Ratio Analysis- Major ratios

Nowadays, stock market plays the important role in raising finance and also helps investors to get income more than bank interest if wisely invested. In order to help investors as well as accounts layman, I am giving below some of the important ratios to check the efficiency of any company:

Ratio analysis is a tool for measuring a firm’s liquidity, profitability, efficiency and use of debt funds for growth etc.

Current ratio:

Current Assets/ Current liabilities

IF current assets in the balance sheet is 200 and current liabilities is 100 , then the ratio will be 2:1

Normally 2:1 is considered to be optimum. But this differs according to industry.

This vouches the capacity of the firm to meet obligations. Current Assets are company’s own property which can be encashed within a short span of time. Liabilities are its payments due within a short  span of one year. If a company has sufficient current assets to meet current liabilities in case of any emergency, it is called a good solid company.

Liquid ratio:

This is similar to above . The only difference is that in current assets, the stocks are excluded. For example, if the current assets excluding the stock comes to 150 as compared to current liabilities of 100, then the ratio is 1.5 :1.

This is further certifying about companye’s ability to meet the short term liabilities at short notice. The stocks take time to get encashed. Hence the stock is excluded for this purpose.

The ideal ratio is 1: 1.

This ratio is also called acid test ratio.

Inventory turn over ratio:

Cost of goods sold/average inventory

The average inventory is (op. stock+cl.stock)/2

The above ratio shows how the inventory or stock of the company moves from stock to cash. For example, if the cost of goods sold is 100 and average inventory is 20, then the inventory turn over ratio will be 5. It means that the stock is converted into cash 5 times within the time period of calcuation. The positive big number indicates good turnover of stock into cash and it is a good sign. Low number indicates poor turn over of stock. The optimum  ratio number depend on industry and the time taken to convert raw materials into finished goods in optimum standard time.

Total asset Turn over ratio:

Sales/average total assets

The sales refer here is net sales.

It shows the capacity of the assets to generat the sales.If the number is more, it is good. If net sales is 200 and average total assets is 100 ( opening total assets plus closing assets/2), then the total asset turn over is 2. This also depends on industry. Each firm should try to increase this ratio.

Profitability ratios:

These ratios show the profit earnig capacity of the firms or companies:

1.Gross Profit margin ratio:

Gross Profit margin/Sales *100

Gross profit is factory level profit without taking into account the office expenses .

If gross profit margin is 6000 and sales 18000, then gross profit margin is 33%.

More % means good profit potential.

Net Profit margin/Sales *100

Net profit is company level profit after taking into account the office and other  expenses .

If net  profit margin is 5000 and sales 18000, then gross profit margin is 28%.

More % means good profit potential. From the above two ratios, one can identify about the expenses % in non-factory expenses % which need to be controlled if high except for marketing companies.

Return on Equity ratio:

Net income/average equity

This shows how the company  earned return on equity capital or capital .

If the company net income is Rs.2000 and equity capital is Rs.10000, then return on equity capital is 20%. Pertinent point to note it here is that the return should be more than bank interest as the owner blocked his money for business

Return on investment ratio:

This is a broad ratio than equity ratio and includes in capital, all capital including equity, pref. equity, long term loans etc. Since business cannot be done without bank loan etc, it is also included if it is long term like more than 5 years etc.

C. R. Venkata Ramani




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