Ratio Analysis

Ratio as a term.

It is the relationship of one thing to another of which the quotient is the

measure i.e a simple division of two numbers.

Simple or pure ratio : It is received by dividing simply one number with the
other.

Percentages: Ratios are expressed in percentage form when the simple ratios
are multiplied by 100.

Rates : Ratios for a period in terms of number of times

So Ratio is a method by which the relationship of items in the financial

statements are determined.

Ratios analysis will be more meaningful when certain standards and norms or
certain benchmarks are laid down.

This will help ratios to get compared .

Ratio analysis can be particularly useful as an indicator of the performance of

business in relation to organizations old performance and its contemporary
peers.

Analysis and Interpretation

Analysis of Financial statement is a systematic and specialized treatment of

the information presented in financial statement.

This helps to measure profitability, liquidity, solvency, activity, valuation etc.

Interpretation means establishment of meaning or a fact or a significance

from the analysis.

Income Statement Ratios

As per financial statements.

Balance Sheet Ratios Current Ratio

Income Statement Ratio- Expense to sales

Inter Statement Ratio Sundry Debtors to Sales

Functional Classification of Ratios

Liquidity Ratios: Shows short term and immediate financial position of a

business and indicate its ability to meet short term commitments.

Leverage Ratios : Capital Structure Ratios that shows the relationship

between proprietors funds and borrowed funds.

Activity Ratio : This shows how efficiently the resources of the business are
used.

Profitability Ratios : It shows the result of business enterprises related to its

sales. It shows the effectiveness and efficiency of the business.

Liquidity Ratio

Current Ratio : Current Asset/ Current Liabilities

Quick Ratio : Quick Asset / Current Liabilities

Cash Position Ratio : Cash or Near Cash Assets/Current Liabilities.

Current ratio is the barometer of short term liquidity

An index of adequacy of working capital in an enterprise.

An indicator of economic health of an enterprise .

Standard current ratio is always subjective.

Current ratio is susceptible to window dressing

Liquid Ratio

This shows the liquid financial position of the enterprise.

Quick assets are those current assets which can be realized immediately at a
very short notice.

They are also called near cash asset.

Quick assets are Current asset less Inventory and Prepaid Expenses.

Quick liability is calculated as current liabilities less Bank Overdraft and

Income received in advance.

It indicates immediate solvency position of the business.

If two firms have the same current ratio but different quick ratio then what
can be the possible significance.

Cash Position Ratio

Cash on hand and Bank/Current Liabilities

Higher the cash position ratio less will be role of receivables in quick ratio.

Solvency is the ability of an entity or individual to pay the debts.

It means the ability to meet the long term fixed expenses.

Liquidity is the ability of a firm to pay its current liability .

It is the ability to easily convert assets into cash.

Inventory Working Capital Ratio

Calculated as Stock or Inventory/Working Capital

Stock is valued at cost price or market price whichever is lower

Stock is the average closing stock as on the date the balance sheet is
prepared. It is ( Opening Stock + Closing Stock)/2

Working Capital is Current Asset minus Current Liabilities.

This ratio measures the extent to which the firm has invested its working
capital to less liquid inventory.

In other words it indicates the degree of importance of inventory in the

working capital of business.

A higher ratio indicates weak working capital and doubtful immediate

liquidity and solvency position.

Other Ratios
Stock to Gross Working Capital

Implication : Higher the ratio means higher the quantum of Inventory in

working capital so lower the liquidity.

So we can say this ratio and liquidity of enterprise will have inverse
relationship.

Assignment 1
A

firms current assets and current

liabilities are 1600 and 1000
respectively. Calculate the net
working capital and current ratio.
How much can it borrow on a short
term basis without reducing the
current ratio below 1.25.

Assignment
Determine

the sales of the firm

from the following details.
Current ratio= 1.4
Quick Ratio = 1.2
&
Current liabilities = 1600
Inventory Turnover Ratio = 8 times.

Assignment
The

current ratio and liquid ratio

of a firm is 2.5 and 1.5.The
working capital is 1,50,000.
Calculate Current Asset, Current
Liability and closing stock.

Assignment

The following information is given for Alpha

Corporation

Sales

Current ratio

1.5

Acid test ratio

1.2

Current liabilities 1000

3500

What is the inventory turnover ratio?

Assignment
The following information is given for Beta
Corporation.
Sales
5000
Current ratio
1.4
Inventory turnover
5
ratio
Acid test ratio
1.0
What is the level of current liabilities?

Profitability Ratios

Gross Profit Ratio : It is known as margin or trading margin ratio.

Gross Profit/ Net Sales expressed as a percentage of net sales.

It measures the results of trading account or manufacturing operations

It shows the gap between revenue and expense at a point after which after
which the enterprise makes non-manufacturing expenses.

It shows the efficiency of two departments Marketing and Production

If the ratio is low then cost of goods sold will be high which could be a result
of unfavourable purchase policy, lower selling price, too much of competition
etc.

Ratio of cost of goods sold to sales = 1- Gross Profit ratio

Assignment

Total Sales (Cash and Credit) Rs.40000

Sales Return

Cost of Sales

Calculate Gross profit ratio

Ratio of cost of goods sold to sales.

- Rs. 2000
Rs. 30000

Operating Ratio and Operating Profit

Ratio

It is calculated as (Cost of Goods Sold + other operating expenses) / Net Sales

* 100.

So it is a ratio that shows a relationship between cost of trading activities and

net sales.

So it explains what percentage of operating expense bear to net sales.

The higher the operating ratio less favourable to the firm since it will leave
small margin to cover interest rate , income tax etc.

Other operating expenses include marketing administration and finance

inputs.

Operating Profit = Net sales Operating Cost

Operating Profit ratio Operating Profit/Net sales*100

Assignment

Calculate the operating ratio from the following

details.

Cost of goods sold

Selling and Distribution expenses Rs.4000

Admin and office expenses Rs.5000

Sales 60000

Sales Return Rs. 6000

Rs.30000

Assignment

Find out the operating profit ratio from the

following

Cost of goods sold

Admin Expense

Selling and Distribution expense 2400

Sales -- Rs.90000

Sales Return - 1600

Rs. 60000

Rs.2000

Net profit ratio & Cash Profit Ratio

Net profit ratio = (Net profit / Net sales)*100

Here net profit is calculated after tax.

It is the overall measure of the profitability of the firm.

So higher the net profit higher the profitability.

Cash profit ratio = (Cash Profit/ Net Sales) *100

Cash profit = Net profit plus depreciation.

Assignment

Tax Rs.40000

EBT

Net sales Rs.130000

Calculate net profit ratio

Ans:40%

Rs.92000

Assignment

Depreciation for the year

Rs.80000

Net Profit for the year

Rs.180000

Sales for the year

Returns from Customer

Compute the cash profit ratio for the year.

Ans:14.52%.

Rs.1800000

Rs.10000

Expense Ratio

Expense ratio highlights the relationship of different expenses to net sales.

Lower the expense ratio greater will be the profitability for the firm.

Particular Expense Ratio

Cost of Goods sold Ratio

Admin Expense ratio

Selling and Distribution Expense ratio

Non-operating expense ratio.

Contribution Analysis

It is calculated as difference of sales and variable cost.

It is excess of sales after deducting marginal cost which is used for fixed cost
and profit expectation of the firm.

If contribution is equal to fixed cost the firm is said to be in break-even point.

Contribution margin is useful in understanding the risk characteristics of

business.

It shows the degree of margin of safety that management reaps in pricing and
expense control under different economic conditions.

It helps in decision making process and fixing the selling price of a commodity.

It also helps in selection of optimal product mix to optimize profit.

Assignment

From the following determine the amount of profit earned during the year.

Fixed cost

Variable Cost Rs.20 per unit

Selling Price

Output level 300000 units

Ans:20,00,000

Rs.10,00,000
Rs.30 per unit

Assignment

Determine variable cost from the following data

Sales Rs.120000

Fixed Cost Rs.20000

Profit Rs.30,000

Ans:70000

Return on Investment

ROI = (Net Profit after int. & taxes/Shareholders funds) *100

Shareholders Funds = (Equity Share capital + Preference Share capital +

Reserve and Surplus Accumulated Loss)

It shows the overall efficiency of the firm i.e. how efficiently the resources of
the firm is employed.

Higher the ratio better the effects and this also helps in inter firm
comparison.

Assignment
Item

Amount in Rs.

1000 ordinary shares of Rs.10 each

10000

2000 preference share of Rs.10 each

20000

General reserve

40000

Capital reserve

48000

Special reserve

30000

Accumulated Loss

10000

Net profit before interest and tax

90000

Interest expense

10000

Income tax @50%

Compute the Return On investment
Ans:28.99%

Return on capital employed

ROCE= (Net Profit/ Capital Employed)

Capital Employed = All Fixed Asset + Investment + All Current Asset-All current
Liabilities-Idle & Intangible Asset

ROCE is principal test of corporate efficiency.

Return on Equity

Earnings available for shareholders / Total Equity

ESH = Net profit after tax-Preference Dividend

Total equity = Paid up equity+ Reserve and Surplus+ share Premium

Accumulated loss.

Earning Per share = (ESH/NOS)

Assignment

ABC Ltd provides you the following information

1000 equity shares of Rs.10 each whose paid up value is Rs.8

10% Preference share (500 shares @rs. 30 each)

Profit before tax Rs.9000

Tax rate 50%

Calculate ROE and EPS.

Ans:37.5,3

Importance of EPS

EPS is used for inter firm comparison

EPS is used for comparing with average of industries

Trend analysis can be done to understand the growth in earnings

Dividend Yield and Pay out ratio

Dividend yield depicts the relationship between dividend per share and
market per share.

Dividend Yield = (DPS/MPS)

DPS = (Proposed dividend / Number of share)

Shareholders are owner so they want to know how much return they get on
their investment.

Market Capitalization Number of shares * MPS.

Dividend Payout ratio shows the proportion of earnings of the company that is
paid as dividend.

DPOR = DPS/EPS (It shows actually how much earning is retained by firm.

Used for inter firm comparison

Price Earning Ratio

P/E ratio = Market price per share/EPS. (Also called Price Earning Multiple)

Higher the ratio the better it is for the shareholders.

If the ratio falls the reason should be investigated.

It helps in determination of the value of market price per share.

Price to Book Value Ratio = MPS/BVPS

BVPS = (Shareholders equity/NOS outstanding)

This indicates net worth per equity share

A higher Price to book value implies greater market confidence.

Cover for Preference Dividend = Profit after tax/ Preference Dividend

Coverage for equity shareholders = Earning available for shareholders/Equity

dividend.

Assignment

Star electricals has provided the following information

10000 equity shares of Rs.10 each.

10% preference shares having 20000 shares @ Rs.10 each.

Profit after tax Rs.24000

Equity Dividend Paid @ 12%

Market price per share Rs.32

Please find Dividend Yield, EPS, PE Ratio, Coverage for Preference Dividend,
Coverage for equity dividend.

Assignment
Equity share capital of Rs 20 each

50000000

Secured Loan @ 15%

25000000

Unsecured Loan @ 12%

10000000

Operating Profit

25000000

Income Tax rate

40%

Market Price per share

50

Calculate PE Ratio.
Ans:10.39

Activity Ratios

It shows how efficiently the assets are used to generate sales.

Effective utilization of asset depends upon different managerial decisions

regarding current assets and fixed assets.

Inventory Turnover ratio

Debtors Turnover ratio

Creditors Turnover ratio

Working capital Turnover ratio

Activity Ratio

Inventory Turnover ratio shows how fast the inventory is moving through the
enterprise and generating sales. Also known as stock turnover ratio.

ITOR = (Cost of Goods Sold/Average Inventory) or (Sales/ Average Inventory)

Higher the inventory turnover the greater the efficiency of inventory

management.

COGS= Sales-Gross profit

COGS = op. stock+ Purchase+ cost of production- closing stock.

Average inventory = (opening stock + Closing stock)/2

A low ratio indicates over stocking thereby making unnecessary cost on

inventory.

Age of Inventory = No. of periods in a year/Inventory Turnover

Debtors and Creditors Turnover ratio

Commonly known as receivable turnover ratio. (Debtors=SD+B/R)

This highlights the number of times debtors are turned over during a year.

(Net annual credit sales / Average debtors)

Higher the debtors turnover the more liquid is the firms debtors.

Average collection Period = (Month in a Year/Debtors Turnover)

Lower ratio means inefficient management of asset.

Creditors turnover ratio is (net credit purchases/Average creditors)

This ratio is important for creditors as he is interested in finding out how

much time the enterprise is likely to avail to repay the creditors.

Average payment period = Number of periods in a year/Creditors Turnover

Where Average Daily purchase = Annual Purchase / no of working days in a

year.

Working Capital Turnover ratio

WCTR = Sales / Working Capital.

WCTR = Cost of Sales/Average working Capital.

This ratio indicates the extent of working capital turns over in generating
sales of the enterprise.

Higher ratio tells the efficient use of working capital.

Fixed asset turnover ratio = Net sales / Net Fixed asset

Higher the ratio greater is the intensive utilization of fixed asset.

Assignment

Following are the ratios relating to the trading activities of national traders ltd.

Average Collection Period 3 months

Age of Inventory 8 months

Average payment period 2 months

Gross Profit Ratio 25%

Gross Profit for the year amounts to Rs.4,00,000

Closing stock of the year is Rs.10000 above the opening stock.

Bills Receivable is Rs.25000 and Bills Payable is Rs.10000

Find out sales , sundry debtors, closing stock and creditors.

Ans:16,00,000; 3,75,000; 8,05,000 ; 1,91,667;

Test of Solvency

It means long term solvency that signifies long term financial stability of the
firm.

The concept solvency refers to the ability of an enterprise to meet its long
term liabilities.

Long term liabilities includes Debenture and term loans from institution.

So long term creditors will try to test whether firm will be able to meet the
interest at regular interval and redemption principal at maturity.

Debt equity ratio, Proprietary ratio, Fixed assets to Networth and different
coverage ratios.

Debt Equity Ratio

Termed as External-Internal Equity ratio which measures the relative claims

of outsiders and owners against the assets of the enterprise.

Outsiders funds include all long term debt to outsiders.

Components of owners fund include equity share capital, reserve and surplus
and credit balance of profit and loss account.

Accumulated losses and deferred expenses are subtracted . This is commonly

called Net worth.

Debt equity ratio of 2:1 is said to be ideal one . Low ratio indicates that the
firm is unable to utilize the debt to earn more profits.

A higher ratio signifies more financial risk of the firm as long term creditors
will have lesser margin of safety.

Status of Preference Share capital.

Usually the preference share capital is eliminated from debt.

But if the DER is to disclose the effect of utilizing fixed interest sources on
earnings of shareholders then it is to be included.

If the debt equity ratio is to investigate financial solvency then the preference
share shall be a part of the capital.

Preference share is included in calculating Capital Gearing Ratio.

Capital Gearing ratio = (Fixed Interest Bearing Funds/ Equity Shareholders Fund)

Fixed Interest Bearing Securities include debentures , long term loans, preference
capital

Equity shareholders fund includes Equity capital and Reserve & Surplus.

This ratio signifies the degree of vulnerability of earnings available for equity
shareholders.

Proprietary Ratio

It is also known as Equity Ratio or Total assets ratios.

It highlights the relationship between shareholders funds and total assets of

the enterprise.

Proprietary ratio = (Shareholders fund/Total Asset) or (Net worth/Total Asset)

Higher the ratio better the long run solvency position of the enterprise.

Total assets will exclude fictitious asset if any.

Coverage ratio

Fixed Charges Coverage ratio =(EBIT + Depreciation) / (Interest + Periodic

loan/[1-Tax Rate].

Periodic loan repayment is not tax deductible expense so it has been adjusted
to tax factor.

This ratio shows how many times the cash flow before interest and taxes
covers all fixed financing charges.

Elaborating this we can get an wide formula

[EBDIT+ Lease Payments]/[Interest on debt + Lease Payments + Loan

Repayment instalment/1-t+ Preference Dividend Paid/(1-t) ]

Interest Coverage ratio = EBIT+ Depreciation/Interest

Preference Dividend Coverage Ratio = EAT/Preference Dividend

Equity Dividend Coverage Ratio= EAT-PD/Equity dividend

Assignment

Fixed Interest Charges Rs.1000

Earning After Tax = Rs.7500

Tax rate = 50%

Determine Interest Coverage Ratio.

Ans : 16

Assignment

XYZ has made plans for next year. It is estimated that

company will employ total assets of Rs.1600000. Fifty
percent of assets being financed by borrowed capital at
an interest rate of 16% per annum. The direct costs for
the year are estimated at Rs.9,60,000. All other operating
expenses are estimated at Rs.1,60,000. The Goods will be
sold to the customer at 150% of the direct cost. Income
tax rate is assumed to be 50%. You are required to
calculate i. Net Profit Margin ii. Assets Turnover iii. Return
on owners equity.

Ans:6.67% ; 0.9 times ; 12%.

Assignment

Prepare the Balance sheet with the following details for Mr.Amarnath:

Current Ratio 2.5

Liquid Ratio 1.5

Proprietary Ratio (Fixed Asset/ Proprietary Fund) - 0.6

Working Capital = 1,50,000

Reserve and Surplus = 1,30,000

Ans : BS total is 4,75, 000. (FA, Cl stock and QA) (Capital, R&S and CL)

Gross profit ratio, Operating ratio, Net

profit ratio matrix and their significance
Gross
Operating Net
Profit Ratio Ratio
Profit
Ratio

Comments

High

High

Low

The favourable gross profit is offset by the

unfavourable non-manufacturing expenses.

High

Low

High

Favourable GP is complemented by a NP
ratio because of control over op. expenses

Low

Low

High

Unfavourable GPR is offset by the control

over OP. expenses and non-manufacturing
expenses so NPR is sustained

Low

High

Low

The unfavourable GPR is worsened by

increase in expenses and the NPR is also
adversely affected.

Book Value per share

BVPS = Net worth/NOS .

It shows the aggregate worth of every unit of investment in a business.

Higher the book value per share greater will be the owners stake

It also signifies high retention and low pay out policy.

Greater opportunities for reinvestment.

Another important ratio to this effect is MVPS/BVPS

Or a ratio of Market Capitalization to owners fund.

This ratio shows the perception of investors regarding the overall

performance of the company.

If it is less than one then it signifies that market perceives the book value of
their investment is relatively less worthy and vice versa.

If it is more than one it signifies that owners fund has been productively
employed.

High P/E Ratio Vs. Low P/E Ratio

High PE

Low PE

Positive Corporate Image

Negative Corporate Image

Low Yield to investors

High yield to investors

Capacity of sustain bid for hostile

takeover.

No capacity to sustain bids for hostile

takeover.

More capital raising capabilities so low

cost of capital

Less capital raising capabilities so high

cost of capital.

Earning Price Ratio

This is called Earnings yield and is calculated as EPS/MPS

It reflects the relationship between the earning power of the equity

share investment and its market price.

Higher ratio indicates greater yield or profitability on investment or

productivity of the portfolio.

It is a measure of attitude of the existing and also potential

shareholders

It has a tendency to remain stable because a rise in income will

trigger an increase in price and offset each other.

But the proportional increase may not be possible so there might be

marginal instability in the ratio.

It is reciprocal to P/E ratio so if higher P/E ratio will mean lower

earning price ratio.

Assignment

From the following particulars prepare the balance sheet of X Ltd

which has only one class of share capital.

Sales for the year 20,00,000

G.P Ratio 25%

Current Ratio 1.50

Quick ratio 1.25

Stock Turnover Ratio 15

Debt Collection Period 1.5 months

Turnover to Fixed Asset 1.5

Ratio of Reserve to share capital 0.33 (1/3)

Fixed Asset to Net Worth 0.83 (5/6)

The term turnover refers to cost of sales and the term stock means
closing stock.

Assignment

From the following details prepare the balance sheet with as many
details as you can.

Gross profit- 80,000

Gross profit to cost of goods sold ratio (1/3)

Stock Velocity 6 times

Opening stock 36,000

Debtors velocity 72 days

Creditors velocity 90 days

Current asset 1,50,000

Bills Receivable 20,000

Bills payable 5,000

Fixed Asset Turnover ratio 8 times.