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Ratio Analysis

The various ratios have been discussed under the following headings: I. Liquidity Ratios. II. Capital Structure Ratios. III. Turnover Ratios IV. Profitability Ratios V. Expense Ratios VI. Profitability Ratio Based on Investments VII. Ratios Showing Profitability on Shares

I. LIQUIDITY RATIOS. Liquidity Ratios are the ratios which clarify the firms capacity to pay its short term liabilities. Therefore these ratios are also known as short term solvency ratios. The ratios are as follows: (a) Current Ratio: Formula :- Current Ratio = Current Assets Current Liabilities Current Assets are those assets which can be converted into cash within one year, and current liabilities are those liabilities which are payable within one year. The examples of current assets and current liabilities are as follows Sl. Current Assets Current Liabilities No. 1. Cash in Hand Creditors for Goods 2. Cash at Bank Bills Payable 3. Marketable Securities Outstanding Expenses 4. Bills Receivables Bank Overdraft 5. Stock of raw material, or Provision for Taxation WIP or Finished Goods 6. Sundry Debtors Income Received in Advance 7. Short term Loans and Advances Unclaimed Dividends 8. Short term Investments Income tax Payable 9. Prepaid Expenses Dividend Payable 10. Accrued Incomes Short term Loans 11. Advance Payment of Tax Proposed Dividends 12. Cash Credit Cash Credits Non trade investments will be taken at their market value but trade investments and other current assets will be taken at their book value. If provision for taxation and advance income tax both are given in the balance sheet then we will take after making them net it means that the provision for taxation will be taken after deducting advance tax balance. If there is any provision for doubtful debt then debtors will be taken after deducting this provision. If the question has given nay investments which are made from any specific fund for example workmen compensation fund or debenture sinking fund or gratuity fund or pension fund etc. then it will not be taken in current assets. If the question has given provision for gratuity, provident fund or other employee retirement benefit fund balance then it will not be considered a current liability but if the question has given gratuity liabilities or liability due from any other fund then it will be taken in current liability. If the question has given any creditor for purchase/construction of fixed assets then it will not be considered as current liability. The current ratio of 2:1 is considered adequate. (b) Quick Ratio : Formula: Quick Ratio = Quick Assets Quick Liabilities Quick assets = Current Asset Stock Prepaid Expenses. Quick Liabilities = Current Liabilities Bank overdraft Cash Credit Other illiquid Liabilities Quick ratio of 1:1 is considered adequate. (c) Cash Position Ratios: Cash is the most liquid asset, therefore cash position ratio helps to estimate the strength of a business to pay its liabilities. The cash position ratios are as follows: i) Absolute Cash Ratio: Formula Absolute Cash Ratio = Cash Reservoir

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Current Liabilities Cash reservoir = Cash + Bank + Non Trade Marketable Investment In the absence of information about the market value of the investment the book value will be considered its market value. ii) Cash interval Measure: The ratio helps to identify that how long the present cash reservoir will continue to serve the business requirements if there is no cash inflow. Formula: Cash Interval = Cash Reservoir Daily Cash expenditure Daily cash expenditure will be calculated as:- = total Cash Exp. 365 days. The Total cash expenditure will be calculated as under Total Expenses as per Trading A/c and P/L A/c. Less: All non cash expenses: Depreciation Preliminary Exp. Written off Transfer to reserves Provision for doubtful debts Provision for taxation

Other non cash expenses included above Add: Advance Tax Paid = Total Cash Expenditure during the year.

II. CAPITAL STRUCTURE RATIOS: These ratios help us to analyses that how much portion of the total capital is financed by debt and how much is financed by equity to ascertain the financial risk of a firm inherent in the financial structure. The important capital structure ratios are as under:(a) Debt Equity Ratio: Formula: Debt-Equity Ratio = Debt Equity Debt = Long term debt + Debentures + Outstanding Interest on Loans and Deb. Equity = Equity share Cap. (paid up) + Pref. share Cap. (paid up) + Reserve and Surplus Accumulated Losses. Equity is also known as net worth or share holders funds or proprietors funds etc. (b) Total debt Equity Ratio: Formula : Total DebtEquity ratio = Total Debt. Equity Total debt = debt (as above) + Current Liabilities (c) Proprietary Ratio: Formula: Proprietary ratio = Proprietors funds Total Assets Total assets means, total of asset side Fictitious assets The proprietary ratio can be further divided into the following i. Fixed assets to proprietors funds ratio = fixed assets (net of depreciation) Proprietors Funds ii. Current Assets to proprietors fund ratio = Current Assets Proprietors fund (d) Debt to Total Asset Ratio: Formula: Total Outside Debts Total Assets (Total outside Debt = total liabilities Equity) (e) Long term fund to fixed asset ratio: Formula: Long term funds Fixed Assets (net) (f) Total Liabilities to net worth ratio: Formula: Total Liability Net Worth (Total liability means total of liability side.) (g) Capital Gearing Ratio: Formula:

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Debentures + Long term Loans + Pref. Share Cap. Equity Share cap + reserve and surplus acc. Losses (h) Debt service Coverage Ratio: Formula: Profit Before Interest and Tax Total Interest Cost III. TURNOVER RATIOS: (a) Inventory Turnover Ratio: i) Raw Material Inventory Turnover Ratio: Formula: Raw Material Consumed Average stock of raw material (Raw material consumed = opening stock + Purchase Closing stock) ii) Finished Goods Inventory Turnover Ratio: Formula: Cost of goods sold Average stock of finished goods (Cost of goods sold = Raw material consumed + direct wages + manufacturing expenses + opening stock of finished goods closing stock of finished goods + opening stock of WIP closing stock of WIP) iii) WIP Inventory Turnover Ratio: Formula: Cost of Production Average Stock of WIP (Cost of production = Raw material consumed + direct wages + manufacturing exp. + opening stock of WIP closing stock of WIP) (Average stock = opening stock + closing stock / 2 iv) Stock Velocity Ratio: Formula: 365 days / 52 days / 12 months Inventory turnover Ratio (b) Debtors Turnover Ratio: Formula: Net Credit Sales Average Debtors If bills receivables are given in the question then it will also be taken in the balance of debtors If credit sales are not given in the question separately then all the sales will be considered for credit only. If there is any provision for doubtful debt or provision for discount on debtors then debtors will be taken before deducting it. (c) Debtors Velocity Ratio or Debtors Collection Period: Formula: 365 days / 52 days / 12 months Debtors turnover ratio (d) Creditor Turnover Ratio: Formula: Net Credit Purchases Average Creditors If credit purchases are not given separately then all the purchases will be considered on credit basis. Credit purchases will be taken after deducting purchase returns. If balance of bills payable is also given in the question then it will be treated as a part of creditors. If provision for discount is given in the question then the balance of the creditors will be taken before deducting it. (e) Creditors Payment Period or Creditors Velocity Ratio: Formula: 365 days / 52 days / 12 months Creditors Turnover Ratio (f) Total Asset Turnover Ratio: Formula: Net sales or Cost of Goods Sold Total Assets This formula can be applied either on net sales or cost of goods sold, both the answer will be considered correct but the answers will be different. Total asset = Total fixed assets (after depreciation) + total current assets. Debtors will be taken after deducting provision for doubtful debts and provision for discount. Estimated losses and fictitious assets are not to be taken. (g) Fixed Assets Turnover Ratio: Formula: Net sales or cost of goods sold Net fixed assets (h) Current Assets Turnover Ratio: Formula: Net sales or cost of goods sold

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Net current assets Working Capital Turnover Ratio: Formula: Net sales or cost of goods sold net working capital (j) Capital Employed Turnover Ratio: Formula: Net sales or cost of goods sold Net capital employed (Capital Employed = Equity share capital (paid up) + Preference share capital (paid up) + Reserve and Surplus + Debentures + Long term Loans Accumulated Losses.) (k) Net worth Turnover Ratio: Formula: Net sales or cost of goods sold Net worth (Net worth = Equity shares capital (paid up) + Preference share capital (paid up) + Reserve and surplus Accumulated Losses.) (i) IV. PROFITABILITY RATIOS: i) Gross Profit Ratio: Formula: Gross Profit X 100 Net Sales ii) Net Profit Ratio: Formula: Net Profit X 100 Net Sales iii) Operating Profit Ratio: Formula: Operating Profit X 100 Net Sales (Operating profit = Net sales Operating exp, (explained below) iv) Operating Ratio or Operating cost Ratio: Formula: Total Operating Cost X 100 Net Sales Operating cost = Total Expenses of Trading Account + Administration Expenses + Selling and distribution Expenses (but excluding all other non trade expenses) Non Trade expenses means loss on sale of fixed assets, loss on sale of investments, income tax, dividend, debenture interest, loss by fire, loss by theft etc. V. EXPENSES RATIOS: i) Raw Material Consumed Ratio: Formula: Raw Material Consumed X 100 Net Sales (Raw Material Consumed = Opening Stock + Purchases Closing Stock) ii) Manufacturing Expenses Ratio: Formula: Manufacturing Expenses X 100 Net Sales Manufacturing Expenses = All the Expenses which are shown in Manufacturing account and Trading account + Cost of Goods Sold This can also be calculated as: 100 Gross Profit Ratio iii) Administration Expenses Ratio: Formula: Administration Expenses X 100 Net Sales iv) Selling and Distribution Expenses Ratio: Formula: Selling and Adm. Expenses X 100 Net Sales v) Non Operating Expenses Ratio: Formula: Non Operating Expenses X 100 Net Sales VI. PROFITABILITY RATIO BASED ON INVESTMENTS: i) Return on Capital Employed: Formula: Net Profit Before Interest and Taxes X 100 Capital Employed (The term capital employed is considered to be interpreted to be of the following three types) Gross Capital employed = Net Fixed assets + Trade Investments + Current asset + intangible asset (having any sale value)

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Net Capital Employed = Gross capital employed current liabilities Average Cap. Employed = Op. Capital employed + Closing Cap. Employed 2 The profit before interest and taxes will be taken Excluding: Income on the non trade investments. Abnormal profits and non operating incomes Abnormal profits and non operating expenses Interest on long term borrowings. If fixed assets are taken at the market values then the profit will be taken after adjustment of the depreciation for change in the value of the assets. Return on Shareholders funds or Equity: Formula: Net Profit after Taxes X 100 Shareholders funds (Shareholders funds = Preference share capital + Equity share capital + All reserves and surplus (fictitious assets + Accumulated Losses) Net profit after taxes refers to profits to which shareholders are entitled to after meeting all expenses including interest on borrowings and income tax. However non operating incomes like interest on investments, dividend received, rent received are included in profit Return on Equity Shareholders fund: Formula: Net profit after Tax Pref. Share Div. X 100 Equity Share holders fund (Equity shareholders fund = Equity share capital + All reserves and surplus (Fictitious assets + Accumulated Losses) Return on Equity share Capital: Formula: Net Profit after tax Pref. Share Div. X 100 Equity Share Capital Paid up Return on Total Asset: Formula: (Net profit after tax + Interest) X 100 Total assets (Total assets = net fixed assets (including intangibles) + current assets + investments (trade and non trade)

ii)

iii)

iv) v)

VII. RATIOS SHOWING PROFITABILITY ON SHARES: i) Earnings per share (EPS): Formula: Net Profit after Tax Preferential Share Dividend No. of Equity Shares outstanding ii) Dividend per Share (DPS): Formula: Dividend Paid to equity share holders No. of Equity Share Outstanding iii) Dividend pay out ratio: Formula: Dividend per share X 100 Earnings per share iv) Dividend Yield Ratio: Formula: Dividend per share X 100 Market price per Equity share v) price earning ratio (P/E Ratio): Formula: Market price per equity share Earnings per Equity share vi) Ratio of revenue reserves to equity share capital: Formula: Revenue reserves X 100 paid up Equity share capital

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VIII. DU PONT CHART: The earning power of an enterprise is gauged by return on capital employed. The return is a combination of two major factors Profit Margin and Turnover of capital employed. The combination effect can be expressed as under: = operating profit Sales ______________ X _____________ Sales Capital Employed = Operating Profit / Capital Employed To arrive at the net return on capital employed, net profit may be taken instead of operating profit. The profit can further be analyzed as to its causes, since it depends on the extent of expenses. Similarly turnover of capital employed i.e. the investment can also be further analyzed as to investment in fixed assets and in working capital being employed generates sales. The analysis has been presented by Du Pont Company of U.S.A. through a chart popularly known as Du Pont Chart. The chart has been presented bellow:

Return on Investment [Operating Profit X 100 / Capital Employed]

DU PONT CHART

_________________________________________________________________

Profit Margin

Investment Turnover

____________________ Operating Profit / Sales

______________________ Sales / Investments ________________

Sales

___________________ (-) Operating Exp.

(+)

Fixed Assets

Working capital

________

Cost of Goods Sold

_______________
(+) Selling administration and other Expenses

______________________

Current assets (-) Current Liabilities

The interaction of profitability and activity ratios is shown by the Du Pont Chart. The overall performance or efficiency of a firm is a result of its working and operations, which are reflected in the margin it gets through carrying on business and the speed at which the assets are usefully employed in the business. The overall performance can be improved either by increasing the profit margin or by accelerating the pace of flow of funds for business activity leading to more sale per rupee of investment. The profit margin can be raised by controlling costs on one hand and increasing sales on the other. The investment turnover can be pushed up by limiting investment in fixed assets or working capital without adversely affecting picture of the spheres which needs more attention to be paid by the management to have better performance. The divisional performance can also be compared and inter firm comparisons can be made on this basis. Shortcoming of financial ratio analysis: _______________________________ (a) A firm is engaged in many business activities at a time. Therefore its comparison with other firms ratios is not possible. (b) Due to inflation past year ratios are not comparable with current year ratios. (c) In seasonal businesses the level of stock and activity is maximum in a particular period and very less in the other part of the year. Therefore the ratios are not reliable in these businesses. (d) Financial ratios are fully based on financial statements according to manipulate the financial statements; in the same manner we can also manipulate ratios.

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(e) Due to differences in accounting policies and financial periods, the comparison between two firms ratios is not possible. (f) We do not have approved standards for financial ratios. (g) The financial ratios can give us results but due to non-availability of standard ratios for comparison, we can not determine that, whether the results are good or bad. (h) Financial ratios are not independently useful, they are beneficial only when they are compared with other ratios.

C. S. Study Centre

Abhishek Agarwal 93515 35743