Analysis of Financial Statements: Ratio Analysis
Families of ratios
Liquidity: current ratio = current assets ÷ current liabilities; quick ratio = quick assets ÷ current liabilities. Solvency: debt-equity = long-term debt ÷ shareholders' funds; proprietary ratio; interest coverage. Activity: inventory turnover = cost of revenue from operations ÷ average inventory; debtors turnover; creditors turnover. Profitability: gross profit ratio, operating ratio, net profit ratio, return on investment, earnings per share.
Method the markers look for
State the formula, substitute the figures, then interpret. Use averages when opening and closing balances are given; closing figures are acceptable otherwise. A ratio is meaningless without the comparison it supports.
Worked example
Current assets ₹6,00,000, including inventory ₹2,00,000 and prepaid expenses ₹20,000; current liabilities ₹2,50,000. Current ratio = 6,00,000 ÷ 2,50,000 = 2.4:1. Quick assets = 6,00,000 − 2,00,000 − 20,000 = ₹3,80,000, so quick ratio = 3,80,000 ÷ 2,50,000 = 1.52:1. Prepaid expenses are excluded because they cannot be converted into cash.
Traps
Including prepaid expenses in quick assets; omitting bank overdraft from current liabilities; mixing average and closing figures in one ratio; and computing EPS as (profit after tax − preference dividend) ÷ weighted average number of equity shares, not simply profit after tax.