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TEST OF SOLVENCY
The short-term obligations of a firm can be met only when there are sufficient liquid assets.
Therefore, a firm must ensure that it does not suffer from lack of liquidity or the capacity to pay
its current obligations. It is very important to have a proper balance in regards to the liquidity of
the firm. Two types of ratios can be calculated for measuring short-term financial position or short-
term solvency of the firm.
Liquidity refers to the ability of a concern to meet its current obligations and when these become
due. The short-term obligations are met by realizing amounts from current, floating or circulating
assets. The current assets should either be liquid or near liquidity. These should be convertible into
cash for paying obligations of short-term nature. To measure liquidity of a firm, following ratios
can be calculated.
(i) Current Ratio
(ii) Quick or Acid Test or liquid Ratio
(iii) Absolute Liquid Ratio or cash position Ratio
CURRENT RATIO:
Current ratio may be defined as the relationship between current assets and current liabilities. This
ratio, also known as working capital ratio, is a measure of liquidity and is most widely used to
make the analysis of short-term financial position or liquidity of affirm it is calculated with the
help of following formula:
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Year Current asset Current Liability Current Ratio
2018 246.51 117.16 2.104045749
2017 238.71 109.65 2.177017784
2016 276.23 79.63 3.468918749
2015 230.35 63.03 3.654608916
2014 230.9 104.77 2.203875155
INTERPRETATION: A ratio equal or near to the rule of thumb of 2:1 i.e. current asset doubles
the current liabilities is considered to be satisfactory. As per the above table current ratio of PTL
is satisfactory as it is greater than 2:1 for last five years.
year Current asset inventories Quick asset Current liability quick ratio
2018-19 246.51 47.44 199.07 117.16 1.6991294
2017-18 238.71 31.92 206.79 109.65 1.8859097
2016-17 276.23 26.08 250.15 79.63 3.141404
2015-16 230.35 27.75 202.6 63.06 3.2128132
2014-15 230.9 33.14 197.76 104.77 1.8875632
INTERPRETATION: As a rule of thumb or as a convention quick ratio 1:1 is considered
satisfactory. Above table shows that quick ratio of PTL for last five years is greater than standard
norms of 1:1 and has shown good liquidity position.
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Some authorities are of opinion that the absolute liquid should be calculated together with current
ratio and acid test ratio so as to exclude even receivable from current assets and find out absolute
liquid assets.
INTERPRETATION: The acceptable norm for this ratio is 0.5:1 or 1:2. As per the table in the
year 2018-19 the ratio is near to 1:2. For the last four years previous to financial year 2018-19 the
absolute liquid ratio was not up to the mark.
Funds are invested in various assets in business to make sales and earn profits. The efficiency with
which assets are managed directly affects the volume of sales. The better the management of assets,
the larger is the amount of sales and the profits. Activity ratios measure the efficiency or
effectiveness with which a firm manages its resources or assets. These ratios are also called
turnover ratios because they indicate the speed with which assets are converted or turned over into
sales. Current ratio and acid test ratio ignore the movement of current assets, it is important to
calculate the following turnover or efficiency ratios to comment liquidity or the efficiency with
which the liquid assets are being used by the firm.
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Every firm has to maintain a certain level of inventory of finished goods to be able to meet the
requirements of business. But the level of inventory should be neither be too high nor too low.
Inventory turnover ratio also known as stock velocity ratio. It would indicate whether inventory
has been efficiently used or not. The purpose is to see whether the required minimum funds have
been locked up in inventory.
INTERPRETATION: According to the table for the last five-year inventory turnover ratio of
PTL was highest in the 2016-17. After that it started decreasing. The declining inventory turnover
ratio of PTL shows the changing scenario adopted by the company of keeping inventory with
supplier instead if keeping with them.
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INTERPRETATION: There is no rule of thumb which may be used as a norm to
interpret the ratio. From the year 2014-15 debtor turnover ratio of PTL is gradually
decreasing year by year. It was 78.02 in the year 2014-15 and 69.84 in the year
2015-16 which shows that the firm is not very efficient in managing its debtors.
INTERPRETATION: Generally shorter the average collection period the better is the quality of
debtors as it implies quick payment by debtors. Average collection period ratio of PTL shows
decrease in average collection period. It was 54 days in the year 2014-15 and 50 days in the year
2015-16 which shows better collection policy and credit terms of company.
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2018-19 665.23 104.15 6.387229957
2017-18 587.56 98.47 5.96689347
2016-17 503.19 70.13 7.175103379
2015-16 404.91 54.01 7.49694501
2014-15 414.6 48.18 8.605230386
INTERPRETATION: Generally higher the creditor velocity better it is. Creditor turnover ratio
of PTL is going on decreasing from the year 2014-15 which shows that firm is not enjoying
actually the credit promised by the supplier.
INTERPRETATION: Average payment period ratio represents the average number of days taken
by the firm to pay its creditors. Generally, lower the ratio better is the liquidity position of the firm.
Average payment period ratio of PTL shows good liquidity position of the company as it decreased
from 61 days in the year 2017-18 to 57 days in the year 2018-19, whereas the previous three years
it had been increasing which shows a very poor liquidity position.
WORKING CAPITAL TURNOVER RATIO:
Working capital turnover ratio indicates the velocity of the utilization of net working capital. This
ratio indicates the number of times the working capital is turned over in the course of a year. This
ratio measures the efficiency with which working capital is used by the firm.
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Average Working Capital
year net sales Current Asset Current Liability Working Capital WCTR
2018-19 871.74 246.51 117.16 625.23 1.394270908
2017-18 766.9 238.71 109.65 528.19 1.451939643
2016-17 662.83 276.23 79.63 386.6 1.714511123
2015-16 523.17 230.35 63.03 292.82 1.786660747
2014-15 536.01 230.9 104.77 305.11 1.756776245
The term ‘solvency’ refers to the ability of a concern to meet its long-term obligations. The long-
term indebtedness of a firm includes debenture holders, financial institutions providing medium-
and long-term loans and other credit selling goods on installment basis. Long term solvency ratios
indicate a firm’s ability to meet the fixed interest and costs and repayment schedules associated
with its long-term borrowing. The following ratios serve the purpose of determining the solvency
of the concern.
(i) Debt-Equity Ratio
(ii) Funded-Debt to Total Capitalisation Ratio
(iii) Proprietory or Equity Ratio
(iv) Solvency Ratio
(v) Fixed Assets to Proprietor’s Fund Ratio
(vi) Fixed Assets to Total Long-Term Funds
(vii) Ratio of Current Assets to Proprietor’s Funds
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(viii) Debt Service Ratio or Interest Coverage Ratio
DEBT-EQUITY RATIO:
Debt- Equity ratio, also known as External- Internal Ratio is calculated to measure the relative
claims of outsider and the owners (i.e. shareholders) against the firm’s assets. This ratio indicates
the relation between the external equities or the outsider’s funds and the internal equities or the
shareholders’ funds, thus:
Outsiders Funds= All debts/liabilities to outsiders, whether Long term or short term
Shareholders’ Funds= Equity Share Capital+ Preference Share Capital+ Capital reserves+
Revenue reserves+ Accumulated profits and surpluses – accumulated losses + Deferred expenses.
Year debt equity ratio
2014-15 11.14 225.85 0.049324773
2015-16 9.35 216.37 0.043213015
2016-17 9.16 270.95 0.033806975
2017-18 10.13 251.02 0.04035535
2018-19 8.49 199.65 0.042524418
INTERPRETATION: The ratio indicates the proportionate claims of owners and the outsiders
against the firm’s assets. The debt-equity ratio of PTL shows that the claim of outsiders has
increased and claim of owners has decreased from 2014-15 to 2016-17 continuously. But from
2016-17 to 2018-19, this shows that the claim of outsiders has decreased and claim of owner has
increased.
PROPRIETARY RATIO OR EQUITY RATIO:
A variant to the debt-equity ratio is the proprietary ratio. This ratio establishes the relationship
between shareholder’s funds to the total assets of the firm. It is an important ratio for determining
long-term solvency of a firm. The ratio can be calculated as under:
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Shareholder’s Fund= Equity Share Capital+ Preference Share capital+ Undistributed
Profits+ Reserves& surpluses- (Accumulated Losses+ Deferred Expenses).
year shareholders fund total asset proprietary ratio
2018-19 237.98 366.28 64.97215245
2017-18 228.5 347.5 65.75539568
2016-17 283.37 372.16 76.14198194
2015-16 263.44 336.59 78.2673282
2014-15 212.07 325.34 65.18411508
INTERPRETATION: As equity ratio represents the relationship of owner’s fund to total assets,
higher the ratio or the share of shareholders in total capital of the company better is the solvency
position of the company. Equity ratio of PTL going on increasing from 2014-15 to 2016-17,which
indicates that the assets of the company can be lost without affecting the interest of creditors of
the company whereas it can be seen that from 2016-17 to 2018-19 it has decreased which indicates
that the assets of the company lost is affecting the interest of the creditors of the company.
INTERPRETATION: The ratio indicates the extent to which shareholders’ funds are sunk into
the fixed assets. A fixed asset to net worth ratio of PTL is going in decreasing from 2014-15 to
2016-17 but we can see an increase from the year 2016-17 to 2018-19.
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FIXED ASSETS TO TOLAL LONG TERM FUNDS:
A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to total long-term funds
which are calculated as:
INTERPRETATION: The ratio indicates the extent to which the totals of fixed assets are
financed by long-term funds of the firm. Generally, the total of fixed assets should be equal to the
total of long-term funds. Long-term funds of PTL for the last three years was more than fixed
assets, it means that a part of the working capital requirements is met out of the long-term funds
of the firm which is a good financial policy, whereas year 2014-15 to 2016-17 the ratio had been
decreasing.
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INTERPRETATION: The table shows the ratio is increasing continuously from the 2014-15.
The increasing trend shows the efficiency level of the company’s solvency position. But we can
see that earlier from the yea 2014-15 to 2015-16 there is a decrease in the ratio. The decreasing
trend of this ratio affects the solvency position of the company.
INTERPRETATION: Long-term creditors of the firm are interested in knowing the firm’s
ability to pay interest on their long-term borrowings. Generally, higher the ratio, safer are the long-
term creditors because even if earnings of the firm fall the firm shall be able to meet its
commitments of fixed interest charges. Debt service ratio shows a huge increase as it is increased
from the year 2017-18 to the current year. Similarly, 2015-16 to 2016-17 there is a huge increase,
but there was a decrease in the year 2014-15 to 2015-16.
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GENERAL PROFITABILITY RATIOS
(i) Gross Profit Ratio
(ii) Operating Ratio
(iii) Operating Profit Ratio
(iv) Expenses Ratio
(v) Net Profit Ratio
INTERPRETATION: There is no standard norm for gross profit ratio but it should be adequate
to provide for fixed charges, dividends and accumulation of reserves. Higher the gross profit ratio
betters the results. But gross profit ratio of PTL for the last three years going on decreasing. Due
to increase in competition and raw material cost the company was not able to increase its selling
price accordingly and due to this gross profit decreases, whereas earlier to that year it had increased
which indicates that there wasn’t much competition and raw material cost the company was able
to increase its selling price.
OPERATING RATIO:
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Operating ratio measures the cost of operations per rupee of sales. It establishes the relationship
between cost of goods sold and other operating expenses on the one hand and the sales on the other
and generally represented as a percentage
INTERPRETATION: Higher the operating ratio, less favorable it is. Operating ratio of PTL
indicates that 90% of sales have been consumed by operating cost and only 10% is left to cover
interest charges, income-tax payment, dividend and the retention of profits as reserves. It is due to
the number of uncontrollable factors beyond the control of the firm.
OPERATING PROFIT RATIO:
This ratio is calculated by dividing operating profit by sales.
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INTERPRETATION: Generally, higher the ratio better it is but the operating profit ratio of PTL
has been increased to 13.84% from 15.10%. It is due to number of uncontrollable factors beyond
the control of firm which affects the operating efficiency of the firm
EXPENSES RATIO:
Expenses ratio indicate the relationship of various expenses to net sales. The operating ratio reveals
the average total variation in expenses. But some of the expenses may be increasing while some
may be falling. Hence, expenses ratios are calculated to analyse the cause of variation of the
operating ratio.
INTERPRETATION: Lower the ratio, greater is the profitability and higher the ratio, lower is
the profitability. Expenses ratio of PTL going on increasing from 2014-15 to 2016-17, due to
increase in salaries, wages & bonus, taxes and export promotion and marketing. But from 2016-
17 it had decreased by a huge margin from 29.73% to 3%, whereas it had again increased from
2017-18 to 2018-19.
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Net Sales
INTERPRETATION: Generally, higher the ratio better it is. But in case of PTL the Net profit
ratio is falling. It is highest in 2017-16 but after that it has declined but this decline is nominal.
Falling net profit ratio is indication of falling profitability so company should give it proper
attention.
CASH PROFIT RATIO:
This ratio measures the relationship between cash generated from operations and the net sales.
Thus,
INTERPRETATION: Cash profit ratio of PTL for first three years i.e. 2014-15 to 2016-17shows
an increase from 12.05% to 12.77%. After that it started decreasing for next two years due to
increase in expenses.
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OVERALL PROFITABILITY RATIOS:
Profits are measure of overall efficiency of a business. Overall profitability or efficiency of a
business can be measured in terms of profits related to investments made in the business. Various
overall profitability ratios are discussed below.
(i) Return on Shareholder’s Investment or Net worth Ratio
(ii) Return on Equity Capital
(iii) Earning per Share
(iv) Return on Capital Employed
(v) Capital Turnover Ratio
Year net profit after int. and tax shareholder's fund Ratio
2018-19 82.42 237.98 34.63316245
2017-18 80.1 228.5 35.05470460
2016-17 68.84 283.37 24.29332675
2015-16 51.13 263.44 19.40859399
2014-15 51.84 212.07 24.44475881
INTERPRETATION: This ratio reveals how well the resources of a firm are being used. Higher
the ratio better are the results. But the ROI ratio of PTL did not show satisfactory results as it going
on increasing after 2016-17. ROI of PTL was highest in the year 2017-18. This ratio also indicates
that the firm is able to face adverse economic condition such price competition, low demand etc.
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performance of a company should be judged on the basis of return on equity capital of the
company. Return on equity capital is the relationship between profits of a company and its equity
capital can be calculated as:
Year net profit after tax - preference dividend equity share capital Ratio
2018-19 82.42 12.13 6.794723825
2017-18 80.1 12.13 660.346249
2016-17 68.84 12.42 554.2673108
2015-16 51.31 12.42 413.1239936
2014-15 51.84 12.42 417.3913043
INTERPRETATION: This ratio is more meaningful to equity shareholders. Higher ratio is better. This
ratio is same as previous ratio, the only difference is that in previous ratio return on total investment is
calculated which includes preference share capital also whereas in ROE only equity capital is taken. In
PTL, preference share capital is not there so both the ratios are same.
Year net profit after tax - preference dividend No. of shares Ratio
2018-19 82.42 1.212772219 67.96
2017-18 80.1 1.239554318 64.62
2016-17 68.84 1.242150848 55.42
2015-16 51.31 1.242372881 41.3
2014-15 51.84 1.241974126 41.74
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the financial year 2015-16to 2018-19 it is going on increasing. The year which it had declined was
in the year 2015-16. The decline is due to adverse economic conditions.
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Year Adjusted Net profit Proprietors' net capital employed ratio
2018-19 82.42 483.44 17.04865133
2017-18 80.1 457.15 17.52160122
2016-17 68.84 451.79 15.23716771
2015-16 51.31 399.62 12.83969771
2014-15 51.84 430.11 12.0527307
INTERPRETATION: Above table indicates that after the increase in the ratio from the year
2015-16. The ratio decreased in the year 2015-16 with a huge margin.
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(iv) Earning Yield Ratio
Year Dividend per equity shares market price per share ratio
2018-19 4.122011542 82.44023083 0.05
2017-18 4.123031253 137.4343751 0.03
2016-17 3.46215781 86.55394525 0.04
2015-16 2.657004831 53.14009662 0.05
2014-15 2.657004831 53.14009662 0.05
INTERPRETATION: The ratio was constant in the year 2014-15 and 2015-16. But then it
decreased from the year 2016-17 to 2017-18 and then again increased in the year 2018-19.
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Dividend per equity
earnings per share ratio
Year shares
2018-19 4.122011542 67.95 60.662422
2017-18 4.123031253 66.05 62.42288
2016-17 3.46215781 55.42 62.47127
2015-16 2.657004831 41.31 64.318684
2014-15 2.657004831 41.74 63.656081
INTERPRETATION: The ratio had ben decreasing continuously from the past four year. The
highest ratio was in the year 2015-16.
Year Market price per equity shares earnings per share ratio
2018-19 121.3 67.95 178.513613
2017-18 121.27 66.05 183.6033308
2016-17 121.2 55.42 218.6936124
2015-16 124.2 41.31 300.6535948
2014-15 124.2 41.74 297.5563009
INTERPRETATION: Generally, higher the ratio better it is. Price earnings ratio of PTL had been
rising from the year 2014-15 to 2015-16 but it again fell in the year 2016-17 and has been falling
continuously.
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Earning Yield Ratio = Earnings per Share X 100
Market Price per Share
Year earnings per share Market price per equity shares ratio
2018-19 67.95 1359 0.05
2017-18 66.05 2201.666667 0.03
2016-17 55.42 1385.5 0.04
2015-16 41.31 826.2 0.05
2014-15 41.74 834.8 0.05
INTERPRETATION: The ratio had been constant in the year 2014-15 to 2015-16. From then it
decreased till the year 2017-18, but again increased in the year 2018-19.
LEVERAGE RATIO:
Leverage or capital structure ratio are calculated to test the long-term financial positions of affirm.
Leverage refers to relationship between various long-term forms of financing such as debentures,
preference share capital and equity share capital including reserves.
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INTERPRETATION: The ratio was highest in the year 2014-15.
INTERPRETATION: The table indicates that the ratio is increasing from the year 2014-15 to
the year 2016-17 which is a good sign for the company. From the year 2016-17 it decreased in the
year 2017-18 but it again increased in the year 2018-19.
TREND ANALYSIS
This method determines the direction upwards and downwards and involves the computation of
percentage relationship that each statement item bears to the same item in base year. The figures
of base year are taken as 100 and trend ratio for other years is calculated on basis of base year.
TREND PERCENTAGES
(Base Year 2014-15=100)
Year net sales trend (%) profit before tax trend (%)
2014-15 871.74 100 127.4 100
2015-16 771.15 88.46100902 122.71 96.3186813
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2016-17 666.15 76.41613325 105.46 82.7786499
2017-18 525.91 60.32876775 76.22 59.8273155
2018-19 539.7 61.91066144 77.83 61.0910518
INTERPRETATION:
SALES
From the above trend it is be seen that sales of PTL have been falling as the years passed by.
Initially it had decreased by a huge margin but from the next year it decreased with minimal
amount.
PROFITS
From the above trend it is seen that the profits were quite low in year 2017-18. After 2017-18 it
started increasing till the current year.it had been declining from the base year till 2017-18.
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