operating Profit ÷ Capital Employed. Business survives ONLY when ROI > Cost of Capital.
- EPS: (PAT − Pref Dividend) ÷ Equity Shares. Does NOT change with market price.
- P/E: Market Price ÷ EPS. DOES change with market price. High P/E = growth expectation.
- Fixed Assets Ratio: FA ÷ LT Funds. Should be ≤ 1. Ideal ≤ 0.67. > 1 = ST funds diverted to LT = BAD!
- D/E: LT Debt ÷ Shareholders’ Funds. Ideal = 1. FD from shareholders = DEBT (not equity!).
- Current Ratio: CA ÷ CL. Ideal 1.2–2. Exclude book debts > 6 months. Include prepaid expenses.
- Quick Ratio: (CA − Stock − Prepaid) ÷ CL. Above 1 = satisfactory. All CLs ARE taken (exam trap!).
- DSCR: Cash profit ÷ (Interest + Principal). Used by BANKERS for term loans. Higher = safer.
- Pay current liability when CR=2 → CR IMPROVES! Collect debtors → NO change. Buy fixed asset cash → CR falls.
- D/E is indicator of SOLVENCY (not profitability!). Higher D/E ≠ higher profit margin.
- High current ratio ≠ efficient management (could mean idle funds!). It’s a LIQUIDITY indicator.
- Debtors turnover HIGHER if MORE sales on CREDIT = FALSE! Higher turnover = faster collection.
- While calculating Quick ratio, ALL CLs are taken. “Not all CLs” = WRONG!
- Fixed Assets Ratio: Ratio of fixed assets to LONG-TERM FUNDS (not net worth!). Exam trap!
- Window dressing = manipulating accounts to show better picture. Distorts ratios.
📝 Past Exam Questions
Memory Tricks
🧠 Trick 1
Solvency, Turnover!”
P = How much you EARN 💰
S = Can you PAY debts? 🏦
T = How FAST money moves 🔄
🧠 Trick 2
(doesn’t change with market price!)
P/E = MARKET opinion 📈
(changes with market price!)
EPS × P/E = Market Price!”
🧠 Trick 3
CR goes UP! ⬆️ (from 2 to 3)
Collect debtors? NO CHANGE 🔄
Buy fixed asset for cash?
CR goes DOWN ⬇️”
🧠 Trick 4
= Short-term money used for LONG-term!
FA Ratio ≤ 0.67 = IDEAL ✅
= Part of WC financed by LT funds”
🧠 Trick 5
REPAY the loan? 🏦
Cash Profit ÷ (Interest + EMI)
Higher = Safer! ≥ 1.5 = OK”
🧠 Trick 6
Slow = Stock + Prepaid
Quick = (CA − Stock − Prepaid) ÷ CL
ALL CLs are taken! (No exclusions!)”
🧠 Trick 7
= DEBT! (Not equity!) 💰
It’s BORROWED money!
Must be REPAID!
Include in D/E as DEBT!”
🧠 Trick 8
They show TEMPERATURE
but NOT the DISEASE!
Need MORE investigation!
They’re INDICATORS, not PROOF!”
Last-Minute Flash Cards
⚡ Module C • Chapter 2 (Unit 20) Done!
- 3 Categories (PST): Profitability (ROI, EPS, P/E, GP, NP), Solvency (FA ratio, D/E, Current, Quick, DSCR), Turnover (Stock, Debtors).
- ROI > Cost of Capital = business viable. EPS doesn’t change with market. P/E does.
- Current Ratio: 1.2-2 ideal. Pay liability → improves. Quick = CA − Stock − Prepaid ÷ CL.
- D/E: Ideal 1. FD from shareholders = DEBT. Measures SOLVENCY, not profitability.
- FA Ratio > 1 = RED FLAG (ST funds diverted to LT). Ideal ≤ 0.67. FA ÷ LT Funds (not TNW!).
- DSCR: Banker’s tool. Cash profit ÷ (Interest + EMI). Higher = safer. ≥ 1.5 = OK.
- Ratios = thermometer, not diagnosis. Indicators, not proof. Window dressing distorts.
Banky says: “PST = Profitability, Solvency, Turnover! DSCR = my best friend for loans! FA Ratio > 1 = red flag! D/E ideal = 1! Now I have X-RAY VISION for any Balance Sheet!” 🎉📊🔬
Next: Chapter 21 — Financial Mathematics: Calculation of Interest and Annuities! 💪