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CA Intermediate · Financial Management and Strategic Management

Financial Analysis and Planning - Ratio Analysis CA Intermediate

Ratio analysis turns figures from the balance sheet and statement of profit and loss into ratios that show liquidity, leverage, efficiency, profitability and market value. To solve a question, write the formula, pull each figure with clear workings, compute the ratio, then add a one-line interpretation.

What this chapter covers

This chapter in Paper 6 Section A (Financial Management) teaches you to read financial statements through ratios. You group them into liquidity, capital structure and leverage, activity, profitability, return on investment, and market ratios. Each group answers one question about the business. Can it pay its dues? How is it financed? How fast does it convert assets into sales? How much does it earn?

The chapter is mostly formula-driven, but the real skill is in picking the right figures. Average or closing balances, credit sales or total sales, capital employed on which basis: these choices decide your answer. Questions often give an incomplete set of data and ask you to rebuild a balance sheet from a few ratios. That needs you to know how the ratios link to each other.

This chapter connects to the rest of the paper. Leverage ratios lead into the cost of capital and capital structure chapters. Working capital ratios feed into working capital management. Return ratios and EPS tie into investment and dividend decisions. Section B (Strategic Management) also uses ratio-based evidence when judging a firm's performance. If you learn this chapter well, later chapters become easier.

Ratio analysis is one of the most scoring chapters in Financial Management because it is formula-based and has little theory to forget. It suits both MCQs, where one quick calculation gives the answer, and the 70 marks of written answers, where a clear format earns step marks even if your final figure slips. It is also a base for later chapters, so time spent here pays back across the paper. There is no negative marking in MCQs, so attempt every one, but a firm grip on definitions will help you eliminate wrong options fast.

Financial Analysis and Planning - Ratio Analysis: topics in the order to study them

  1. 1Meaning and Classification of RatiosStart here to see the five or six groups of ratios and what each one tells you, so later formulas fit into a map.
  2. 2Liquidity RatiosThese are the simplest, and they use current assets and current liabilities, which you must classify correctly for every other ratio.
  3. 3Capital Structure and Leverage RatiosNext comes debt versus equity and interest cover, which prepares you for the cost of capital and leverage chapters.
  4. 4Activity or Turnover RatiosThese bring in averages, credit sales and cost of goods sold, and they link directly to working capital and the operating cycle.
  5. 5Profitability Ratios Based on SalesMargins are easy once you know the statement of profit and loss lines, and they are needed before you study returns and DuPont.
  6. 6Return on Investment RatiosROI, return on equity and return on capital employed need both profit and balance sheet figures, so they come after the earlier groups.
  7. 7Market and Valuation RatiosEPS, P/E and dividend ratios need profit and share data, and they connect to later dividend and valuation topics.
  8. 8DuPont Analysis and Ratio Based ProblemsFinish with the DuPont breakdown and mixed problems that combine every group, since they need all the formulas ready.

How to prepare Financial Analysis and Planning - Ratio Analysis

Treat this chapter as a formula set that you must practise, not read. Aim for speed and accuracy in picking the right figures.

  1. Make a one-page sheet listing every ratio with its formula and the exact numerator and denominator. Write it from memory, then check it against the study material.
  2. For each group, solve two or three questions. In each, first write down the formula, then a workings note showing where each figure comes from.
  3. Practise rebuilding financial statements from given ratios. Start from the figure you can find directly, such as sales from stock turnover, and work step by step.
  4. Fix your conventions. Use credit sales for debtors turnover and cost of goods sold for stock turnover when data allow, and state your assumption when the question is silent.
  5. Add a one-line interpretation to every answer, for example whether a higher or lower figure is better and what it signals about the firm.
  6. Solve MCQs in timed sets. For each, estimate the answer roughly first, then eliminate options that are far off before calculating exactly.
  7. In the last week, redo DuPont and mixed problems and recite your formula sheet until you make no errors.

Common mistakes in Financial Analysis and Planning - Ratio Analysis

  • Using total sales instead of credit sales, or sales instead of cost of goods sold, in turnover ratios.

    Fix: Read the data first. Use credit sales for debtors, purchases for creditors and cost of goods sold for stock, and note any assumption you make.

  • Mixing closing and average balances.

    Fix: Use average balances when opening and closing figures are both given. Use closing figures only when that is all you have, and say so.

  • Putting the wrong items in quick assets or current liabilities.

    Fix: Make a quick list of every current asset and liability before computing, and strike out stock and prepaids for quick assets.

  • Giving a number with no interpretation.

    Fix: Add a short line on what the ratio says about the firm, for example that a falling current ratio suggests tighter liquidity.

  • Getting stuck when a question gives ratios but not the statements.

    Fix: Begin with the ratio that links to a given figure, such as sales or net worth, then use that to derive others one at a time and show each step.

  • Confusing ROE, ROCE and return on assets in definitions.

    Fix: Write each with its profit measure and base side by side, such as profit after tax and equity for ROE, and EBIT and capital employed for ROCE.

Last-day revision: Financial Analysis and Planning - Ratio Analysis

  • Current ratio = Current assets ÷ Current liabilities.
  • Quick ratio = Quick assets ÷ Current liabilities, where quick assets exclude stock and prepaid expenses.
  • Debt-equity ratio = Debt ÷ Equity, so check whether the question defines debt as long-term only.
  • Interest coverage ratio = EBIT ÷ Interest.
  • Stock turnover = Cost of goods sold ÷ Average stock.
  • Debtors turnover = Credit sales ÷ Average debtors, and collection period = 365 ÷ turnover (or the days the question gives).
  • Gross profit margin = Gross profit ÷ Sales × 100; net profit margin = Net profit ÷ Sales × 100.
  • Return on capital employed = EBIT ÷ Capital employed × 100.
  • Earnings per share = (Net profit after tax − Preference dividend) ÷ Number of equity shares.
  • P/E ratio = Market price per share ÷ EPS.
  • DuPont: ROE = Net profit margin × Total asset turnover × Equity multiplier.
  • State your assumptions whenever the question leaves the basis of a figure unclear.

Financial Analysis and Planning - Ratio Analysis practice questions

Financial Analysis and Planning - Ratio Analysis in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Financial Analysis and Planning - Ratio Analysis: frequently asked questions

How many marks does Ratio Analysis carry in the FM exam?

ICAI does not publish fixed marks for each chapter. Treat it as a major, high-scoring chapter because it tests both through MCQs and written questions, and it supports later chapters.

Do I need to memorise all the ratio formulas?

Yes, and you also need to know the exact basis of each figure. Keep a one-page formula sheet and test yourself from memory until you can write it without errors.

How do I solve a question where only ratios are given?

Start with the ratio that gives you a figure directly, then build the balance sheet or statement of profit and loss step by step. Show each working so you earn step marks.

What should I do if the question does not say whether to use average or closing balances?

Use the figures available, and write your assumption clearly. If both opening and closing balances are given, use the average.