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

&iquidity Ratios

Profitability Ratios

olvency Ratios

-ctivity Ratios

Liquidity Ratios: hort term solvency ratios. !Pure Ratio shown in " # " form$ %urrent Ratio &iquid Ratio 'uick Ratio Current Assets Current Ratio = Current Liabilities Objective#

1.

(he ob)ective 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. ,t suggests whether firm can meet its short term obligation from short * term -ssets. Components:

%urrent -ssets refer to those assets which are held for their conversion into cash normally within a year and include the following# Cash Ba ance Ban! Ba ance 'ebtors (after deductin) $rovision* Bi s Receivab e (after deductin) $rovision* Listed ,ar!etab e Securities (non - trade* Stoc! of Ra. - materia s Stoc! of /or! - in - $ro)ress Stoc! of "inished #oods $repaid %&penses O+S income -dvance Payment of ta. (a. deducted at source !(/ $ !debit 0alance$

Current Liabi ities:1

%urrent &iabilities refer to those liabilities which are e.pected to be matured normally within a year and include the following# Creditors for )oods Bi s $ayab e Creditors for %&penses (or O+S %&p0* Ban! Overdraft $roposed dividend Interpretation: ,t 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 short1term insolvency. (raditionally, a current ratio of 3#" is considered to be a satisfactory ratio. $rovision for Ta& 2nclaimed dividend ,ncomes received * in * advance

2 .

Liquid Assets Liquid Ratio or Acid Test =Ratio Liquid Liabilities

&iquid -ssets 4 %urrent -ssets * tock &iquid &iability 4 %urrent liabilities * 0ank 5+/ * cash credit

Objective:

(he ob)ective is to measure the ability of the firm to meet its short * term obligations as and when due without relying upon the reali6ation of stock. Interpretation :

,t indicates rupees of quick assets available for each rupee of liability due on short term notice. (raditionally, a quick ratio of "#" 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 ", 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 ", may be meeting its short*term obligations in time because of its very efficient debtors management.

3.

Quick Assets Quick Ratio = Liquid Liabilities

'uick -ssets 4 %urrent ratio less stock and debtor. (his ratio suggests whether available cash & cash equivalent !which can quickly convertible in cash$ are sufficient to meet its short term liabilities.

 $rofitabi ity Ratios !-lways is percentage e.cept 7P $ In re ation to Sa es a$ 8ross profit ratio b$ 9et profit Ratio c$ 5perating Ratio In re ation to Investment a$ Return on %ap. 7mployed b$ Return on 7quity c$ Return on equity shareholder Fund d$ Return on equity share capital e$ 7arning per share f$ Return on total assets

Income statement
&ess# 2 &ess# -dd # 4 &ess# -dd# 2 &ess# 4 &ess# 4 1. 1et Sa es %ost 5f 8oods old #ross $rofit 5perating 7.p !-dministrative & elling 7.pense$ 5perating income !commission, discount received.$ Operatin) $rofit ($BIT* 9on operating 7.penses# ,nt. on /ebentures &oss on ale of assets or loss due to fire 9on1operating ,ncome# ,nterest & /ividend on ,nvestment Profit on sale of -ssets & ,nvestment 1et $rofit before ta& (a. 1et $rofit after ta& Preference dividend 7quity Profit

Gross Profit Gross Profit Ratio = 1 !! Net ales 8ross Profit 4 ales * %ost of goods sold. %ost of goods sold 4 5pening stock : 9et purchase : Purchase 7.p :wages * closing stock Objective :

(he ob)ective is to determine the efficiency with which production and+or purchase operations are carried on. Interpretation:

(his ratio indicates !a$ an average gross margin earned on a sale of Rs. ";;, !b$ the limit beyond which the fall in sales prices will definitely result in losses. -nd !c$ what portion of sales is left to cover operating e.penses and non * operating e.penses like to pay dividend and to create reserves. Higher the ratio, the more efficient the production and +or purchase management. (his ratio may increase due to one of the following factors# !i$ !ii$ !iii$ Higher ales Prices with constant %ost of 8oods old< &ower %ost of 8oods old with constant ales Prices< - combination of aforesaid two factors. Net Profit After Ta" Net Profit Ratio = 1 !! Net ales Objective:3

2.

(he ob)ective is to determine the overall profitability due to various factors such as operational efficiency. Interpretation:

(his ratio indicates !a$ an average net margin earned on a sale of Rs. ";; !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. #$eratin% Ratio = Cost of Goods sold & Ad'inistrati(e ) ellin% ) *istribution ) +inancial ,"$enses 1! ! Net ales Objective:

(he ob)ective is to determine the operational efficiency with which production and +or purchases and selling operations are carried on. Interpretation:1

(his ratio indicates an average operating cost incurred on sales of goods worth Rs. ";;. &ower the ratio, greater is the operating profit to cover the non * operating e.penses, to pay dividend and to create reserves and vice* versa.

In re ation to Investment Profit before ,nt & ta. &ess# &ess# &ess# 4 ,nterest Profit before ta. (a. Profit after ta. Pref. /ividend 7quity Profit >profit available to equity shareholder, Pref. shareholder, debenture holder

>Profit available to equity shareholder & Pref. shareholder? >Profit available to equity share holder?

"ormat of Capita %mp oyed:

7quity share capital Reserve & urplus @iscellaneous 7.penditure %quity share ho der4s fund Preference share capital Share ho der4s fund (%quity* /ebt !debenture and term loan$ Capita %mp oyed

-dd# &ess# 4 -dd# 4 -dd# 4

1.

P.../.T Return on Ca$ital ,'$lo-ed = 1! ! Ca$ital ,'$lo-ed

%apital employed 4 total investment4long term fund Objective: (he ob)ective is to find out how efficiently the long * term funds supplied by the /ebenture holder and shareholders have been used. Interpretation:1

Higher the ratio, the more is the efficient the management and utili6ation of %apital 7mployed.
";; 50 Return on %quity 2 Equity P. A. T

7quity 4 shareholder Fund 4 5wners fund 4 Proprietors Fund Objective:3

(he ob)ective is to find out how efficiently the funds belonging to the shareholders !equity and preference$ have been used. Interpretation:

(his ratio indicates the firm=s ability of generating profit per ";; rupees of shareholders= funds. Higher the ratio, the more efficient the management and utili6ation of shareholders= funds is. Equity Profit ";; Equity shareholder fund A. Return on %quity shareho der fund 4 Objective:

(he ob)ective is to find out how efficiently the funds supplied by the equity shareholders have been used.

Interpretation:

This ratio indicates the firms 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. B. Return on equity share capita 4 Equity!hare apital";; Objective:
Equity Profit

(he ob)ective is to find out how efficiently the funds supplied by the equity shareholders have been used. Interpretation:

(his ratio indicates the firm=s ability of generating profit per ";; rupees of equity share capital. Higher the ratio, the more efficient the management and utili6ation of equity shareholders= %apital is. C. %arnin) $er Share 4 "o. of Equity!hares Objective:3
Equity Profit

(he ob)ective is to measure the profitability of the firm on per equity share basis. Interpretation:

,n, general, higher the 7P , better it is and vice versa. 7P helps in determining the market price of the equity shares of the company. ,t also helps in estimating the company=s capacity to pay dividend. So vency Ratios (Lon) term So vency* /ebt * 7quity Ratio %apital 8earing Ratio Proprietary Ratio ,nterest %overage Ratio /ebt ervice %overage Ratio &ong term fund to fi.ed -sset
#ebt

60 'ebt - %quity Ratio (Levera)e Ratio* 2 Equity";; Objective :3

(he ob)ective is to measure the relative proportion of debt and equity in financing the assets of a firm. Interpretation:1

,t indicates the margin of safety to long * term /ebt. - low debt equity ratio implies the use of more equity than debt which means a larger safety margin for /ebt providers since owner=s equity is treated as a margin of safety by debenture holder and vice versa. (he implications from the point of view of long term providers of loan and the firm may be seen as under.

50 Capita #earin) Ratio 2 Equity!hare apital";; Objective:3

#ebt+ Pref. !hares

(he ob)ective is to find proportion of fi. return bearing security to not fi. return bearing securities in total capital of firm. Interpretation:3

,t indicate that for every ";; Rs. of equity capital what proportion of fi. return bearing capital e.isting. @ore this ratio higher is the risk of fi. commitment & more burden for generating equity profit. However it may result in to benefit by effect on trading on equity.
Prop.fund $equity% ";; Total Asset

70 $roprietary ratio 2 Objective:1

(he ob)ective is to find out how much the proprietors have financed for the purchases of assets. Interpretation:3 (otal -ssets 4 -ll -ssets !7.cluding Fictitious -ssets like preliminary e.p. underwriting e.p, debenture discount.$
P. ).(. T (nterest'n &oan

(his ratio indicates the e.tent to which the assets of the firm have been financed out by proprietors= fund.

80 Interest Covera)e Ratio 4 Objective:3

(he ob)ective is to measure the debt servicing capacity of a firm so far fi.ed interest on long * term debt and debenture is concerned. Interpretation:

,nterest 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. ,t 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. 90 'ebt Service Covera)e Ratio 2
ash A*ailable for #ebt!er*ice (nt.'n.#ebt+ (nstall#ue 'n &oanduring finance year

%ash available for debt payment means P.-.(. :/epreciation & other non cash e.penditure dr. to P & & account : ,nterest on debt
&ong Term+und ";; +i,edAssets

:0 Lon) term "und to "i&ed Assets 4 Interpretation:

ound business technique it to -cquire ma)or permanent assets from permanent capital & temporary capital should be invested in current assets. ,f temporary capital is invested in permanent assets than financial position may get disturbD (his 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:3 %apital (urnover Ratio /ebtors (urnover Ratio !/ebtors Ratio$ Fi.ed -ssets (urnover Ratio %reditors (urnover Ratio !%reditors Ratio$ tock (urnover Ratio
"et !ales

60 Capita Turnover Ratio (In times* 4 $A*g.% apitalEmployed.#ebt+ Equity Objective:

(he ob)ective is to determine the efficiency with which the capital employed is utili6ed. Interpretation:

,t indicates the firm=s ability to generate sales per rupee of capital employed. ,n general, higher the ratio, the more efficient the management and utili6ation of capital employed is. "et !ales 50 "i&ed Assets Turnover Ratio (in times* 2 $A*g.%+i,ed Assets Objective:

(he ob)ective is to determine the efficiency with which the fi.ed assets are utili6ed. Interpretation:

,t indicates the firm=s ability to generate sales per rupee of investment in fi.ed assets. ,n general, higher the ratio, the more efficient the management and utili6ation of fi.ed assets is and vice versa.
ost'f 0oods !old A*g. !toc/

70 Stoc! Turnover Ratio (in times* 2 Objective:3

(he ob)ective is to determine the efficiency with which the inventory is utilised. Interpretation:3

,t indicates the speed with which the inventory is converted into sales. ,n general, a high ratio indicates efficient performance. However, too high ratio and too low ratio should be called for further investigation. - 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. 5n the other hand, a too low ratio may be the result of e.cessive inventory levels, slow moving or obsolete inventory and thus, the firm may incur high carrying costs. (hus, a firm should have neither very high ratio nor low ratio. ! tock out means customer going out of shop due to unavailability of stock.$ 80 'ebtors Turnover Ratio (in times* 4 $A*g.%#ebtors + )12 /ebtors Ratio OR /ebt Eelocity Ratio !in days$ 4 Objective:3
$A*g% #ebtors + )12 6741670115 145( 3ee/ * redit !ales
r. !ales

(he ob)ective is to determine the efficiency with which the trade debtors are managed.

Interpretations:

High /ebtors (+5 ratio 4shorter debtors ratio 4 quick recovery of money. &ow debtors (+5 ratio 4 higher debtor ratio 4 delay in recovery of money. ,t shows the efficiency of collection policy of the firm. ,t 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 ,n profit due to ,n sales Cost ,n bad * debt ,n collection e.penses ,n ,nterest cost on money blocked with debtor

Tutoria 1otes: !i$ (he FProvision 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 reali6able value of debtors. !ii$ !iii$ ,f the figure of -verage /ebtors cannot be ascertained due to the absence of the figure of opening /ebtors, the figure of closing /ebtors may be applied by giving a suitable note to that effect. ,f the figure of 9et %redit ales is not ascertainable, the figure of total sales given may be used assuming that all sales are credit sales.
"et redit Purchase reditors + ).P.

90 Creditors Turnover Ratio (in times* 4 $A*g% %reditors Eelocity Ratio !in days$ 5R %reditors Ratio 4

$A*g% reditors + ).P. 6741670115 145$3ee/% "et reditPurchase

Objective: 3

(he ob)ective is to determine the efficiency with which the creditors are managed. Interpretation:

High creditor (+5 ratio 4 low creditor ratio 4 quick payment to creditor &ow creditor (+5 ratio 4 high creditor ratio 4 delayed payment to creditor ,t shows the market standing of the firm. - new firm may have less creditor=s ratio, as their market standing will be less. -n 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.
"et !ales Total Assets

:0 Tota Assets Turnover Ratio (in times* 4 Objective: Interpretation:

How efficiently assets are employed in business. (his ratio suggests how a rupee of asset contributes to earn sales more the ratio more efficiently assets are used in gainful operation. ". A';A1TA#%S: Simp ifies financia statements: Ratio -nalysis simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of the business. ,t gives reader full idea about overall situations of the firm without going deep in to the financial statement. 3. "aci itates inter - firm comparison: Ratio -nalysis provides data for inter * firm comparison. Ratios highlight the factors associated with successful and unsuccessful firms. (hey also reveal strong firms and weak firms, over valued and undervalued firms. A. ,a!es intra - firm comparison possib e: Ratio -nalysis also makes possible comparison of the performance of the different divisions of the firm. (he ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future. B. <e ps in p annin): Ratio analysis helps in planning and forecasting. 5ver a period of time a firm or industry develops certain norms that may indicate future success or failure. ,f relationship changes in firm=s data over different time periods, the ratios may provide clues on trends and future problems.

:0

<e ps in decision ma!in) : ome times ratio may indicate better guideline for decision making. %&amp e# good trend of profitability and dividend payout ratio helps investor to buy shares. &ower debt service coverage ratio & int coverage ratio prevent bank from financing to company. LI,ITATIO1S: Comparative study required: Ratios are useful in )udging 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.

60

50

Ratios a one are not adequate: Ratios are only indicators< they cannot be taken as final )udgment regarding good or bad financial position of the business. 5ther things have also to be seen. For e.ample, 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.

70

/indo. dressin): (he 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, 5n account of such a situation, presence of a particular ratio may not be a definite indicator of good or bad management. For e.ample, a high stock turnover ratio is generally considered to be an indication of operational efficiency of the business. 0ut this might have been achieved by unwarranted price reductions of closing stock or failure to maintain proper stock of goods.

80

$rob ems of price eve chan)es: Financial analysis based on accounting ratios will give misleading results if the effects of changes in price level are not taken into account. For e.ample, two companies set up in different years, having plant and machinery of different ages, cannot be compared, on the basis of traditional accounting statements. (his 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.

90

1o fi&ed standards: 9o fi.ed standards can be laid down for ideal ratios. For e.ample, 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. ,t 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.

0.

/naccurate base1 (he accounting ratios can never be more correct than the information from which they are computed. ,f the accounting data is not accurate, the accounting ratios based on these figures would give misleading results.

=0

Investi)ation necessary: ,t must be remembered that accounting ratios are only a preliminary step in investigation. (hey suggest areas were investigation or inquiry is necessary. ,t can never be used as conclusion.

>0

Ri)idity harmfu : ,f in the use of ratios, the manager remains rigid and sticks to them, it will lead to dangerous situation. For e.ample, if the manager believes the current ratio should not fall below 3# ", then many profitable opportunities will have to be foregone.

Ratio Ana ysis "ormu a

Liquidity Ratios Ratio %urrent Ratio "ormu a %urrent -sset %urrent &iabilities 'uick -sset %urrent &iabilities ,nventory !%urrent -ssets * %urrent &iabilities$ %ash : %ash 7quivalents %urrent &iabilities Location 0. . -sset portion 0. . &iability portion 0. . -sset portion 0. . &iability portion 0. . -sset portion 0. . &iability & -sset portion 0. . %ur. -sset 0. . &iability portion %&p anation (o indicate the ability to meet currently maturing obligations (o indicate instant debt paying ability

'uick (est

,nventory to 9et Gorking %apital

(o indicate the cushion of e.cess current assets over current liabilities may be threatened by unfavorable changes in inventory (o indicate how many current obligations can be met with cash or cash equivalents

%ash Ratio

$rofitabi ity Ratios

Activity Ratios Ratio Ratio 9et Profit @argin ,nventory (urnover !J$ "ormu a "ormu a 9et profit 9et -fter ales (a.es 9et ales ,nventory Location Location ,ncome tatement tatement ,ncome ,ncome tatement 0alance sheet %&p anation %&p anation

8ross Profit @argin ales * %ost of 8oods old !J$ 9et /ays 5f ,nventory !days$ ales ,nventory %58 +AHC Return 5n 9et Profit -fter ta.es ,nvestment !J$ (otal -ssets 9et Gorking %apital 9et ales (urnover 9et Gorking %apital 7arnings per hare -sset (urnover !K$ !9et Profit ales -fter (a. * Preferred stock /ividends$ (otal -ssets -verage L 5f %ommon hares Fi.ed -sset (urnover ales Fi.ed -ssets -verage %ollection Period !days$ -ccounts Receivable (urnover -ccounts Payable Period -ccounts Receivable ales for Iear+AHC -nnual %redit ales -ccounts Receivable -ccounts Payable
Purchases for year+AHC

,ndicates the revenue required (o assess the efficiency in to earn a dollar profit after ta. the management of ,nventory ,ncome tatement ,ndicates the profit available for ,ncomesheet tatement non1manufacturing overhead 0alance (o assess the efficiency in ,ncome tatement the management of ,ncome tatement ,ndicates the efficiency that ,nventory 0alance sheet management uses the companies assets ,ncome tatement (o assess the effectively the 0alance sheet !%-1%&$ 9et Gorking %apital is used to generate sales !,ncometatement ,ncome tatement10. 0alance sheet $ 0. . !sometimes$ ,ncome tatement 0alance sheet 0alance heet ,ncome tatement Gork sheet &+or ub. &edgers 0alance heet 0alance heet Gork sheet ,ndicates the after ta. earnings (o assess the amount of for sales the common stock generated by each asset shareholders dollar (o assess the amount of sales generated by each fi.ed asset dollar (o assess the efficiency in the management+collection of -ccounts receivable (o assess the efficiency in the management+collection of -ccounts receivable (o assess the efficiency in the management+payment of -+P

Levera)e Ratios

Ratio /ebt to -sset Ratio !J;

"ormu a (otal /ebt (otal assets (otal /ebt hareholder=s 7quity & *( debt hareholder=s 7quity Profit pre ta. : ,nterest %harges ,nterest %harges Profit pre ta. : ,nterest %harges :&ease %harges ,nterest %harges :&ease %harges %urrent &iability hareholders 7quity

Location 0alance heet 0alance heet 0alance heet 0alance heet 0alance heet 0alance heet ,ncome tatement ,ncome tatement ,ncome tatement ,ncome tatement

%&p anation -ssess the amount of borrowed funds used to finance company assets -ssess the funds provided by creditors versus the funds by owners -ssess the long1term component of the capital structure ,ndicates the ability of the company to meet its annual interest -ssess the company=s ability to meet all of its fi.ed e.penses

/ebt to 7quity Ratio !J$

&ong (erm /ebt to %apital tructure !J$ (ime ,nterest 7arned !dec.$ %overage of Fi.ed %harges !dec.$

%urrent &iabilities to equity !J$

0alance heet 0alance heet

-ssess the short1term financing portion versus that provided by owners

Other Ratios Ratio Price+7arnings Ratio !/ec.$ /ividend Payout Ratio !J$ /ividend Iield on %ommon tock !J$ "ormu a @arket price per hare 7arnings per share -nnual dividends per hare -nnual 7arnings per hare -nnual dividends per hare %urrent @arket price per share Location %&p anation

tock @arket Reports -ssess the amount investors ,ncome tatement are willing to pay for each dollar of earnings ,ncome tatement ,ncome tatement ,ncome tatement tock @arket ,ndicates the percentage of profit that is paid out as dividends ,ndicates the dividend rate of return to common shareholders at the current market price