Ratio analysis explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
A profit and loss account and a balance sheet hold dozens of figures, and none of them says whether the business is getting stronger or weaker. Ratio analysis divides one figure by another so that two years, or two firms of different size, can be compared fairly. Owners, finance managers and lenders all use it, each looking at a different group of ratios.
A ratio is one figure divided by a related figure. The main families are liquidity (can the firm pay its short-term bills), leverage and coverage (how much is borrowed and whether interest is comfortably earned), activity (how fast stock, debtors and creditors turn over) and profitability (what is earned on sales and on the owner's money). Compute the same ratios for at least two years, then read the direction of change and the reason behind it, not a single figure against a rule.
When to use it and what data you need
Use ratios when you review the year, when a bank asks for your figures, or when you want to know why profit rose but cash got tighter. You need two years of the profit and loss account and the balance sheet. Most figures come straight from the trial balance; the split of current assets and current liabilities is shown in the schedule III format, which our guide on the analytical ratios in the schedule III format explains.
Firms that close their books every month can produce the ratios monthly through MIS reporting rather than once a year.
Choose one convention and keep it. In this article closing balances are used throughout, and sales and cost of goods sold are for the full year. If you use average balances instead, use them in both years.
The ratio families and their formulas
| Family | Ratio | In words | In symbols |
|---|---|---|---|
| Liquidity | Current ratio | Current assets over current liabilities | CA / CL |
| Liquidity | Quick ratio | Current assets less stock, over current liabilities | (CA - stock) / CL |
| Leverage | Debt-equity | All borrowings over owners' funds | Debt / Equity |
| Coverage | Interest cover | Profit before interest and tax over interest | EBIT / Interest |
| Activity | Stock turnover | Cost of goods sold over stock | COGS / Stock |
| Activity | Debtor days | Debtors over credit sales, times days in the year | Debtors / Sales x 365 |
| Activity | Creditor days | Creditors over purchases or cost of goods sold, times 365 | Creditors / COGS x 365 |
| Profitability | Gross margin | Gross profit over sales | GP / Sales |
| Profitability | Net margin | Profit after tax over sales | PAT / Sales |
| Profitability | Return on equity | Profit after tax over owners' funds | PAT / Equity |
Return on equity can be split into three parts: net margin times asset turnover (sales over total assets) times the equity multiplier (total assets over owners' funds). Written out, PAT/Equity = (PAT/Sales) x (Sales/Assets) x (Assets/Equity). The split tells you whether a return came from pricing, from using assets hard, or from borrowing.
Worked example: Mehta Stationery Traders
Mehta Stationery Traders is an invented wholesaler. Figures are in rupees lakh. The tax rate of 30 per cent is assumed for illustration.
| Item | Year 1 | Year 2 |
|---|---|---|
| Sales | 400 | 480 |
| Cost of goods sold | 320 | 384 |
| Gross profit | 80 | 96 |
| Operating expenses (incl. depreciation) | 40 | 50 |
| EBIT | 40 | 46 |
| Interest | 8 | 10 |
| Profit after tax (30 per cent assumed) | 22.4 | 25.2 |
| Balance sheet item | Year 1 | Year 2 |
|---|---|---|
| Fixed assets | 90 | 96 |
| Stock | 80 | 100 |
| Debtors | 60 | 80 |
| Cash | 20 | 24 |
| Total assets | 250 | 300 |
| Owners' funds | 120 | 140 |
| Term loan | 40 | 36 |
| Cash credit | 40 | 64 |
| Creditors | 50 | 60 |
| Total | 250 | 300 |
Current assets are 160 and 204; current liabilities (creditors plus cash credit) are 90 and 124. Ratios, rounded to two decimals (days to one decimal):
| Ratio | Year 1 | Year 2 |
|---|---|---|
| Current ratio | 160 / 90 = 1.78 | 204 / 124 = 1.65 |
| Quick ratio | 80 / 90 = 0.89 | 104 / 124 = 0.84 |
| Debt-equity | 80 / 120 = 0.67 | 100 / 140 = 0.71 |
| Interest cover | 40 / 8 = 5.00 | 46 / 10 = 4.60 |
| Stock turnover | 320 / 80 = 4.00 times | 384 / 100 = 3.84 times |
| Debtor days | 60 / 400 x 365 = 54.8 | 80 / 480 x 365 = 60.8 |
| Creditor days | 50 / 320 x 365 = 57.0 | 60 / 384 x 365 = 57.0 |
| Gross margin | 20.0 per cent | 20.0 per cent |
| Net margin | 22.4 / 400 = 5.60 per cent | 25.2 / 480 = 5.25 per cent |
| Asset turnover | 400 / 250 = 1.60 | 480 / 300 = 1.60 |
| Equity multiplier | 250 / 120 = 2.08 | 300 / 140 = 2.14 |
| Return on equity | 22.4 / 120 = 18.67 per cent | 25.2 / 140 = 18.00 per cent |
Check on the three-part split for Year 2: 5.25 per cent x 1.60 x 2.143 = 18.0 per cent, the same as 25.2 / 140.
What Mehta's owner reads from it. Sales grew 20 per cent, yet return on equity slipped from 18.67 to 18.00 per cent. The gross margin held, so pricing is not the problem. Net margin fell because operating expenses and interest grew faster than gross profit. Debtor days lengthened by about six days and stock turned slower, while creditor days stayed put, so the firm financed the extra stock and debtors with cash credit, which rose from 40 to 64. That explains the weaker current and quick ratios and the lower interest cover. The action is to tighten collections and trim slow stock before asking for a bigger limit; our guide on the working capital cycle shows how to size that need.
How owners and lenders read the same numbers
An owner looks at margins and return on equity. A supplier looks at the current ratio and creditor days. A lender looks at debt-equity, interest cover and the trend in debtors and stock. No single ratio is a rule, and there is no universal figure that every firm must reach. A level many lenders look for differs by industry and by lender, so compare with your own earlier years, with your own target, and with firms in the same line of trade.
Common mistakes and limits
- Comparing a ratio with a "standard" figure from a textbook instead of with the firm's own history and trade.
- Mixing closing balances in one year and averages in the other.
- Using total sales when part of the sales is for cash; debtor days then look better than they are.
- Reading a ratio in isolation: a high current ratio can mean idle stock or slow debtors.
- Ignoring seasonality: a year-end balance sheet may catch the firm at its lightest or heaviest.
- Forgetting that ratios rest on book values and on the accounting policies used.
Ratios point at questions; they do not answer them. The answer lies in stock registers, debtor ageing and the cost sheet. A related tool is break-even analysis, which explains why margins move when volume moves.
Need help with ratio analysis and reporting?
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Key takeaways
- A ratio divides one figure by a related figure so that years and firms can be compared.
- Use the same ratios, the same year-end convention and at least two years.
- Return on equity splits into margin, asset turnover and the equity multiplier; the split shows where a change came from.
- Read the direction and the cause, and compare with your own history, not with a textbook figure.
- Ratios raise questions; the answers sit in stock, debtors and cost records.
Read next
- Working capital cycle and estimating working capital requirement
- Projected financial statements for a bank loan
- Operating, financial and combined leverage
- Schedule III analytical ratios
Disclaimer: The methods described are standard cost accounting and financial management techniques. The worked example uses an invented business and invented figures, including any tax, interest or exchange rate, which are assumptions for illustration and not current rates. Where the article refers to a legal requirement, the linked guide and the official text should be checked. This article is general information, not legal advice; check the official text before acting.