Balance Sheet Ratio Analysis Formula

Important Balance Sheet Ratios measure liquidity and solvency (a business's ability to
pay its bills as they come due) and leverage (the extent to which the business is
dependent on creditors' funding). They include the following ratios:
Liquidity Ratios
These ratios indicate the ease of turning assets into cash. They include the Current
Ratio, Quick Ratio, and Working Capital.
Current Ratios. The Current Ratio is one of the best known measures of financial
strength. It is figured as shown below:
Total Current Assets
Current Ratio = ____________________
Total Current Liabilities
The main question this ratio addresses is: "Does your business have enough current
assets to meet the payment schedule of its current debts with a margin of safety for
possible losses in current assets, such as inventory shrinkage or collectable
accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a specific
ratio is satisfactory depends on the nature of the business and the characteristics of
its current assets and liabilities. The minimum acceptable current ratio is obviously
1:1, but that relationship is usually playing it too close for comfort.
If you decide your business's current ratio is too low, you may be able to raise it by:
• Paying some debts.
• Increasing your current assets from loans or other borrowings with a maturity
of more than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.
Quick Ratios. The Quick Ratio is sometimes called the "acid-test" ratio and is one of
the best measures of liquidity. It is figured as shown below:
Cash + Government Securities + Receivables
Quick Ratio = _________________________________________
Total Current Liabilities
The Quick Ratio is a much more exacting measure than the Current Ratio. By
excluding inventories, it concentrates on the really liquid assets, with value that is
fairly certain. It helps answer the question: "If all sales revenues should disappear,
could my business meet its current obligations with the readily convertible `quick'
funds on hand?"
An acid-test of 1:1 is considered satisfactory unless the majority of your "quick
assets" are in accounts receivable, and the pattern of accounts receivable collection
lags behind the schedule for paying current liabilities.
Working Capital. Working Capital is more a measure of cash flow than a ratio. The
result of this calculation must be a positive number. It is calculated as shown below:
Working Capital = Total Current Assets - Total Current Liabilities
Bankers look at Net Working Capital over time to determine a company's ability to
weather financial crises. Loans are often tied to minimum working capital
requirements.
A general observation about these three Liquidity Ratios is that the higher they are
the better, especially if you are relying to any significant extent on creditor money to
finance assets.
Leverage Ratio
This Debt/Worth or Leverage Ratio indicates the extent to which the business is
reliant on debt financing (creditor money versus owner's equity):
 Total Liabilities
Debt/Worth Ratio = _______________
Net Worth
Generally, the higher this ratio, the more risky a creditor will perceive its exposure in
your business, making it correspondingly harder to obtain credit.
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Income Statement Ratio Analysis
The following important State of Income Ratios measure profitability:
Gross Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the cost of goods
sold from net sales. It measures the percentage of sales dollars remaining (after
obtaining or manufacturing the goods sold) available to pay the overhead expenses of
the company.
Comparison of your business ratios to those of similar businesses will reveal the
relative strengths or weaknesses in your business. The Gross Margin Ratio is
calculated as follows:
Gross Profit
Gross Margin Ratio = _______________
Net Sales
(Gross Profit = Net Sales - Cost of Goods Sold)
Net Profit Margin Ratio
This ratio is the percentage of sales dollars left after subtracting the Cost of Goods
sold and all expenses, except income taxes. It provides a good opportunity to
compare your company's "return on sales" with the performance of other companies
in your industry. It is calculated before income tax because tax rates and tax
liabilities vary from company to company for a wide variety of reasons, making
comparisons after taxes much more difficult. The Net Profit Margin Ratio is calculated
as follows:
Net Profit Before Tax
Net Profit Margin Ratio = _____________________
Net Sales
Management Ratios
Other important ratios, often referred to as Management Ratios, are also derived from
Balance Sheet and Statement of Income information.
Inventory Turnover Ratio
This ratio reveals how well inventory is being managed. It is important because the
more times inventory can be turned in a given operating cycle, the greater the profit.
The Inventory Turnover Ratio is calculated as follows:
Net Sales
Inventory Turnover Ratio = ___________________________
Average Inventory at Cost
Accounts Receivable Turnover Ratio
This ratio indicates how well accounts receivable are being collected. If receivables
are not collected reasonably in accordance with their terms, management should
rethink its collection policy. If receivables are excessively slow in being converted to
cash, liquidity could be severely impaired. The Accounts Receivable Turnover Ratio is
calculated as follows:
Net Credit Sales/Year
__________________ = Daily Credit Sales
365 Days/Year
 Accounts Receivable
Accounts Receivable Turnover (in days) = _________________________
Daily Credit Sales
Return on Assets Ratio
This measures how efficiently profits are being generated from the assets employed
in the business when compared with the ratios of firms in a similar business. A low
ratio in comparison with industry averages indicates an inefficient use of business
assets. The Return on Assets Ratio is calculated as follows:
Net Profit Before Tax
Return on Assets = ________________________
Total Assets
Return on Investment (ROI) Ratio.
The ROI is perhaps the most important ratio of all. It is the percentage of return on
funds invested in the business by its owners. In short, this ratio tells the owner
whether or not all the effort put into the business has been worthwhile. If the ROI is
less than the rate of return on an alternative, risk-free investment such as a bank
savings account, the owner may be wiser to sell the company, put the money in such
a savings instrument, and avoid the daily struggles of small business management.
The ROI is calculated as follows:
Net Profit before Tax
Return on Investment = ____________________
Net Worth
These Liquidity, Leverage, Profitability, and Management Ratios allow the business
owner to identify trends in a business and to compare its progress with the
performance of others through data published by various sources. The owner may
thus determine the business's relative strengths and weaknesses.

RATIO ANALYSIS

Meaning & Definition

• Ratio: The term ratio refers to the numerical or quantitative relationship between
two items /variables.
• According to Wixon, Kell and Bedford, “a ratio is an expression of the quantitative
relationship between two numbers’
• Ratio Analysis: the process of determining and interpreting numerical relationship
b/w figures of the financial statements.

Nature of ratio analysis

• Powerful tool for financial analysis
• Helps analyze financial statements more clearly
• They are not deciding factor , rather help to take correct decisions.
• Serve as indicators of financial strength, soundness, weakness & position of a
concern
• Figures convey much meaning when studied in relation to one another

Inter-Firm & Intra-Firm comparison

• Inter-firm comparison refers to comparison of two or more firms organized by a
trade association with the objective of providing information regarding the
competitive position of participating companies to improve
productivity & profitability.
• Intra-firm comparison refers to the comparison of the different department or
divisions belonging to a single firm with a view of ascertaining the strength &
weaknesses of the different departments.

Conditions for inter-Firm comparison

• Similarities of firm – nature, size, age, capital, product…
• Uniformity in accounting procedure – inventory, depreciation
• Disclosure of information
• Use of accounting ratios for comparison.
• The success depends on cooperation of all participating firms, confidentiality, full
disclosure by all firms.

Advantages of Ratio analysis

• Important technique of financial analysis
• Helps in judging financial health of a firm
• Helps in decision-making
• Useful in simplifying accounting figures
• Useful in judging operating efficiency
• Useful in forecasting & planning
• Useful in locating weak areas
• Useful in in comparison of performance
• Useful to all stakeholders

Limitations of Ratio Analysis

• Limited use of a single ratio - Comparative study required
• Limitations of financial statements
• Only quantitative aspects
• Lack of adequate standards
• Problems of price level changes
• Changes in accounting procedures / polices
• Personal bias
• Ratios devoid of absolute figures may distort facts.

CLASIFICATIONOF RATIOS
Traditional Classification
Functional Classification
Significance
Ratios
a. Balance
sheet
Ratios
b. P & L A/C
Ratios
c. Composite
Ratios
a. Profitabilit
y Ratios
b. Turnover
Ratios
c. Liquidity
Ratios
d. Long-term
solvency /
Leverage
Ratios
a. Primary
Ratios
b. Secondary
Ratios

Profitability Ratios
Based on Sales
• Gross Profit ratio
• Operating ratio
• Operating profit ratio
• Net profit ratio
• Expense ratio
Based on Investments
• Return on investment
• Return on capital
employed
• Return on shareholder’s
equity
• Return on Equity
shareholder’s funds
• Return on total Assets
• Earnings per share
• Price-Earning ratio

Turnover ratios
1. Inventory / Stock turnover ratio
2. Debtors turnover ratio/Debtors velocity
3. Debt collection period
4. Creditors turnover ratio/Creditors velocity
5. Debt payment period
6. Fixed Assets turnover ratio
7. Total Asset turnover ratio
8. Capital turnover ratio
9. Working Capital turnover ratio

Liquidity Ratios
1. Current Ratio
2. Liquid ratio/ Acid test ratio / quick ratio
3. Absolute liquid or Cash ratio
Leverage Ratios
1. Debt-Equity ratio
2. Debt to Shareholders equity
3. Debt to total funds ratio
4. Proprietary Ratio
5. Capital Gearing ratio
6. Interest Coverage ratio
7. Dividend coverage ratio

Profitability Ratios
• Gross Profit Ratio: Gross Profit Ratio shows
the relationship between Gross Profit of the
concern and its Net Sales. Gross Profit Ratio can
be calculated in the following manner: -
• Gross Profit Ratio = Gross Profit/Net Sales x
100
• Where Gross Profit = Net Sales – Cost of Goods
Sold
• Cost of Goods Sold = Opening Stock + Net
Purchases + Direct Expenses – Closing Stock
• And Net Sales = Total Sales – Sales Return

Gross Profit Ratio

• Gross Profit Ratio provides guidelines to the
concern whether it is earning sufficient profit to
cover administration and marketing expenses and
is able to cover its fixed expenses.
• It is desirable that this ratio must be high and
steady because any fall in it would put the
management in difficulty in the realisation of
fixed expenses of the business.

Net Profit Ratio:

• Net Profit Ratio shows the relationship between
Net Profit of the concern and Its Net Sales. Net
Profit Ratio can be calculated in the following
manner: -
• Net Profit Ratio = Net Profit/Net Sales x 100
• Where Net Profit = Gross Profit – Selling and
Distribution Expenses – Office and
Administration Expenses – Financial Expenses –
Non Operating Expenses + Non Operating
Incomes.
• And Net Sales = Total Sales – Sales Return
Net Profit Ratio:
• Objective and Significance:
This ratio is helpful to determine the
operational ability of the concern. While
comparing the ratio to previous years’
ratios, the increment shows the efficiency of
the concern.

Operating Profit Ratio:

• Operating Profit Ratio shows the relationship
between Operating Profit and Net Sales. Operating
Profit Ratio can be calculated in the following
manner: -
• Operating Profit Ratio = Operating Profit/Net
Sales x 100
• Where Operating Profit = Gross Profit – Operating
Expenses
• Or Operating Profit = Net Profit + Non Operating
Expenses – Non Operating Incomes
• And Net Sales = Total Sales – Sales Return

• Objective and Significance: Operating

Profit Ratio indicates the earning capacity
of the concern on the basis of its business
operations and not from earning from the
other sources. It shows whether the business
is able to stand in the market or not.

Operating Ratio:
• Operating Ratio matches the operating cost to the net
sales of the business. Operating Cost means Cost of
goods sold plus Operating Expenses.
• Operating Ratio = Operating Cost/Net Sales x 100
• Where Operating Cost = Cost of goods sold + Operating
Expenses
• Cost of Goods Sold = Opening Stock + Net Purchases +
Direct Expenses – Closing Stock
• Operating Expenses = Selling and Distribution
Expenses, Office and Administration Expenses, Repair
and Maintenance.

• Objective and Significance: Operating

Ratio is calculated in order to calculate the
operating efficiency of the concern. As this
ratio indicates about the percentage of
operating cost to the net sales, so it is better
for a concern to have this ratio in less
percentage. The less percentage of cost
means higher margin to earn profit.

Return on Investment or Return

on Capital Employed
a. This ratio shows the relationship between the
profit earned before interest and tax and the
capital employed to earn such profit.
• Return on Capital Employed = Net Profit before Interest,
Tax and Dividend/Capital Employed x 100
• Where Capital Employed = Share Capital (Equity +
Preference) + Reserves and Surplus + Long-term Loans
– Fictitious Assets. OR
• Capital Employed = Fixed Assets + Current Assets –
Current Liabilities

Objective and Significance

• ROCE measures the profit, which a firm earns on
investing a unit of capital.
• The return on capital expresses all efficiencies and
inefficiencies of a business.
• To shareholders it indicates how much their
capital is earning and to the management as to
how efficiently it has been working.
• This ratio influences the market price of the
shares.
• The higher the ratio, the better it is.

Return on Equity
a. The ratio establishes relationship between profit
available to equity shareholders with equity
shareholders’ funds.
• Return on Equity = Net Profit after Interest,
Tax and Preference Dividend/Equity
Shareholders’ Funds x 100
• Where Equity Shareholders’ Funds = Equity
Share Capital + Reserves and Surplus –
Fictitious Assets

Objective and Significance

• Return on Equity judges the profitability
from the point of view of equity
shareholders.
• This ratio has great interest to equity
shareholders.
• The investors favour the company with
higher ROE.

Earning Per Share

• Earning per share is calculated by dividing
the net profit (after interest, tax and
preference dividend) by the number of
equity shares.
• Earning Per Share = Net Profit after
Interest, Tax and Preference
Dividend/No. Of Equity Shares

Objective and Significance

• EPS helps in determining the market price of the
equity share of the company.
• It also helps to know whether the company is able
to use its equity share capital effectively when
compared to other companies.
• It also tells about the capacity of the company to
pay dividends to its equity shareholders.

Price-Earning ratio
• Price-Earning ratio =
Market Price per Share
Earning per Share
• Indicates:
* Price which investors are ready to pay for every
rupee of earning