Financial Statement Analysis and Ratio Analysis
Ratio analysis converts absolute figures into comparable relationships. The exam usually asks for computation plus a one-line interpretation of what the ratio signals.
Formulae
- Current ratio = current assets ÷ current liabilities; a rough benchmark is 2:1.
- Quick ratio = (current assets − stock − prepaid expenses) ÷ current liabilities; benchmark 1:1.
- Debt–equity ratio = long-term debt ÷ shareholders' funds.
- Proprietary ratio = proprietors' funds ÷ total assets.
- Inventory turnover = cost of goods sold ÷ average stock.
- Debtors turnover = credit sales ÷ average debtors; average collection period = 365 ÷ turnover.
- Gross profit ratio = gross profit ÷ revenue from operations × 100; net profit ratio follows the same pattern.
- Return on capital employed = profit before interest and tax ÷ capital employed.
Worked example
Current assets ₹6,00,000, including stock ₹2,00,000 and prepaid expenses ₹20,000; current liabilities ₹3,00,000. Current ratio = 6,00,000 ÷ 3,00,000 = 2:1. Quick ratio = (6,00,000 − 2,00,000 − 20,000) ÷ 3,00,000 = 3,80,000 ÷ 3,00,000 = 1.27:1.
Traps
- Including stock, prepaid expenses or loose tools in quick assets.
- Using total sales instead of credit sales for debtors turnover.
- Treating bank overdraft as a non-current liability.
- Mixing definitions of capital employed; use total assets − current liabilities, or proprietors' funds + long-term debt, and state which.