Ratio analysis

In short

Ratio analysis expresses one figure from the financial statements as a relationship with another - a quotient, a percentage or a number of times/days - so that size is stripped away and performance becomes comparable across years and across firms. It converts the Balance Sheet, Statement of Profit and Loss and cost records into usable signals on liquidity, solvency, efficiency and profitability, and is the backbone of credit appraisal, management reporting and investment analysis. Since the Schedule III amendment effective FY 2021-22, every company reporting under Schedule III Divisions I-II must disclose eleven specified ratios in the notes to accounts, with an explanation for any change exceeding 25%. It carries heavy marks in B.Com, M.Com, CA Inter and CMA papers (both numerical and "comment on the position" questions) and is asked in almost every finance, audit, FP&A, credit and equity-research interview in India.

Explained

Meaning, objectives and the process

• A ratio is an arithmetical relationship between two accounting figures; ratio analysis is the interpretation of that relationship. Three forms: pure ratio (2.5 : 1), percentage (gross profit 25%), times/rate (stock turnover 7.5 times, 48 days).
• Objectives: measure short-term and long-term solvency, judge operating efficiency, assess earning capacity, locate weaknesses, help forecasting and control, and standardise comparison.
• Steps: (1) select the objective and the user; (2) extract comparable figures (restate for Ind AS/Schedule III regroupings); (3) compute the ratio; (4) compare against a standard - past years (trend/intra-firm), other firms or industry median (inter-firm), or budget/standard; (5) interpret jointly, never in isolation; (6) report with the cause of variance.
• A ratio is meaningful only if the two figures are logically related and drawn on a consistent basis (cost of goods sold against inventory at cost; credit sales against trade receivables).
• Averages vs closing figures: turnover ratios should use average balances (opening + closing)/2; use closing only when the opening figure is not given - state the assumption.
• Allied tools: comparative statements, common-size statements (every item as % of revenue or of total assets), trend percentages (base year = 100), fund/cash flow analysis and cost ratios.

Classification of ratios

• By statement: Balance Sheet ratios (current, quick, debt-equity, proprietary); Revenue Statement ratios (gross profit, operating, net profit, interest coverage); composite/inter-statement ratios (ROCE, turnover ratios, ROE) - these mix a flow with a stock.
• By function: liquidity (short-term solvency), solvency/leverage (long-term), activity/turnover (efficiency), profitability (in relation to sales, to investment, to shares), market/valuation.
• By user: short-term creditors - current and quick; debenture holders and bankers - debt-equity, DSCR, interest coverage; management - turnover, operating, cost ratios; shareholders - ROE, EPS, dividend payout.

Liquidity and short-term solvency

• Current ratio = current assets ÷ current liabilities. Rule-of-thumb 2 : 1 (bankers often accept 1.33 : 1 for working-capital finance). Too high means idle inventory, slow debtors or surplus cash.
• Quick/acid-test/liquid ratio excludes inventory and prepaid expenses; norm 1 : 1. A high current ratio with a low quick ratio points to inventory build-up.
• Absolute liquid/cash ratio = (cash + bank + marketable securities) ÷ current liabilities; norm about 0.5 : 1.
• Defensive interval = quick assets ÷ average daily cash operating expenses (days a firm can survive without fresh inflow).
• Working capital = CA − CL (an absolute figure, not a ratio); net capital turnover = revenue ÷ working capital.
• Window dressing: when the current ratio is above 1, paying off a creditor just before the year-end raises it (and lowers it when below 1); so support it with turnover ratios and the operating cycle.

Solvency, leverage and coverage

• Debt-equity ratio = long-term debt ÷ shareholders' funds (an alternative base is total debt ÷ equity - state which). Norm 2 : 1 for industry, lower for services; Schedule III uses total debt ÷ total equity.
• Proprietary ratio = shareholders' funds ÷ total assets; capital gearing = (preference capital + debentures + other fixed-cost funds) ÷ equity shareholders' funds. High gearing = trading on equity: it magnifies ROE when ROCE exceeds the rate of interest on borrowed funds, and magnifies losses when it does not.
• Interest coverage (times interest earned) = EBIT ÷ interest; DSCR = (PAT + depreciation + interest on term loan + non-cash charges) ÷ (interest on term loan + instalment of principal). Term lenders typically look for DSCR of about 1.5-2 and an average over the loan tenure; banks also test fixed asset coverage and TOL/TNW (total outside liabilities to tangible net worth).
• Fixed assets to long-term funds < 1 shows part of the long-term funds supports working capital - a sound position; > 1 means short-term funds have financed fixed assets.
• Shareholders' funds for these ratios = equity + preference + reserves and surplus, less debit balance of P&L and (in traditional computation) intangibles/deferred revenue expenditure for *tangible* net worth.

Activity / turnover ratios and the operating cycle

• Inventory turnover = cost of goods sold ÷ average inventory → holding period = 365 ÷ turnover. Compute separately for raw material (on raw material consumed), WIP (on cost of production) and finished goods (on cost of goods sold).
• Trade receivables turnover = net credit sales ÷ average trade receivables → collection period; trade payables turnover = net credit purchases ÷ average trade payables → payment period.
• Fixed asset turnover = revenue ÷ average net fixed assets; total asset turnover = revenue ÷ average total assets; capital turnover = revenue ÷ capital employed.
• Gross operating cycle = raw material + WIP + finished goods + receivables days; net operating (cash conversion) cycle = gross cycle − payables days. A shorter cycle releases working capital - the direct link between management accounting and cash.
• Interpretation: high turnover = efficient use of resources, but an abnormally high stock turnover may mean stock-outs, and a very short collection period may mean credit terms are losing sales.

Profitability and market ratios

• On sales: gross profit ratio = GP ÷ revenue from operations; operating ratio = (COGS + operating expenses) ÷ revenue; operating profit ratio = 100 − operating ratio; net profit ratio = PAT ÷ revenue; individual expense ratios (material, labour, factory overhead, selling and distribution, finance cost as % of revenue) isolate the cause of a margin slide.
• On investment: ROCE (return on investment) = EBIT ÷ capital employed, where capital employed = shareholders' funds + long-term debt = total assets − current liabilities (liability side), or net fixed assets + investments + working capital (asset side) - both must agree. ROE = (PAT − preference dividend) ÷ equity shareholders' funds. RONW = PAT ÷ net worth (ROE under another name); ROA = PAT (or PAT + interest) ÷ average total assets.
• DuPont decomposition: ROE = net profit margin × total asset turnover × equity multiplier; equivalently ROCE = operating profit margin × capital turnover. This tells management *whether* a weak return is a margin problem or a turnover problem - the single most useful interview-level insight.
• For shareholders: EPS = (PAT − preference dividend) ÷ number of equity shares (AS 20 / Ind AS 33 require basic and diluted EPS, using the weighted average number of shares); DPS; dividend payout = DPS ÷ EPS; retention ratio = 1 − payout; dividend yield = DPS ÷ market price; earnings yield; P/E ratio = market price ÷ EPS; book value per share; price-to-book.

Indian reporting framework, standards and limitations

• Schedule III to the Companies Act, 2013 (amended, effective 1 April 2021) mandates disclosure of eleven ratios in the notes: current ratio, debt-equity, debt service coverage, return on equity, inventory turnover, trade receivables turnover, trade payables turnover, net capital turnover, net profit ratio, return on capital employed and return on investment - with numerator, denominator and an explanation for any variance of more than 25% from the previous year.
• Other Indian uses: SEBI (LODR) Regulations, 2015 require ratio-based disclosures by listed entities; RBI prescribes CRAR under Basel III (minimum 9% plus capital conservation buffer for Indian banks - the applicable buffer phases have been revised from time to time, so check the current RBI master direction), GNPA/NNPA, PCR, CD ratio, LCR and NSFR; IRDAI prescribes a solvency margin of 1.5 times; CMA data formats of banks are built entirely on ratios; IBC/NCLT stress tests use DSCR and leverage. Cost records and cost audit under the Companies (Cost Records and Audit) Rules, 2014 require ratio-type cost data (capacity utilisation, material cost %, value addition).
• Advantages: simplifies mass data; enables inter-firm and inter-period comparison; aids forecasting, budgetary control and ratio-based cost control; locates the cause of change; useful for credit rating and valuation.
• Limitations: only as reliable as the statements behind them (window dressing, estimates, creative accounting); historical and therefore backward-looking; ignores price-level changes (an old asset base inflates ROCE); non-comparable when accounting policies, depreciation methods or year-ends differ; no single ratio is conclusive; qualitative factors (management quality, order book, brand) are missed; a ratio has no meaning without a standard; seasonal year-end figures distort turnover ratios.

Key points

• Ratio - arithmetical relationship between two related accounting figures, shown as pure ratio, percentage or times/days.
• Current ratio - CA ÷ CL; norm 2 : 1, bankers' comfort 1.33 : 1; tests short-term solvency.
• Quick ratio - (CA − inventory − prepaid) ÷ CL; norm 1 : 1; the sharper liquidity test.
• Window dressing - repaying a current liability lifts a current ratio already above 1; cross-check with the operating cycle.
• Debt-equity - long-term debt ÷ shareholders' funds; 2 : 1 traditional norm; measures the cushion for lenders.
• Proprietary ratio - owners' funds ÷ total assets; the higher, the safer for creditors.
• Interest coverage - EBIT ÷ interest; DSCR adds principal repayment in the denominator and depreciation back in the numerator.
• Trading on equity - using fixed-cost debt to raise ROE; pays only while ROCE > the rate of interest on debt.
• Inventory turnover - COGS ÷ average inventory; convert to days by 365 ÷ turnover.
• Net operating cycle - inventory days + receivable days − payable days; the working capital a firm must finance.
• Operating ratio - (COGS + operating expenses) ÷ revenue; its complement is the operating profit ratio.
• ROCE - EBIT ÷ (shareholders' funds + long-term debt); the primary test of overall efficiency, independent of financing mix.
• ROE - PAT less preference dividend ÷ equity shareholders' funds; what the owner earns.
• DuPont - ROE = margin × asset turnover × equity multiplier; separates pricing, efficiency and leverage.
• EPS and P/E - EPS per AS 20/Ind AS 33 on weighted average shares; P/E = market price ÷ EPS, a valuation multiple, not a performance ratio.
• Schedule III (from FY 2021-22) - eleven mandatory ratios in the notes, with numerator, denominator and reasons for variance above 25%.
• Limitations - historical data, price-level changes, differing accounting policies, single-ratio fallacy, qualitative factors ignored.

Formulas and examples

Example 1 - Liquidity and the window-dressing effect. Inventories ₹6,00,000; trade receivables ₹4,50,000; cash and bank ₹1,50,000; prepaid expenses ₹30,000; trade payables ₹3,20,000; short-term borrowings ₹1,80,000; other current liabilities ₹1,00,000.

• CA = 6,00,000 + 4,50,000 + 1,50,000 + 30,000 = ₹12,30,000; CL = 3,20,000 + 1,80,000 + 1,00,000 = ₹6,00,000.
• Current ratio = 12,30,000 ÷ 6,00,000 = 2.05 : 1; working capital = ₹6,30,000.
• Quick assets = 12,30,000 − 6,00,000 − 30,000 = ₹6,00,000 → quick ratio = 1.00 : 1; absolute liquid ratio = 1,50,000 ÷ 6,00,000 = 0.25 : 1.
• Now pay ₹1,00,000 of trade payables out of cash: CA = ₹11,30,000, CL = ₹5,00,000 → current ratio = 2.26 : 1, while quick ratio = 5,00,000 ÷ 5,00,000 = 1.00 : 1 (unchanged). Liquidity has not improved - only the ratio has.

Example 2 - Turnover ratios and operating cycle. Revenue ₹60,00,000 (credit sales ₹54,00,000); COGS ₹45,00,000; credit purchases ₹40,00,000; inventory ₹5,00,000 → ₹7,00,000; receivables ₹6,00,000 → ₹8,00,000; payables ₹4,00,000 → ₹6,00,000.

• Average inventory ₹6,00,000 → turnover = 45,00,000 ÷ 6,00,000 = 7.5 times; holding period = 365 ÷ 7.5 = 48.7 days.
• Average receivables ₹7,00,000 → turnover = 54,00,000 ÷ 7,00,000 = 7.71 times; collection period = 7,00,000 × 365 ÷ 54,00,000 = 47.3 days.
• Average payables ₹5,00,000 → turnover = 40,00,000 ÷ 5,00,000 = 8 times; payment period = 45.6 days.
• Gross operating cycle = 48.7 + 47.3 = 96.0 days; net operating cycle = 96.0 − 45.6 = 50.4 days of working capital to be financed.

Example 3 - Profitability, DuPont and market ratios. Revenue ₹60,00,000; COGS ₹45,00,000; operating expenses ₹7,00,000; interest ₹1,50,000; tax 25%. Equity share capital ₹20,00,000 (2,00,000 shares of ₹10); reserves ₹10,00,000; long-term debt ₹15,00,000; current liabilities ₹6,00,000; total assets ₹51,00,000; market price ₹50; dividend ₹1 per share.

• GP = ₹15,00,000 → GP ratio 25%. EBIT = 15,00,000 − 7,00,000 = ₹8,00,000. Operating ratio = 52,00,000 ÷ 60,00,000 = 86.67%; operating profit ratio = 13.33%.
• PBT = 8,00,000 − 1,50,000 = ₹6,50,000; tax = ₹1,62,500; PAT = ₹4,87,500 → net profit ratio = 8.13%.
• Capital employed = 30,00,000 + 15,00,000 = ₹45,00,000 → ROCE = 8,00,000 ÷ 45,00,000 = 17.78%; ROE = 4,87,500 ÷ 30,00,000 = 16.25%.
• DuPont: 0.0813 × (60,00,000 ÷ 51,00,000 = 1.176) × (51,00,000 ÷ 30,00,000 = 1.70) = 16.25% ✓.
• Debt-equity = 15 ÷ 30 = 0.50 : 1; interest coverage = 8,00,000 ÷ 1,50,000 = 5.33 times.
• EPS = 4,87,500 ÷ 2,00,000 = ₹2.44; P/E = 50 ÷ 2.44 = 20.5 times; payout = 1 ÷ 2.44 = 41%; yield = 2.0%; BVPS = ₹15 → P/B = 3.33.

Example 4 - Reconstructing the statements from ratios (classic exam pattern). Current ratio 2.5, quick ratio 1.5, current liabilities ₹4,00,000, stock turnover 6 times on closing stock, gross profit 20% of sales, credit sales 80% of sales, collection period 36.5 days.

• CA = 2.5 × 4,00,000 = ₹10,00,000; quick assets = 1.5 × 4,00,000 = ₹6,00,000 → inventory = ₹4,00,000; working capital = ₹6,00,000.
• COGS = 6 × 4,00,000 = ₹24,00,000; since GP is 20% of sales, COGS = 80% of sales → sales = 24,00,000 ÷ 0.8 = ₹30,00,000; GP = ₹6,00,000.
• Credit sales = ₹24,00,000 → debtors = 24,00,000 × 36.5 ÷ 365 = ₹2,40,000; cash and bank = 6,00,000 − 2,40,000 = ₹3,60,000.
• Working capital turnover = 30,00,000 ÷ 6,00,000 = 5 times.

Example 5 - DSCR and two routes to the same ROCE. PAT ₹18,00,000; depreciation ₹7,00,000; interest on term loan ₹5,00,000; annual principal instalment ₹12,00,000 → DSCR = (18 + 7 + 5) ÷ (5 + 12) = 30 ÷ 17 = 1.76 times - acceptable to most term lenders.

Where it is used

• Bank and NBFC credit appraisal: SBI, HDFC Bank, Bajaj Finance and others build CMA data and sanction notes on current ratio, TOL/TNW, DSCR and turnover ratios; MSME loans under CGTMSE are screened the same way.
• Credit rating and bond markets: CRISIL, ICRA and CARE Ratings score leverage, coverage and profitability ratios to assign ratings that drive borrowing cost.
• Equity research, investment banking and PE/VC: margin, ROCE, ROE, working-capital and P/E comparisons across listed peers; red flags such as receivables growing faster than revenue.
• Corporate FP&A, MIS and management accounting: monthly dashboards of segment ROCE, contribution ratios, inventory days and expense-to-revenue ratios for responsibility reporting and working-capital control.
• Statutory and internal audit: analytical procedures under SA 520 use ratio comparisons to spot misstatement; Schedule III ratio disclosure and cost records/cost audit reporting.
• Job roles: credit analyst, financial analyst, management trainee (finance), internal auditor, CA/CMA articleship, treasury and working-capital managers; also the staple of bank PO and SEBI/RBI Grade B descriptive papers.

Interview questions

• Q: A company has a current ratio of 3 but a quick ratio of 0.7 - what do you conclude? A: Current assets are dominated by inventory (and possibly prepaid items), so despite the comfortable current ratio the firm may struggle to pay bills immediately; check inventory days for slow-moving or obsolete stock.
• Q: Which is a better measure of overall performance - ROCE or ROE? A: ROCE, because it measures the return on all long-term funds before the effect of financing mix and tax, making it comparable across firms; ROE is the owner's return and is inflated by leverage.
• Q: What is trading on equity and when does it hurt? A: Financing with fixed-cost debt to raise the equity return; it hurts when ROCE falls below the rate of interest on debt, because the shortfall is borne entirely by equity.
• Q: Why might a rising inventory turnover not be good news? A: It can arise from stock-outs or distress selling at low margins; read it with the gross profit ratio and lost-sales data.
• Q: Difference between interest coverage and DSCR? A: Interest coverage covers only interest out of EBIT; DSCR covers interest plus principal repayment out of cash profit, so it is the stricter test used by term lenders.
• Q: Two firms have identical net profit ratios but very different ROEs - why? A: Different asset turnover, different leverage, or both - the DuPont identity separates the three drivers.
• Q: How does an average vs closing balance change a turnover ratio? A: A fast-growing firm's closing inventory or receivables are higher, so using closing figures understates turnover and overstates days; averages smooth this.
• Q: What does Schedule III now require on ratios? A: Disclosure of eleven specified ratios with their numerator and denominator, plus an explanation for any variance of more than 25% against the previous year - effective from FY 2021-22.
• Q: Does a sale of goods on credit change the current ratio? A: Yes if sold at a profit - current assets rise by the sale value while inventory falls by cost, so CA increase and the ratio improves; at cost there is no change.
• Q: Can a profitable company go insolvent? A: Yes - profit is accrual-based while solvency depends on cash; a long operating cycle, blocked receivables or heavy principal repayments can starve a profitable firm of cash.
• Q: Why is comparing ROCE of a 30-year-old plant with a new one misleading? A: The old plant's book value is heavily depreciated and stated at historical cost, so the denominator is understated and ROCE flattered; price-level change is ignored.
• Q: Which ratios would you check first for a possible receivables fraud? A: Receivables turnover and collection period against past years and peers, revenue growth versus receivables growth, and the ageing schedule with provision for doubtful debts.

Common mistakes

• Mixing bases - using total sales instead of credit sales for debtors turnover, or revenue instead of COGS for inventory turnover.
• Using closing balances when opening figures are available, or averaging a flow figure (revenue, COGS) instead of the stock figure.
• Treating prepaid expenses as a quick asset, or including short-term investments in inventory; omitting short-term borrowings and current maturities of long-term debt from current liabilities.
• Getting capital employed wrong - including current liabilities, or forgetting to deduct non-trade investments and fictitious assets; the liability-side and asset-side computations must tally.
• Using PAT instead of EBIT in ROCE and interest coverage, or forgetting to deduct preference dividend in ROE and EPS.
• Quoting days without stating the base (365 or 360) and losing marks on consistency, or reporting a pure ratio as a percentage.
• Judging a firm on one ratio, without a standard or trend, and writing an interpretation that merely restates the number instead of giving the cause.

Related topics

Working capital management · Cash flow statement · Marginal costing and break-even analysis · Budgeting and standard costing · Financial statement analysis and common-size statements · Company final accounts under Schedule III