08 Ratio Analysis

RATIO ANALYSIS

OBJECTIVE OF RATIO• TO UNDERSTAND THE RELATIONSHIP

BETWEEN TWO VARIABLES.• FACILITATES COMPARISON WITH

SIMILAR TYPE OF BUSINESS CONCERN.• FACILITATES TO ASSESS FINANCIAL

STRENGTH OF A BORROWER.• HELPS IN ASSESSING REPAYING

CAPACITY OF A BORROWER.• FOR ASSESSMENT OF LIQUIDITY &

SOLVENCY OF A BUSINESS CONCERN.

OBJECTIVE OF RATIO• TO KNOW THE TREND OF BUSINESS

GROWTH.• ASSIST CONCERN TO FORECAST

BUSINESS AND FOR PLANNING.• HELP CREDITOR TO TAKE A CREDIT

DECISION.• HELPS INVESTORS TO TAKE A

DECISION FOR MAKING INVESTMENT.

HOW DO WE EXPRESS RATIOS?

• AS A PERCENTAGEEG. NET PROFIT IS 25% OF SALES.• AS FRACTION / DECIMALSEG. NET PROFIT IS 1/4 OF SALES• AS A PROPORTIONEG. THE RATIO OF NET PROFIT TO SALE

IS 1 :4• AS A NUMBER OF TIMESEG. SALES ARE 4 TIMES OF NET PROFIT

TYPES OF RATIOS

•SOLVENCY RATIO•LIQUIDITY RATIO•LEVERAGE RATIO•PROFITABILITY RATIO•ACTIVITY RATIO

SOLVENCY RATIO

• A UNIT IS SAID TO BE SOLVENT IF ITS TANGIBLE ASSETS ARE MORE THAN IT OUTSIDE LIABILITIES.

• SOLVENCY CAN BE MEASURED BY FINDING OUT TANGIBLE NET WORTH (TNW) ----

TNW = NET WORTH - INTANGIBLE ASSETS • A UNIT IS SOLVENT IF ITS TNW IS

POSSITIVE . WHERE THE TNW IS NEGATIVE IT IS NOT SOLVENT.

SOLVENCY RATIO• TNW CAN ALSO BE FOUND OUT BY

DEDUCTING TOTAL OUT SIDE LIABILITIES (TOL) FROM TOTAL TANGIBLE ASSETS ( TTA)

TNW = TTA - TOL• ANOTHER METHOD OF MEASURING SOLVENCY

RATIO TOTAL TANGIBLE ASSETSSOLVENCY RATIO =

-------------------------------------------- TOTAL OUTSIDE LIABILITIES• WHERE THIS RATIO IS MORE THAN ONE , THE

UNIT IS SOLVENT.

LIQUIDITY RATIO• ABILITY T0 MEET CURRENT OBLIGATION

IS KNOWN AS LIQUIDITY.• A CONCERN IS SAID TO HAVE LIQUIDITY

IF IT IS IN A POSITION TO MEET ITS CURRENT LIABILITY OUT OF ITS CURRENT ASSETS..

• LIQUIDITY IS ALSO REFERRED TO AS SHORT TERM SOLVENCY WHICH MEANS THE UNIT IS IN A POSITION TO MEET ITS SHORT TERM LIABILITIES ( CURRENT LIABILITIES ) OUT OF ITS SHORT TERM ASSETS ( CURRENT ASSETS )

WHAT IS THE IMPORTANCE OF CURRENT ASSETS OF A

BUSINESS CONCERN?• CURRENT ASSETS OF A FIRM ARE THE

ASSETS REQUIRED TO RUN THE DAY TO DAY OPERATIONS OF THE FIRM

• IT IS ALSO CALLED THE WORKING FUND OR WORKING CAPITAL IN A WIDER SENSE

• CURRENT LIABILITIES ARE SUPPOSED TO BE MET THROUGH REALIZATION OF CURRENT ASSETS

• TO ASCERTAIN THE RELATIONSHIP BETWEEN CURRENT ASSETS AND CURRENT LIABILITIES.

CURRENT RATIO CURRENT ASSETS CURRENT RATIO = -------------------------- CURRENT LIABILITIES• THE IDEAL CURRENT RATIO IS 2:1 • ACCEPTABLE CURRENT RATIO IS 1.33 : 1,

1.17 : 1 AS AN ACCEPTABLE LEVEL.• A HIGHER CURRENT RATIO MAY INDICATE A

VERY COMFORTABLE POSITION FOR SHORT TERM LENDERS BUT IT AFFECTS PROFITABILITY ADVERSELY.

• I F THE CURRENT RATIO IS LESS THAN ONE, THE UNIT MAY BE SICK OR TENDING TOWARDS SICKNESS.

QUICK RATIO ( ACID TEST RATIO )

• INDICATES THE EXTENT TO WHICH LIQUID RESOURCES ARE AVAILABLE TO QUICKLY ( IMMEDIATELY ) MEET CURRENT OBLIGATION.

• IT IS A MEASURE OF INSTANT LIQUIDITY POSITION OF THE CONCERN

QUICK ASSETS • QUICK RATIO =--------------------------- OUTSIDE LIABILITIES

QUICK RATIO(ACID TEST RATIO)

• QUICK ASSETS = C.A. - INVENTORY• OUT SIDE LIABILITIES = CURRENT

LIABILITIES - BANK BORROWING• THE IDEAL QUICK RATIO IS ; 1: 1• QUICK RATIO SHOULD BE STUDIED WITH

CURRENT RATIO AND NOT IN ISOLATION.• A HIGHER CURRENT RATIO BUT LOW

QUICK RATIO MAY INDICATE LARGE STOCK OF INVENTORY.

LEVERAGE RATIO LONG TERM DEBT• DEBT EQUITY RATIO = --------------------------- TANGIBLE NET WORTH• MEASURES THE BORROWINGS OF A FIRM

COMPARED TO ITS EQUITY /NET WORTH• ALSO MEASURED AS TOTAL OUTSIDE

LIABILITY TO EQUITY ( TOL/TNW)• ACCEPTABLE ; 2 :1 (NORMAL) : 4:1 ( SSI)• HIGHER THE RATIO MORE THE BORROWED

FUNDS.

PROFITABILITY RATIOS• A STRONG AND HEALTHY UNIT MUST

ACHIEVE PROFIT AT EACH STAGE OF ITS OPERATION.

1. IT SHOULD MANUFACTURE GOODS AT LEAST COST AND SHOULD GENERATE SUFFICIENT GROSS PROFIT.

2. IT SHOULD KEEP OPERATING EXPENSES UNDER CONTROL AND SHOULD LEAVE SUFFICIENT OPERATING PROFIT.

3. IT MUST EARN ENOUGH FOR ITS SHARE HOLDERS/OWNERS BY GENERATING MORE NET PROFIT AFTER TAX.

PROFITABILITY RATIOS• A STRONG AND HEALTHY UNIT MUST

ACHIEVE PROFIT AT EACH STAGE OF ITS OPERATION.

1. IT SHOULD MANUFACTURE GOODS AT LEAST COST AND SHOULD GENERATE SUFFICIENT GROSS PROFIT.

2. IT SHOULD KEEP OPERATING EXPENSES UNDER CONTROL AND SHOULD LEAVE SUFFICIENT OPERATING PROFIT.

3. IT MUST EARN ENOUGH FOR ITS SHARE HOLDERS/OWNERS BY GENERATING MORE NET PROFIT AFTER TAX.

PROFITABILITY RATIOS GROSS PROFIT GROSS PROFIT RATIO = --------------------- X

100 NET SALES• IT IS A INDICATOR OF THE PRODUCTION

EFFICIENCY.• A LOW RATIO MAY INDICATE HIGH

MANUFACTURING EXPENCES, LOW PRICE OR INABILITY TO PUSHUP SALES.

• A HIGHER GROSS PROFIT RATIO INDICATES EFFICIENCY IN PRODUCTI0N, HIGHER SALES VOLUME , LOW MANUFACTURING EXPENCES,OR ABILITY TO INCREASE THE SELLING PRICE.

PROFITABILITY RATIOS OPERATING PROFITOPERATING PROFIT RATIO = ---------------X100 NET SALES• THIS RATIO INDICATES THE NET MARGIN

ON SALES AFTER TAKING INTO ACCOUNT ALL EXPENSES , EXCEPT FINANCIAL EXPENSES ( INTEREST) & TAXES.

• A HIGHER MARGIN INDICATES THAT THE COMPANY HAS A HIGHER PERCENTAGE OF PROFIT ON SALES TO MEET THE PAYMENT OF INTEREST, DIVIDENT & OTHER CORPORATE NEEDS..

PROFITABILITY RATIOS

NET PROFITNET PROFIT RATIO = ---------------------------X

100 NET SALES• IT MEASURES OVERALL PROFITABILITY.• NET PROFIT RATIO MAY GO UP DUE TO

NON BUSINESS INCOME.

PROFITABILITY RATIOS NET PROFIT AFTER TAXRETURN ON NET WORTH = ------------------X

100 TANGIBLE NET WORTH

PROFIT BEFORE INTEREST & TAXRETURN ON NETINVESTMENT = ------------X

100 TOTAL TANGIBLE ASSETS• THIS IS THE MOST WIDELY USED RATIO TO

MEASURE THE PROFITABILITY

ACTIVITY RATIO• ACTIVITY RATIO ARE CALCULATED TO FIND OUT

THE EFFICIENCY OF OPERATION• INVENTORY TURNOVER RATIO.• IT IS CALCULATED BY DIVIDING COST OF SALES

BY AVERAGE INVENTORY. COST OF SALES ( COST OF GOODS SOLD)INVENTORY TURN OVER RATIO =---------------------- AVERAGE INVENTORY• A HIGHER TURN OVER COMPARED TO PAST YEAR

MEANS BETTER MANAGEMENT OF INVENTORY /WORKING CAPITAL.

• A LOW TURN OVER MAY DUE TO EXCESS STOCKING OR SLOW / NON -MOVING INVENTORY.

ACTIVITY RATIO

• DEBTORS TURNOVER RATIO• INDICATE THE EFFICIENCY OF DEBT

COLLECTION PROCESS / MECHANISM OF THE UNIT

• IT IS ALSO KNOWN AS DEBTORS VELOCITY

• IT INDICATES THE EFFECTIVENESS OF THE ORGANISATION IN GRANTING CREDIT AND THE COLLECTION OF DEBT.

ACTIVITY RATIO

SALES (GROSS SALES)• DEBTOR T. RATIO AVERAGE DEBTORSAVERAGE DEBTOR = OPENING

DEBTORS + CLOSING DEBTORS / 2DEBTOR COLLECTION PERIOD= 365 / DTR =-------- NO. OF DAYS

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