LEARNING OUTCOME

L8 - Understand the relevance of Ratio

Analysis to know the financial performance
of a business
Meaning of Ratio:

It is the quantitative relation between two amounts

showing the number of times one value contains or is
contained within the other

Liabilities

Assets
Meaning and Scope of Ratio analysis :

Powerful and most commonly used tool to analyze and interpret financial
statements. It helps to analyze past performance of company for making
future projections.

It helps various interested parties, like management, shareholders, potential

investors, creditors, government and other analysts to make an evaluation
of various aspects of company’s performance from their own point of view
and interest.
Ratio analysis compares relationships between financial
statement accounts. This means that one income statement or
balance sheet account is being compared to another. These
relationships between financial statement accounts will not only
give a manager or investor an idea of the how healthy the
business is on a whole, it will also give them keen insights
into business operations.
Example:

Inventory turnover is the ratio between cost of goods sold and average
inventory. It tells managers and investors not only how much inventory the
company maintained, it also tells them how efficient the company was with
its inventory.

A high inventory turnover ratio means that the company is lean and is able
to move its inventory quickly. This could indicate proper management and
thoughtful inventory purchasing.

The opposite is true about a low inventory turnover. A low inventory

turnover usually means either that companies buy too much inventory or
they have problems selling it. Neither of these facts indicate a healthy
business.
Scope:

1) Judging Profitability

2) Judging Liquidity

3) Judging Solvency

4) Judging efficiency of Management

5) Inter Firm Comparisons

6) Forecasting and Budgeting

Source: text book 14.3-14.4 pg

Advantages:

1) Helps to understand efficacy of decisions

2) Simplify complex figures and establish relationships

3) Helpful in comparative analysis

4) Identification of problem areas

5) Enables SWOT analysis

6) Various comparisons

Source: http://www.ncert.nic.in/NCERTS/l/leac205.pdf
Limitations:

1) Historical

2) Inflation

3) Aggregation

4) Operational Changes

5) Accounting Policies

6) Business Conditions

7) Interpretation

8) Company Strategy

9) Point in time

Source: https://www.accountingtools.com/articles/what-are-the-limitations-of-ratio-

analysis.html
Users of ratio:

1) Management

2) Shareholders

3) Creditors

4) Purchasers of business

5) Government

6) Other Interested Groups

CLASSIFICATION OF RATIOS
• Analysis of Short Term Financial Position
or Test of Liquidity.
• Analysis of Long Term Financial Position
or Test of Solvency.
• Activity Ratios.
• Profitability Ratios.
Important Ratios In Test Of
Liquidity

•Current ratio.

•Quick ratio.
 CURRENT RATIO
It is the most widely used of all analytical devices based on
the balance sheet. It establishes relationship between total
current assets and current liabilities.

Current Ratio = Current assets / Current

Liabilities

Ideal ratio: 2:1

High ratio indicates under trading and over
capitalization .Low ratio indicates over trading
and under capitalization
• Calculate Current Ratio from the following
information:

Inventories…………………………………………….
50,000
Trade receivables…………………………………..
50,000
Advance
tax……………………………………………. 4,000
Cash and cash equivalents…………………….
30,000
Trade payables……………………………………
1,00,000
Short-term borrowings (bank overdraft)…. 4,000
Current Assets = Inventories + Trade receivables + Advance tax + Cash
and cash equivalents
= Rs. 50,000 + Rs. 50,000 + Rs. 4,000 + Rs. 30,000
= Rs. 1,34,000

Current Liabilities = Trade payables + Short-term borrowings

= Rs. 1,00,000 + Rs. 4,000
= Rs. 1,04,000
Current Ratio = 1.29:1
• A very high current ratio implies heavy investment in current assets
which is not a good sign as it reflects under utilisation or improper
utilisation of resources.

• A low ratio endangers the business and puts it at risk of facing a

situation where it will not be able to pay its short-term debt on time. If
this problem persists, it may affect firms credit worthiness adversely.

• Normally, it is safe to have this ratio within the range of 2:1.

• The excess of current assets over current liabilities provides a

measure of safety margin available against uncertainty in realisation of
current assets and flow of funds.

• The ratio should be reasonable. It should neither be very high or very

low.
QUICK RATIO
 QUICK RATIO
Also known as Acid Test or liquid ratio. It shows the
ability of business to meet its immediate financial
commitments

Quick Ratio = Quick Assets/ Quick

Liabilities

Quick ratio of 1:1 is considered satisfactory

Quick assets are current assets minus stock and prepaid assets
and Quick Liabilities are all current liabilities except Bank
overdraft
Calculate Quick Ratio from the following information:

Inventories……………………………………………. 50,000
Trade receivables………………………………….. 50,000
Advance tax……………………………………………. 4,000
Cash and cash equivalents……………………. 30,000
Trade payables…………………………………… 1,00,000
Short-term borrowings (bank overdraft)…. 4,000
Quick Assets = Current assets – (Inventories + Advance
tax)
= Rs. 1,34,000 – (Rs. 50,000 + Rs. 4,000)
= Rs. 80,000

Current Liabilities = Rs. 1,04,000

Quick Ratio = 0.77 :1

It is advocated to be safe to have a ratio of 1:1
as unnecessarily;
low ratio will be very risky and a high ratio
suggests unnecessarily deployment of
resources in otherwise less profitable short-
term investments.
 Numerical
• Calculate ‘Liquidity Ratio’ from the following
information:
Current liabilities = Rs. 50,000
Current assets(including all other assets
mentioned) = Rs. 80,000
Inventories = Rs. 20,000
Advance tax = Rs. 5,000
Prepaid expenses = Rs. 5,000
 Numerical
The following is the balance sheet of AB & Co. as on 30 June
2018:
Liabilities Amount Assets Amount
Equity capital 300000 Land and Building 150000
Creditors 48000 Plant and Machinery 85000
Bills payable 10000 Short term investment 16000
Bills overdraft 5000 Stock 50000
Outstanding Expenses 2000 Debtors 59000
Prepaid expenses 1000
Cash in hand 4000
365000 365000

Calculate Current and Quick Ratio and comment on company’s

liquidity position.
 Numerical
• X Ltd., has a current ratio of 3.5:1 and
quick ratio of 2:1. If excess of current
assets over quick assets represented by
inventories is Rs. 24,000, calculate current
assets and current liabilities.
 Solution
Current Ratio = 3.5:1

Quick Ratio = 2:1

Let Current liabilities = x

Current assets = 3.5x and Quick assets = 2x

Inventories = Current assets – Quick assets

24,000 = 3.5x – 2x
24,000 = 1.5x
x = Rs.16,000
Current Liabilities = Rs.16,000
Current Assets = 3.5x = 3.5 × Rs. 16,000 = Rs. 56,000.

Verification : Current Ratio = Current assets : Current liabilities =

Rs. 56,000 : Rs. 16,000 = 3.5 : 1

Quick Ratio = Quick assets : Current liabilities = Rs. 32,000 : Rs.

16,000 = 2 : 1
MULTIPLE CHOICE
QUESTIONS
Liquidity ratios are expressed in

a) Pure ratio form

b) Percentage
c) Rate or time
d) None of the above
Which of the following statements are true about Ratio
Analysis?
A) Ratio analysis is useful in financial analysis.
B) Ratio analysis is helpful in communication and coordination
C) Ratio Analysis is not helpful in identifying weak spots of the
business.
D) Ratio Analysis is helpful in financial planning and
forecasting.

a) A, B and D
b) A, C and D
c) A, B and C
d) A, B , C, D
The ideal level of current ratio is

a) 4:2
b) 2:1
c) Both a and b
d) None of the above
• Liquid ratio is also known as

a) Quick ratio
b) Acid test ratio
c) Working capital ratio
d) Stock turnover ratio

a) A and B
b) A and C
c) B and C
d) C and D
The ideal level of liquid ratio is

a) 3:3
b) 4:4
c) 5:5
d) All of the above
Quick ratio is 1.8:1, current ratio is 2.7:1
and current liabilities are Rs 60,000.
Determine value of stock.

a) Rs 54,000
b) Rs 60,000
c) Rs 1, 62,000
d) None of the above
Calculate the current ratio from the following
information:
Total assets = Rs. 3,00,000
Non-current liabilities = Rs. 80,000
Shareholders’ Funds = Rs. 2,00,000
Non-Current Assets:
Fixed assets = Rs. 1,60,000
Non-current Investments = Rs. 1,00,000
Total assets = Non-current assets + Current assets
Rs. 3,00,000 = Rs. 2,60,000 + Current assets
Current assets = Rs. 3,00,000 – Rs. 2,60,000 = Rs. 40,000

Total assets = Equity and Liabilities

= Shareholders’ Funds + Non-current liabilities +
Current liabilities
Rs. 3,00,000 = Rs. 2,00,000 + Rs. 80,000 + Current Liabilities
Current liabilities = Rs. 3,00,000 – Rs. 2,80,000 = Rs. 20,000
1. Current liabilities of a company are Rs.
5,60,000, current ratio is 2.5:1 and quick
ratio is 2:1.
Find the value of the Inventories.
2. Current ratio = 4.5:1, quick ratio = 3:1.
Inventory is Rs. 36,000.

Calculate the current assets and current

liabilities.
3. Current assets of a company are Rs.
5,00,000. Current ratio is 2.5:1 and Liquid
ratio is 1:1.

Calculate the value of current liabilities,

liquid assets and inventories.
From the following information, if Rs 1000 is
paid to creditors what will be the effect
(increase or decrease or no change) on
current ratio, if before payment, balances
are : Cash Rs 15000, Creditors Rs 7,500?
The balance sheet of ABCD Ltd. shows the following
figures :
Share capital ………………………………..Rs 152,000
Cash in hand and at Bank ………………….Rs 30,000
Fixed Assets ………………………………...Rs 113,000
Creditors ……………………………………..Rs 20,000
5% Debentures ………………………………Rs 24,000
Bill Payables …………………………………..Rs 4,000
Debtors ……………………………………….Rs 18,000
Stock ………………………………………….Rs 52,000
General reserve ……………………………….Rs 8,000
Profit and Loss A/c …………………………….Rs 5,000
Calculate (i) current ratio and (ii) liquid ratio
Calculate liquidity ratios from the following
information :

Total current assets ……………………..Rs 90,000

Stock (included in current assets) ……..Rs 30,000
Prepaid exp (included in current assets).Rs 3,000
Current liabilities …………………………Rs 60,000
Calculate liquidity ratio from the following :
Sundry debtors………………………….. 4,00,000
Stock ………………………………………160,000
Marketable securities……………………. 80,000
Cash………………………………………. 120,000
Prepaid expenses ………………………….40,000
Bill payables……………………………….. 80,000
Sundry creditors………………………….. 160,000
Debentures …………………………………200,000
Outstanding Expenses……………………160,000