Analysis of Financial Statements: Ratio Analysis
Four families of ratios
Liquidity (current, quick, cash), solvency (debt-equity, proprietary, interest coverage), activity or turnover (inventory, debtors, creditors, working capital turnover) and profitability (gross profit, operating, net profit, return on capital employed, earnings per share).
Formulas
- Current ratio = current assets ÷ current liabilities.
- Quick ratio = (current assets − inventory − prepaid expenses) ÷ current liabilities.
- Debt-equity = long-term debt ÷ shareholders' funds.
- Inventory turnover = cost of goods sold ÷ average inventory.
- ROCE = profit before interest and tax ÷ capital employed.
Worked example
Current assets ₹6,00,000, including inventory ₹2,00,000 and prepaid insurance ₹20,000; current liabilities ₹2,50,000. Current ratio = 6,00,000 ÷ 2,50,000 = 2.4 : 1. Quick ratio = (6,00,000 − 2,00,000 − 20,000) ÷ 2,50,000 = 3,80,000 ÷ 2,50,000 = 1.52 : 1. The quick ratio is comfortably above 1, so liquidity is sound even though a large part of the current assets is stock.
Interpretation
A very high current ratio can signal idle inventory or weak collection rather than strength. When opening and closing balances are both given, use averages and say so. Compare with the previous year or the industry - a ratio alone proves nothing.
Marks-losing traps
- Including prepaid expenses in quick assets.
- Using closing inventory when opening inventory is available.
- Treating total liabilities instead of long-term debt in the debt-equity ratio.
- Giving the calculation but no interpretation, which carries separate marks.