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RATIO ANALYSIS Vikash Kumar- 2010237
Pallavi Bhati- 2010214Fallan Menezes-2010198
What is Ratio Analysis?
A tool used to conduct a quantitative analysis of information in a company's financial statements.
Why is it used?
Ratio Analysis enables to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry.It enables analysts to evaluate past performance, assess current financial position, and gain insights for projecting future results.
Category Description
Turnover Measures how efficiently a company performs day-to-day tasks, such as collection of receivables and management of inventory.
Liquidity Measures the company’s ability to meet its short-term obligations.
Solvency Measures a company’s ability to meet long-term obligations.
Profitability Measures the company's ability to generate profitable sales from its resources(assets).
CATEGORIES OF FINANCIAL RATIOS
Liquidity Ratios
Turnover Ratios
Solvency Ratios
Profitability Ratios
Current Ratio Inventory Turnover Ratio
Debt Equity Ratio
Gross Profit Ratio
Quick Ratio(Acid Test Ratio)
Debtor Turnover Ratio
Interest Coverage ratio
Net Profit Ratio
Cash RatioAsset Turnover Ratio
Operating ratio
Expense Ratio
Return on Capital Employed
Return on Shareholder’s Funds
CLASSIFICATION OF RATIOS
Liquidity is the ability of a firm to meet its current liabilities. It is of great importance to creditors. Eg- Current Ratio, Quick Ratio, Cash Ratio.
Current Assets are the assets which can be converted into cash within a period of one year.
It includes cash in hand, cash in bank, Accounts Receivable, Inventory, Prepaid Expenses, Marketable Securities, Short term investments.
Current Liabilities are liabilities which are due to be paid by the company within a period of one year.
It includes Accounts payable, Short term loans.
LIQUIDITY RATIOS
Net Working Capital = Current Assets – Current Liabilities
NET WORKING CAPITAL
Current Ratio = Current Assets/Current Liabilities
Indicates a firm’s ability to meet its short term liabilities on time Current Assets= Rs 40000 & Current Liabilities =Rs.20,000
Current Ratio will be : Rs.40,000/Rs.20,000 = 2 : 1 The ideal current ratio is 2:1 i.e. Current Assets should be at least twice of
its current liabilities. Although the ideal ration varies from industry to industry
If current ratio is less than 2:1, it indicates lack of liquidity and shortage of working capital
If current ratio is higher than 2:1, then stock might be piling up, large amount in debtors due to inefficient debt collection policy & cash laying idle due to poor inadequate investments
CURRENT RATIO
Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities
Quick Current Assets= Current assets – stock- prepaid expenses.
Indicates whether the firm is in a position to pay its current liabilities within a month or immediately
Ideal quick ratio is said to be 1:1 The quick ratio is a more conservative and realistic than current ratio because it
includes only the more liquid assets Better test of short term financial position of a firm than the current ratio.
QUICK RATIO/ ACID TEST RATIO
Cash Ratio= Cash+ Cash equivalents/Current Liabilities
The cash ratio is even more conservative than the quick ratio It measures the amount of cash & cash equivalents such as short-
term marketable investments to cover current liabilities
CASH RATIO
Following is the Balance Sheet of X ltd.
Problem 1
Liabilities Amount Assets Amount
Equity Share Capital 150,000 Goodwill 80,000
12% Preference Share capital
1,30,000 Land and Building 150,000
Bank Loan 80,000 Machinery 130,000
P&L a/c 110,000 Long Term Investments
50,000
14% Debentures 50,000 Stock 1,10,000
Sundry Creditors 35,000 Debtors 20,000
Bills Payable 25,000 Bills Receivable 40,000
Outstanding Expenses 10,000 Short Term Investments
10,000
Provision For Taxation 15,000 Cash 30,000
Proposed Dividends 20,000 Prepaid Expenses 5,000
625,000 625,000
Calculate:1. Net Working Capital2. Current Ratio3. Quick Ratio4. Cash Ratio
Current Assets Amount
Current Liabilities Amount
Stock 110,000 Sundry Creditors 35,000
Debtors 20,000 Bills Payable 25,000
B/R 40,000 Outstanding Expenses 10,000
Short Term Investments 10,000 Provision for Tax 15,000
Cash 30,000 Proposed Dividends 20,000
Prepaid Expenses 5,000 _______
215,000 105000
Solution:
1. Net Working Capital= Current Assets – Current Liabilities = 2,15,000-1,05,000 = Rs. 1,10,000
2. Current Ratio= Current Assets/ Current Liabilities = 2,15,000/1,05,000 = 2.05:1
3. Quick Assets= Current Assets- Stock- Prepaid Expenses = 2,15,000- 1,10,000- 5,000 = Rs. 1,00,000 Quick Ratio= Quick Assets/ Current Liabilities = 1,00,000/1,05,000 = 0.95:1
4.Cash Ratio= (Cash+ Short term investments)/ Current Liabilities = (30,000+10,000)/ 1,05,000 = 0.38:1
Measures how well the resources of the company are being utilized.
Measures the rapidity with which the resources like stock, debtors, fixed assets, working capital etc. are being used to produce sales.
Eg- Stock Turnover, Receivable Turnover, Fixed Asset Turnover Ratio
TURNOVER RATIOS
Stock Turnover Ratio= Cost of Goods Sold/ Average stock
Cost of Goods Sold= Opening Stock+ Purchases - Closing StockAverage Stock = (Opening Stock + Closing Stock)/ 2
Indicates the efficiency in utilization of stock It shows the number of times the stock is converted into sales during the year Low ratio indicates that stock is lying idle in the godown for long High Ratio indicates the stock is being utilized efficiently
STOCK/ INVENTORY TURNOVER RATIO
EXAMPLE: Calculate the Stock Turnover Ratio.Trading Account
Particulars Amount Particulars Amount
Opening Stock 60,000 Sales 1,40,000
Purchases 1,00,000 Less: Sales Returns40,000
1,00,000
Gross Profit 8,000 Closing stock 68,000
1,68,000 1,68,000
Cost of goods sold = 60,000 +1,00,000-68,000 = 92,000Average Stock= (60,000+ 68,000)/2= 64,000Stock Turnover ratio= 92,000/64,000 =1.44 Times
Debtors Turnover Ratio= Net Credit Sales/ Average Debtors+ Average Bills Receivable
(NOTE: use Net Sales if Net Credit Sales is not given)
Indicates the speed with which the amount is collected from debtors
Higher the ratio, the better since it indicates the collection from debtors are more rapid
Lower Debtor turnover ratio indicates inefficient credit sales policy of the management
DEBTORS TURNOVER RATIO
EXAMPLE: Calculate the Debtor’s Turnover Ratio.
Particulars Amount
Total Sales for the Year 1,75,000
Credit Sales @ 60% of total sales 1,05,000
Sales Return out of credit sales 5,000
Sundry Debtors: Opening Balance Closing Balance
8,00012,000
Net Credit Sales= 1,05,000- 5,000= 1,00,000Average Debtors= 8,000+ 12,000/ 2= 10,000Debtors Turnover Ratio= 1,00,000/ 10,000= 10 Times
Fixed Asset Turnover Ratio = Revenue/ Net Fixed Assets
Net fixed Assets = Fixed Assets – Depreciation Ratio indicates how efficiently the fixed assets are
being utilized High asset turnover ratio indicates better utilization of
fixed assets
FIXED ASSET TURNOVER RATIO
Total Asset Turnover Ratio = Revenue /Average Total Assets
Total Assets = Fixed Assets + Current Assets Indicates how efficiently the assets are being utilized High asset turnover ratio indicates that the Company is
growing along with the Sales Companies with high profit margins have low Asset
Turnover Ratios & vice versa
TOTAL ASSET TURNOVER RATIO
Indicates the long term solvency of the firm.
Long term lenders are interested to in these ratios to learn how able is the company to make timely interest payments & repay principal.
Eg-Debt-Equity Ratio, Interest Coverage Ratio
SOLVENCY RATIO
Debt Equity Ratio= Debt/ Equity OR
Debt Equity Ratio= Long term Loans/ Shareholder’s Funds
Long Term Loans: Long-term liabilities which mature after one year like Debentures, Mortgage Loan, Bank Loan, Loan from financial institutions and Public Deposits
Shareholder’s funds: Equity share capital, preference share capital, share premium, General reserve, Capital reserve, Other reserves and credit balance of P&L account
Ratio indicates the ability of a firm to meet its long term liabilities
Debt equity ratio of 2:1 is considered to be safe
Higher debt equity ratio shows a risky financial position as it indicates more and more funds invested in the business are provided by long term lenders
DEBT- EQUITY RATIO
Liabilities Rs Assets Rs.
Equity Share Capital 2,00,000 Fixed Assets 3,80,000
Preference Share Capital
50,000 Current Assets 2,20,000
Reserves 50,000
P&L a/c 60,000
Current Liabilities 70,000
15% Debentures 100,000
Bank Loan 70,000 _________
6,00,000 6,00,000
Long Term Debt= 1,00,000 + 70,000= 170,000Shareholder’s Funds= 2,00,000+ 50,000+ 50,000+ 60,000 = 3,60,000Debt Equity Ratio= 170,000/ 360,000= 0.47:1
EXAMPLE: Calculate the debt- equity ratio.
Interest Coverage Ratio= NPBIT/ Fixed interest charges
Ratio indicates the no. of times interest charges are covered by the profits to pay interest charges
Higher ratio implies greater safety for long term lenders
Appropriate interest coverage ratio must be 6-7 times
INTEREST COVERAGE RATIO
EXAMPLE:From the Following Data Calculate the Interest Coverage ratio:
Particulars Amount
Net Profit before Interest and Tax 3,60,000
15% Debentures 2,00,000
Fixed Interest = 2,00,000*15%= 30,000
Interest Coverage Ratio= Rs. 360,000/ 30,000= 12 Times
Profitability Ratios measure the return earned by the company during a period
It reflects a company’s competitive position in the market
Eg -Return on capital employed, Return on equity, Asset turnover ratio
PROFITABILITY RATIOS
ROCE= (NPBITD/ Capital employed)*100
NPBITD= Net profit before interest, tax and dividends
Capital Employed= Equity Share Capital + Preference Share Capital + Reserves+ P&L A/C + Debentures
The higher the ratio, the more efficient is the use of capital employed
RETURN ON CAPITAL EMPLOYED
ROE= (Net Profit after tax, interest and preference dividend/Equity Share Holder’s Funds)*100
Equity Share Holder’s Funds= Equity Share Capital + Preference Share Capital+ Reserves+ P&L A/C
ROE is calculated to see the profitability of owner’s investment
RETURN ON SHAREHOLDER’S EQUITY
Following is the Balance Sheet of X Ltd
Problem 2
Liabilities Rs Assets Rs
Equity Share Capital 4,00,000 Fixed Assets 8,00,000
12% Preference Share Capital
2,00,000 Current Assets 3,80,000
Reserves 30,000
P&L a/c 2,20,000
15% Debentures 1,00,000
Current Liabilities 2,30,000 __________
11,80,000 11,80,000
Profit for Current Year before interest and tax= Rs. 3,55,000Tax Rate 50%Calculate:a) ROCEb) Return on Equity Shareholder’s Funds
SOLUTION:a) ROCE= (NPBIT/ Capital Employed)*100 Capital Employed= Equity Share Capital +
Preference Share Capital + Reserves+ P&L A/c + Debentures
Capital Employed = 4,00,000+ 2,00,000+ 30,000+ 220,000+100,000= Rs. 9,50,000ROCE= (355,000/ 950,000)*100 = 37.37%
b) ROE= NPAT/ Equity Share holder’s fundsCalculation of NPAT
Particulars Amount
NPBIT 3,55,000
Less: Interest in Debentures @ 15% on Rs. 100,000 15,000
3,40,000
Less: Tax@ 50% 1,70,000
NPAT 1,70,000
Less: Dividend on Pref. Share Capital @ 12% on Rs. 200,000 24,000
Net Profit after interest, tax and preference dividend 1,46,000
Equity Share Holder’s Funds= Equity Share Capital + Preference Share Capital +Reserves+ P&L a/c = 400,000+ 200,000+30,000+220,000 =Rs. 8,50,000ROE= (1,46,000/ 8,50,000)*100= 17.18%
The homogeneity of a company’s operating activities: difficult to find comparable industries
The need to use judgment: • cannot be used alone • Indicator of some aspect of a company’s performance ,telling what
happened but not why happened
The use of alternative accounting methods: the difference in accounting can distort ratios, and for a meaningful comparison may involve adjustment to the financial data
Company size sometimes confers economies of scale, so the absolute amounts of net income and revenue are useful. But, ratios reduce the effect of size to enhance comparison between companies and over time
LIMITATIONS
1)In order to assess a company’s ability to fulfill it’s long-term obligations, you would most likely examine
a) Activity ratiosb) Liquidity ratiosc) Solvency ratios
Ans. c
REVIEW QUESTIONS
2) Which ratio would a company most likely use to measure its ability to meet short-term obligations
a) Interest coverage ratio b) Current ratioc) Debt-to-equity ratio
Ans b
3) In general, a creditor would consider a decrease in which of the following ratios to be positive news
a) Interest coverage ratio b) Current ratioc) Debt-to-equity ratio
Ans c
4) Data for XYZ Ltd.(figures in millions of Rs.)
Select the correct optiona) Company is becoming increasingly less solventb) Company is becoming less liquidc) Company is becoming increasingly more liquid
Ans a 2003: 0.35, 2004: 0.4222, 2005: 0.50( debt to equity ratios)
2003 2004 2005
Total debt 1750 1900 2000
Total equity 5000 4500 4000
5) Select the most appropriate cause of increase in debtors turnover of XYZ Ltd.
a) The company adopted new credit policies and began offering credit to customers with weak credit historiesb) The company had accumulated a substantial amount of uncollectible accounts and wrote off a large amount of its receivablesc) Due to competition, the company adopted new payment terms, requiring payment in 30 days rather than previous requirement of 15 days
Ans b
6) Select the most appropriate cause of decrease in inventory turnover of XYZ Ltd.
a) The company installed a new inventory management system, allowing more efficient inventory management.b) The company wrote off a large amount of obsolescent inventoryc) The company installed a new inventory management system, but experienced some operational difficulties resulting in duplicate orders being placed with suppliers
Ans c
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