Ratio analysis is one of the most widely used tools for reading a set of financial statements. The accounts of a business are prepared with care, but the raw figures on their own rarely tell a stakeholder how liquid, solvent or profitable the company actually is.
Once the financial statements are prepared, they have to be analysed, and ratio analysis is the quantitative technique most commonly used for that analysis. It converts absolute figures into relationships that can be compared across years, across firms and against industry norms.
- The formulas in this guide follow the NCERT Class 12 Accountancy Part II chapter on Accounting Ratios (Reprint 2026-27) and the ICAI Board of Studies Financial Management material
- Inventory Turnover Ratio is cost of revenue from operations divided by average inventory, not net sales divided by closing inventory
- Return on Investment is profit before interest and tax divided by capital employed, while return on shareholders' funds is Return on Net Worth
- IFRS 18, issued in April 2024, replaces IAS 1 for annual reporting periods beginning on or after 1 January 2027 and introduces two required subtotals, operating profit and profit before financing and income taxes.
What Is Ratio Analysis?
Ratio analysis is a quantitative technique that studies the relationship between two or more figures drawn from a company's financial statements in order to assess its liquidity, solvency, efficiency and profitability. An accounting ratio can be expressed as a fraction, a proportion, a percentage or a number of times, turning raw statement data into comparable insight.
A ratio is a mathematical number calculated by referring to the relationship between two or more numbers. When both numbers come from the financial statements, it is called an accounting ratio. If gross profit is Rs 10,000 and revenue from operations is Rs 1,00,000, the gross profit ratio is 10 per cent.
Ratio analysis is a cornerstone of fundamental equity analysis. Investors, lenders, suppliers and management all use it, but each group looks at a different set of ratios depending on the decision in front of them.
Where Accounting Ratios Come From
- Statement of profit and loss ratios use two variables from the statement of profit and loss, such as the gross profit ratio.
- Balance sheet ratios use two variables from the balance sheet, such as the current ratio.
- Composite ratios take one variable from each statement, such as the inventory turnover ratio.
- Ratios can be shown as a proportion (2:1), a fraction, a percentage or a number of times.
Why Do Businesses Use Ratio Analysis?
Businesses use ratio analysis to convert lengthy financial statements into a short set of comparable indicators. It highlights strengths and weaknesses, measures liquidity, solvency, efficiency and profitability, supports year on year and firm to firm comparison, and gives lenders, investors and management an evidence base for credit, valuation and operating decisions.
Analysing and interpreting ratios requires skill and reliable data. The same ratio serves different parties in different ways, so the objective of the analysis decides which ratios are worth calculating.
The Main Objectives of Ratio Analysis
- It indicates the operating strengths and weaknesses of the business in a single comparable figure.
- It helps evaluate liquidity, solvency, profitability and the level of operating efficiency.
- It provides reporting transparency to shareholders, lenders, suppliers and regulators.
- It supports intra-firm comparison across years and inter-firm comparison against competitors.
- It helps management judge whether financial resources are being used efficiently.
- It gives banks and creditors a quick read on whether obligations can be met when they fall due.
What Are the Main Types of Ratio Analysis?
Accounting ratios are grouped by the question they answer. The standard functional classification used by NCERT and the ICAI covers liquidity or short term solvency ratios, long term solvency and capital structure ratios, coverage ratios, activity or turnover ratios, and profitability ratios, including ratios related to sales and to overall return on investment.
- Liquidity ratios show whether the business can meet its short term obligations. They include the current ratio, the quick or acid test ratio and the cash ratio.
- Solvency and capital structure ratios measure long term stability. They include the debt equity ratio, the proprietary ratio, the debt to total assets ratio and the capital gearing ratio.
- Coverage ratios test the ability to service fixed financial commitments. The interest coverage ratio, EBIT divided by interest, is the most common.
- Activity or turnover ratios measure how efficiently assets are used. They include inventory turnover, trade receivables turnover, trade payables turnover, fixed asset turnover and working capital turnover.
- Profitability ratios measure returns. Sales based ratios include gross profit, operating profit and net profit ratios, while investment based ratios include Return on Investment and Return on Net Worth.
Which Formulas Are Used in Ratio Analysis?
The core formulas are short and easy to compute once the financial statements are ready. The table below sets out the ratios most often examined, using the definitions given in the NCERT Class 12 Accountancy chapter on Accounting Ratios and the ICAI Board of Studies Financial Management material, together with what each ratio is meant to reveal.
| Ratio (2026 Reference Formula) | Formula | What It Measures |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | Short term debt paying ability. Commonly cited as ideally 2:1. |
| Quick or Acid Test Ratio | Quick Assets / Current Liabilities | Immediate liquidity, excluding inventory and prepaid expenses. Commonly cited as ideally 1:1. |
| Debt Equity Ratio | Long term Debts / Shareholders' Funds | Long term solvency. Commonly considered safe at 2:1. |
| Interest Coverage Ratio | EBIT / Interest | Ability to meet interest obligations. |
| Inventory Turnover Ratio | Cost of Revenue from Operations / Average Inventory | How quickly inventory is converted into sales. |
| Trade Receivables Turnover Ratio | Net Credit Revenue from Operations / Average Trade Receivables | Efficiency of collecting from debtors. |
| Working Capital Turnover Ratio | Net Revenue from Operations / Working Capital | Sales generated per unit of working capital. |
| Gross Profit Ratio | Gross Profit / Net Revenue from Operations x 100 | Gross margin available to cover other costs. |
| Operating Profit Ratio | Operating Profit / Revenue from Operations x 100 | Operating margin, or 100 minus the operating ratio. |
| Net Profit Ratio | Net Profit / Revenue from Operations x 100 | Overall margin after all expenses. |
| Return on Investment (ROCE) | Profit before Interest and Tax / Capital Employed x 100 | Return earned on all long term funds employed. |
Two formulas are frequently stated incorrectly. Inventory turnover uses the cost of revenue from operations over average inventory, not net sales over closing inventory. Return on Investment uses profit before interest and tax over capital employed; profit after interest and tax over shareholders' funds is Return on Net Worth, a different ratio.
Capital employed means the long term funds in the business, that is shareholders' funds plus debentures and long term loans, or alternatively non-current assets plus working capital.
How Is the Current Ratio Calculated and Read?
The current ratio is current assets divided by current liabilities, and it is the liquidity ratio firms use most often. A figure above one suggests the business can settle short term dues such as wages, tax payable and trade payables from assets convertible into cash within a year, while a very high figure may signal idle resources.
Current assets include current investments, inventories, trade receivables, cash and cash equivalents, short-term loans and advances, and other current assets such as prepaid expenses and advance tax. Current liabilities include short-term borrowings, trade payables, other current liabilities and short-term provisions.
- Formula: Current Assets / Current Liabilities, usually expressed as a proportion such as 2:1.
- A ratio below one means current liabilities exceed current assets, which points to liquidity pressure.
- The quick ratio removes inventories and other non-liquid current assets and acts as a stricter check.
- The conventional benchmark of 2:1 is a rule of thumb, not a rule; the right level varies by industry.
What Do Liquidity Ratios Measure?
Liquidity ratios measure whether a business can meet obligations falling due in the short term out of its current assets. Banks, suppliers and short term creditors rely on them the most. The group includes the current ratio, the quick or acid test ratio, the cash or absolute liquidity ratio and the net working capital ratio.
- Current ratio: current assets over current liabilities, the broadest liquidity measure.
- Quick ratio: quick assets over current liabilities, excluding inventory and prepaid items.
- Cash ratio: cash, bank balances and marketable securities over current liabilities, the strictest test.
- Net working capital: current assets minus current liabilities, a measure of the cushion available in a crisis.
How Should Financial Ratios Be Interpreted?
A calculated ratio means little until it is compared with something. Interpretation requires a benchmark, a trend and an understanding of how the underlying statements were prepared. Analysts read a single ratio against a standard, against the same firm in earlier years, against competitors, and alongside related ratios before drawing any conclusion.
- Single absolute ratio: a figure such as 2:1 is read against a conventional standard for that ratio.
- Trend or time series: the same ratio is tracked across several years to reveal the direction of travel.
- Inter-firm comparison: the ratio is compared with competitors and with the industry average.
- Group of ratios: liquidity, solvency, activity and profitability ratios are read together, since one ratio in isolation can mislead.
- Context: accounting policies, one-off items and the basis of preparation must be understood before the ratio is trusted.
Which Financial Statements Does Ratio Analysis Use?
Ratio analysis draws on the complete set of financial statements prepared at the end of each accounting period. Under IAS 1 that set comprises the statement of financial position, the statement of profit or loss and other comprehensive income, the statement of changes in equity, the statement of cash flows and the explanatory notes.
In India, listed and larger companies report under Ind AS, the IFRS converged standards notified by the Ministry of Corporate Affairs, while other companies follow the Accounting Standards issued by the ICAI. Because ratios are only as good as the statements behind them, the reporting framework matters.
IFRS 18, Presentation and Disclosure in Financial Statements, was issued in April 2024 and replaces IAS 1 for annual reporting periods beginning on or after 1 January 2027. It requires two new subtotals, operating profit and profit before financing and income taxes, and requires disclosure of management-defined performance measures. Both changes affect how margin and return ratios will be built from 2027 reporting onward.
- Investors and analysts can read the statements using vertical analysis, horizontal analysis or ratio analysis.
- Reviewing full statements is slow, so stakeholders use ratios as a summary of the same information.
- The balance sheet supplies liquidity and solvency inputs; the statement of profit and loss supplies margin inputs.
- Comparability depends on the same accounting policies being applied in the periods being compared.
What Are the Limitations of Ratio Analysis?
Ratios are derived from financial statements, so every weakness in those statements carries into the analysis. Accounting data reflect recorded facts, conventions and personal judgement, ignore price level changes and qualitative factors, and can be distorted by different accounting policies, window dressing or a single unusual year.
Ratio analysis remains the most widely used tool for reading financial statements, but its conclusions are only as reliable as the data and the analyst behind them.
- Limitations of accounting data: the figures combine recorded facts, accounting conventions and personal judgement.
- Historical cost basis: ratios ignore changes in price levels and so can overstate or understate performance.
- Policy differences: two firms using different depreciation or inventory policies are not directly comparable.
- Qualitative factors ignored: management quality, brand and workforce skill do not appear in any ratio.
- Window dressing: year end transactions can flatter liquidity ratios for the reporting date only.
- Single ratios mislead: no one ratio, taken alone, describes the financial health of a business.
- Skill dependent: interpretation requires knowledge of the business and of how the statements were prepared.