Ratio Analysis Formulas

Ratio analysis is an important tool that we frequently use in inter-business and intra-business comparisons of the data. For a quick indication of a business’s financial health in various key areas, the ratio analysis procedure provides many handy formulas. In this article, the student will learn many ratio analysis formulas with examples. In these formulas, various financial terms will be used. Let us start the topic!

Ratio Analysis Formulas

What is ratio analysis?

Ratio analysis is a set of computing and analysis methods with suitable formulas. It is broadly classified into four types:

1. Liquidity Ratios
2. Profitability Ratios
3. Activity Ratios
4. Solvency Ratios

Liquidity Ratios:

It helps to identify the short term liquidity of a firm. It has mainly two types of ratios. The first one is the Current ratio which let us know the short term solvency of any firm.

Current Ratio= \(\frac{CurrentAsset}{CurrentLiabilities}\)

The second one is the Quick ratio which helps to find the solvency for six months. Here the reason why inventory is subtracted is that inventory usually takes more than six months for the conversion of liquid assets.

Quick Ratio= \(\frac{Total\;current\;ratio-  Inventory}{TotalCurrentLiabilities}\)

Profitability Ratios:

Profit is the main purpose of doing the business. All business needs to be running on profit. These ratios are used to find out the profitability of a business and hence to measure the success effectively over a period of time.

These ratios are used by the business owners, tax holders, stakeholders, government officials, etc. to know how the business is performing. If a business is asking for a loan from a bank, then the bank will also by default check the profitability status using these ratios.

Some main ratios covered within this category are:

(1) Net Profit Ratio= \(\frac{Netprofitaftertax X 100}{NetSales}\)

(2) Gross Profit Ratio= \(\frac{GrossProfit X 100}{NetSales}\)

(3) Earnings per share = \(\frac{(NetIncome−PreferredDividend)}{WeightedAveragenumberofsharesoutstanding}\)  × 100

Activity Ratios:

It is also known as the turnover ratio, and it measures the efficiency of a firm and converting its products into cash. The ratio is measured in the duration of days.

Some ratios under this category are:

(1) Inventory turnover ratio helps the business to know how many times the product is turning into cash during a given period of time.

Inventory Turnover Ratio= \(\frac{Cost of goods sold}{Average Inventory}\)

(2) The receivables turnover ratio helps to know how many times the credit is collected in a given period of time.

Receivables Turnover Ratio= \(\frac{Net Credit Sales}{Average Trade Receivable}\)

Solvency Ratios:

Solvency ratio is used to see if the business can survive for the long term period. This ratio also helps to evaluate the ability to pay the long term debt of a business. It has the following ratios:

(1) Debt-Equity Ratio: To see the soundness of the long-term financial policies of a business, the debt-equity ratio can be used. It simply means the total liabilities divided by total stakeholder’s equity.

Debt-Equity Ratio= \(\frac{Total Liabilities}{Stakeholders Equity}\)

(2) Proprietary Ratio: This ratio is used to evaluate the soundness of the capital structure of a business. Different business is using different capital structures, and It could be 50% equity and 50% debt as well. While for others it might be 30% equity and 70% debt.

Proprietary Ratio= \(\frac{Stakeholders Equity}{Total Assets}\) × 100

Solved Examples

Q.1: For a firm, some measurable terms are as follows:

Current Assets = Rs. 11971

Inventory= Rs. 8338

Current Liability= Rs. 8035

Find the value of the Quick ratio.

Solution: As given,

Current Assets = Rs. 11971

Inventory= Rs. 8338

Current Liability= Rs. 8035

And formula for quick ratio is:

QuickRatio= \(\frac{Total\;current\;ratio-  Inventory}{TotalCurrentLiabilities}\)

i.e. QuickRatio= \(\frac{11971- 8338}{8035}\)

i.e Quick ratio= 0.45