RATIO ANALYSIS

Expressing the relationship between two numbers

 Ratio analysis is one of the powerful tools of financial analysis. A ratio can be defined as the relationship between two or more things. A ratio can be used as a yardstick for evaluating the financial position and performance of a concern because the absolute accounting data cannot provide meaningful understanding and interpretation.

Accounting ratios can be expressed in various ways A pure ratio Say ratio of CA and CL is 2:1 A rate CA are 2 times of CL A percentage say CA are 200% of CL

IMPORTANCE OF RATIO ANALYSIS

Financial stability and health of the concern: Ratio analysis helps in judging the financial stability and health of the concern. Useful in financial position analysis Useful in simplifying accounting figures Useful in assessing the operational efficiency Useful in forecasting purposes It helps in comparison

CLASSIFICATION OF RATIOS
Classification according to the NATURE OF ACCOUNTING STATEMENT from which the ratios are derived. 1. BALANCE SHEET RATIOS: Example: Current Ratio, Liquid Ratio, Debt Equity Ratio 2. PROFIT AND LOSS RATIOS: Example: Gross Profit Ratio, Net Profit Ratio, Operating Ratio 3. COMBINED OR COMPOSITE RATIO Example: Debtors Turnover ratio, Stock Turnover Ratio, Capital Turnover Ratio

CLASSIFICATION FROM THE POINT OF VIEW OF FINANCIAL MANAGEMENT OR OBJECTIVE

The following analyses are made while making financial statement analysis: Liquidity Analysis Profitability Analysis Capital Structure or Gearing Analysis Market Strength or Investors Analysis Growth and Stability Analysis

LIQUIDITY ANALYSIS OR SHORT TERM ANALYSIS Aims to determine the ability of a business to meet its financial obligations during the short-term and to maintain its short-term debt-paying ability. The aim of liquidity analysis is for a company to have adequate funds on hand to pay bills when they are due and to meet unexpected needs for cash. If a business enterprise cannot maintain its short- term debt paying ability obviously it cannot maintain a longterm debt paying ability or long term solvency. Liquidity analysis mainly focuses on balance sheet relationships that indicate the ability of a business to liquidate current and non-current liabilities.

Analyzing Liquidity

Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due. A second meaning includes the concept of converting an asset into cash with little or no loss in value.

Analyzing Liquidity The comparison and ratios related to evaluating liquidity or short term solvency are as follows:
WORKING CAPITAL POSITION

CURRENT RATIO QUICK RATIO CASH RATIO

WORKING CAPITAL RATIO OR CURRENT RATIO Current ratio is defined as the relationship between current assets and current liabilities. It is also known as working capital This ratio is most widely used to make the analysis of a short-term financial position or liquidity of a firm. It is calculated by dividing the total of current assets by total of the current liabilities

Net Working Capital (NWC) NWC = Current Assets - Current Liabilities

CURRENT RATIO (CR) Current Assets CR = Current Liabilities

INTERPRETATION OF CURRENT RATIO

A HIGH CURRENT RATIO Indicates that the firm is liquid and has the ability to pay its current obligations in time as and when they become due A LOW CURRENT RATIO Indicates that the liquidity position of the firm is not good and the firm shall not pay its current liabilities in time. INCREASE IN CURRENT RATIO represents improvement in the liquidity position DECREASE IN CURRENT RATIO Represents deterioration in the liquidity position

STANDARD CURRENT RATIO = 2:1 is considered to be satisfactory The idea of having Double the current assets as compared to current liabilities is to provide for delays and losses in the realization of current assets.

QUICK OR ACID TEST RATIO OR LIQUID RATIO

Current ratio is generally use to evaluate an enterprise overall short term solvency or liquidity position If an enterprise wants to know immediate position or instant-debt paying ability of a firm than that indicated by the current ratio. Liquid ratio is the relationship between liquid assets and liabilities An asset is said to be liquid if it can be converted into cash within a short period within a short period without loss of value.

Liquid assets are : Cash in hand Cash at bank Bills receivable Marketable securities Debtors NOTE: Inventories cannot be termed to be liquid asset because they cannot be converted into cash immediately without a sufficient loss of value. Prepaid expenses are also excluded from the list of liquid assets because they are not expected to be converted into cash.

LIQUID RATIO = LIQUID ASSETS LIQUID LIABILITIES INTERPRETATION OF QUICK RATIO HIGH LIQUID RATIO: Indicates that the firm is liquid and has the ability to meet its liquid liabilities LOW LIQUID RATIO: Indicates that the firms liquidity position is not good STANDARD LIQUID RATIO: 1:1 is considered satisfactory

CASH RATIO
Liquidity of a firm can be viewed from an extremely conservative point of view. This may be the case when severe liquidity problem with inventory and receivables are likely to happen or when the company has pledged its receivables and inventory. In this situation the short-term liquidity of a company may be measured through cash ratio.

CASH RATIO = CASH + MARKETABLE SECURITIES CURRENT LIABILITIES

PROFITABILITY ANALYSIS The long-term survival of a business enterprise depends on satisfactory income earned by it. An evaluation of a companys past profits may give the investors, creditors and others a better understanding for decision-making. The profitability position also affects the liquidity position which is vital to creditors as well. Profitability ratios are calculated either in relation to sales or in relation to investment.

PROFITABILITY RATIOS RELATED TO SALES

GROSS PROFIT RATIO NET PROFIT RATIO OPERATING RATIO OPERATING PROFIT RATIO EXPENSES RATIO

GROSS PROFIT RATIO

Measures the relationship of gross profit to net sales It is represented as a percentage GROSS PROFIT RATIO = GROSS PROFIT x 100 SALES

INTERPRETATION:
Reflects the efficiency with which a firm produces its products. Gross profit is found by deduction cost of goods sold from net sales HIGHER GROSS PROFIT = BETTER THE RESULTS NO STANDARD NORM FOR GROSS PROFIT RATIO

NET PROFIT RATIO

Measures the relationship between net profit to sales Indicates the efficiency of the management in manufacturing, selling, administration and other activities of the firm. It is the overall measure of firms profitability It is represented as a percentage NET PROFIT RATIO = NET PROFIT x 100 SALES

OPERATING RATIO
Operating ratio establishes the relationship between operating cost and sales Operating ratio = Operating cost x 100 Net sales Operating cost = Cost of goods sold + Operating expenses Interpretation: High operating ratio : Not favorable because it would have a small margin to cover interest, income tax, dividend and reserves.

EXPENSES RATIO
Expenses ratios indicates the relationship of various expenses to net sales INTERPRETATION: LOWER THE RATIO : GREATER THE PROFITABILITY HIGHER THE RATIO: LOWER THE PROFITABILITY

PROFITABILITY RATIOS BASED ON INVESTMENTS

PROFITABILITY RATIOS

RELATING

PROFITS

INVESTMENTS

ROI

DIFFERENT CONCEPTS OF INVESTMENTS IN FINANCIAL LITERATURE

ASSETS CAPITAL EMPLOYED SHAREHOLDERS EQUITY

BASED ON EACH OF THEM THEY ARE THREE CATEGORIES OF ROI

RETURN ON CAPITAL EMPLOYED RETURN ON PROPRIETORS EQUITY RETURN ON EQUITY RETURN ON ASSETS

RETURN ON CAPITAL EMPLOYED

Most Important test of profitability of a business. It measures the over all profitability. Profits are related to capital employed It is ascertained by comparing profit earned and capital employed to earn it. Capital employed refers to long term funds supplied by the lenders and owners of the firm.

ROI = Profit before Interest and Tax ( EBIT) x 100 Capital employed Capital employed can be calculated in 2 ways Capital Employed is Equity Share Capital Add: Preference Share capital Add: Reserves and Other Undistributed profits Add: Long term loans and Debentures Less: Fictitious Assets Or Capital Employed can be calculated as follows: Fixed Assets Cost Less Depreciation Add: Net Working capital

 A comparison of this ratio with similar firms with the industry averages would provide insight how efficiently the long term funds of owners and lenders are being used. HIGHER THE RATIO = MORE EFFICIENT USE OF CAPITAL EMPLOYED

SIGNIFICANCE
ROI is the only ratio which measures satisfactorily the overall performance of a business from the point of view of profitability.

From the following Balance Sheet of Modi Steel Ltd, Calculate Return on Investment. LIABILITIES Share Capital Rs 500000 General Reserve Rs 100000 Debentures Rs 200000 Creditors Rs 50000 Total Liabilities Rs 850000 ASSETS Land and Buildings Rs 400000 Plant and Machinery Rs 300000 Stock Rs 70000 Debtors Rs 30000 Cash Rs 50000 Total Assets Rs 850000 Net profit for the year Rs 120000 and sales Rs 10,00,000.

 ROCE = 15%

RETURN ON SHAREHOLDERS EQUITY ( ROE)

Also Known as Return on Total Shareholders Funds. Measures the return on the owners investments in the firm. Shareholders: Both preference and Equity It shows the ratio of net profit to owner s equity.

SEVERAL WAYS OF CALCULATING ROE

Return on total shareholders equity Return on ordinary shareholders equity EPS Dividend pay out ratio Dividend per share Price earnings ratio

Return on Proprietors Equity

Profitability is measured by dividing the net profits after tax but before preference dividend by shareholders fund Net Profit after taxes and Shareholders Fund x100

 Ratio reveals how profitably = owners funds have been utilised by the firm.

 Net profit : Net profit after interest and tax Shareholders funds: Equity capital Preference Capital Capital reserve General reserves Other undistributed profits

CALCULATE RETURN ON SHAREHOLDERS FUNDS 10% Preference Capital Rs 100000 Equity Capital Rs 250000 Capital Reserve Rs 10000 General Reserve Rs 60000 Profit and Loss account 30000 Net Profit for the year Rs 76500

 17%

RETURN ON EQUITY CAPITAL

Real owners equity shareholders BEAR ALL RISK Participate in management Entitled to all profits remaining after all outsider claims including preference dividends.

RETURN ON EQUITY CAPITAL

This ratio establishes the relationship between the net profit available to equity shareholders and the amount of capital invested by them. Return on Equity Capital =
Net Profit after taxes and Preference Dividend x 100 Equity Shareholders Funds

Given the following Information: 10% Preference Capital Rs 100000 Equity Capital Rs 250000 Capital Reserve Rs 10000 General Reserve Rs 60000 Profit and Loss account 30000 Net Profit for the year Rs 76500 Preference Dividend Rs 10000 Calculate Return on Equity Capital

 19%

EPS EPS: Measures the profitability of the firm on a per share basis. Amount that can get on every share held
EPS= Net Profit after taxes Preference Dividend No of Equity Shares

INFERENCES ON THE BASIC OF EPS

Comparison with the EPS of other firms

BOOK VALUE PER SHARE

Represents equity claim of the equity shareholders on a per share basis. BOOK VALUE PER SHARE = NET WORTH / Number of Equity shares

NET WORTH
Equity share capital Reserves and Surpluses - Accumulated losses - Used as a benchmark for comparision with the market price per share - Limitation : historical cost

PRICE TO BOOK VALUE RATIO

Also known as P/B ratio Measures the relationship between the market price of an equity sahre ( MPS) with book value per share ( BPS) Siginificance: used in predicting future stock returns

DPS
DPS = dividend paid to equity sahreholders / Number of equity shareholders

 Dividend Pay out Ratio: It indicates the percentage of equity share earnings distributed as dividend to equity shareholders. Relationship between earning belongs to ESH and dividend paid to them Dividend Pay out Ratio = Dividend per share EPS Or D/P ratio = Total dividends belongs to ESH / Total net profit to ESH

PRICE EARNINGS RATIO ( P/E Ratio) This ratio is the market price of shares expressed as multiple of EPS. P/E Ratio = Market price per equity share EPS This ratio guides investors to decide whether to buy shares of a company or not.

For Example: If EPS of a company is Rs 9 and its market price is Rs 63 per share, then its P.E. Ratio is 7. Market price of every rupee of earning is seven times. Accordingly an investors can decide whether to purchase share of a company with a P/E Ratio of seven.

ROA
Shows the relationship between net profit and assets Net profit may be - Net profit after tax - Net profit after tax plus interest - Net profit after tax plus interest tax savings

ASSETS
TOTAL ASSETS FIXED ASSETS TANGIBLE ASSETS

 ROA = EAT + INTEREST TAX SAVINGS ON INTEREST TOTAL ASSETS / TANGIBLE/ FIXED ASSETS DIFFRERETNT SOURCES OF FUNDS WHICH FINANCED THE TOTAL ASSETS

CAPITAL STRUCTURE OR GEARING RATIOS OR SOLVENCY RATIOS

 They are used to analyze the long term solvency of any particular business concern. They are 2 aspects of solvency Ability to repay the principle amount when due Regular payment of interest.

DEBT-EQUITY RATIO
Calculated to measure the extent to which debt financing has been used in a business. Ratio Indicates the proportionate claims of owners and the outsiders against the firms assets Express the relationship of long term debt to total capital Also known as debt-equity ratio or External Internal Ratio. Ratio indicates the relationship between the external equities or the outsiders funds and the internal equities or the shareholders funds.

DEBT-EQUITY RATIO = DEBT x 100 EQUITY INTERPRETATION:

A ratio of 1:1 is considered to be satisfactory. A Low ratio :

Debt being low in comparison to shareholders funds is considered favorable from the long-term creditors point of view because a high proportion of owners funds provide a larger margin to them. A High Ratio: Indicates that the claims of outsiders are greater than those of owners may not be considered by the creditors because it gives a lesser margin of safety for them at the time of liquidation of the firm.

 High debt or low debt ?

High Debt Equity Ratio = Serious Implications High proportion will lead to inflexibility in the operations of the firm. Creditors would exercise pressure and interfere in management Firm will be able to borrow under very restrictive terms and conditions. Heavy burden of interest payments

Larger proportion of debt in financial structure, the earnings available to the owners would increase more than proportionately with an increase in the operating profits of the firm? Do you agree

Because

..

Debt carries a fixed charge on loans If the firm is able to earn on the borrowed funds a rate higher than the fixed charge on loans the benefit will go to the equity shareholders It is referred as .

LEVERAGES OR TRADING ON EQUITY

Is the use of borrowed funds in expectation of higher return to equity shareholders.

particulars

Total Assets Financing pattern Equity Debt 15% EBIT(OP) Less: INT EBT Less: Tax(35%) EAT Return on Equity %

1000 1000 ----300 . 300 105 195 19.5

1000 800 200 300 30 270 94.5 175.5 21.9

1000 600 400 300 60 240 84 156 26

1000 200 800 300 120 180 63 117 58.5

LEVARAGES CAN WORK OPPOSITE IF RETURN ON BORROWED FUNDS IS LESS THAN THE FIXED CHARGES

HIGH DEBT OR LOW DEBT

 = not desirable Strike a proper balance between debt and equity Depends upon - Circumstance - Prevailing pratices

PROPRIETORY RATIO OR EQUITY RATIO

This ratio establishes the relationship between shareholders funds to total assets of the firm. The ratio of shareholders funds to total funds is an important ratio for determining long-term solvency of a firm. PROPRIETORY RATIO = SHAREHOLDERS FUNDS TOTAL ASSETS INTERPRETATION: HIGHER THE RATIO = BETTER IS THE LONG TERM SOLVENCY POSITION OF THE COMPANY

INTEREST COVERAGE RATIO ( DEBT SERVICE RATIO OR FIXED CHARGES COVER

INTEREST COVERAGE RATIO ( DEBT SERVICE RATIO OR FIXED CHARGES COVER)

This ratio indicates whether the business earns sufficient profit to pay periodically the interest charges. It provides the value in terms of the number of times the total debt service obligations are covered by the total operating funds available after the payment of taxes. Debt obligation : Principle and interest

Higher ratio = Better Lower ratio = long term solvency problem

INTEREST COVERAGE RATIO:
EAT + Interest + Depreciation ( Earnings before depreciation and interest and after tax ) FIXED INTEREST CHARGES (INTEREST ON DEBENTURES AND LONG TERM LOANS) and Principle obligation

 A Ratio of less than 1 may be taken as a sign of long term solvency problem.

Agro Industries Limited Has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR). Figures in Rs lakh The net profit has been made after charging depreciation of Rs 17.68 lakh every year
YEAR NET PROFIT FORTHE YEAR IN TER EST ON TER M LOAN DURING THE YEAR REPAYM ENT OF TER LOAN IN THE YEAR

1 2 3 4 5 6 7 8

21.67 34.77 36.01 19.20 18.61 18.40 18.33 16.41

19.14 17.64 15.12 12.60 10.08 7.56 5.04 NIL

10.70 18 18 18 18 18 18 18

As the manager of a financial services company, you have received a proposal seeking a term loan of Rs 300 lakh from a firm planning an investment in fixed assets of Rs 500 lakh in a new project. 1. The loan is indicated to be repayable in three annual installments commencing from the end of the second year. The following information concerning the project is available. Compute appropriate financial ratio which in your opinion would guide the financing decision and interpret briefly the ratio so computed and give your views on the proposal.
Particulars
Year 1 Year 2 Year 3 Year 4

Rs in lakhs

Gross Pro f it b ef o re D ep reciation D ep reciatio n In terest o n term loa n Wo rk in g C a p ita l b o rro w in g i n t e re s t tax

75 50 25 10 .

1 00 45 45 15 . .

150 40 30 20 10

1 50 35 15 20 30

DSCR
Is very unsatisfactory as it is less than one for all the three years in which installments are to be paid. The firm will not have enough cash to service installments and is likely to commit default. The proposal is not financially viable and tern loans should not be sanctioned by the financially service company.

TURNOVER RATIO Turnover ratios are used to indicate the efficiency with which assets and resources of the firm are being utilized. They are called turnover ratios because they indicate the speed with which assets are being converted or turned into sales. Turnover ratios express the relationship between sales and various assets. A higher turnover ratio generally indicates better use of capital resources which in turn has a favourable effect on the profitability of the firm.

INVENTORY TURNOVER RATIO COST OF GOODS SOLD AVERAGE STOCK Cost of Goods sold: Opening Stock + Purchases + Carriage Inward and other Direct Expenses Closing Stock Average Stock = Opening Stock + Closing Stock 2

 This ratio indicates the efficiency of a firm s inventory management. This ratio gives the rate at which stocks are converted into sales and then into cash. LOWER INVENTORY TURNOVER RATIO: Means Accumulation of inventories, over investment in inventory or unsaleable goods.

DEBTORS TURNOVER RATIO OR RECEIVABLES TURNOVER RATIO:

This ratio indicates the relationship between net credit sales and trade debtors. It shows the rate at which cash is generated by the turnover of debtors. A debtor includes trade debtors and Bills receivables. DEBTORS TURNOVER RATIO = CREDIT SALES AVERAGE DEBTORS

 AVERAGE COLLECTION PERIOD: Calculation of daily sales = NET SALES (CREDIT) No Of Working days in a year Calculation of average collection period Days in a year Debtors Turnover ratio

FIXED ASSET TURNOVER RATIO

Indicates the efficiency with which the firm is utilizing its investments in fixed assets such as Plant and Machinery etc Higher Ratio indicates efficient utilization of fixed assets in generating sales Lower Ratio Indicates = Excessive Investment in fixed assets Fixed assets mean depreciated value of fixed assets. FIXED ASSET TURNOVER RATIO = SALES OR COST OF SALES NET FIXED ASSETS

WORKING CAPITAL TURNOVER RATIO

This ratio indicates the efficiency or inefficiency in the utilization of working capital in making sales. Working capital Turnover Ratio = Sales or Cost of sales Net Working Capital

CREDITORS TURNOVER RATIO Relationship between credit purchases and average accounts payables. Creditors Turnover Ratio = Net credit purchases Average Accounts Payable

GROWTH RATIOS
Growth ratios measure the performance and financial strength of a company GROWTH RATIOS ARE: GROWTH IN SALES GROWTH IN TOTAL RETURNS GROWTH IN EARNINGS

COMPARISON WITH INDUSTRY AVERAGES

FOR JUDGING RATIOS ARE HIGH OR LOW ONE HAS TO TAKE A COMAPRATIVE ANALYSIS SUCH AS a) CROSS SECTION ANALYSIS INDUSTRY AVERAGES ARE USED AS BENCHMARK

b) TIME SERIES ANALYSIS RATIOS OF THE FIRM ARE COMPARED OVER TIME