Ratio Analysis
Ratio Analysis turns the raw numbers in a Balance Sheet and Profit & Loss Account into clear, comparable signals — so you (and every banker, investor, or manager) can judge whether a business is healthy, efficient, and profitable at a glance.
Every board exam question on Analysis of Financial Statements expects you to calculate and interpret ratios — and in real life, this is exactly how banks decide whether to give your business a loan, how investors pick stocks, and how managers spot problems before they become crises.
Concept
Lots of students think…
"A higher Current Ratio is always better — the higher it is, the stronger the company."
Actually…
The ideal benchmark is around 2:1. A very high ratio (like 4:1 or 5:1) may signal too much idle cash or unsold inventory sitting unused — both are inefficient. The goal is a healthy range near the standard, not the highest possible number.
By the end of this chapter, you'll know how to read a company's financial health from just a few numbers — the way a bank does before giving a loan. Ratio analysis turns raw balance sheet figures into clear, meaningful signals.
Why Raw Numbers Aren't Enough
A firm reports ₹12 lakh profit. Is that good or bad? You can't tell without context. Ratio analysis fixes this by comparing one financial number with another — turning isolated figures into a story you can actually judge.
Meenakshi Textiles in Thrissur earned ₹12 lakh profit on ₹60 lakh sales. That's a Net Profit Ratio of 20% — meaning 20 paise profit for every rupee sold. Now the number means something you can compare.
Liquidity Ratios — Can You Pay Today's Bills?
Liquidity ratios tell you if a firm can pay what it owes in the short term. The Current Ratio = Current Assets ÷ Current Liabilities. The safe benchmark is 2:1 — meaning the firm has ₹2 available for every ₹1 it owes soon. The Quick Ratio removes inventory from current assets (since stock takes time to sell) and the benchmark is 1:1.
A bakery in Kochi has current assets of ₹60,000 (including ₹20,000 of flour and sugar inventory) and current liabilities of ₹30,000. Current Ratio = 60,000 ÷ 30,000 = 2:1 (healthy). Quick Ratio = (60,000 − 20,000) ÷ 30,000 = 1.33:1 (also healthy).
Solvency Ratios — Is the Business Safe Long-Term?
Solvency ratios check if a firm can survive its long-term debts. The Debt-to-Equity Ratio = Long-term Debt ÷ Shareholders' Equity. Note: only long-term borrowings go in the numerator — not short-term creditors. A high ratio means the firm leans heavily on borrowed money, which is riskier. The Interest Coverage Ratio = Net Profit before Interest and Tax ÷ Interest Expense. A higher number means the firm earns well above its interest costs — so it's unlikely to default.
A cotton mill in Coimbatore has long-term bank loans of ₹50 lakh and owner's equity of ₹50 lakh — Debt-to-Equity = 1:1. It earns ₹30 lakh before interest and pays ₹6 lakh interest — Interest Coverage = 5 times. The bank sees a manageable risk.
Activity Ratios — Are Resources Being Used Well?
Activity ratios (also called turnover ratios) measure how efficiently the firm uses what it has. Inventory Turnover = Net Sales ÷ Average Inventory — how many times stock is sold and restocked in a year. Trade Receivables Turnover = Net Credit Sales ÷ Average Trade Receivables — how quickly customers actually pay their bills.
A saree shop in Thrissur has ₹12 lakh in annual sales and average inventory of ₹2 lakh. Inventory Turnover = 6 times a year — stock sells and refills every two months. A rival shop with turnover of 3 times is holding unsold stock twice as long, locking up cash unnecessarily.
Profitability Ratios — Is the Business Making Money?
Profitability ratios measure how much profit is earned at each stage. Gross Profit Ratio = (Gross Profit ÷ Net Sales) × 100 — what's left after production costs. Net Profit Ratio = (Net Profit after Tax ÷ Net Sales) × 100 — the final bottom line. Return on Equity (ROE) = (Net Profit after Tax ÷ Shareholders' Equity) × 100 — what owners actually earn on their investment.
A mobile accessories shop in Calicut earns ₹5 lakh gross profit on ₹20 lakh sales — Gross Profit Ratio = 25%. After paying rent, salaries, and taxes, net profit is ₹2 lakh — Net Profit Ratio = 10%. If the owner invested ₹10 lakh, ROE = 20%, better than a fixed deposit.
The Higher-the-Better Trap
A very high Current Ratio sounds great — but it might mean the firm has too much idle cash sitting around doing nothing. The goal is a healthy range near 2:1, not the highest number possible. Also, never use total liabilities for the Debt-to-Equity Ratio — only long-term borrowings belong in the numerator. Using all liabilities gives a wrong, inflated answer.
If a supermarket in Thiruvananthapuram has a Current Ratio of 5:1, it likely has a huge pile of unsold packaged goods and cash sitting idle — money not being reinvested or generating returns. The 2:1 benchmark exists for a reason.
One Ratio Is Never Enough
Never judge a business by a single ratio. A firm can look profitable on the Net Profit Ratio yet be in a cash crisis if the Quick Ratio is dangerously low. Always compare ratios across three ways: with the firm's own past data (trend), with industry peers (inter-firm), and against standard benchmarks like the 2:1 and 1:1 rules.
Meenakshi Textiles had a good Net Profit Ratio but its Quick Ratio fell to 0.68 (below 1:1) and Debt-to-Equity rose to 1.1. Taken together, these told the bank: profitable but cash-stressed — so they approved the loan at a higher interest rate and asked for quarterly reports.
Notes
The full picture
Financial statements are full of numbers: ₹80 lakh in assets, ₹12 lakh in profit, ₹40 lakh in debt. On their own, these figures don't say much. Is ₹12 lakh profit good or bad? It depends — is the company small or large, growing or shrinking, in a high-margin trade or a thin-margin one? Ratio analysis solves this by expressing one financial figure as a proportion of another. For example, dividing profit (₹12 lakh) by sales (₹60 lakh) gives a Net Profit Margin of 20%. Now you can compare that 20% with last year's figure, or with a competitor's margin, and the number actually means something.
The Kerala SCERT Plus Two syllabus groups ratios into four families, each answering a different question. Liquidity Ratios — Current Ratio and Quick (Liquid) Ratio — ask: can the firm pay its short-term bills? Solvency Ratios — Debt-to-Equity Ratio, Total Assets to Debt Ratio, and Interest Coverage Ratio — ask: is the firm financially stable in the long run? Activity (Turnover) Ratios — Inventory Turnover, Trade Receivables Turnover, Trade Payables Turnover, and Working Capital Turnover — ask: how efficiently is the firm using its resources? Profitability Ratios — Gross Profit Ratio, Net Profit Ratio, Operating Ratio, Return on Investment, and Return on Equity — ask: is the firm making adequate profit? Each family gives a different angle on the same business.
Liquidity ratios measure a firm's ability to meet short-term obligations. The Current Ratio = Current Assets ÷ Current Liabilities. The standard benchmark is 2:1 — meaning the firm should have ₹2 of current assets for every ₹1 of current liabilities. A ratio well below 2 signals potential difficulty paying short-term bills; a ratio far above 2 may mean too much cash is sitting idle. The Quick Ratio (also called Liquid Ratio) removes inventory from current assets — since inventory takes time to sell — and the standard is 1:1. If a firm's current assets are ₹60 lakh (including ₹20 lakh inventory) and current liabilities are ₹30 lakh, its Current Ratio is 2:1 and its Quick Ratio is (60 − 20) ÷ 30 = 1.33:1, both healthy.
Solvency ratios assess long-term financial stability. The Debt-to-Equity Ratio = Long-term Debt (Long-term Borrowings) ÷ Shareholders' Equity. Note carefully: the numerator is long-term debt only — not all liabilities. A ratio of 1:1 means the firm has borrowed an equal amount to its owners' funds; a higher ratio signals greater dependence on external debt, which increases financial risk. The Interest Coverage Ratio = Net Profit before Interest and Tax ÷ Interest Expense. A higher figure means the firm earns well in excess of its interest costs, reducing the risk of default. Activity ratios show operational efficiency: Inventory Turnover = Net Sales (or Cost of Goods Sold) ÷ Average Inventory, telling you how many times stock is sold and replaced in a year. Trade Receivables Turnover = Net Credit Sales ÷ Average Trade Receivables, revealing how quickly customers pay.
Profitability ratios reveal how much profit the firm generates at each stage. Gross Profit Ratio = (Gross Profit ÷ Net Sales) × 100 shows what percentage of sales revenue remains after direct production costs. Operating Ratio = (Operating Cost ÷ Net Sales) × 100 shows the cost consumed per rupee of sales — a lower operating ratio means higher operating efficiency. Net Profit Ratio = (Net Profit after Tax ÷ Net Sales) × 100 captures the final bottom line. Return on Investment (ROI) = (Net Profit before Interest and Tax ÷ Capital Employed) × 100 measures how productively the total capital is used. Return on Equity (ROE) = (Net Profit after Tax ÷ Shareholders' Equity) × 100 tells shareholders what return they earned on their own investment.
Interpreting any ratio correctly requires comparison — three kinds. First, compare with the firm's own past data (trend analysis): is the current ratio improving or deteriorating over three years? Second, compare with similar firms or industry averages (inter-firm comparison): is the firm's margin above or below the sector norm? Third, compare with standard benchmarks where they exist: the 2:1 Current Ratio and 1:1 Quick Ratio are widely accepted reference points in textbook and board exam contexts. No single ratio gives the full picture. A firm with a strong Net Profit Ratio but a very slow Trade Receivables Turnover is profitable on paper yet may be struggling with cash. Always analyse ratios as a set.
An Indian example
Meenakshi Textiles, a small saree-weaving unit in Thrissur, applied to a local bank for a ₹25 lakh working capital loan. The bank's credit officer pulled two years of balance sheets. In Year 1, Current Assets were ₹30 lakh and Current Liabilities ₹15 lakh — Current Ratio 2:1, healthy. By Year 2, current liabilities had jumped to ₹22 lakh while current assets grew only to ₹33 lakh — Current Ratio now 1.5:1, below the 2:1 benchmark. The Quick Ratio fell from 1.2 to 0.68, below the 1:1 standard, because unsold inventory had piled up (₹18 lakh): Quick Assets = ₹33 − ₹18 = ₹15 lakh; Quick Ratio = 15 ÷ 22 = 0.68. The Debt-to-Equity Ratio rose from 0.6 to 1.1 — long-term borrowings now exceeded owner's equity. Together, these three ratios told a story: the business was growing but stretching itself thin. The bank approved the loan at a higher interest rate and asked for quarterly ratio reports going forward. Meenakshi's owner used those same ratios to renegotiate credit terms with her fabric suppliers, reducing trade payable days and improving cash flow within six months.
Common misconceptions to watch for
- Students think a higher Current Ratio is always better. In reality, the ideal benchmark is 2:1 — a very high ratio (say, 4:1 or 5:1) may mean the firm has too much idle cash or unsold inventory, both of which are inefficient. The goal is a healthy range near the 2:1 standard, not the highest possible number.
- Students use Total Liabilities (or Total Debt) in the Debt-to-Equity Ratio. The correct SCERT/NCERT formula uses Long-term Debt (Long-term Borrowings) in the numerator — current liabilities like creditors and bank overdraft are excluded. Mixing in current liabilities gives a wrong, inflated ratio and costs marks in board exams.
- Students believe one strong ratio proves the business is fine. A single ratio never tells the whole story — a firm can show an excellent Net Profit Ratio yet have a dangerously low Quick Ratio (cash crisis) or a very high Debt-to-Equity (insolvency risk). Board exam questions that ask you to 'comment on the financial position' always expect you to examine ratios from multiple categories together.
Questions
Sunitha Textiles Ltd. (Kottayam) shows: Current Assets ₹45 lakhs (Cash ₹8L, Receivables ₹25L, Inventory ₹12L), Current Liabilities ₹20L, Fixed Assets (net) ₹80L, Long-term Debt ₹30L, Equity ₹75L. Sales ₹200L, Cost of Goods Sold ₹140L, Operating Expenses ₹15L, Net Profit ₹45L. Calculate and interpret: Current Ratio, Quick Ratio, Net Profit Margin.
- 1Extract current assets and current liabilities from the balance sheet.
Current Assets = ₹45 lakhs Current Liabilities = ₹20 lakhs
Current assets (cash, receivables, inventory) are resources available within 12 months. Current liabilities are debts due within 12 months. We gather these to measure short-term liquidity.
Question 1 of 5 · easy
A retailer has a Current Ratio of 0.9. The banker is concerned, but the retailer argues: 'I sell inventory fast—within days. My cash is always healthy.' Why does the retailer's argument have merit?
Quiz
Test yourself — pick an answer, then hit "Check" to see the explanation and your running score.
Question 1 of 5 · easy
A retailer has a Current Ratio of 0.9. The banker is concerned, but the retailer argues: 'I sell inventory fast—within days. My cash is always healthy.' Why does the retailer's argument have merit?
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