Ratio Analysis
Classification you must be able to state
- Liquidity: current ratio (CA ÷ CL), quick or acid-test ratio ((CA − stock − prepaid) ÷ CL), absolute liquid ratio (cash + marketable securities ÷ CL).
- Solvency/leverage: debt–equity ratio, debt to total funds, proprietary ratio, interest coverage (EBIT ÷ interest), capital gearing.
- Activity/turnover: stock turnover (COGS ÷ average stock), debtors turnover (credit sales ÷ average debtors), creditors turnover, working capital turnover, fixed-asset turnover.
- Profitability: gross profit ratio, net profit ratio, operating ratio, return on investment (EBIT ÷ capital employed), earnings per share, dividend payout.
Worked example
Current assets ₹6,00,000 including stock ₹2,00,000 and prepaid expenses ₹20,000; current liabilities ₹2,00,000. Current ratio = 6,00,000 ÷ 2,00,000 = 3:1. Quick ratio = (6,00,000 − 2,00,000 − 20,000) ÷ 2,00,000 = 3,80,000 ÷ 2,00,000 = 1.9:1. Sales ₹10,00,000 with gross profit ₹2,50,000 give a GP ratio of 25%. Reasoning: liquidity is comfortable on both counts, but a 3:1 current ratio with stock-heavy current assets can signal idle funds rather than strength - always read the composition, not just the number.
Traps that cost marks
Memorising "2:1 and 1:1 are ideal" as a universal law - ideal levels vary by industry; including prepaid expenses in quick assets; mixing opening, closing and average balances within one ratio; inverting debt–equity (it is debt ÷ equity, not equity ÷ debt); assuming a higher ratio is always better; ignoring window dressing just before the balance-sheet date; comparing ratios computed on different bases.