RATIO ANALYSIS

What is Ratio Analysis?

Ratio analysis is a widely used tool of financial analysis. Can be used to compare the risk and return relationship of

firms of different sizes.

Systematic use of ratios to interpret the financial statements so

that the strengths and weaknesses of a firm

Helps determine a firms historical performance and current

financial condition.

Why Ratio Analysis?

Ratios reveal the relationship between two items/ variables in

a more meaningful way so as to enable equity investors, management and lenders to arrive at the following factors for making better investment and credit decisions.
Liquidity position Profitability Solvency Financial Stability

Quality of the Management

Safety & Security of the loans & advances to be or already

been provided

How a Ratio is expressed?

such as 25% or 50% . For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/then the net profit can be said to be 25% of the sales. As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.
As Percentage -

Classification of Ratios
Liquidity Ratios Current Ratio Quick Ratio (Acid Test Ratio) Turnover Ratios Stock Turnover Ratio Debtor Turnover Ratio Asset Turnover Ratio Solvency Ratios Debt Equity Ratio Interest Coverage ratio Profitability Ratios Gross Profit Ratio Net Profit Ratio

Operating ratio

Cash Ratio

Expense Ratio Return on Capital Employed

Return on Shareholders Funds

Liquidity Ratios
Liquidity refers to the ability of the firm to meet its current

liabilities
Liquidity ratios are therefore called Short-term Solvency Ratios

Used to assess the short-term financial position of a firm

Include firms ability to meet its current obligations out of current

resources.
Of prime importance to Short term creditors as they want to know

how promptly or readily the firm can meet its current liabilities

Current Assets and Current Liabilities

Current

Assets= Assets which can be converted into cash in less than 1 year Eg. Cash in hand + Cash in bank, Cash equivalent, Accounts Receivable, Inventory, Prepaid Expenses, Marketable Securities, Short term investments Of prime importance to creditors since these assets can be easily liquidated if the company goes bankrupt Source of funds for day to day business operations
Current

Liabilities=Liabilities which are due to be paid by the company within a period of one year Eg. Accounts payable, Short term loans

Net Working Capital = Current Assets Current Liabilities

Current Ratio

It is the relationship between the current assets and current liabilities of a concern. Current Ratio = Current Assets/Current Liabilities

Significance: Used to assess the firms ability to meet its short term liabilities on time EXAMPLE: If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1

According to Accounting principle a current ratio of 2:1 is supposed to be an ideal ratio i.e. Current Assets should be at least twice of its current liabilities. If current ration less than 2:1. it indicates lack of liquidity and shortage of working capital However, a very high current ratio also not necessarily good for the company as it may indicate poor investment policies of the management.

Drawbacks of High Current Ratio:

1. Stock might be piling up because of poor sales
2. Large amount is locked up is locked up in debtors due to

inefficient collection policy 3. Cash and bank balances lying idle due to non availability of proper investment options

Quick Ratio/ Acid Test Ratio

It is the ratio between Quick Current Assets and Current Liabilities.

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Quick Current Assets/ Liquid Assets : Assets which yield cash very shortly.

Includes all current assets excluding stock and prepaid expenses Liquid Assets= Current assets stock- prepaid expenses
Significance:

Indicates whether the firm is in a position to pay its current liabilities within a period of 3 months or immediately Ideal quick ratio is said to be 1:1 Rationale being for every rupee of current liabilities there should be at least one rupee of current assets Better test of short term financial position of a firm than the current ratio, as it considers only those assets which can be readily and easily converted into cash

Example :
Current Assets Cash Debtors Prepaid Expenses Amount 50,000 1,00,000 20,000 Current liabilities Creditors Pre Received income Amount 100,000 30,000

Inventories
TOTAL

1,50,000
3,20,000 TOTAL 1,30,000

Quick Current Assets= 320000-20000-150000=150,000 Quick Ratio= 150,000/130,000= 1.15:1

Current Ratio V/s Quick Ratio

Current Ratio Position of a firm to pay its current liabilities within a year Current Ratio= Current Assets/ Current Liabilities Ideal Ratio is 2:1 Does not disclose the true short term financial position of the firm as it may include a large amount of stock which may not be quickly convertible into cash Quick Ratio Position of a firm to pay its current liabilities immediately or within a period of 3 months Quick Ratio= Liquid Assets/ Current Liabilities Ideal Ratio is 1:1 Removes this short coming by excluding the amount of stock

Cash Ratio
It is a ratio of cash and cash equivalents to current liabilities

Trade investment or marketable securities are equivalent of cash Significance: Cash is the most liquid asset

The cash ratio is an indicator of a company's liquidity that further

refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities.

Problem 1
Following is the Balance Sheet of X ltd.
Liabilities Equity Share Capital 12% Preference Share capital General Reserve P&L a/c 14% Debentures Sundry Creditors Amount Assets Amount 50,000 150,000 140,000 60,000 1,20,000 50,000 200,000 Goodwill 1,00,000 Land and Building 60,000 Machinery 150,000 Long Term Investments 50,000 Stock 35,000 Debtors

Bills Payable
Outstanding Expenses Provision For Taxation Proposed Dividends

5,000 Bills Receivable

10,000 Short Term Investments 20,000 Cash 20,000 Prepaid Expenses 650,000

26,000
20,000 30,000 4,000 650,000

 Calculate:
1. 2. 3. 4.

Net Working Capital Current Ratio Quick Ratio Cash Ratio

Solution:
Current Assets Stock Debtors B/R Short Term Investments Cash Prepaid Expenses Amount 120,000 50,000 26,000 20,000 30,000 4,000 Current Liabilities Sundry Creditors Bills Payable Outstanding Expenses Provision for Tax Proposed Dividends Amount 35,000 5,000 10,000 20,000 20,000 ______ _ 90,000

250,000 1. Net Working Capital= Current Assets Current Liabilities = 250,000-90,000 = Rs. 160,000

2. Current Ratio= Current Assets/ Current Liabilities = 250,000/90,000 = 2.7: 1 3. Quick Assets= Current Assets- Stock- Prepaid Expenses = 250,000- 120,000- 4,000 = Rs. 126,000 Quick Ratio= Quick Assets/ Current Liabilities = 126,000/90,000 = 1.2:1

4.Cash Ratio= (Cash+ Cash Equivalents)/ Current Liabilities = (30,000+ 20,000)/ 90,000 = 0.55: 1

Turnover ratios
Measure how well the resources at disposal of the concern are

being utilized
Indicate the rapidity with which the resources available to the

concern are being used to produce sales

They measure the efficiency and rapidity of resources of the

company, like stock, debtors, fixed assets, working capital etc.

Stock/ Inventory Turnover Ratio

Indicates the relationship between the cost of goods sold during the year and average stock

during that year

Stock Turnover Ratio= Cost of Goods Sold/ Average stock a) Cost of Goods Sold= Opening Stock+ Purchases+ Carriage Inwards+ wages+ Other Direct Charges- Closing Stock OR Cost of Goods Sold= Net - Gross Profit b) Average Stock = Opening Stock + Closing Stock/ 2
Significance Indicates whether stock has been efficiently used or not It shows the speed with which stock is rotated into sales or the number of times the stock is

turned into sales during the year Higher the better, since it indicates that stock is selling quickly Low ratio indicates that stock does not sell quickly and remains lying in the godown for a long time. Can be used for comparing the efficiency of sales policies of two firms doing same type of business Stock policy of the management of that firm, whose stock turnover ratio is higher, will be treated as more efficient.

 EXAMPLE:

Trading Account
Particulars Opening Stock Purchases Carriage inwards Wages Gross Profit Amount Particulars 5,40,000 40,000 5,00,000 68,000 ________ _ 5,68,000 Amount 60,000 Sales 2,50,000 Less: Returns 20,000 Closing stock 58,000 1,80,000 5,68,000 Cost of goods sold = 60,000 + 250,000+ 20,000+ 58,000- 68,000 = 320,000

Average Stock= 60,000+ 68,000/2l= 64,000 Stock Turnover Ratio= 320,000/ 64,000= 5 Times

Debtor/ Receivables Turnover Ratio

Indicates relationship between credit sales and average debtors during the year

Debtors Turnover Ratio= Net Credit Sales/ Average Debtors+ Average Bills Receivable

(NOTE: use Total Sales if Credit Sales not given)

Significance: Indicates the speed with which the amount is collected from debtors Higher the better, since it indicates amount from debtors is being collected more quickly. Lower Debtor turnover ratio indicates inefficient credit sales policy of the management

i.e. credit sales have been made to customers who do not deserve much credit assessed whether the sales policy of management is efficient or not.

By comparing the debtors turnover ratio of the current year and previous year, it may be

 EXAMPLE:
Particulars Total Sales for the Year Amount 1,75,000

Credit Sales @ 80% of total sales

Sales Return out of credit sales Sundry Debtors: Opening Balance Closing Balance Net Credit Sales= 140,000- 10,000= 130,000 Average Debtors= 8,000+ 12,000/ 2= 10,000 Debtors Turnover Ratio= 130,000/ 10,000= 13 Times

1,40,000
10,000 8,000 12,000

Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio = Cost of Goods Sold/ Average Net Fixed Assets

Net fixed Assets = Fixed Assets Depreciation Significance

Of importance in manufacturing concerns where the

investment in fixed assets is quite high Reveals how efficiently the fixed assets are being utilized High asset turnover ratio indicates better utilization of fixed assets

Solvency Ratios/ Capital Structure Ratios

Analyze the long term solvency of the firm Long term lenders, debenture holders and financial

institutions are interested in these ratios

Help judge the ability of a firm to pay the interest regularly

as well as repay the principal when due.

Debt- Equity Ratio

It is the relationship between borrowers fund (Debt) and Owners Capital (Equity).

Debt Equity Ratio= Debt/ Equity OR Long term Loans/ shareholders Funds or net worth
Long Term Loans: these refer to long-term liabilities which mature after one year. These include

Debentures, Mortgage Loan, Bank Loan, Loan from financial institutions and Public Deposits etc. premium, general reserve, capital reserve, other reserves and credit balance of P&L account.

Shareholders funds: These include equity share capital, preference share capital, share

Significance:

Calculated to assess the ability of a firm to meet its long term liabilities Debt equity ratio of 2:1 considered safe Higher debt equity ratio shows a risky financial position from the long term point of view

as it indicates more and more funds invested in the business are provided by long term lenders.

EXAMPLE:
Liabilities
Equity Share Capital Preference Share Capital Reserves P&L a/c Current Liabilities 15% Debentures

Rs
2,00,000 50,000 50,000 60,000 70,000 100,000

Assets
Fixed Assets Current Assets

Rs.
3,80,000 2,20,000

Bank Loan

70,000
6,00,000

_________
6,00,000

Long Term Debt= 1,00,000 + 70,000= 170,000 Shareholders Funds= 2,00,000+ 50,000+ 50,000+ 60,000= 3,60,000 Debt Equity Ratio= 170,000/ 360,000= 0.47:1

Interest Coverage Ratio

Also known as Debt Service Ratio Calculated by dividing the net profit before charging interest and income tax by fixed

interest charges

Interest Coverage Ratio= NPBIT/ Fixed interest charges Significance Indicates how many times the interest charges are covered by the profits available to pay

interest charges.

Long term lender is interested in finding out whether the business will earn sufficient

profits to pay the interest charges regularly

Higher ratio implies greater safety for long term lenders. Also indicates the extent to which profits can decline without in any way affecting the

firms ability to meet its fixed interest obligation

Interest coverage ratio of 6-7 times considered appropriate

 EXAMPLE:

From the Following Data Calculate the Interest Coverage ratio:

Particulars
Net Profit before Interest and Tax 15% Debentures

Amount
3,60,000 2,00,000

Fixed Interest = 2,00,000*15%= 30,000 Interest Coverage Ratio= Rs. 360,000/ 30,000= 12 Times

Particulars Sales

-Variable Cost/ Direct Cost Contribution

-Depreciation Profit before interest and tax (PBIT) -Interest Profit Before Tax -Tax Profit After Tax (PAT) -Preference dividend Earning for equity shareholders -Equity Dividend Reserves/ Retained Earnings

Trading Account

P&L account

Appropriation A/c

Profitability Ratios
Main object of every business is to earn profits

Business must be able to earn adequate profits in relation to

the risk and capital invested in it The efficiency and success of a business can be measured with the help of profitability ratios Can be of two types: based on sales and based on investment in business Profitability ratios based on investment in business reflect the true earning capacity of the resources employed in the business

Profitability Ratios Based on Sales

Profitability Ratios Based on Investment in Business

Gross Profit Ratio Net Profit Ratio

Return on Capital Employed Return on Shareholders Funds

Operating Ratio
Expenses Ratio

Return on Capital Employed (ROCE)

Reflects the overall profitability of the business Calculated by comparing the profit earned and the capital employed

to earn it.

ROCE= (NPBITD/ Capital employed)*100

NPBITD= Net profit before interest, tax and dividends PBIT in the table
Capital Employed= Equity Share Capital + Preference Share Capital +

Reserves+ P&L A/c + Debentures

Generally, the higher the net profit, the higher the ROC The higher the ROCE, the more efficient is the use of capital

employed.

Question - ROCE Assets 10,00,000 Liabilities 2,00,000 Revenue 3,00,000 Operating Expenses 2,00,000 Calculate ROCE if Capital Employed can be calculated as (Assets Liabilities)

Return on Shareholders Equity

It is calculated to see the profitability of owners investment. It is net profit after taxes, interest and preference dividend

divided by shareholders equity.

ROE= (Net Profit after tax, interest and preference dividend/Equity Share

Holders Funds)*100
Earnings for equity share holders in the table Equity Share Holders Funds= Equity Share Capital + Reserves+ P&L a/c

Question - RoE Equity share capital 10,00,000 9% preference share capital 5,00,000 Tax rate 50 % Net profit 4,00,000 Calculate Return on Equity

Earnings Per Share (EPS)

It is calculated by dividing the profit after taxes by total number

of ordinary shares outstanding.

EPS= PAT/Number of shares outstanding It indicates that whether or not the firms earnings power on

per-share basis has changed over the year. Generally, the higher the net profit, the higher the ROC The higher the ROCE, the more efficient is the use of capital employed.

Problem 2
Following is the Balance Sheet of X Ltd
Liabilities Equity Share Capital 12% Preference Share Capital Reserves Rs 4,00,000 2,00,000 50,000 Assets Fixed Assets Current Assets Underwriting Commission Rs 8,00,000 3,80,000 20,000

P&L a/c
15% Debentures Current Liabilities

2,20,000
1,00,000 2,30,000 12,00,000 __________ 12,00,000

Profit for Current Year before interest and tax= Rs. 3,55,000 Tax Rate 50% Calculate: a) ROCE b) Return on Equity Shareholders Funds

 SOLUTION:

ROCE= (NPBIT/ Capital Employed)*100 Capital Employed= Equity Share Capital + Preference Share Capital + Reserves+ P&L A/c + DebenturesUnderwriting Commission Capital Employed = 400,000+ 200,000+ 50,000+ 220,000 +100,000- 20,000= Rs. 9,50,000 ROCE= (355,000/ 950,000)*100 = 37.43%
a)

b) ROE= NPAT/ Equity Share holders funds Calculation of NPAT

Particulars Amount

NPBIT
Less: Interest in Debentures @ 15% on Rs. 100,000 Less: Tax@ 50%

3,55,000
15,000 3,40,000 1,70,000

NPAT
Less: Dividend on Pref. Share Capital @ 12% on Rs. 200,000 Net Profit after interest, tax and preference dividend

1,70,000
24,000 1,46,000

Equity Share Holders Funds= Equity Share Capital + Preference Share Capital +Reserves+ P&L a/c+ Debentures - Underwriting Commission = 400,000+ 200,000+ 220,000- 20,000 =Rs. 650,000 ROE= (146,000/ 650,000)*100= 22.46%

Problem 3
Liabilities
Sundry creditors Bills payable Tax provision Outstanding expenses 10% Mortgage Loan

Rs.
60,000 100,000 130,000 10,000 700,000

Assets
Bank Investment @ 12% Debtors Stock Fixed Assets: 18,00,000

Rs. 50,000 150,000 200,000 300,000 13,00,000

12% Preference Share Capital Equity Share Capital

Reserve Fund

100,000 500,000
400,000 20,00,000

Less: Dep:

5,00,000

_______ 20,00,000

Other information: 1. Net Sales = Rs. 27,00,000 2. Cost of goods sold= Rs. 22,80,000 3. Net profit before tax= Rs.2,00,000 4. Net profit after tax= Rs. 1,20,000

Calculate:
1. Net Working Capital

2. Current Ratio
3. Interest Coverage Ratio 4. Stock Turnover Ratio 5. Debtors Turnover Ratio 6. Fixed Asset Turnover Ratio 7. ROCE 8. ROE

Solution:
Current Assets = Bank + Debtors + Stock = 50,000+ 200,000 + 300,000 = Rs. 550,000 Current Liabilities = Creditors+ Bills Payable + Tax Provision+ O/S Expenses = 60,000 + 100,000 + 130,000 + 10,000 = Rs. 300,000
1.

Net Working Capital = 550,000- 300,000= Rs. 250,000

2. 3.

Current Ratio= 550,000/ 300,000 = 1.83: 1 Interest Coverage Ratio = NPBIT/ Fixed Interest Charges = (200,000+ 70,000)/70,000 = 3.86 Times

4.

Stock Turnover Ratio = COGS/ Avg. Stock

= 22, 80, 000/ 300,000 = 7.6 times

5.

Debtors Turnover Ratio = Credit Sales/ Avg. Stock = 27,00,000/ 200,000

Fixed Asset Turnover Ratio = COGS/ Avg. Net Fixed Assets = 22,80,000/ 13,00,000

6.

7. ROE= NPA ( interest, tax and pref. dividend)/ equity

shareholders funds* 100

Particulars NPAT Amount 120,000

Less: Pref. Dividend

12,000 108,000

ROE = [108,000/ (500,000+ 400,000)]*100 = 12%

8. ROCE= (PBIT/ Capital Employed)*100

Particulars NPAT Add: Interest on Debentures Amount 2,00,000 70,000 2,70,000 Less: Interest on Investments 18,000

PBIT

252,000

Calculation of capital employed: Particulars

12% preference share capital Equity share capital
Reserve Fund 10% Mortgage Loans Less: Investments

Amount
100,000 500,000
400,000 700,000 17,00,000 150,000 15,50,000

ROCE= (252,000/ 15,50,000)*100= 16.26%