Ratio Analysis

Financial statements: The statement which provides us the financial position of a Balance Sheet are called “Finance Statements”, which includes – Trading Account (in case of Manufacturing concerns), Profit & Loss Account, Balance Sheet, Cash Flow Statement and Funds Flow Statement. The analysis of Balance Sheet is a process of bringing down the difficult matter into a simple and easily understandable one. To have a clear understanding of the financial position of the Business concern, at least three years financial statements are to be ascertained. They provide us treasure of information. Balance Sheet of a business concern shows the strength of the concern on a given date but not reveal the current state of affairs of the concerns. Balance Sheet is having certain limitations, because it does not disclose the critical factors, such as Managerial Efficiency, Technical competence, Marketing capabilities and Competition in the market.

Ratio means a comparison of two items which are having cause and relationship. Ratios can be expressed in percentage or in number of times. Depending upon the nature, the ratios are broadly classified in to four categories viz., Liquidity Ratios, Leverage Or Solvency Ratios, Activity Ratios and Profitability Ratios.

I. LIQUIDITY RATIOS: These Ratios helps to find out the ability of the business concern to pay the short term liability of its liquidity. Any adverse position in liquidity leads to sudden fall of the unit.

Current Ratio: Current Ratio denotes the capacity of the business concern to meet its current obligation out of the 50ttest50ed50 value of the Current Assets. Current Ratio = Current Assets / Current Liabilities. Term Loan installments falling due for payment in next 12 months are to be taken as Term Liability for the purpose of calculation of Current Ratio /MPBF. Inter-corporate deposits are to be treated as Non-Current Assets. Ideal Current Ratio is 2:1. Acceptable Ratio as per our Loan Policy guidelines is 1.33:1 for the limits enjoying above Rs.6.00 crores and 1.15:1 for the business concerns availing limits of below Rs.6.00 crores. Any deviation below the required ratio requires ratification of Higher Authority.

Quick Ratio Or Acid Test Ratio: This ratio is a comparison of Quick Assets to Current Liabilities. Quick Assets mean the assets which have instant liquidity of the business concern. Though the Inventory and Prepaid expenses are part of Current Assets, it may be difficult to sell and realize the inventory. Hence, Inventory and Prepaid expenses are to be excluded for arriving the Quick Asset Ratio. Current Assets – (Inventory+Prepaid Exp) Quick Ratio or Acid Test Ratio = ---------------------------------------------- Current Liabilities Ideal Quick Ratio is 1:1. Current Ratio is always to be read along with Quick Ratio. A fall in the Quick Ratio in comparison to the Current Ratio indicates high inventory holdings.

II. LEVERAGE AND SOLVENCY RATIOS: These Ratios helps to find out the Long Term Financial stability of the business concern

i)Debt Equity Ratio: Long Term Debt / Equity – Here, Equity refers Tangible Net worth. The Ideal ratio is 2:1 and the higher may also be considered as safe.

ii) Debt Service Coverage Ratio: It helps to know the capacity of the firm to repay the Long Term Loan Instalment and Interest. Ideal DSCR is 2:1. The higher the DSCR, we may fix the lower repayment period. However, banks may also consider DSCR 1.20:1 where fixed income generation is assured, such as Rent Receivables etc.

Net Profit After Tax + Depreciation +Int. on TL DSCR = ------------------------------------------------------------- Int. on TL + Instalment on TL

iii) Fixed Assets Coverage Ratio (FACR): This ratio indicates the extent of Fixed assets met out of long term borrowed funds. Ideal Ratio is 2:1

Net Block FACR = --------------------------- (Net Block means Total Assets– Depreciation) Long Term Debt

iv) Interest Coverage Ratio:

EBIDT Interest Coverage Ratio = --------------- Interest

Where EBIDT is Earning Before Interest, Depreciation and Tax. This ratio indicates the interest servicing capacity of the unit. Higher the ratio has probability of nonservicing of interest and hence avoidance of slippage of asset.


Inventory Turnover Ratio: Inventory constitutes raw material, work in process, finished goods etc. The ratio is arrived by dividing Inventory by average monthly Net sales to arrive at inventory levels in number of months. Lower the ratio, the faster the movement of inventories and Higher the ratio slower the movement of inventories. It also indicates the time taken to replenish the inventories. Separate parameters are laid down for fabrication units & seasonal industries (maintaining peak level inventories as at March) where operating cycle is longer compared to other businesses and others Inventory x (RM+WIP+FG) x 12 (OR ) Cost of Goods Sold Net Sales = Average Stock ((Opening Stock+Closing stock)/2)

ii) Debtors Velocity Ratio:

Debtors ------------ x period Credit sales Lower the collection period indicates efficiency in realization of receivables and viceversa.

iii) Creditors Velocity Ratio:

Trade Creditors ---------------------- x period Credit Purchase Higher velocity denotes that the company is enjoying credit from its suppliers and it has bearing on Maximum Permissible Bank Finance (MPBF)

iv) Assets Turnover Ratio:

Net Sales ASSET TURNOVER RATIO=----------------------------- Total Operating Assets Total Operating Assets= Total Assets – Intangible Assets. Higher the ratio indicates favorable situation of optimum utilization of all the fixed assets.


c) Gross Profit Ratio -> Gross Profit/Net Sales*100 – Gross Profit Ratio indicates the manufacturing efficiency and Pricing policy of the concern. Higher percentage indicates higher sales volume, better pricing of the product or lesser cost of production.

ii) Net Profit Ratio:

Net Profit After Tax ----------------------------------- X 100 Net Sales A decline trend is a pointer to some unhealthy development unless the company had made usurious profits in the past and has consciously decided to reduce its profits by lowering the prices of its product.

iii) Return on Equity:

Net Profit After Tax ----------------------------------- X 100 Tangible Networth

Working Capital Assessment

i) Turnover Method: (for WC limits up to & inclusive of Rs.6.00 Crore)

  1. Accepted Projected Sales Turnover
  2. 25% of Sales Turnover
  3. Margin @ 5 % of Sales Turnover
  4. Actual NWC available as per latest Audited Balance Sheet
  5. B-C
  6. B-D
  7. M.P.B.F = E or F, whichever is less.

ii) Inventory Method – For WC limits up to & inclusive of Rs.6.00 Crore

  1. Total Current Assets
  2. Current Liabilities (other than Bank Borrowings)
  3. Working Capital Gap = A – B
  4. Margin @ 13% of Projected Current Assets
  5. Actual NWC available as per latest Audited Balance Sheet
  6. C-D
  7. C-E
  8. M.P.B.F = F or G, whichever is less.
  • Maximum Working Capital credit limit up to which Turn Over method can be extended is Rs.6 Crores. Where the limits of above Rs.6.00 Crore, the margin is to be taken as 25% projected current assets. If actual NWC is less than required margin, the borrower has to bring in the short fall.
  • The minimum acceptable Current Ratio for working capital credit facility up to Rs.6 crore & above Rs.6 crore is 1.15 & 1.33 respectively.
  • Maximum acceptable level of Total Debt- Equity Ratio is 4.
  • Maximum permissible Gearing Ratio while assessing the eligibility for nonfunded limits is 10.
  • Standard average DSCR specified for all Term Loans is 1.50 to 2.00. However, in case of assured source of income, it can be taken as 1.20. Lower DSCR can be accepted for Rural Godowns.