RATIO ANALYSIS 1

RATIO ANALYSIS

WHY FINANCIAL ANALYSIS

Lenders’ need it for carrying out the following

Technical AppraisalCommercial AppraisalFinancial AppraisalEconomic AppraisalManagement Appraisal

RATIO ANALYSIS

A ratio is a simple arithmetical expression of the relationship of one number to another. It an expression of the quantitative relationship between two numbers.

Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing in interpreting various ratios for helping in making certain decision

How a Ratio is expressed?

As Percentage - 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.

USE OF RATIO ANALYSIS

Useful to ManagementHelps in decision-makingHelps in financial forecasting and planningHelps in communicationHelps in control

Useful to ShareholdersUseful to CreditorsUseful to EmployeesUseful to GovernmentTax Audit Requirements

LIMITAION OF RATIO ANALYSIS

Limited use of single ratioLack of adequate standardInherent limitation of accountingChange of accounting procedureWindow dressingPersonal biasIncomparablePrice level changes

Classification of RatiosBalance Sheet

RatioP&L Ratio or

Income/Revenue Statement Ratio

Balance Sheet and Profit & Loss

Ratio

Financial Ratio Operating Ratio Composite Ratio

Current RatioQuick Asset RatioProprietary RatioDebt Equity Ratio

Gross Profit RatioOperating RatioExpense RatioNet profit RatioStock Turnover Ratio

Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors’ Turnover Ratio,

Format of balance sheet for ratio analysisLIABILITIES ASSETS

NET WORTH/EQUITY/OWNED FUNDSShare Capital/Partner’s Capital/Paid up Capital/ Owners FundsReserves ( General, Capital, Revaluation & Other Reserves) Credit Balance in P&L A/c

FIXED ASSETS : LAND & BUILDING, PLANT & MACHINERIES Original Value Less DepreciationNet Value or Book Value or Written down value

LONG TERM LIABILITIES/BORROWED FUNDS : Term Loans (Banks & Institutions)Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities

NON CURRENT ASSETSInvestments in quoted shares & securitiesOld stocks or old/disputed book debtsLong Term Security DepositsOther Misc. assets which are not current or fixed in nature

CURRENT LIABILTIESBank Working Capital Limits such as CC/OD/Bills/Export CreditSundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or depositsExpenses payable & provisions against various items

CURRENT ASSETS : Cash & Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks & inventory (RM,SIP,FG) Stores & Spares, Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months

INTANGIBLE ASSETSPatent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses

Some important notes

Liabilities have Credit balance and Assets have Debit balanceCurrent Liabilities are those which have either become due

for payment or shall fall due for payment within 12 months from the date of Balance Sheet

Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital

Net Worth & Long Term Liabilities are also called Long Term Sources of Funds

Current Liabilities are known as Short Term Sources of Funds

Long Term Liabilities & Short Term Liabilities are also called Outside Liabilities

Current Assets are Short Term Use of Funds

Some important notes Assets other than Current Assets are Long Term Use of Funds Installments of Term Loan Payable in 12 months are to be taken

as Current Liability only for Calculation of Current Ratio & Quick Ratio.

If there is profit it shall become part of Net Worth under the head Reserves and if there is loss it will become part of Intangible Assets

Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other securities are to be treated Current if they are quoted. Investments in allied/associate/sister units or firms to be treated as Non-current.

Bonus Shares as issued by capitalization of General reserves and as such do not affect the Net Worth. With Rights Issue, change takes place in Net Worth and Current Ratio.

TYPES OF RATIOS

Liquidity RatiosLong-term solvency RatiosActivity RatiosProfitability Ratios

LIQUIDITY LONG TERM SOLVENCY & LEVERAGE RATIOS

ACTIVITY PROFITABILITY

Current RatioLiquid RatioAbsolute liquid Ratio

Debt Equity RatioDebt to Total Capital RatioInterest Coverage Ratio

Inventory Turnover RatioDebtors Turnover RatioFixed Assets Turnover RatioTotal Assets Turnover RatioWorking Capital Turnover Ratio

(A) In relation to SalesGross ProfitOperatingOperating ProfitNet profitExpenses (B) In relation to InvestmentReturn On InvestmentReturn on EquityEarning Per SharePrice Earning Ratio

CLASSIFICATION OF RATIOS

LIQUIDITY RATIOS

Liquidity refers to the ability of a concern to meet its current obligations as and when these become due. The short-term obligations are met by realizing amounts from current, floating or circulating assets. To measure liquidity of a firm the following ratios can be calculated.

i) Current Ratios

ii) Quick Ratio/Acid Test Ratio/Liquid Ratio

iii) Absolute Liquid Ratio / Super Quick Ratio / Cash position Ratio

CURRENT RATIO

Current Ratio may be defined as the relationship between current assets and current liabilities. This ratio, also commonly known as working capital ratio, is a measure of general liquidity

Current Ratio = Current Assets / Current Liabilities

A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current Obligations in time when they become due. A ratio equal or near to rule of thumb of 2:1 is considered to be satisfactory.

Components of Current Ratio

Current AssetsCash in HandCash at bankMarketable securities (Short term)Short – term InvestmentBills ReceivableSundry DebtorsInventories (Stock)Work-in-progressPrepaid Expenses

Current LiabilitiesOutstanding Expenses / Accrued ExpensesBill PayableSundry CreditorsShort-term AdvancesIncome-tax PayableDividend PayableBank overdraft (if not a permanent arrangement)

1. Current Ratio : It is the relationship between the current assets and current liabilities of a concern.

Current Ratio = Current Assets/Current Liabilities

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

The ideal Current Ratio preferred by Banks is 1.33 : 1

2. Net Working Capital : This is worked out as surplus of Long Term Sources over Long Tern Uses, alternatively it is the difference of Current Assets and Current Liabilities.

NWC = Current Assets – Current Liabilities

QUICK OR ACID TEST OR LIQUID RATIO

Quick ratio may be defined as the relationship between quick/liquid assets and current Liabilities. An asset is said to be liquid if it can be converted into cash in a short period of time without loss of value. Inventories and prepaid expenses cannot be converted in cash within a short period without loss of value). As a thumb rule 1:1 is standard ratio.

Components of Current Ratio

Quick / Liquid AssetsCash in HandCash at bankMarketable securities (Short term)Short – term InvestmentBills ReceivableSundry Debtors

Current LiabilitiesOutstanding Expenses / Accrued ExpensesBill PayableSundry CreditorsShort-term AdvancesIncome-tax PayableDividend PayableBank overdraft (if not a permanent arrangement)

ABLOSUTE LIQUID OR CASH RATIO

Although receivable, debtor's and bills receivable are generally more liquid than inventories, yet there may be doubts regarding their realization into cash immediately or in time

Absolute Liquid Assets includes cash in hand and at bank and marketable securities or temporary investments.

Absolute Liquid Ratio = Cash & Bank + Short –term Securities / Current Liabilities

The acceptable norm for this ratio is .05 : 1 or 2:1

3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current Assets and Current Liabilities.

Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits

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

Example : Cash 50,000Debtors 1,00,000Inventories 1,50,000 Current Liabilities 1,00,000Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3 : 1Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1

LONG TERM SOLVENCY RATIOS AND LEVERAGE RATIOS

Long term solvency ratios convey a firms ability to meet the interest costs and repayment schedules of its long-term obligations. Leverage ratios show proportion of debt and equity in financing of the firm. These ratios measure the contribution of financing by owners as compared to financing by outsiders. The leverage ratios can be further classified into (i) Financial Leverage, (ii) Operating Leverage, (iii) Composite Leverage.

LONG TERM SOLVENCY RATIOS AND LEVERAGE RATIOS

Debt – Equity Ratio =

Long term Debt / Share holders Fund

This ratio indicates the relationship between loan funds and net worth of the company, which is known as “Gearing” .If the porting of debt to equity is low, a company is said to be low-geared and vice versa. A ratio of 2:1 is the accepted ratio.

4. DEBT EQUITY RATIO : It is the relationship between borrower’s fund (Debt) and Owner’s Capital (Equity).

Long Term Outside Liabilities / Tangible Net Worth

Liabilities of Long Term Nature

Total of Capital and Reserves & Surplus Less Intangible Assets

For instance, if the Firm is having the following :

Capital = Rs. 200 Lacs Free Reserves & Surplus = Rs. 300 Lacs Long Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1

Proprietary Ratio =

Shareholders Funds / Total Assets (Tangible)

This Ratios is also known as Equity Ratio, Shareholders to Equity ratio, or Net worth to Total Assets. In this ratio the relationship is established between the shareholders fund and the total assets.

Share Holders Funds (or Net Worth) = (Equity Share capital + Preference Share Capital + Undistributed Profits + reserve and surplus)

Capital Gearing Ratio

= Fixed Interest Bearing Funds / Equity share holders FundsThis ratio indicates the degree of vulnerability of earnings available for equity shareholders.

Fixed Interest Bearing Funds includes (Debentures, Long – term loan, Preference share capital).

Equity share holders Funds includes (Equity share capital and reserve and surplus)

Interest Cover = PBDIT / InterestThis ratio indicates how many times interest charges are covered by funds that are available for payment of interest. A ratio of 2:1 is acceptable. A high ratio indicates that the firm is conservative in using debt and a very low ratio indicates excess use of debt.

Dividend Cover = NPAT / DividendThis ratio indicates the number of times the dividends are covered by net profit.

Debt Service Coverage Ratio == PAT + Depreciation & Interest / Interest + Loan

installment.This ratio indicates whether the business is earning sufficient profits to pay not only the interest charges, but also loan installments

ACTIVIY / TURN OVER RATIOS

Activity ratios are calculated to measure the efficiency with which resources of a firm have been employed. These ratios indicate the speed with which assets are being turned over into sale, e.g. Debtors turnover ratio.

Inventory turn over ratio

= Cost of Gods Sold / Avg. inventory

*Avg. Inventory = (Opening stock + Closing Stock)/ 2

OR

Net Sales / Avg. inventory (If COGS is not given)

OR

Net Sales / Closing stock (If COGS & Opening stock is not given )

This ratio is also known as Stock turn over ratio or Stock velocity. This ratio indicates whether inventory is efficiently used or not.

Inventory conversion period (No. of days)

= 365(Days in a year) / Inventory turn over ratio

Debtors Receivable) turn over ratio/Velocity= Credit Sales / Avg. Trade Debtors

Trade Debtors = Sundry Debtors + Bills Receivables & Accounts receivable

Avg. Trade Debtors = (Opening Trade Debtors + Closing Debtors) / 2

Note: Debtors should always be take at Gross Value. No provisions for bad and doubtful debts to be deducted. If information about opening and closing balances of trade debtors and credit sales is not given it can be calculated as

= Total sale / Debtors (inclusive of B/R)

9. STOCK/INVENTORY TURNOVER RATIO :

(Average Inventory/Sales) x 365 for days (Average Inventory/Sales) x 52 for weeks

(Average Inventory/Sales) x 12 for months

Average Inventory or Stocks = (Opening Stock + Closing Stock)

-----------------------------------------

2

. This ratio indicates the number of times the

inventory is rotated during the relevant accounting period

Average Collection Period= Avg. Debtors (Drs + B/R)/ Credit Sales * 365

It measures how long it take to collect amount from debtors.

Creditors Turnover Ratio= Credit Purchases / Avg. Creditors (Crs+B/P)

Creditors Payment Period= Avg. Creditors / Purchases * 365

Fixed assets Turn over

= Sales / Fixed AssetsTotal Assets Turn over

= Sales / Total Assets

Working Capital Turn over

= Sales / Working Capital

PROFITABILITY RATIOS

These ratios measure the results of business operations or overall performance and effectiveness of the firm, e.g. , Gross profit ratio, operating ratio, return on capital employed.

Profitability ratio can be calculated

(i) In relation to sales

(ii) In relation to Investments

PROFITABILITY RATIOS

Gross Profit Ratio: The gross profit is the difference between Net sale and Cost of goods soled.

= Gross Profit / Sale * 100

This Ratio shows the margin left after meeting the manufacturing costs. It measures the efficiency of production as well as pricing. A high gross profit means a high margin for covering other expenses, other than cost of goods soled, therefore higher the ratio, the better it is.

Net Profit Ratio:= Net Profit / Sales * 100

It shows earnings left for shareholders. It measures the overall efficiency of all the functions of a business firm like production, administration, selling, financing, pricing , tax management. This ratio is very useful for prospective investors because it reveals the overall profitability of the concern. Higher the ratio better.

Operating Net Profit Ratio = Operating Net profit / Sale * 100

This ratio establishes the relationship between operating net profit and sales. The concept of operating net profit is different from the concept of net profit.

Operating net profit = Net Profit + Non operating expenses – non operating incomes.

Alternatively this profit can be calculated by deducting only operating expenses from gross profit.

Operating Ratio:

= Cost of Goods Sold + Operating expenses / Net sale * 100

Return on Equity :

= Net profit after interest, tax and preference dividend / Equity capital + Reserve & surplus

This ratio is also known as return on share holders funds or return on proprietors funds or return on net worth, indicates the percentage of net profit available for equity shareholders

Return on total assets:= NPAT / Total Assets* 100

This ratio compares NPAT with total assets

Market Test Ratio

Dividend pay out RatioDividend yieldBook valuePrice/Earnings Ratio

Dividend pay out ratio:

= Dividend per share / EPS*100

This ratio indicates the percentage of profit distributed as dividend to share holders.

Dividend yield ratio :

= Dividend per share / Market price per share * 100

This ratio compares the dividend per share with the market price of the share and important for the investors.

Earning Per Share : = Net profit after tax & preference dividend / No of equity shares

This ratio indicates the amount of net profit available to equity share holder

Price Earnings (P/E) Ratio : = Market Price per equity share / EPS

LIABILITES ASSETS

Capital 180 Net Fixed Assets 400

Reserves 20 Inventories 150

Term Loan 300 Cash 50

Bank C/C 200 Receivables 150

Trade Creditors 50 Goodwill 50

Provisions 50

800 800

EXERCISE 1

a. What is the Net Worth : Capital + Reserve = 200b. Tangible Net Worth is : Net Worth - Goodwill = 150 c. Outside Liabilities : TL + CC + Creditors + Provisions = 600

d. Net Working Capital : C A - C L = 350 - 250 = 50 e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2

LIABILITIES 2005-06 2006-07 2005-06 2006-07

Capital 300 350 Net Fixed Assets

730 750

Reserves 140 160 Security Electricity 30 30

Bank Term Loan 320 280 Investments 110 110

Bank CC (Hyp) 490 580 Raw Materials 150 170

Unsec. Long T L 150 170 S I P 20 30

Creditors (RM) 120 70 Finished Goods 140 170

Bills Payable 40 80 Cash 30 20

Expenses Payable 20 30 Receivables 310 240

Provisions 20 40 Loans/Advances

30 190

Goodwill 50 50

Total 1600 1760 1600 1760 1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 20 + 240 + 2+ 190 ) / (580+70+80+70) 820 /800 = 1.02

3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21

Exercise 3.

LIABIITIES ASSETS

Equity Capital 200 Net Fixed Assets 800

Preference Capital 100 Inventory 300

Term Loan 600 Receivables 150

Bank CC (Hyp) 400 Investment In Govt. Secu.

50

Sundry Creditors 100 Preliminary Expenses 100

Total 1400 1400

1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 24. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

LIABILITIES ASSETS

Capital + Reserves 355 Net Fixed Assets 265

P & L Credit Balance 7 Cash 1

Loan From S F C 100 Receivables 125

Bank Overdraft 38 Stocks 128

Creditors 26 Prepaid Expenses 1

Provision of Tax 9 Intangible Assets 30

Proposed Dividend 15

550 550

Q. What is the Current Ratio ? Ans : (125 +128+1+30) / (38+26+9+15) : 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW = 100 / ( 362 – 30) = 100 / 332 = 0.30 : 1

Exercise 4.

LIABILITIES ASSETS

Capital + Reserves 355 Net Fixed Assets 265

P & L Credit Balance 7 Cash 1

Loan From S F C 100 Receivables 125

Bank Overdraft 38 Stocks 128

Creditors 26 Prepaid Expenses 1

Provision of Tax 9 Intangible Assets 30

Proposed Dividend 15

550 550

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100 [ (362 - 30 ) / (550 – 30)] x 100 (332 / 520) x 100 = 64%

Q . What is the Net Working Capital ? Ans : C. A - C L. = 255 - 88 = 167

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover Ratio in Times ? Ans : Net Sales / Average Inventories/Stock 1500 / 128 = 12 times approximately

Exercise 4. contd…

LIABILITIES ASSETS

Capital + Reserves 355 Net Fixed Assets 265

P & L Credit Balance 7 Cash 1

Loan From S F C 100 Receivables 125

Bank Overdraft 38 Stocks 128

Creditors 26 Prepaid Expenses 1

Provision of Tax 9 Intangible Assets 30

Proposed Dividend 15

550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12 = 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ? Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months

Exercise 4. contd…

Exercise 5. : Profit to sales is 2% and amount of profit is say Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100 2 = (5 x100) /Sales Therefore Sales = 500/2 = Rs.250 Lac

Exercise 6. A Company has Net Worth of Rs.5 Lac, Term Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25 Lac. There is no intangible Assets or other Non Current Assets. Calculate its Net Working Capital. AnswerTotal Assets = 16 + 25 = Rs. 41 LacTotal Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L = 25 – 26 = (- )1 Lac

Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities hence the NWC would be NIL

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the amount of Current Assets ?

Answer : 4 x - 1 x = 30,000 Therefore x = 10,000 i.e. Current Liabilities is Rs.10,000 Hence Current Assets would be 4x = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per month, monthly average interest on TL is Rs.5000/-. If the amount of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment = (270000 + 30000 + 60000 ) / 60000 + 120000 = 360000 / 180000 = 2

Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs. Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10 Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10 i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which should be Rs. 10 Lac

Questions on Fund Flow Statement

Q . Fund Flow Statement is prepared from the Balance sheet : 1.Of three balance sheets2.Of a single year3.Of two consecutive years4.None of the above.

Q. Why this Fund Flow Statement is studied for ?

1.It indicates the quantum of finance required2.It is the indicator of utilisation of Bank funds by the concern3.It shows the money available for repayment of loan4.It will indicate the provisions against various expenses

Q . In a Fund Flow Statement , the assets are represented by ?

1.Application of Funds2.Sources of Funds3.Surplus of sources over application4.Deficit of sources over application