Notes On Ratio Analysis

RATIOS  Introduction: Ratios are presentation technique, which helps the reader to get idea about the performances & Position of a firm with least efforts. He can get overall view of the firm from the ratios presented to him. He can compare such ratios with the ratios of the past & also with ratios other firm in industry. For getting insight we must know how such ratios are calculated. Types of Ratios

Liquidity Ratios

Profitability Ratios

Solvency Ratios

Activity Ratios

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Liquidity Ratios: Short term solvency ratios. (Pure Ratio shown in 1 : 1 form)

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Current Ratio



Liquid Ratio



Quick Ratio

1.



Current Ratio =

Current Assets Current Liabilities

Objective:

The objective is to measure the ability of the firm to meet its short – term obligations and to reflect the short – term financial strength/ solvency of a firm. It suggests whether firm can meet its short term obligation from short – term Assets. 

Components:

Current Assets refer to those assets which are held for their conversion into cash normally within a year and include the following: Cash Balance Bank Balance Debtors (after deducting Provision) Bills Receivable (after deducting Provision) Listed Marketable Securities (non – trade) Stock of Raw – materials Stock of Work – in – Progress

Stock of Finished Goods Prepaid Expenses O/S income Advance Payment of tax Tax deducted at source (TDS) (debit Balance)



Current Liabilities:-

Current Liabilities refer to those liabilities which are expected to be matured normally within a year and include the following: Creditors for goods Bills Payable Creditors for Expenses (or O/S Exp.) Bank Overdraft Proposed dividend

Provision for Tax Unclaimed dividend Incomes received – in – advance

Interpretation: It indicates rupees of current assets available for each rupee of current liability. Higher the ratio, greater is the margin of safety for short–term creditors and vice versa. However, too high/too low ratio calls for further investigation since the too high ratio may indicate the presence of idle funds with the firm or the absence of investment opportunities with the firm and too low ratio may indicate problem of short-term insolvency. Traditionally, a current ratio of 2:1 is considered to be a satisfactory ratio.

2.

Liquid Ratio or Acid Test Ratio=

Liquid Assets Liquid Liabilities

Liquid Assets = Current Assets – Stock Liquid Liability = Current liabilities – Bank O/D – cash credit 

Objective:

The objective is to measure the ability of the firm to meet its short – term obligations as and when due without relying upon the realization of stock. 

Interpretation :

It indicates rupees of quick assets available for each rupee of liability due on short term notice. Traditionally, a quick ratio of 1:1 is considered to be a satisfactory ratio. However, this traditional rule should not be used blindly since a firm having a quick ratio of more than 1, may not be meeting its short–term obligations in time if its current assets consist of doubtful and slow paying debtors while a firm having a quick ratio of less than 1, may be meeting its short–term obligations in time because of its very efficient debtors management.

3.



Quick Ratio =

Quick Assets Liquid Liabilities

Quick Assets = Current ratio less stock and debtor. This ratio suggests whether available cash & cash equivalent (which can quickly convertible in cash) are sufficient to meet its short term liabilities.

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Profitability Ratios (Always is percentage except EPS) In relation to Sales a) Gross profit ratio b) Net profit Ratio c) Operating Ratio

In relation to Investment a) Return on Cap. Employed b) Return on Equity c) Return on equity shareholder Fund d) Return on equity share capital e) Earning per share f) Return on total assets

Income statement Less: = Less: Add : = Less: Add: = Less: = Less: =

Net Sales Cost Of Goods Sold Gross Profit Operating Exp (Administrative & Selling Expense) Operating income (commission, discount received.) Operating Profit (PBIT) Non operating Expenses: Int. on Debentures Loss on Sale of assets or loss due to fire Non-operating Income: Interest & Dividend on Investment Profit on sale of Assets & Investment Net Profit before tax Tax Net Profit after tax Preference dividend Equity Profit Gross Profit ×100 Net Sales

1.

Gross Profit Ratio =



Gross Profit = Sales – Cost of goods sold.



Cost of goods sold = Opening stock + Net purchase + Purchase Exp +wages – closing stock



Objective :

The objective is to determine the efficiency with which production and/or purchase operations are carried on. 

Interpretation:

This ratio indicates (a) an average gross margin earned on a sale of Rs. 100, (b) the limit beyond which the fall in sales prices will definitely result in losses. And (c) what portion of sales is left to cover operating expenses and non – operating expenses like to pay dividend and to create reserves. Higher the ratio, the more efficient the production and /or purchase management. This ratio may increase due to one of the following factors:

2.

(i)

Higher Sales Prices with constant Cost of Goods Sold;

(ii)

Lower Cost of Goods Sold with constant Sales Prices;

(iii)

A combination of aforesaid two factors.

Net Profit Ratio =

Net Profit After Tax ×100 Net Sales



Objective:-

The objective is to determine the overall profitability due to various factors such as operational efficiency. 

Interpretation:

This ratio indicates (a) an average net margin earned on a sale of Rs. 100 (b) what portion of sales is left to pay dividend and to create reserves, and (c) firm’s capacity to withstand adverse economic conditions when selling price is declining. 3.

Operating Ratio = Cost of Goods sold + Administrative / Selling/ Distribution / Financial Expenses × 100 Net Sales



Objective:

The objective is to determine the operational efficiency with which production and /or purchases and selling operations are carried on. 

Interpretation:-

This ratio indicates an average operating cost incurred on sales of goods worth Rs. 100. Lower the ratio, greater is the operating profit to cover the non – operating expenses, to pay dividend and to create reserves and vice–versa.

In relation to Investment Profit before Int & tax Less: Less: Less: =

Interest Profit before tax Tax Profit after tax Pref. Dividend Equity Profit

[profit available to equity shareholder, Pref. shareholder, debenture holder

[Profit available to equity shareholder & Pref. shareholder] [Profit available to equity share holder]

Format of Capital Employed:

Add: Less: = Add: = Add: =

1.

Equity share capital Reserve & Surplus Miscellaneous Expenditure Equity share holder’s fund Preference share capital Share holder’s fund (Equity) Debt (debenture and term loan) Capital Employed

Return on Capital Employed =

P.B.I.T × 100 Capital Employed

Capital employed = total investment=long term fund 

Objective:

The objective is to find out how efficiently the long – term funds supplied by the Debenture holder and shareholders have been used. 

Interpretation:-

Higher the ratio, the more is the efficient the management and utilization of Capital Employed. 2.

Return on Equity =

P. A. T ×100 Equity

Equity = shareholder Fund = Owners fund = Proprietors Fund 

Objective:-

The objective is to find out how efficiently the funds belonging to the shareholders (equity and preference) have been used. 

Interpretation:

This ratio indicates the firm’s ability of generating profit per 100 rupees of shareholders’ funds. Higher the ratio, the more efficient the management and utilization of shareholders’ funds is. Equity Profit × 100 3. Return on Equity shareholder fund = Equity shareholder fund 

Objective:

The objective is to find out how efficiently the funds supplied by the equity shareholders have been used.



Interpretation:

This ratio indicates the firm’s ability of generating profit per 100 rupees of equity shareholders’ funds. Higher the ratio, the more efficient the management and more is the utilisation of equity shareholders’ funds. 4.



Return on equity share capital =

Equity Profit ×100 Equity Share Capital

Objective:

The objective is to find out how efficiently the funds supplied by the equity shareholders have been used. 

Interpretation:

This ratio indicates the firm’s ability of generating profit per 100 rupees of equity share capital. Higher the ratio, the more efficient the management and utilization of equity shareholders’ Capital is.

5.



Earning Per Share =

Equity Profit No. of Equity Shares

Objective:-

The objective is to measure the profitability of the firm on per equity share basis. 

Interpretation:

In, general, higher the EPS, better it is and vice versa. EPS helps in determining the market price of the equity shares of the company. It also helps in estimating the company’s capacity to pay dividend.

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Solvency Ratios (Long term Solvency)   

Debt – Equity Ratio Capital Gearing Ratio Proprietary Ratio

  

Interest Coverage Ratio Debt Service Coverage Ratio Long term fund to fixed Asset

1.

Debt – Equity Ratio (Leverage Ratio) =



Objective :-

Debt ×100 Equity

The objective is to measure the relative proportion of debt and equity in financing the assets of a firm. 

Interpretation:-

It indicates the margin of safety to long – term Debt. A low debt equity ratio implies the use of more equity than debt which means a larger safety margin for Debt providers since owner’s equity is treated as a margin of safety by debenture holder and vice versa. The implications from the point of view of long term providers of loan and the firm may be seen as under.

2.

Capital Gearing Ratio =



Objective:-

Debt + Pref. Shares ×100 Equity Share Capital

The objective is to find proportion of fix return bearing security to not fix return bearing securities in total capital of firm. 

Interpretation:-

It indicate that for every 100 Rs. of equity capital what proportion of fix return bearing capital existing. More this ratio higher is the risk of fix commitment & more burden for generating equity profit. However it may result in to benefit by effect on trading on equity.

3.

Proprietary ratio =



Objective:-

Prop. fund (equity) ×100 Total Asset

The objective is to find out how much the proprietors have financed for the purchases of assets. 

Interpretation:-

This ratio indicates the extent to which the assets of the firm have been financed out by proprietors’ fund. 

Total Assets = All Assets (Excluding Fictitious Assets like preliminary exp. underwriting exp, debenture discount.)

4.

Interest Coverage Ratio =



Objective:-

P. B. I. T Interest On Loan

The objective is to measure the debt servicing capacity of a firm so far fixed interest on long – term debt and debenture is concerned. 

Interpretation:

Interest coverage ratio shows the number of times the amount of interest on long – term debt is covered by the profits out of which that will be paid. It indicates the limit beyond which the ability of the firm to service its debt would be adversely affected. Higher the ratio, greater the firm’s ability to pay interest but very high ratio may imply lesser use of debt and very efficient operations. 5. Debt Service Coverage Ratio = Cash Available for Debt Service Int. On. Debt + Install Due On Loan during finance year Cash available for debt payment means P.A.T. +Depreciation & other non cash expenditure dr. to P & L account + Interest on debt

6. Long term Fund to Fixed Assets = 

Long Term Fund ×100 Fixed Assets

Interpretation:

Sound business technique it to Acquire major permanent assets from permanent capital & temporary capital should be invested in current assets. If temporary capital is invested in permanent assets than financial position may get disturb? This ratio suggests how much proportion of permanent assets is purchased from permanent capital. Higher the ratio more is the finance from long term sources.  Activity Ratios:

Capital Turnover Ratio → Debtors Turnover Ratio (Debtors Ratio)

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Fixed Assets Turnover Ratio → Creditors Turnover Ratio (Creditors Ratio)

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Stock Turnover Ratio

1.

Capital Turnover Ratio (In times) =



Objective:

Net Sales (Avg.) Capital Employed [Debt + Equity]

The objective is to determine the efficiency with which the capital employed is utilized. 

Interpretation:

It indicates the firm’s ability to generate sales per rupee of capital employed. In general, higher the ratio, the more efficient the management and utilization of capital employed is. Net Sales 2. Fixed Assets Turnover Ratio (in times) = (Avg.)Fixed Assets 

Objective:

The objective is to determine the efficiency with which the fixed assets are utilized. 

Interpretation:

It indicates the firm’s ability to generate sales per rupee of investment in fixed assets. In general, higher the ratio, the more efficient the management and utilization of fixed assets is and vice versa.

3.

Stock Turnover Ratio (in times) =



Objective:-

Cost Of Goods Sold Avg. Stock

The objective is to determine the efficiency with which the inventory is utilised. 

Interpretation:-

It indicates the speed with which the inventory is converted into sales. In general, a high ratio indicates efficient performance. However, too high ratio and too low ratio should be called for further investigation. A too high ratio may be the result of a very low inventory levels which may result in

frequent stock – outs and thus the firm may incur high stock – out costs. On the other hand, a too low ratio may be the result of excessive inventory levels, slow moving or obsolete inventory and thus, the firm may incur high carrying costs. Thus, a firm should have neither very high ratio nor low ratio. (Stock out means customer going out of shop due to unavailability of stock.) 4.

Debtors Turnover Ratio (in times) =

Cr. Sales (Avg.) Debtors + B/R

Debtors Ratio OR Debt Velocity Ratio (in days) = 

(Avg) Debtors + B/R × 365/360/12/52(week ) Credit Sales

Objective:-

The objective is to determine the efficiency with which the trade debtors are managed. 

Interpretations:

High Debtors T/O ratio =shorter debtors ratio = quick recovery of money. Low debtors T/O ratio = higher debtor ratio = delay in recovery of money. It shows the efficiency of collection policy of the firm. It is always a goods idea to collect quickly, money from debtors as uncertainty of collection increases with credit policy being liberal. However a firm should under take cost benefit study of liberal credit policy, if benefit is more than cost than it should increase credit period. Benefit ↑ In profit due to ↑ In sales

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Cost ↑ In bad – debt ↑ In collection expenses ↑ In Interest cost on money blocked with debtor

Tutorial Notes: (i)

The ‘Provision for doubtful debts’ is not deducted from the total amount of trade debtors since here, the purpose is to calculate the number of days for which sales are tied up in debtors and not to ascertain the realizable value of debtors.

(ii)

If the figure of Average Debtors cannot be ascertained due to the absence of the figure of opening Debtors, the figure of closing Debtors may be applied by giving a suitable note to that effect.

(iii)

If the figure of Net Credit Sales is not ascertainable, the figure of total sales given may be used assuming that all sales are credit sales.

5.

Creditors Turnover Ratio (in times) =

Net Credit Purchase (Avg) Creditors + B. P.

Creditors Velocity Ratio (in days) OR Creditors Ratio =

(Avg) Creditors + B. P. × 365/360/12/52(week) Net Credit Purchase



Objective: -

The objective is to determine the efficiency with which the creditors are managed. 

Interpretation:

High creditor T/O ratio = low creditor ratio = quick payment to creditor Low creditor T/O ratio = high creditor ratio = delayed payment to creditor It shows the market standing of the firm. A new firm may have less creditor’s ratio, as their market standing will be less. An established firm will have greater market standing hence it is in position to pay their creditor later. However a firm should study advantage of paying early and availing of cash discount.

6.

Total Assets Turnover Ratio (in times) =



Objective:

Net Sales Total Assets

How efficiently assets are employed in business. 

Interpretation:

This ratio suggests how a rupee of asset contributes to earn sales more the ratio more efficiently assets are used in gainful operation. •

1.

ADVANTAGES: Simplifies financial statements: Ratio Analysis simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of the business. It gives reader full idea about overall situations of the firm without going deep in to the financial statement.

2.

Facilitates inter – firm comparison: Ratio Analysis provides data for inter – firm comparison. Ratios highlight the factors associated with successful and unsuccessful firms. They also reveal strong firms and weak firms, over valued and undervalued firms.

3.

Makes intra – firm comparison possible: Ratio Analysis also makes possible comparison of the performance of the different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future.

4.

Helps in planning: Ratio analysis helps in planning and forecasting. Over a period of time a firm or industry develops certain norms that may indicate future success or failure. If relationship changes in firm’s data over different time periods, the ratios may provide clues on trends and future problems.

6.

Helps in decision making : Some times ratio may indicate better guideline for decision making. Example: good trend of profitability and dividend payout ratio helps investor to buy shares. Lower debt service coverage ratio & int coverage ratio prevent bank from financing to company. •

1.

LIMITATIONS: Comparative study required: Ratios are useful in judging the efficiency of the business only when they are compared with the past results of the business or with the results of a similar business. However, such a comparison only provides a glimpse of the past performance, and forecasts for future may not be correct since several other factors like market conditions, management policies, competition, local factors etc., may affect the future operations.

2.

Ratios alone are not adequate: Ratios are only indicators; they cannot be taken as final judgment regarding good or bad financial position of the business. Other things have also to be seen. For example, a high current ratio does not necessarily mean that the concern has a good liquid position in case current assets mostly comprise of outdated stocks.

3.

Window dressing: The term window dressing means manipulation of accounts in a way so as to conceal vital facts and present the financial statements in a way to show a better position than what it actually is, On account of such a situation, presence of a particular ratio may not be a definite indicator of good or bad management. For example, a high stock turnover ratio is generally considered to be an indication of operational efficiency of the business. But this might have been achieved by unwarranted price reductions of closing stock or failure to maintain proper stock of goods.

4.

Problems of price level changes: Financial analysis based on accounting ratios will give misleading results if the effects of changes in price level are not taken into account. For example, two companies set up in different years, having plant and machinery of different ages, cannot be compared, on the basis of traditional accounting statements. This is because the depreciation charged on plant and machinery in case of old company would be at a much lower figure as compared to the company which has been se up recently.

5.

No fixed standards: No fixed standards can be laid down for ideal ratios. For example, current ratio is generally considered to be ideal if current assets are twice the current liabilities. However, in case of those concerns which have adequate arrangements with their banks for providing funds when

they require, it may be perfectly ideal if current assets are equal to slightly more than current liabilities. It is therefore necessary to avoid many rules of thumb. Financial analysis is an individual matter and value for a ratio which is perfectly acceptable for one company or one industry may not be at all acceptable in case of another. 6.

Inaccurate base: The accounting ratios can never be more correct than the information from which they are computed. If the accounting data is not accurate, the accounting ratios based on these figures would give misleading results.

7.

Investigation necessary: It must be remembered that accounting ratios are only a preliminary step in investigation. They suggest areas were investigation or inquiry is necessary. It can never be used as conclusion.

8.

Rigidity harmful: If in the use of ratios, the manager remains rigid and sticks to them, it will lead to dangerous situation. For example, if the manager believes the current ratio should not fall below 2: 1, then many profitable opportunities will have to be foregone.