Ratio Analysis Definition – Meaning, Formulas and Importance

ratio analysis definition

Definition of Ratio Analysis

Ratio Analysis Definition – “A means of analyzing the information contained in the three financial statements. A financial ratio is two key numbers from a company’s financial statements expressed in relation to each other”.

In simple words, it analyzes the relationship of one variable with the other variable which appears in three financial statements. These statements are Balance Sheet, Income statement and Cash Flow statement.

This relationship is shown in term of percent or a quotient. Ratios are very important from the perspective of the stakeholders of the company  such as investors, banks, creditors, management and tax department. However the type of information among these parties may differ.

Creditors and banking institutions have more interest in knowing liquidity of the company. However, for management it is kind of report card which shows business efficiency , costs, profitability, etc.

Types of Ratios

Ratio in Ratio Analysis are broadly classified into four main groups. They are namely – Liquidity ratios, Working capital ratios, profitability ratio and Capital structure ratios.

Liquidity Ratios

  1. Current Ratio = Current Assets/ Current Liabilities
  2. Quick Ratio/ Acid-test = Quick Assets/ Current Liabilities
  3. Absolute Liquid = Absolute Liquid Assets/ Current Liabilities

Working Capital Ratios

  1. Asset Turnover = Net sales/ (Net fixed Assets + current assets)
  2. Net working capital = Net sales/ Net working capital
  3. Inventory Ratio = Net Sales/ Inventory
  4. Debtors Turnover = Total Sales/ Account Receivables
  5. Debt Collection = (Receivables /Net credit sales for the year) × months or day in a year
  6. Creditors turnover = Net credit purchases / Average accounts payable
  7. Average payment period = (Average trade creditors/ Net credit purchase) × 100
  8. Fixed Assets Turnover = Cost of goods sold / Total fixed assets
  9. Capital Turnover = Cost of sales/ capital employed

Profitability Ratios

  1. Gross Profit = (Gross Profit/ Net Sales) × 100
  2. Operating Cost = (Operating Cost/Net Sales) × 100
  3. Operating Profit  = [Operating Profit/ Sales(net) ]× 100
  4. Net Profit =  (Operating Profit/Net Sales) × 100
  5. Return on Investment Ratio = (Net Profit After Interest  And Taxes/ Shareholders Funds or                                                                         Investments) × 100
  6. Return on Capital Employed = (Profit after Taxes/ Gross Capital Employed) × 100
  7. Earnings Per Share = Profit After Tax & Preference Dividend /No of Equity Shares
  8. Dividend Pay Out  = (Dividend Per Equity Share/Earning Per Equity Share) × 100
  9. Earning Per Equity Share = Profit after Tax & Preference Dividend / No. of Equity Share
  10. Dividend Yield = (Dividend Per Share/ Market Value Per Share) × 100
  11. Price Earnings  = (Market Price Per Share Equity Share/ Earning Per Share) × 100
  12. Net Profit to Net Worth = (Net Profit after Taxes / Shareholders Net Worth) × 100

Capital Structure Ratios

  1. Debt Equity = Total Long Term Debts / Shareholders Fund
  2. Proprietary  = Shareholders Fund/ Total Assets
  3. Capital Gearing  = Equity Share Capital / Fixed Interest Bearing Funds
  4. Debt Service = Net profit Before Interest & Taxes / Fixed Interest Charges

Ratio Analysis Example

To understand Ratio analysis definition more clearly, let’s discuss an example. Suppose the current liabilities of XYZ are Rs. 50,000 and the Current Assets are Rs. 70,000.

Now the current Ratio will be 70,000/50,000 = 1.4

This implies that XYZ has the sufficient cash to pay off their obligations. However, the picture gets more clear after calculation quick ratio.

Importance of Ratio Analysis – Why Ratio Analysis is Used?

Without discussing the importance of ratios, Ratio Analysis definition is incomplete.

  • It is an important technique for analyzing the financial statements. This helps in understanding the financial position of the the company. This is very helpful from the view point of stake holders.
  • It tells about the company’s efficiency.
  • Though the ratios are for comparing past performance but can also used for predicting future trends.
  • Helps in comparing financial performance of tow or more organization.
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