Ratio analysis

Ratio Analysis------ By: ANKIT PORWAL & KUMAR SAURAV

1 JAIN COLLEGE OF ENGINEERING, MBA DEPARTMENT. BELGAUM

Ratio Analysis

Ratio: Relationship between two numbers.

Accounting of Ratio: Relationship between accounting figure.

Ratio Analysis: It is a process of computing and presenting the relationship between the items in the financial statements.

Ratio analysis is the important tool of financial analysis because it helps to the study the financial performance and position of the firm.

Why ratios are used?

Ratio speaks about a business

Is profitable?

Is assign its assets efficiency?

Has a gearing problem?

Can the employee be paid higher wages?

Is a target/investor?

List of Users

1. Investors 5. Employees 2. Managers 6. Customers 3. Government 7. Other agencies 4. Suppliers & trade creditors.

Has a business made a good profit compared to the turnover? profitability



Does a business have enough money to pay its bill? Liquidity

Have a business made a enough profit as compared to assts and capital employed? Return ratio

How has a company used its fixed and current assets? Turnover, activity & uses

Forms of Ratio Analysis

Pure Ratio - Relationship between current assets & current liabilities.

Percentage - Profit & Sales

Rates – number of items

Classification of Ratio

1. Based on financial statement 2. Based on function 3. Based on users

1. Based on Financial Statement

Based on Balance Sheet Liquidity ratio, quick ratio, proprietary ratio, debt equity

ratio, working capital, capital gearing ratio.

Based on Revenue Statement Gross profit ratio, net profit ratio, operating ratio, stock

turnover, Net-operating profit ratio.



Based on composite Ratio Return on capital employed, return on equity capital, debtor turnover ratio, creditor turnover ratio, dividend

payout, debt service coverage ratio.

2. Based on function

Liquidity / Solvency

Leverage Ratio

Debt equity Ratio

Proprietary Ratio

Capital Gearing

Activity Ratio (turnover or productivity)

Inventory turnover Ratio

Debtor turnover Ratio

All turnover Ratios.

Profitability Ratio Gross profit Ratio relation of profit Net profit Ratio & sales Expenses Ratio

Return on Investment relation of profit

&Return on capital employed investment

Coverage Ratio

Debt service coverage Ratio

Dividend payout Ratio



Based on Users

For short term Creditors Current ratio, quick ratio, working capital ratio

Long term Creditors Debt equity ratio, return on capital employed

For management Operating ratio, expenses ratio, return on capital employed, turnover ratio

For shareholders Return on equity, return on proprietor fund

Current ratio “Comparison between current assets & current liabilities”

“Pure ratio”

Formula: Current Assets Current Liabilities Components of Current Assets

Debtors (less provision)

Income accrued (due)

Bill receivable

Cash & bank balance

Marketable investment and securities

Closing stock of row material, work in progress, finished goods, stores & spare.

Any prepaid expenses

Short term loan & advances

Advance tax payment



Components of Current Liabilities Creditors

Bill payable

Any outstanding expenses

Unclaimed and proposed dividend

Provision for any taxation

Income received in advance

Bank overdraft

Purpose “Help to understanding the ability of the firm to meet its short term obligation”

Uses “It is used by creditor to judge the safety margin available, which help them to ascertain the amount and the term of the credit”

Limitation

Ignores comparison of working capital EX: company A & company B have the same current ratio, company A has more of stock and company B has more cash. Company B has a better liquidity and solvency.

Ignores quality EX: company A and company B have a same current ratio and the same amount of stock & debtor, but the company A has more stock and doubtful debts than company B has a better liquidity.



1. Current Ratio “This ratio has to be studied with ‘Quick Ratio’ and ‘stock to working capital Ratio’ for judging the short term solvency” 2:1 is standard ratio.

When result are higher than standard?

Good short term liquidity position

It might significance excess stock

Bad debts –credit prepaid may be more

Idle cash

Under treading –not utilised full capacity

When results are lower than standard?

Unsatisfactory liquidity

Over trading

Lower stocks

Idle cash

2. Quick Ratio Used to check liquidity of the firm.

Also define as a pure ratio

Formula:

Quick Assets Quick Liabilities

Quick Assets = Current assets – (Stock + Prepaid expenses) A. Stock is executed because it is uncertain as to when & how it

will be realise. B. Prepaid expenses are executed because they can’t be

converted into cash.

Quick Liabilities = Current Liabilities – Bank Over Draft



A. Bank over draft is excluded because it is a permanent arrangement & it is not required to be paid as long as the firm exists.

Purpose:

It is a solvency ratio which indicates the ability of the firm to meet its short term liabilities without selling the stock.

How it is helpful?

It measures the immediate solvency of the firm.

It overcomes the limitation of current ratio. i.e. It considers both the composition and quality of working capital.

It emphasises of quality of Current Assets rather than the quantity.

The standard of this is 1:1

Higher Than Standard:

It indicates very good day to day solvency/liquidity.

Idle cash balance.

Under investment.

Lower Than Standard:

Not satisfactory day to day liquidity/solvency.

Low cash balance.

High investment.



3. Debt Equity Ratio This ratio compares a long term debts with shareholder funds. It is also expressed as a Pure Ratio.

FORMULA:

Debt => Borrowing Funds

Equity proprietor’s fund

Borrowing Funds Proprietor’s Fund

Debenture - Equity Share Capital

Loans - Preference Share - Reserve & Surplus – (losses + item not written off)

Purpose or Function:

This ratio is a solvency ratio which indicates the proportion of debt & equity in financing the assets of the firm.

Helpful:

It helps to understand and analyse margin of safety for long term credits.

Standard is 2:1

It also helps to ascertain the balance between debt & equity.


Low safety margin for lender.

More interest payment.

Low scope for loan.

Treading on equity.



4. Gross Profit Ratio This ratio compares gross profit with net sales. It is expressed in form of percentage. FORMULA: Gross Profit * 100 Net Sales Gross Profit = sales – cost of goods sold Cost of goods sold in treading firm = Opening stock+ purchase+ direct exp. – closing stock Cost of goods sold for manufacturing firm = Opening stock+ cost of materials+ labour+ exp. – closing stock Net Sales = Sales – (sales return + any allowances)


It is profitability ratio. This ratio helps to judge-

How efficiently the firm is managing its production, purchase, selling & inventory.

How good is the control over direct cost?

How productive the firm is?

How much amount is left to meet other expenses & earn net profit?

Higher Then Standard:

It indicates higher efficiency in managing purchase production labour, sales & inventory.

High productivity.

Large amount available to meet other expenses.



5. Stock Turnover/ Inventory Turnover Ratio This ratio shows the relationship between the costs of goods sold and average stock this ratio is normally expressed as time or rate.

FORMULA: Cost of Goods sold Average Stock

Average stock = opening stock + closing stock

2

NOTE: in the absence of information, closing stock can be used instead of average stock.

Stock holding period

Month = 12

STR

Days = 365

STR

Function or Purpose:

This is an activity ratio, which shows the relationship between sales & stock. Its purpose is to:

Calculate the speed at which stock is being turned over into sales.

Calculate the stock holding period.

To judge how efficient the stock are managed and utilised to generate sales.




Stock sold out very quickly.

Working capital requirement is less.

Over trading.

6. Operating Ratio This ratio expresses the relationship between total operating cost and net sales. It is expressed by the way of percentage. FORMULA: Cost of goods sold + operating expenses * 100 Net sales Operating expenses = office & administration exp., selling & distribution exp., financial exp. (OD)

Function or Purpose:

This ratio indicates cost of operations.

Its purpose to measure and ascertain efficiency of management with regard to operations.

Helpful:

This ratio helps to judge how much amount of sales revenue is used in carrying the operation if the firm.

Operating ratio shows total of all cost in all the area such as administration, sales etc. It is advisable to break it up into various expenses ratio so that we can identify which expenditures are increasing disproportionately.

This ratio has to be studied with expenses ratio and operating net profit ratio before commenting on profitability of the firm.




Low efficiency in managing purchase, production, labour, inventory & sales.

Low productivity.

Small amount available to meet other expenses.

7. Return on Capital Employed Ratio (ROCE) or Return on Investment (ROI)

The ratio measures the relationship between profit (before interest & tax) and the capital to earn it. The ratio is also known as return on investment (ROI). FORMULA: Profit before Interest & Tax * 100 Capital Employed Capital employed = Equity capital + preference share + reserve & surplus +credit balance of P&L + debenture + long term loans – debit balance of P&L.


It is a profitability ratio.

It purposes is to measure overall profitability from the total funds made available by the owners and lenders.

Helpful:

The ratio helps to judge how efficiently the firm is managing the funds at its disposal.



Higher than Standard:

It signifies more profit on each of the rupee invested.

Scope to attract fresh fund both from owner & lender.

It signifies higher amount of sales.

High increase in net worth.

Large amount of appropriation (interest, taxes, dividend)

8. Dividend Payout Ratio This ratio shows the relationship between the dividends paid to equity shareholders out of the profit available. It is expressed in percentage.

FORMULA: Dividend Paid * 100 Profit Available to Equity Shareholder (PAT) Profit availability to equity share holder means net profit after interest, income tax & Preference dividend.


This ratio is type of coverage ratio.

A coverage ratio shows the relationship between the profit and the claim of outsider to be paid out if such profits.

Its purpose is to measure to dividend paying capacity of the firm.




Scope to issue fresh equity share at a higher price. Called FPO: follow up public offering.

High price in stick exchange.

During merger high price of shares.

Very high dividend makes shirt term equity holders happy.

Less reserve may mean low growth in future.

No possible of bonus issue.

9. Debt Service Coverage Ratio

This ratio shows the relation between net profit and interest + instalment payable on loan. It is expressed as pure number.

Coverage means availability of profits for debts servicing.

FORMULA:

Cash profit available for debt servicing

(Interest + instalment due on loan)

Cash profit available for debt servicing

PAT + non cash debits

CFAT / no pat / NCF

Purpose:

It helps to measure debt service capacity of the company.




Strong capacity to pay interest as and when due.

Further loans easily available at the lower rate.

Large amount of profit available for taxes & dividend.

It also signifies that the firm is not treading on equity.

10. Debtor Turnover Ratio

This ratio shows the relationship between credit sales & average debtors. It is expressed as a rate or as a time.

Formula:

Credit Sales

Average Debtor

Average Debtor = Bill Receivable + Debtor

Debtor Collection Period

12 OR 365

DTR DTR

Purpose:

To calculate speed at wage debtor get settled on an average during the year.

It calculates the debtor collection period which helps to indicate the period of credit allowed who an average debtor.

It helps to judge how efficiently the debtors are managed.




Debts are collected at lower rate.

More chances of bad debts.

More credits are provided.

11. Creditors Turnover Ratio

This ratio shows the relationship between credit purchases and average creditors. This also expressed in the form of rates or times.

Formula:

Credit Purchase

Average Creditors

Average Creditors = Bills payable + Creditors

Creditors Payment Period:

12 OR 365

CTR CTR

Purpose:

It helps to analyse as to how quickly the creditors are paid off on an average during the year.

It helps to calculate the period taken to pay off creditors.

Note: This ratio should be studied with STR & DTR to understand the combined effect over the operating cycle.




It signifies slow rate of payment.

More credit is available from creditors.

Working capital requirements is less.

Operating Cycle = STR + DTR – CTR

12. Stock to Working Capital Ratio This ratio shows the relationship between the closing stock and working capital. It helps to judge the quantum of inventories in relation to the working capital of the business. It is expressed as a percentage. It is also known as inventory working capital ratio.

Formula: Stock * 100 Working Capital

Stock = closing stock

Purpose:

It is liquidity ratio.

It indicates the composition and quality of the working capital and also helps to study the salvage of the firm.

It shows the extant of the funds blocked in stock.

If investment of stock is higher it signifies that the amount of liquid assets is lower.

This ratio should be studied with stock turnover ratio, current ratio and quick ratio.




More other current assets are available to pay current liabilities.

13. Return on Equity Capital

This ratio measures the relationship between net profit (after interest, tax & preference dividend) and the equity share holders.

Formula:

Net Profit * 100

Equity Share Holders Funds

Equity Share Holders Funds = equity capital and reserve & surplus.

This ratio is expected as a percentage.

Purpose:

It is a profitability ratio.

Its purpose is to calculate the amount of profit available to take care of equity dividends, transfer to reserve etc.

It is used by the present or perspective investor for deciding whether to purchase, keep or selling the equity shares.

This ratio should be studied with capital gearing ratio to know the effect of gearing on EPS.




Large amount of appropriations (reserve & surplus, dividend, etc.)

Higher EPS, in case of merger & acquisition it gives batter purchase consideration.

Higher increase in net worth in the company.

14. Capital Gearing Ratio Gearing means the process of increasing equity shareholders return through the case of debt. Equity share holders earn more when the rate of return on the capital is more than the rate of interest on debt. This is also known as leverage or treading on equity. This ratio shows the relationship between two type of capital, equity capital increasing reserves & preference share capital and long term borrowings. It is usually expressed as a pure ratio. This is also known as capital structure ratio.

Formula: Preference Capital + Borrowed Funds

Equity Funds

Purpose:

It indicates the proportion of debt & equity in the financing of assets of a firm.


Higher return for the shareholder if rate of the fixed return is less than return on investment.



15. Return on proprietor’s Fund This ratio measures the relationship between profit (after interest & tax) & the proprietor’s capital. It is usually expressed as a percentage. It is also known as return on net worth.

Formula:

Net Profit (after tax)

Proprietor’s Fund

Proprietor’s fund = equity, reserve & surplus and preference capital

Purpose:

It is profitability ratio.

It measures the rate of return on the total funds made available from owners.

It helps to judge how efficiently the firm is managing the owners fund at the disposal.

This ratio should be studied with debt equity ratio to know the effect of capital structure on earnings of the proprietors.

Higher Than Standards:

Large amount available for appropriation.

Scope to attract fresh funds from the owner.



16. Net Profit Ratio The ratio indicates the relationship between net profit and sales. It is usually expressed in the form of percentage.

Formula: Net Profit (before tax) Sales Net profit before tax: Net operating profit Add: non operating income Less: non operating expenses.

Purpose:

It is profitability ratio.

It indicates net profit for all types or activities of the entire business.

It measures the overall profitability from: - Operating activities of buying or selling the products. - Financing activity of borrowing or lending. - Buying or selling of investment.

This ratio helps to judge: - How efficiently the firm is managing all its activities of

operations, financing & investments. - How much amount is available for appropriations?

This ratio is studied with return on capital employed & return on proprietor’s fund.


Good control over all expenses.

Large amount available for appropriation.

Strong capacity to face bad economic condition.

High increase in net worth.

It signifies unusual gain.

Ratio analysis

Education

belgaum ratio analysis

quick ratio

standard ratio

accounting of ratio

capital gearing ratio

creditor turnover ratio

composite ratio return

management operating