Subject Financial Management

Chapter 3 Ratio Analysis

Nature of Ratio:Ratio are among the best know and most widely used tools of financial analysis. Financial ratio is relation between financial value As companys turnover ratio :- Total Asset / Sales Figure The resulting figure is also index of how many times the value of total asset was incorporated in the firm product. It is worthwhile to mention that the ratio must express relationship that has significance. The relationship between two figures of Balance Sheet is called Balance Sheet Ratio The relationship between Profit & Loss Figures is called Income Statement Ratio The relationship between figures of Profit & Loss Statement & Balance Sheet is called as Inter Statement Ratio

Ratio may be expressed in three firm 1. Pure Ratio 2. Rate :- Inventory turnover as so many times a year 3. As percentage :- Return on shareholders equity being 10% Significance of Ratio as Tool of Financial Analysis D.1 Liquidity Ratio :- for Short Term Obligation 1. Current Ratio :- Current Asset 2:1 Current Liabilities Higher ratio shows companys payment ability of short term obligation on maturity and vise versa for lower ratio 2. Acid Test Ratio or Quick Ratio :- Quick Current Assets ( Excluding Inventory) 1:1 Current Liabilities D.2 Leverage Ratio:- Basically relate with measuring the contribution of Owners/ Shareholder Fund, Repayment of Suppliers & repayment of Short Term & Long Term Loans 1. Debt to Total Asset :- Total Debt Total Asset This ratio indicates solvency of the company. Lower ratio greater cushion of creditors lost in liquidation. Moderate ratio which is creditors requirement & Higher ratio which is stakeholders requirement 2. Debt Equity Ratio:- Total Debt(Current & Long Term Loan) Tangible Net worth (Stock & Reserves & Surplus) Higher Ratio - Indicates more investment of creditors than an business owner, they ultimately get suffer more than owner at the time of liquidation Lower Ratio Creditors Prefer ability

Subject Financial Management

Chapter 3 Ratio Analysis

3. Long Term Debt to Total Capitalization All long term debt Net Worth Its a relationship between long term debt & capital invested. Thumb rule Is maximum 33.5% of long term debt against capital invested in manufacturing concern while 50% in public sector 4. Time Interest Earned :- Profit Before Tax & Interest ( PBIT) Interest Charge High Ratio indicates low burden of borrowing of the business & lower utilization of borrowing capacity D.3 Activity Ratio :- Reflects the efficiency of company about managing its resources. Its a relationship between the level of sales & Investment in various asset 1. Inventory Turn Over ratio : Cost of Goods Sold Average Inventory for the period High Ratio :- Higher turnover & lower blocking of funds in inventory Lower Ratio :- Slow moving inventory

2. Average Collection Period :- Receivable x 365 Days Net Sales It Indicates companies credit & collection policy & the effectiveness of collection machinery. Long Period :- Leniency of company in credit policy Shorter Period :- Aggressive Collection policy 30 days credit period is acceptable while 90 days credit period indicates three months receivable in hand 3. Total Asset Ratio : Cost of Goods Sold Average Total Asset

It indicates efficiency with which asset of the company have been utilized. Higher ratio indicates better utilization & vice versa

4. Fixed Asset Ratio :- Cost of Goods Sold Fixed Asset Lower ratio indicates poor utilization of existing plant capacity

Subject Financial Management

Chapter 3 Ratio Analysis

D.4 Profitability Ratio :- Are the best indicators of overall efficiency of business concern because they compare nature of return over & above the value put into business with sales & services carried by enterprises. 1. Profitability relates to Sales a. Gross Profit to Sales :- Gross Profit ( Sales Cost of Goods Sold) Sales It indicates operating efficiency of company to reflect its pricing policy b. Operating Profit to Sales :- Operating Profit Sales It indicates marginal efficiency which may not be reflected in operating income c. Net Profit to Sales Ratio :- Net Income ( After Tax) Net Sales It Indicates overall efficiency of the business. Higher ratio indicates higher overall efficiency & better utilization of all resources. Lower ratio means poor financial planning & low efficiency. 2. Profit as related to Investment :- It indicates return of total capital employed and return on net worth. a. Return on Capital Employed :Net Profit Total Capital Employed

Higher ratio indicates better utilization of funds b. Return on Net Worth :Profit Before Tax Net Worth

It means productivity of shareholders fund. Higher ratio indicates better utilization of owners fund & high productivity. D.5 Investment Ratio :- This ratio used by investors to analysis invisibility of company 1. Earnings Per Share (E.P.S.) :Earning After Tax Preferred Dividend (If Any) Common Shares Outstanding It indicates the change in the wealth of shareholders over period of one years. Year on year comparison of EPS can be very important to investors. 2. Price Earnings Ratio (P/E) :Market Price Earnings Per Share It helps in valuation of stock in future period 3. Payout Ratio :Dividend per Share Earnings Per Share

Subject Financial Management 4. Dividend Yield Ratio :-

Chapter 3 Ratio Analysis

Dividend Per Share Price Per Share It helps to potential investors who are searching for regular income. 5. Return on Investment (Du Pont Approach) :- Sales Total Assets X Earning per Share Sales

Return On Investment is one of the most successful yet simple technique aid both decision making & performance evaluation.