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FINANCIAL ANALYSIS THROUGH RATIO ANALYSIS

UNIT VI

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RATIO is a simple mathematical expression, which explains Quantitative Relationship between the two.

RATIO ANALYSIS is a technique of interpretation of financial statements.

INTRODUCTION

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CLASSIFICATION OF RATIOS

Liquidity Ratios (short term solvency)
Leverage Ratios (long term solvency)
Turnover Ratios (performance)
Profitability Ratios

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LIQUIDITY RATIOS

Also called as short term solvency ratios.
These ratios are used to measure the short term solvency of the firm.

Following are liquidity ratios

1. Current ratio

2. Quick ratio

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CURRENT RATIO

Also called as working capital ratio.

It is the ratio of current assets and current liabilities.

Current ratio = C.A / C.L

A current ratio of 2:1 is usually considered as ideal.

If it is less than 2, it indicates there is no adequate liquidity.

If it is greater than 2, it indicates funds are idle and are not invested properly.

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WORKING CAPITAL

Also called as circulating capital.
It is minimum amount of money or finances that are required to meet regular operating expenses of business.
It should be neither excess nor inadequate.
From accounting point of view working capital is difference between current assets (C.A) and current liabilities (C.L)
Working capital = C.A – C.L

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ASSETS

Assets are resources that add value to the business and helps in generating income.
Assets are classified in to fixed assets and current assets. (Assets = F.A +C.A )
Current assets are also called as short term assets.
Current assets are assets that are expected to be converted into cash within one year.
They possess high liquidity.

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CURRENT ASSETS

Cash
Cash in hand
Cash at bank
Closing stock
Sundry debtors
Bills receivables
Prepaid expenses
Outstanding incomes
Short term investments.

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FIXED ASSETS

They are acquired to use for long period of time.
They possess less liquidity compared to current assets.
Plant and machinery
Land and buildings
Furniture and fittings
Motor van
Good will
Intellectual property
Long term investments

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LIABILITIES

A company's debts or obligations that arise during the course of business operations.
Liabilities = Current liabilities + long term liabilities.
Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a longer period.

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CURRENT LIABILITIES

Bank over draft
Sundry Creditors
Bills payable
Outstanding expenses
Income received in advance
Short term loans
Provision for taxation
Proposed dividends

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LONG TERM LIABILITIES

Share capital
Debentures
Term loans

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QUICK RATIO

Also called as acid test ratio.
It is the ratio of quick assets to current liabilities. (Quick ratio = Q.A / C.L )
Quick assets or liquid assets = Current assets – (stock + prepaid expenses).
A quick ratio of 1, is usually considered ideal.
If it is less than 1, it is indication of inadequate liquidity.
A high quick ratio is not advisable, as funds can be more profitably employed.

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Absolute liquid Ratio or Super Quick Ratio:

= Absolute liquid Assets

Current Liabilities

Absolute Liquid Assets: Cash in hand, Cash at Bank and short term Investments.

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Leverage Ratios (long term solvency)

Debt Equity Ratio

Proprietary Ratio

Fixed Assets Ratio

Interest Coverage Ratio

Dividend Coverage Ratio

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1. Debt-Equity Ratio = (Debt/Equity) or (Outsiders fund/ Insider’s fund)

Debt Equity Ratio = long term liabilities/ share holders fund

Ideal Debt Equity Ratio is 2 : 1

Debt equity ratio indicates relative claim of debenture holders and share holders against the assets of the business.

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2. Interest Coverage Ratio = Profit before Interest and taxes/Fixed interest charges

Ideal Interest Coverage Ratio is 6 times
The higher the ratio the better it is for the firm
The above ratio indicates firms ability to pay interest to debenture holders out of available profits

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3. Ratio of Proprietors funds to total Assets = proprietors funds/total Assets × 100

Above ratio indicates financial strength of a firm
Proprietor fund also referred as share holders fund
The higher the ratio the better it is for the firm

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4. Fixed Assets Ratio = Fixed Assets / capital employed

Above ratio indicates mode of financing fixed assets
A financially well managed company always uses long term source of finance for financing its fixed assets
Ideal fixed assets ratio is 0.67

5. Dividend Coverage Ratio = PAT/Preference Dividend

It indicates firms ability to pay dividends out of its profits

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Turnover Ratios (performance)

Inventory Turn over ratio or Stock Turnover ratio
Debtors Turn over ratio
Creditors Turn over ratio
Working Capital Turn over ratio
Fixed assets turnover ratio

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1. Stock Turnover Ratio: Cost of Goods sold

Avg stock

Cost of Goods sold: Opening stock+ Net Purchases+ All Direct Expenses - Closing stock

Average Stock: Opening stock + Closing stock

2

Ideal inventory turnover ratio is 8 times

2. Inventory holding Period = 365/Stock Turnover Ratio

ideal Inventory holding Period is 45 days

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3. Debtors Turnover Ratio = Credit Sales

Trade Debtors

Credit sales = Sales – Sales Returns

Trade Debtors = (Sundry Debtors + Bills Receivables)/2

Ideal debtor turnover ratio is 10 -12 times
Also consider if any opening and closing debtors*

4. Debt Collection Period = 365/ Debtors Turnover Ratio

Ideal debt collection period id 30 – 37 days

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4. Creditors Turnover Ratio = Credit Purchases

Trade Creditors

Credit Purchase = Credit Purchase – Purchase return

Trade Creditors = Sundry Creditors + Bills Payables/2

Ideal creditor turnover ratio is 12 times

Debt payment Period = 365/ creditor Turnover Ratio

Ideal debt payment period is 30 days

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5. Fixed Assets Turnover Ratio =

Net sales / fixed assets

This ratio indicates how well a firm is utilizing its fixed assets

Ideal fixed assets turnover ratio is 5 times

The higher the ratio, the better it is for the firm.

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PROFITABILITY RATIOS

Gross Profit Ratio

Net Profit Ratio

Operating Ratio

Return on investment or Capital Employed

Return on equity capital

Earning Per Share (EPS)

Price Earning Ratio (P/E Ratio)

Earning yield ratio

Dividend yield ratio

Dividends Per Share (DPS)

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1. Gross profit Ratio = (Gross profit / net sales) × 100

2. Net profit Ratio = (Net profit after taxes/ Net sales) × 100

3. Operating Ratio = (Operating expenses / Net sales) × 100

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Net sales = Sales – Sales Return

Where operating expenses = (Cost of goods sold+ Administrative expenses+ selling and distribution expenses)

Administrative expenses = expenses cover all office and management expenses such as salaries, office rent, insurance, director’s fee, legal expenses, and so on.

Selling and distribution expenses include salaries to sales staff, advertising expenses, travelling expenses, and cost of samples and so on.

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4. Return on Investment (ROI) =Profit before interest and tax / Total Investment

5. Return on Equity (ROE) = (Net profits- Dividends payable to Preference shareholders) / Equity share capital.

6. Earnings per Share (EPS) = Net profit after taxes – preference dividend /Number of equity shares outstanding

7. Price/Earnings Ratio = Market price per share/ Earning per share

8. Earnings yield ratio = Earning per share / Market price per share

9. Dividend yield ratio = Dividend per share / Market price per share

10. Dividend payout ratio = Dividend per share/ Earning per share

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LIMITATIONS OF RATIO ANALYSIS

Limitations should be kept in mind while making use of ratio analyses for interpreting the financial statements. The following are the main limitations of ratio analysis.

1. False results if based on incorrect accounting data: Accounting ratios can be correct only if the data (on which they are based) is correct. Sometimes, the information given in the financial statements is affected by window dressing, i.e. showing position better than what actually is.

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2. No idea of probable happenings in future: Ratios are an attempt to make an analysis of the past financial statements; so they are historical documents. Now-a-days keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future.

3.Variation in accounting methods: The two firms’ results are comparable with the help of accounting ratios only if they follow the some accounting methods or bases. Comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock.

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4. Price level change: Change in price levels make comparison for various years difficult.

5. Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making so, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis.

6. No common standards: It is very difficult to by down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different.

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7. Different meanings assigned to the same term: Different firms, in order to calculate ratios may assign different meanings. This may affect the calculation of ratio in different firms and such ratio when used for comparison may lead to wrong conclusions.

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PRACTICE PROBLEMS

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1.) Following is the balance sheet of xyz ltd, you are required to comment on liquidity of the firm.

Liabilities	Amount	Assets	Amount
Equity share capital Preference share capital Long term loans Debentures Sundry creditors Bills payable Provision for taxation Proposes dividend Bank over draft	5,00,000 3,00,000 3,25,000 1,50,000 75,000 30,000 70,000 24,000 20,000 14,94,000	good will Premises Machinery Investments Short term investments Stock Debtors Bills receivable Cash Prepaid expenses	1,00,000 3,00,000 4,50,000 1,00,000 44,000 1,75,000 1,75,000 1,25,000 10,000 15,000 14,94,000

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2.Calculate Turnover ratios from the given below information.

Profit & Loss Account

Particulars	Amount	Particulars	Amount
To opening stock To purchases Cash Credit To administration expenses Profit c/d	80,000 96,000 7,00,000 1,69,000 75,000 11,20,000	By sales 10,40,000 (-) returns 40,000 By closing stock	10,00,000 1,20,000 11,20,000

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Liabilities	Amount	Assets	Amount
Share capital reserves Debentures Creditors Bills payable Provisions	3,00,000 1,50,000 2,00,000 1,30,000 70,000 60,000 9,10,000	Buildings Plant Investments (within business) Stock Debtors 50,000 Less provisions 10,000 Bills receivable 1,75,000 Less provisions 15,000 cash	2,50,000 2,10,000 80,000 1,20,000 40,000 1,60,000 50,000 9,10,000

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3. Following is the balance sheet of xyz ltd as on 31^st March, 2005

Liabilities	amount	Assets	amount
Equity share capital 9% Preference share capital Reserves 12% debentures Current liabilities provisions	2,00,000 1,00,000 8,00,000 8,00,000 81,000 44,000 20,25,000	Fixed assets Current assets Miscellaneous expenses	17,50,000 2,00,000 75,000 20,25,000

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Additional Information:

During the year ended xyz ltd reported a profit before tax of 2,00,000, after providing for interest on debentures.

Assuming tax rate 50%, you are required to calculate relevant solvency ratios.

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END