Cenegage - Financial Statement AnalysisCh09

Chapter
Analysis and Interpretation of Information for Decision I: Decision Determinant
Chapter Outline
Introduction to Financial Statement Analysis Horizontal Analysis Vertical Analysis Trend Analysis Ratio Analysis Objectives and Limitations of Ratio Analysis Common Size Statements Classification of Ratios Based on Financial Statements: Balance Sheet Ratios u Profit and Loss Ratios u u u u u u u u u u u u u u u u u Combined Ratios Ratios based on the need: Profitability ratios Liquidity Ratios Solvency Ratios Activity Ratios Gearing Ratios Investors Ratios Growth and Stability Ratios Criticisms on Financial Statement Analysis
learning ObjeCtives
After studying this chapter, one should be able to: 1 2 3 4 5 6 Present the interdependency of analysis and interpretation Identify the relevance of analysis and interpretation Present the tools used for analysis and interpretation Describe needbased ratios Introduce who, why and what of ratios Present calculation and interpretation of ratios
532
Financial Accounting for Management
INTRODUCTION
Financial statement analysis is an information processing system designed to provide the necessary input (refined data) for decisionmaking models, such as portfolio selection model, enterprises financial management model, lending decision model, funds procurement and utilization policy, overall performance efficiency improvement model, etc.
Analysis and interpretation of a companys financial statements means analysing and interpreting its trading and profit and loss account, the profit and loss appropriation account (together called income statement), statement of retained earnings, and balance sheet (position statement). The analysis of these statements is of particular help for the companys management. It also proves beneficial for the shareholders and other users of information in general. For the management this job of analysis is a soul searching event (self-appraisal). For the shareholders and other users of this information it means judging the managements performance. According to Henry Guthimann, the first and the most important function of financial statement is, of course, to serve those who control and direct the business, to the end of securing the profits and maintaining a sound financial condition. questions like how efficiently the capital of the business is being utilized, how well credit standards are being observed and whether financial condition is being improved may be answered from the financial statements. When a financial statement is analysed, it means resolving the statement by breaking it into simpler statements by a process of rearrangement and calculating the ratios. Interpretation, on the other hand, means mentally understanding the terms of such statements and drawing inferences about profitability, liquidity, financial stability, efficiency and such other aspects of an enterprise. Analysis and interpretation are closely related to each other. This is because interpretation is not possible without analysis and analysis has no value without interpretation. In the sense, unless data is converted into information and information is segregated into useful components to make comparisons meaningful by means of objective measurements (say, ratios), interpretation will not be possible. When the analysed information is interpreted objectively to draw certain conclusions called inferences, it helps the management, the shareholders, etc., in decision making. Thus, analysis and interpretation of financial statements (information) has a key role in decision making.
OBJECTIVES OF ANALYSIS AND INTERPRETATION

The objectives of analysis and interpretation of financial statements differ from situation to situation, depending on users of information and purpose for which the information is used. However, the objectives of analysis and interpretation of financial statements depend on the end users, i.e., (1) management, (2) shareholders, (3) shortterm creditors, (4) long-term creditors, (5) Government, (6) financial analysts, and (7) others.
Finger Tips 9.1 Financial Statements

According to the American Institute of Public Accounts financial statements are prepared for the purpose of presenting a periodical review or report on the progress by the management and deal with the status of investment in the business and results achieved during the period under review. They reflect combination of recorded facts, account-
ing conventions, and personal judgements, and the judgement and conventions applied affect them materially. The soundness of the judgments necessarily depends on the competence and integrity of those who make them and on their adherence to generally accepted accounting principles and conventions.
Analysis and Interpretation of Information for Decision I
533
Analysis and interpretation of financial statements is done with the following objectives: 1. To assess the financial health of an enterprise: An enterprises financial health depends on how well it manages its funds. It means the enterprise needs to procure necessary funds at the lowest cost at the right time and utilize them objectively to get maximized returns. Further, the enterprise needs to ensure repayment of borrowed funds as and when they become due. Analysis and interpretation enables the management (at the first instance) and others interested to know how effectively funds are sourced and utilized. Apart from the management and shareholders, bankers, creditors and other lenders are equally interested to judge the financial health of the enterprise. 2. To assess the performance of the enterprise through its earnings: Financial statements are also analysed and interpreted so that the management can enhance its base of retained earnings, the shareholders can get maximized returns in the form of dividends, and potential investors can decide on their investment strategy. 3. To assess the growth potential and sound financial base of the enterprise: Institutional investors such as LIC, UTI, Development Banks analyse and interpret information provided in financial statements over a period of time with the objective to identify an enterprises growth potential and sound financial base. According to Harry Guthmann, investors as a class need to know, first, that the whole financial structure is strongnot merely that the concern will be able to meet current obligations; and second, that there is sufficient evidence in the history of its earnings to warrant a belief in future growth or at least reasonable stability. This statement aptly proves how (potential) investors and shareholders are interested in the growth potential and financial soundness of a firm, because based on the inference that they are able to draw they make the decision to continue or discontinue the relationship with the enterprise. 4. To assess the ability of the enterprise to repay borrowed funds along with interest: Generally, companies raise funds by issuing debentures at a fixed rate of interest (considered to be low-cost borrowings). Debenture holders and other lenders will want to know the arrangements for amortization of debts and the security available for sure recovery of the debts along with interest. Thus debenture holders, in particular, and any other lenders, in general, as lenders of substantial funds, will want to analyse and interpret the financial statements with the objective of keeping their funds safe. 5. To assess solvency of the enterprise: Any person who has financial relationship with an enterprise is interested in the solvency of the enterprise. As trade credit is a common phenomenon in business enterprises, the trade creditors are interested in knowing the liquidity of the enterprise. The trade creditors want to know the solvency position of the company as it has to pay the debts owed to them as and when they fall due. They assess the liquidity position of a company with the objective of knowing (a) whether current assets are sufficient to pay current liabilities; (b) what is the proportion of liquid assets to current assets; (c) whether
Finger Tips 9.2 Concept and Objectives of Analysis and Interpretation
Analysis is a process of rearranging financial results and calculating ratios. Interpretation is the mutual process of understanding the impact of the ratios and drawing inference. Interpretation is not possible without analysis and analysis has no value without interpretation. The important objective of analysis and Interpretation is to assess: financial health, performance, growth potential, ability to repay debt, solvency, and such other factors of the enterprise.
534
the debenture holders are secured by a floating charge on the current assets; (d) whether earnings and growth promote favourable prospects; and (e) whether the over all financial management of the enterprise is sound. The data exhibited by financial statements are the result of the combined effect of (1) recorded facts; (2) based on accounting conventions; and (3) personal judgement used in the application of accounting conventions. Using personal judgement for applying accounting conventions indicates the interpretation part of the recorded data being analyzed. One feature of financial statements is that only those facts which are recorded in the books are reflected and those which are not recorded are seldom reflected. For example, assets are recorded at their historical cost and not at current cost (market price). That means the balance sheet fails to depict a true picture as it is prepared on the basis of recorded cost. The second feature is that the accounting records are made on the basis of concepts and conventions. For example, conservative principle of accounting indicates that all anticipated losses should be recorded but not the anticipated profits. Suppose, the enquiry reveals that profits are anticipated and not losses. Then the recorded facts fail to project the real picture of the financial affairs of the enterprise. The third feature is that the financial statements reflect the personal judgement of the accountant/financial manager. Personal judgement is subjective. For example, the choice of the method of depreciation or change in the method of depreciation to show increased profits or a revenue expense being capitalized or an expense which can be capitalized is treated as revenue. Such kinds of personal judgements are reflected in the financial statements. The limitations of financial statements are listed as follows: 1. The financial statements prepared annually are only interim reports and not final reports. In the sense, on the basis of the going concern concept, the final financial reports can be prepared only on the closure of the enterprise. Therefore, the annual reports and interim reports fail to depict the exact position of the enterprise. 2. The accounting concepts and conventions followed for preparing the financial statements sometimes make them unrealistic. For example, recording the assets at historical cost, accounting for anticipated losses and not for anticipated profits on the basis of conservative principle. If the statements are unrealistic, they cannot depict the realistic position of the enterprise. 4. These financial statements are influenced by personal judgement of the accountant/ finance manager. For example, selecting a depreciation method objectively depends on the integrity and competency of the accountant/finance manager. If the statements are subject to personal judgement of the person who has no integrity, they cannot depict a true picture of the position of the enterprise. 5. The assumption made while accounting for business transactions that rupee value is constant, which is not true, makes the financial statement depict an unrealistic picture. 6. The change in the value of money not being recorded acts as another limitation, where the values of assets hardly represent their true value. The financial statements prepared with the revised costs without taking into account the changing prices are not able to depict a true picture of the financial position of the enterprise. 7. Moreover, we record only such items which can be measured in terms of money. Items such as reputation, efficiency, loyalty, integrity, etc., contribute for the status of the enterprise but they are not recorded, because they cannot be measured in terms of money. Financial statements prepared without taking into account the non-monetary items cannot depict a true picture of the financial position of the enterprise.
The financial statements prepared and presented to provide the necessary information may or may not reflect the true picture of the financial position of the enterprise.
535
The limitations stated above and many more, which affect the financial conditions and operating results act as constraints and hence, the financial statements fail to depict the true picture of the financial status of the enterprise. Except for the personal judgement issues, all other limitations are common and they are within the prescribed norms of accounting principles and standards. They are common to every enterprise and, hence, do not act virtually as limitations. Therefore, the financial statements are prepared and presented to meet the needs of information users to depict the realistic picture of the financial status of the enterprise.
TOOLS AND TEChNIqUES OF FINANCIAL STATEmENT ANALYSIS AND INTERPRETATION

In the accounting process of data to information, analysis and interpretation is the last step. According to Kennedy and Memullez, analysis and interpretation of financial statements are an attempt to determine significance and meaning of the financial statements data so that a forecast may be made of the prospects for future earnings ability to pay interest and debt maturities (both current and long term), and probability of a sound dividend policy. This definition is self explanatory in character as to the objective of analysis and interpretation is concerned. Keeping such futuristic objectives in mind, professionals have developed various techniques to analyse financial data in such a way that inferences can be drawn by interpreting the results of the analysis, which in turn help the users of information in decision making. The techniques developed are intended to show relationships and changes which will act as pointers to decision making. Of the techniques developed, the following four techniques are widely used: 1. Horizontal analysis: Comparison of absolute data or percentage of two or more years. 2. Vertical analysis/structural analysis: Increase or decrease in absolute data or percentages are compared. 3. Trend analysis/dynamic analysis: Percentage change over number of years with the base year figures are compared. 4. Ratio analysis: Expression of relationship between two figures which are mutually interdependent.
Finger Tips 9.3 Features and Limitations of Analysis and Interpretation

It is an information processing system through which different models such as decision-making models, portfolio selection models, financial management models, lending decision models, funds procuring and utilization policies, overall performance efficiency, improvement models are formulated. Limitations: Annual reports being interim reports fail to depict the exact position of the enterprise. Accounting concepts and conventions followed sometimes make the statements unrealistic Financial statements are influenced by personal judgements Assumptions of rupee value being constant acts as a constraint to depict a true picture Change in the value of money not being taken into account acts as a constraint Non-monetary transactions being not recorded acts as a constraint and so, on In spite of limitations, if the analysis is done on an objective principle, this serves as a best measure for drawing inferences which lead to decision making.
536
horizontal Analysis
It is a comparative analysis of increase or decrease in percentages between the corresponding items in financial statements of previous year and current year. Itemwise figures are compared between the statements of two periods, the increase or decrease is noted down and the percentage is calculated keeping the previous years figure as the base. If the horizontal analysis includes three or more years figures for item-wise comparison, the percentage increase or decrease may be calculated keeping figures of the earliest year as the base for comparing all the later year figures or each years item-wise figures may be compared with immediately preceding years figures. Exhibits 9.1 to 9.3 depict horizontal analysis.
Exhibit 9.1
Horizontal Analysis 1 Purchases during the years 2008-09 and 2009-10 were `1,50,000 and `2,00,000, respectively. The difference in the amount of purchase is `50,000 (increase over previous year). The percentage increase is calculated as: Change (decrease or increase in value) 100 50,000 100 = = 33.33% increase 1,50,00 Base year value
Exhibit 9.2
Horizontal Analysis 2 Investments during the years 2007-08, 2008-09 and 2009-10 were `3,00,000; `,40,000 and `2,10,000, respectively. The difference in the amount of investments keeping 2007-08 as the base year is For the year 2008-09 (3,00,000 2,40,000) = `60,000 decrease For the year 2009-10 (3,00,000 2,10,000) = `90,000 decrease The percentage decrease in investment is calculated as follows: Change (decrease or increase in value) 100 Base year value For the year 2008-09 = `60,000 100 = 20% Decrease `3,00,000 For the year 2008-09 = ` 90,000 100 = 30% Decrease 3,00,000
Exhibit 9.3
Horizontal Analysis 3 Suppose the base year is shifted. When the base year is shifted to 2008-09 (`2,40,000 2,10,000) = `30,000 decrease. The percentage decrease in investment is calculated as: Change (decrease or increase in value) 100 Base year value For the year 2008-09 = `60,000 100 = 20% Decrease `3,00,000 For the year 2008-09 = `30,000 100 = 12.5% Decrease `2,40,000
when compared to 2008-09
537
Notes: (i) When the base year is common, i.e., 2007-08, the comparison of increase or decrease for the years 2008-09 and 2009-10 is made in relation to the value of the year 2007-08 which resulted in a (percentage) decrease of 20% and 30%, respectively. (ii) When the base year is shifted to 2008-09, the comparison of increase or decrease for the year 2009-10 is made in relation to the value of the year 2008-09 which resulted in a (percentage) decrease of 12.5% (forward comparison becomes relevant for steps to be taken for future decisions). Therefore, backward comparison (i.e., 2008-09 as the base and 200708 for comparison) is considered irrelevant.
Vertical Analysis
In vertical analysis the relationship between the two figures of a single statement is calculated and expressed in the form of percentage. This is a percentage to the total. In the sense, the total figure in the statement is considered equal to 100 and the percentage is calculated for each component in the statement. For instance in the case of income statement, for total revenue or sales what is the percentage of each component. In the case of balance sheet for total assets or for total liabilities or for total equity what is the percentage of each relevant component. Vertical analysis helps the management to compare the percentage of different components with competitive enterprises percentages or industry average percentages, find the problem-oriented components and set them right to improve the situation. Suppose the industry average net profit is 15% on sales. In contrast the enterprises net profit is 10% on sales. It is possible for the enterprise to find the reasons for reduced net profit by means of industry enterprise vertical analysis of each component represented on the income statement. The percentages such as percentage of gross profit to sales, percentage of operating expenses to sales, percentage of operating income to sales, percentage of net income to sales, etc., are calculated to critically analyse the income statement.
Exhibit 9.4
Vertical Analysis of Income Statement The following income statement of Virgo Ltd is presented to you for the year ending March 31, 2010 to determine the pattern of vertical analysis.
Virgo Ltd Income statement For the year ending March 31, 2001 Particulars Net sales Cost of gods sold Gross Profit (Income) (A) Operating Expenses: Selling expenses Administrative expenses Total operating expenses (B) Operating Income (A-B) Less: Interest Expense Income before Income Tax Less: Income Tax Net profit (Income) 40,000 50,000 90,000 1,30,000 4,000 1,26,000 36,000 90,000 8.00% 10.00% 18.00% 26.00% 0.8% 25.2% 7.2% 18.00% ` 5,00,000 2,80,000 2,20,000 Vertical Analysis Percentage 100.00% 56.00% 44.00%
538

Note: The percentage to sales of the cost of goods sold 56%; gross profit 44%; selling expenses 8%; administrative expenses 10%; total operating expenses 18%; operating income 26%; interest expense 0.8%; income before income tax 25.2%; income tax expense 7.2% and net profit 18%, is compared with competitive enterprises or industry average to investigate whether it is favourable or not and take necessary steps of redressal.
Trend Analysis
Trend analysis helps the user of information to observe the percentage changes over time of the selected data. For example, it helps the users to observe whether the net profit of the enterprise is increasing, decreasing or stable, or there are ups and downs over the number of years. The trend facilitates the user of information to make certain decisions which may be crucial. In this analysis, percentage changes are calculated for several years instead of between two years. By looking at the trend in a particular ratio, the user is in a position to identify a problem or observe a sign of good management. Here index numbers are constructed keeping one year as the base year; the value of the item represented in that base year is equal to 100%. The values of the same item for other years are measured in relation to the value of the base year. The base year should be carefully selected because the year to be used for constructing an index number should not suffer from any abnormalities. A person who is interested to assess the earning capacity of an enterprise may consider sales and earnings comparison for a period of 3, 5, 7 years through trend analysis. For example, the sales and net profit of Zenith Company for five years is shown in Exhibit 9.5.
Exhibit 9.5
Zenith Company Ltd

Years Sales Net profit 2005-06 ` 15,00,000 1,60,000 2006-07 ` 18,00,000 2,10,000 2007-08 ` 21,00,000 2,50,000 2008-09 ` 25,00,000 3,35,000 2009-10 ` 30,00,000 4,50,000
You are required to show the trend keeping year 2005-06 as the base year. Calculation of Trend percentage Base year 2005-06
Years Sales Net profit 2005-06 % (15,00,000) = 100 (1,60,000) = 100 2006-07 % 120 131 2007-08 % 140 156 2008-09 % 167 209 2009-10 % 200 281
Calculation The base year is 2005-06. Therefore, sales and net profit of years 2006-07, 200708, 2008-09 and 2009-10 are divided by the base year sales and base year profit respectively, and multiplied by 100 to get the trend percentage. For example, for the year 2006-07 (Base year 2005-06) For Sales Sales of 2006-07 18,00,000 100 = 100 = 120% Sales of 2005-06 15,00,000 For Net profit Net Profit of 2006-07 2,10,000 100 = 100 = 131% Net Profit of 2005-06 1,60,000 This process goes on for every year keeping 2005-06 as the base year.
539
Interpretation: The trend of performance in sales and net profit are growth oriented as there is an increasing trend. However, the net profit parentage growth has outstepped the sales percentage growth. Other things remaining constant this is a company which can be preferred for investment.
Exhibit 9.6
Keeping 2005-06 as the base year we can observe that the increase in sales and net profit percentage is as follows:
Years Items Increase in sales percentage Increase in net profit percentage 2005-06 100 100 2006-07 2007-08 2008-09 2009-10 (200) 100%
(120) 20% (140) 40% (167) 67%
(131) 31% (156) 56% (209) 109% (281) 181%
When we compare the growth of sales and net profit together, we observe the net profit growth is higher than sales growth. In the sense, if sale has increased by 100%, the net profit has increased by 181% in five years time. The yearly increase in sales and net profit vertical comparison indicates that: For the year 2006-07, if sales has increased by 20%, the net profit has increased by 31%. For the year 2007-08, if sales has increased by 40%, the net profit has increased by 56%. For the year 2008-09, if sales has increased by 67%, the net profit has increased by 109%. For the year 2009-10, if sales has increased by100%, the net profit has increased by 181%. This comparative growth clearly indicates that the management is very efficient and effective.
Note: Only positive growth is shown in the exhibit, but the growth can be negative also. There can be consistency without positive or negative growth. There can be ups and downs in the growth. Based on the type of the trend one can interpret the result and make a decision based on the inference.
Ratio Analysis
Ratio is an expression of mathematical relationship between two variables or figures. It is effectively used as a tool of management for analysis of financial statements along with cash and funds flow statements. Even in trend analysis ratios are used as effective tools.
The financial statements provide necessary information in absolute form in a nut-shell to the users of information. When this information should be used for decision making there is a need to establish certain relationships and check whether the relationship is favourable or unfavourable. For example, what is the relationship that net profit bears to sales? Is it 1:4 or 1:5 or 1:10? Ratio analysis is the calculation of different ratios from a set of financial statements. In fact, ratios are easy to calculate, simple to understand and effective to analyse. It is because of simplicity and effectiveness that ratios are popular and are widely used as a tool of analysis. Many times absolute figures fail to give a correct picture of the relationship one figure bears to other. Therefore, the ratios are used for the purposes of analysis either in pure ratios form, i.e., 2:1, 4:5, 1:1, etc., or in rates form, i.e., stock turnover is five times a year or in percentage form, i.e., the gross profit to sales is 25% or the return on shareholders equity is 20% on capital employed. When ratios are obtained, comparison becomes easy and meaningful. Such a comparison may be done within the enterprise or between the enterprises and other similar enterprises or between the enterprise and the industry averages published by the authorized agencies and the government. However, one should bear it in mind that obtaining ratios is one of the starting points. The end point of decision making depends on the interpretation of the analysed ratios.
540
Finger Tips 9.4 Important Four Techniques of Analysis

Horizontal Analysis: Comparison of absolute data or percentage for two or more years. Vertical Analysis or Structural Analysis: Calculation of increase or decrease in absolute data or in percentages of that year, generally having sale as the base. Trend Analysis or Dynamic Analysis: Calculation of percentage change over number of years with the base years figures. Ratio Analysis: Expression of relationship between two figures which are mutually interdependent.
Objectives of ratio analysis

1. 2. 3. 4. 5. 6. 7. 8. To understand the financial statements figures in a better way. To enquire into the reasons for change. To make comparisons to facilitate decision making. To facilitate horizontal and vertical comparisons to understand the type of relationship that a figure bears to the other. To analyse the operational activity, profitability, performance efficiency, liquidity, and other related issues. To facilitate the information users to understand the financial statements better. To compare the past and the present performance of the enterprise. To compare the performance with the competitors performance and the industry performance (inter-firm and firm-industry comparison).
Merits of ratio analysis

1. Ratios are easy to calculate, simple to understand and effective in analysis and interpretation. 2. Ratios are used as an aid to analysis and interpretation of financial statements. 3. Ratio analysis acts as an index of the efficiency or otherwise of the enterprise. 4. Ratios help in inter-comparison and intra-comparisons. 5. Ratio analysis helps in planning and control. 6. Investment decisions are made possible through ratio analysis. 7. Ratio analysis helps in forecasting and provides clues for future problems. 8. Ratios help in strengthening the accounting reports. 9. Ratio analysis helps to understand the performance and position of the enterprise at a glance. 10. Ratios can be expressed as pure ratios, rates or percentages depending on the nature of the item (figure) to be compared.
Limitations of ratio analysis

1. Ratios suffer from the inherent weakness of the accounting system itself. 2. Since ratios are based on past happenings, prediction of future may prove to be futile, because future happenings may not be similar to past happenings. 3. Ratio analysis is not free from individual bias (for example, selecting a base year for comparison while presenting trend analysis through ratios).
541
5. There are no definite standards for ratios there are many thumb rules followed while calculating some important ratios. 6. Ratios obtained through window dressed balance sheets may misguide the information users. 7. Ratios are only numbers and they do not indicate any thing unless there is a standard norm for comparison. In spite of the number of limitations from which ratio analysis suffers, it is a most widely used and and popular tool for financial statement analysis (both horizontal and vertical) because of its simplicity and easy understanding.
How to make effective use of ratio analysis

1. Comparison of the results of the analysis can be with past results, with the results of other competing enterprises. 2. Whenever growth of the business should be interpreted, better to compare the trend ratios over a substantial period of time (say, 5 years, 7 years). 3. For interpreting the financial condition and earning performance of the enterprise, it is better to use the combined effect or various ratios, so that the ills and wills can be properly diagnosed. 4. Though the ratios obtained by the analysis of past results can be a choice, better to use budgeting and standard ratios for predicative analysis. 5. As ratios are not ends in themselves, but only means to ends, ratios can only be pointers for conclusions. That means, conclusions should be drawn very carefully by considering the inside out of the pointers. 6. Analyst should be able to prescribe an appropriate medicine to the malady indicated by the ratio analysis. In the sense, the analyst should be non-prejudicial in interpreting the analysed information to come to an objective judgement/ decision.
COmmON SIZE STATEmENTS AND RATIO ANALYSIS

Exhibit 9.7
In any accounting statement for that matter, comparison of absolute figures can mislead the user of information. Company X and Company Y have earned a profit of `2,00,000 and `80,000 respectively, during the year 2009-10. Their sales during the year were `10,00,000 and `3,00,000, respectively. If a question is asked which company has performed better, looking at the absolute figures of profit and sales any one will say that X Company has performed well. But is this observation true? X Company Profit 100 Sales ` 2,00,000 100 = 20% `10,00,000 Y Company Profit 100 Sales `80,000 100 = 26.67% `3,00,000
X Company has a profit of 20% where as Y company has a profit of 26.67% on their sales turnover, respectively. Since the ratio of profit of X and Y companies is 20%: 26.67% or 2:2.67, Y company has performed better than X company.
542
Let us convert the absolute into percentage ratios and compare: Common size statements are prepared in order to (1) compare percentages of a current year/ period with past years/periods, (2) compare individual businesses (3) compare one business with another (4) compare one business with industry standard percentages published by the authorized service agencies, etc. Common size statements contain the percentage of key figures alone, without the corresponding amount figures. As it has already been explained in Exhibit 9.7, percentages convey better meaning compared to absolute figures. Therefore, percentages are commonly used in common size financial statements to make the analysis easy and interpretation meaningful. Common size statements can be prepared in vertical analysis as well as in horizontal analysis. Let us understand the construction of common size statements for (i) vertical analysis and (ii) horizontal analysis through Illustration 9.1.
Illustration
9.1
Prepare the vertical and horizontal common size income statements of Dildar Company Ltd for three years ending on 31 March.
Particulars For the years ending on 31 March 2007-08 ` Sales revenue Cost of goods sold (-) Gross Profit (A) Operating expenses: Selling expenses (i) General expenses (ii) Total operating expenses [(i) + (ii)] (B) Operating income before Income Tax (A- B) Income Tax @ 30% Net Profit 5,00,000 3,40,000 1,60,000 60,000 40,000 1,00,000 60,000 18,000 42,000 2008-09 ` 4,50,000 3,20,000 1,30,000 52,000 35,000 87,000 43,000 12,900 30,100 2009-10 ` 4,00,000 3,05,000 95,000 40,000 29,000 69,000 26,000 7,800 18,200
Solution 1.
Particulars
Vertical Common Size Statement

For the years ending on 31 March 2007-08 ìn Percentage Sales revenue Cost of goods sold (-) Gross Profit (A) Operating expenses: Selling expenses (i) General expenses (ii) Total operating expenses [(i) + (ii)] (B) Operating income before Income Tax (A- B) Income Tax @ 30% Net Profit 100% 68.00 32.00 12.00 08.00 20.00 12.00 03.60 8.40 2008-09 ìn Percentage 100% 71.00 29.00 11.60 07.80 19.40 09.60 02.90 06.70 2009-10 ìn Percentage 100% 76.00 24.00 10.00 07.30 17.30 06.60 02.00 04.60
543
2.
Particulars
Horizontal Common Size Statement

For the years ending on 31 March 2007-08 ìn Percentage Sales revenue Cost of goods sold (-) Gross Profit (A) Operating expenses: Selling expenses (i) General expenses (ii) Total operating expenses [(i) + (ii)] (B) Operating income before Income Tax (A-B) Income Tax @ 30% Net Profit 100% 100% 100% 100% 100% 100% 100% 100% 100% 2008-09 ìn Percentage 90.00 94.10 81.30 86.70 87.50 87.00 71.70 71.70 71.40 2009-10 ìn Percentage 80.00 89.70 73.10 66.70 72.50 69.00 43.30 43.30 43.30
Notes: (i) In vertical analysis, sales revenue is the base. The value of which is equal to 100 and the percentages of other figures are obtained in relation to sales in the respective years. (ii) In horizontal analysis year 2007-08 is the base. Therefore, the figures of each item in that year are equal to 100 and the percentage of the other two years are obtained in relation to 2007-08 years figures of each item.
CLASSIFICATION OF RATIOS
Ratios can be broadly classified into two categories: 1. Classification based on financial statements 2. Classification based on need Figure 9.1 classifies ratios based on financial statements. Figure 9.1 Classification of Ratios
Classification based on Financial Statements
Balance Sheet Ratios
Profit and Loss Account Ratios
Combined Ratios
1. Balance sheet ratios: When ratios are calculated by using the required figures appearing in the balance sheet for establishing a relationship, they are termed as balance sheet ratios. Balance sheet ratios are calculated to know the financial positions and other related issues of the enterprise. For example, Current Assets Current Ratio = Current Liabilities 2. Profit and loss account ratios: When ratios are calculated by using the required figures appearing in the income statement /profit and loss account for establishing a relationship, they are termed as profit and loss ratios. Profit and loss ratios are calculated to know the profitability and other related issues of the enterprise. For example, Cost of Goods Sold + Operating Expenses Operating Ratio = 100 Net Sales
544
Figure 9.2 Classification of Ratios Based on Need

Classification Based on Need 6. Investors Ratios or market strength 7. Growth and Stability Ratios i) Growth in sale ii) Growth in total returns iii) Growth in earnings iii) Dividend yield iv) Dividend cover v) Payout ratio vi) Dividend to cash flow vii) Price/Earning ratio viii) Earning yield ix) Net assets value per share x) Cash flow per share iv) Maximum decline in coverage of interest charges v) Percentage decline in return of total capital vi) Percentage decline in return on equity capital vii) Percentage decline in earning pershare
1. Profitability Ratios 2. Liquid Ratio 3. Solvency Ratios 4. Activity Ratios 5. Gearing Ratios i) Capital Gearing Ratio (a) Stock turnover ratio (b) Debtors turnover ratio
(a) Gross profit ratio (a) Current ratio (b) Acid test ratio (c) Absolute liquidity ratio (a) Debtequity ratio (b) Total assets to debt ratio (c) Proprietary ratios (d) Interest coverage ratio (c) Creditors turnover ratio (d) Working capital turnover ratio (e) Assets turnover ratio
(b) Net profit ratio
i) Earning per share ii) Dividend per share
Combined ratios are calculated to ascertain the performance and the position of the enterprise taking into account the various aspects which will contribute for performance and position. Figure 9.2 classifies ratios based on need.
Notes: 1. In this classification, both the organizational needs and the investor needs are identified separately. 2. Need-based classification serves the purpose for which ratios are calculated. 3. There may be many more ratios calculated based on the specific need.
3. Combined ratios: When ratios are calculated by using the required figures, one from the balance sheet and the other from the profit and loss account for establishing a relationship, they are termed as combined ratios. For example, Net Profit Return on Shareholders Investment = 100 Shareholders funds
(c) Operating ratio (d) Return on capital employed (e) Return on net worth/Equity
545
Finger Tips 9.5 Who, Why and What Ratios

Who are the users of the ratios 1. Short-term creditors, money lenders, investors, social investigators and others Why are the ratios used (the test) To test liquidity and solvency What ratios are applied (a) Current Ratio (b) Liquid Ratio (c) Absolute Liquid Ratio (d) Proprietary Ratio (e) Assets to Equity Ratio (f) Debt-Equity Ratio (g) Capital Gearing Ratio (a) Stock Turnover Ratio (b) Debtors Turnover Ratio (c) Creditors Turnover Ratio (d) Turnover to Working Capital (e) Turnover to Total Assets (f) Operating Ratios (g) Current Ratios (a) Gross Profit Ratio (b) Net Profit Ratio (c) Operating Ratio (d) Return on Capital Employed (e) Dividend Ratio (f) Price Earning Ratio (g) Earnings Per Share Ratio (h) Dividend Per Share (i) Other Ratios connected with profitability (h) Turnover to Capital Employed (a) Growth in sales (b) Growth in Total Returns (c) Growth in Earnings (d) Maximum Decline in Coverage of interest charges (e) Percentage decline in Return on capital (f) Percentage decline in Return on Equity capital (g) Percentage decline in Earnings per share
2. Management
To test efficiency
Note: Efficiency test will be effective when the efficiency ratios are interpreted along with liquidity and solvency ratios. 3. Shareholders, long-term creditors, Government, social investigators and others To test profitability
4. Shareholders - Long-term investors - Potential investors - Management - Others
To test growth and stability
Note: Interpretation of the ratios in relevant combinations will yield better results for decision making.
1. Profitability ratios: Profitability is measured in terms of sales (performance) or/ and in terms of investment (return on owners equity) to assess the capacity of the management to earn profits and to ensure returns to owners. Five different types of ratios are considered very important as stated in the classification chart. (a) Gross profit ratio Gross profit Gross profit ratio is calculated as: 100 Net sales Gross profit is the difference between the net sales and the cost of goods sold (i.e., the direct cost of sales). The net sale is sales minus returns inwards. This ratio is expressed as a percentage of sales as indicated in the above formula. Gross profit ratio is the measure of the efficiency of production/purchase as well as pricing. The higher the gross profit, the better is the efficiency of the management in relation to production/purchase and pricing.
546
(b) Net profit ratio Net Profit Ratio is calculated as: Net Profit 100 Net Sales
Net profit is the difference between the net sales and total expenses during the accounting period. The total expenses include direct expenses and operating and other expenses plus tax on the income. The higher the net profit, the better is the efficiency of the management. The management is in a better position to distribute higher returns to the owners on the capital invested by them. (While considering the net profit, non-operating incomes such as interest, dividends, etc., and non-operating expenses like loss on sale of fixed assets are deducted.) (c) Operating ratio Operating Profit Operating ratio is calculated as: = 100 Net Sales It is calculated purely to establish the relationship between operating profit and net sales when the non-operating incomes and non-operating expenses are not taken into account. The higher the ratio, the better it is. If the net profit ratio is the result of the total activities of the business, then the operating profit ratio is the result of pure operating activities of the business.
Illustration
9.2
Dandeli Company Ltd has furnished its Trading and Profit and Loss Account for the year ending March 31, 2010. Utilizing the necessary figures, you are required to calculate (1) gross profit ratio, (2) net profit ratio and (3) operating ratio.
Particulars To Stock To Purchases To Wages To Gross Profit c/d To Administrative Expenses To Selling and Distribution expenses To Loss on sale of Machinery To Net Profit Total Amount ` 1,05,000 6,75,000 18,000 5,52,000 13,50,000 30,000 42,000 30,000 4,50,000 5,52,000 Total 5,52,000 By Gross Profit b/d 13,50,000 5,52,000 Particulars By Sales By Closing Stock Amount ` 12,00,000 1,50,000
Solution (See working notes to get the figures used for calculation) Gross Profit `5,52,000 100 = 100 = 46% 1. Gross Profit Ratio = Net Sales `12,00,000 2. Net Profit Ratio =
Net Profit ` 4,50,000 100 = 100 = 37.5% Net Sales `12,00,000
547
3. Operating Ratio = Cost of Goods sold + Operating Expenses 100 Net Sales =
`6,48,000 + `72,000 100 = 60% `12,00,000
Working Notes (a) Loss on sale of machinery will not be considered for calculating the operating ratio. (b) Cost of goods sold = Opening Stock + Purchases + Wages Closing Stock = `1,05,000 + `6,75,000 + `18,000 = `6,48,000 (c) Operating Expenses = Administration Expenses + Selling and Distribution Expenses = `30,000 + `42,000 = `72,000
(d) Return on capital employed (ROCE): It is calculated to establish a relationship between earnings before interest and taxes (EBIT) and capital employed. This ratio is expressed as a percentage and calculated as: EBIT 100 ROCE = Capital employed Capital employed means, share capital + reserves and surpluses fictitious assets + long-term loans. It means the effectiveness of the enterprise in using all its assets to increase the earnings of the enterprise. The higher ratio indicates the ability of the management in using the available resources to generate increased income. (e) Return on net worth/equity: It is calculated to establish a relationship between the net profit after tax and net worth. Net worth means share capital + reserves + surplus fictitious assets. It measures the rate of return on the owners funds/ resources provided by the shareholders. This ratio serves as a measurement of percentage return per rupee of shareholders investment. Here, shareholders mean equity shareholders with an investment risk (preference shareholders who are assured of a certain percentage of returns are excluded). Return on net worth is calculated as: Profit after Tax 100 Net Worth
Illustration
9.3
You are required to calculate: (1) Return on capital employed and (2) Return on net worth from the following information submitted to you by Wex Ltd for the year 2009-10.
Particulars Profit before tax (PBT) Provision for tax Profit and loss account balance General Reserve Share capital (4,00,000 equity shares of `10 each) 15% Debentures ` 28,00,000 10,00,000 10,00,000 30,00,000 40,00,000 60,00,000
548
Solution (See working notes to get the figures used for calculation) EBIT 100 1. Return on capital employed (ROCE) = Capital employed =
`37,00,000 100 = 26.43% `1,40,00,000 Profit after Tax 100 Net Worth
`18,00,000 100 = 22.50% `80,00,000
Comment: Return on capital employed, i.e., 26.43% is not attractive 2. Return on net worth (return on equity) = =
Comment: Return on net worth, i.e., 22.50% is not attractive taking into account the present day industry performance. Working Notes 1. Net worth
Particulars Share Capital General reserve Profit and Loss Account Net Worth ` 40,00,000 30,00,000 10,00,000 80,00,000
2. Capital employed
Particulars Equity Capital (Net Worth) 15% Debentures Capital Employed ` 80,00,000 60,00,000 1,40,00,000
3. Earnings before interest and tax or EBIT

Particulars Profit before tax (PBT) Add: Debentures Interest @ 15% on `60,00,000 EBIT ` 28,00,000 9,00,000 37,00,000
4. Capital employed
Particulars Profit Before Tax Less: Provision for tax Capital Employed
Note: These ratios are explained in greater detail in Chapter 10.
` 28,00,000 10,00,000 18,00,000
2. Liquidity ratios: Liquidity ratios refer to the ratios which measure an enterprises ability to meet its current/short-term obligations. Short-term means a period of one year, preferably accounting year. Liquidity means cash or cash equivalents available to pay to creditors for trade and expenses. Cash is the most liquid asset which includes cash on hand and demand deposits in the bank. Cash or equivalents are short-term highly
549
liquid marketable securities, which can be converted into cash without much loss of time and money and accounts receivable which are somewhat less liquid (as it requires little more time realization). Liquidity is essential for an enterprise not only to meet its current obligations, but also to facilitate working capital needs, to buy materials when they are cheep (particularly seasonal items to take advantage of the investment opportunities, to meet the conditions of boom and slump in sales, interest rates, etc., and to invest in projects which are already committed). The important ratios that are generally considered to assess the liquidity are (a) current ratios and (b) acid test ratio, quick ratio or liquid ratio, (c) absolute ratio. (a) Current ratio is the ratio of current assets to current liabilities. Current ratio which is otherwise called as working capital ratio is the most widely used ratio. This ratio is expressed as a single figure ratio and not as a percentage ratio. Generally 2:1 is considered to be a favourable ratio, i.e., current assets should be twice current liabilities. Current assets include cash in hand, cash at bank, cash equivalents, short-term investments, trade debtors, bills receivables, accrued income, prepaid expenses, stock in trade, and advance tax. Current ratio is calculated as: Current assets Current ratio = Current liabilities Current liabilities include trade creditors, bills payable, outstanding expenses, liability for taxes, income received in advance, provision for taxation, proposed dividend, short-term bank loan in the form of cash credits, overdrafts, etc., and current portion of long-term loan payable during the year. To make sure that the current liabilities are paid in time, current assets ratio should be slightly higher than current liabilities, if not strictly the ratio of 2:1. Further, the current ratio shows the margin of safety available to cover the loss on sale of non-cash current assets and to meet the uncertainties of the enterprises cash flow. If the current ratio is more than 2:1, it indicates that the current assets are not ideally used for generating income. Conversely, if the ratio is less than 2:11, there arises a liquidity problem. Another important aspect to be considered in current ratio is the availability of stock component. Stock cannot be sold at once to increase the cash flow to meet the current obligations. In fact, sudden and hasty measures to dispose of stock may land the enterprise into trouble. In the sense, the enterprise may lose the regular customers, the confidence enjoyed hither to may be lost and such other complications may arise. Therefore, maintaining a current ratio at 2:1 is a tight rope walking exercise. (b) Acid test ratio or quick ratio or liquid ratio is calculated to establish a relationship between liquid/quick assets and current liabilities. Quick assets are nothing but cash, cash equivalents, accounts receivables, and readily realizable marketable securities (current assets minus stock and prepaid expenses). Quick ratio/acid test ratio/liquid ratio is calculated to test the short-term solvency of the enterprise. This ratio is considered as an ideal test for liquidity. The standard ratio is 1:1. This ratio is calculated as: Quick Assets Acid Test Ratio = Current Liabilities The difference between current ratio and liquid/quick/acid test ratio is that for current ratio, stock, and prepaid expenses are included in the current assets and
550
for quick ratio, stock and prepaid expenses are excluded. That means, if quick ratio is compared with current ratio, one can easily note the influence of stock on current assets considered for calculation. As inclusion of stock in the current assets for determining the ratio and relaying on it may pose problems which have already been explained. The acid test ratio is considered as the best measure for liquidity. Let us illustrate this through Illustration 9.4.
Illustration
9.4
Calculation of Liquidity Ratios From the following information extracted from the books of Good Luck Company Ltd, compute current ratio and acid test ratio, compare the resultant ratios and offer your comments. Balance sheet As on March 31, 2009
Liabilities Share capital: 20,000 shares of `10 each 10% Debentures Sundry creditors Bills payable Bank Overdraft Provision for Taxation Provision for Deferred Taxes Proposed dividend Total Amount (`) 2,00,000 1,00,000 40,000 5,000 15,000 1,000 4,000 10,000 3,80,000 Assets Goodwill Land and Buildings Stock Sundry debtors Bills Receivable Cash Payment in advance Advance income tax Total Amount (`) 1,00,000 1,80,000 50,000 30,000 8,000 5,000 3,000 4,000 3,80,000
Solution Working Notes 1. Current Assets

Particulars Stock Debtors Bills receivables Cash Payment in advance Advance income tax Total Current Assets ` 50,000 30,000 8,000 5,000 3,000 4,000 1,00,000
2. Current Liabilities
Particulars Sundry creditors Bills payable Bank overdraft Provision for taxation Proposed dividend Total Current Liabilities ` 40,000 5,000 15,000 6,000 10,000 76,000
551
Notes: (i) It is assumed that overdraft is payable on demand. (ii) Provision for deferred taxes should not be taken into account for computing current ratio or quick ratio.
(a) Current Ratio =
Current Assets `1,00,000 = = 1.32 `76,000 Current Liabilities
Therefore, current assets to current liabilities ratio is 1.32:1. Comment: Current ratio is less than the standard ratio of 2:1, but higher than the liabilities. That means, the company is in a position to meet the current obligation with little difficulty. For Calculation of Quick Ratio Working Notes Quick /Liquid Assets
Particulars Sundry Debtors Bills receivables Cash Total Quick /Liquid assets ` 30,000 8,000 5,000 43,000
Current liabilities remain the same as calculated before, i.e., `76,000.

Note: Payment in advance and advance income tax cannot be converted into cash.
(b) Acid Test Ratio =
Quick Assets ` 43 ,000 = = 0.57 Current Liabilities `76,000
Therefore, quick assets to current liabilities ratio is 0.57:1. Comment: Quick/Liquid ratio is very much less than the standard ratio of 1:1. This indicates the company is not in a position to honour its current obligations. As for as cash flow is concerned it is in danger zone. Inference: Even though current ratio gives an impression that the company can meet its current obligations with little difficulty, quick ratio clearly indicates that the company cannot honour its current obligations completely. Therefore, acid test ratio is the best measure for assessing the liquidity of the enterprise.
(c) Absolute liquid ratio is calculated by considering fully liquid assets such as cash in hand, cash at bank and readily marketable short-term securities. Even though bills receivables are liquid than the stock, there may be debts having doubt regarding their realizeability in time. Therefore, bills receivables along with stock are excluded while calculating the absolute liquid ratio. This ratio is calculated as: Absolute Liquid Ratio = Cash in hand and at Bank + Short-term marketable securities Current Liabilities The desirable standard ratio in this case is 1:2, i.e., rupee one worth absolute liquid assets are sufficient to meet rupees two worth current liabilities. Though the ratio gives more meaningful measure of liquidity, it is not much in use, because maintaining 50% of the value of the current liabilities in an asset, in the form of cash and bank balance is not advisable, because liquid cash does not yield any thing in return. Therefore, most of the enterprises do not prefer this ratio for ascertaining their liquidity.
552
3. Solvency ratios: Solvency means the enterprises ability to meet the total obligations (i.e., both short term and long term) when they fall due. Solvency depends upon the profitability of the business enterprise. If liquidity refers to the ability of the enterprise to meet short-term obligations, then solvency refers to the soundness of the enterprise, i.e., to honour any type of obligation whenever they fall due. It is profitability and best management that ensures soundness to the enterprise. In fact, solvency ratios measure the extent to which the enterprise has been financed by debts and its ability to honour these debts without risking the cash required for business operations. Four ratios are considered very important under solvency ratios. They are (a) debt-equity ratio, (b) total assets to debt ratio, (c) proprietary ratio, and (d) interest coverage ratio. (a) Debt-equity ratio. This ratio establishes a relationship between long-term debts and shareholders funds. Debts include any long-term obligation in the form of debentures, bonds, loans from financial institutions and any other type of longterm borrowings. Shareholders funds include equity share capital + preference share capital + reserves and surpluses fictitious assets such as debit balance of profit and loss account, discount on issue of shares and other items of losses. Debt-equity ratio should be generally less than one to show that the owners funds are greater than the lenders funds. This ratio measures the contribution of the lenders relative to the contribution of the owners. This is also considered as a measure of debt exposure, since it reveals the extent to which the enterprise has been financed by debts. In fact, it is considered unhealthy or risky to have debts more than shareholders funds. If the ratio of debt to equity is more than one, it is an indication that there is high degree of debt in the capital structure, which means the lenders should bear larger risks of the enterprise. The debtequity ratio is calculated as Long-term Debts Debt-equity ratio = Shareholders Funds The debt-equity ratio is one of the most commonly used measures to test the solvency of an enterprise. (b) Total assets to debts ratio. This ratio establishes a relationship between total assets and the debts of the firm. That means it is a measure that indicates the proportion of an enterprises total assets that are financed by long-term debts. The long-term debts include debentures, bonds, long-term loans from financial institutions, and any other type of long-term borrowings. Higher ratio represents large degree of security to lenders and lower ratio represents less degree of security. A lower ratio of assets to debts sends a warning signal to the lenders that their investment in the enterprise is not fully secured. Total assets to debts ratio is calculated as: Total Assets Total Asset to Debt Ratio = Long-term Debt If the ratio is more than one, the lenders can breathe a free air as their investment is secured. (c) Proprietary ratios. Proprietary ratio is calculated to assert the solvency and financial stability of the enterprise in the long run. This ratio establishes a relationship between shareholders funds and total assets, i.e., it indicates the proportion of total assets of the business financed by utilizing the shareholders funds. The higher is the ratio, the greater is the degree of security to lenders. It means, larger amount of shareholders funds are used to acquire total assets of
553
the business. The lower is this ratio, the lower is the degree of security to the lenders, because larger amount of debt funds are used to acquire total assets. On the other hand, if the proprietary ratio is very high, it is an indication that the enterprise is relaying more on owners funds than debt funds. This ratio is calculated as: Shareholders Funds Proprietary Ratio = Total Assets It should be noted that total assets to debts ratio and proprietary ratios are opposed to each other in relationship. (d) Interest coverage ratio. Every enterprise which has long-term debts in the form of debentures, bonds, etc., should service its debts out of the current earnings. Current earnings mean earnings before interest and taxes. Long-term debts carry interest charges which should be paid regularly. Failure to pay interest charges may lead to legal compilations which in turn, may have a telling effect on solvency. That is why this ratio is considered as a rough indicator of long-term solvency of the enterprise. Current operating income being the basic source of funds to debt servicing, if this ratio is several times higher than the interest charges, it is an indication that the enterprise enjoys long-term solvency. This ratio is calculated as: EBIT Interest Coverage Ratio = Interest Charges It should be noted that no standard ratio is prescribed as a cut off to ensure solvency. However, a lower ratio is considered to be a negative sign of long-term solvency. Let us understand the solvency ratio through Illustration 9.5.
Illustration
9.5
Calculation of Solvency Ratios The balance sheet of sturdy limited as on March 31, 2010 is as follows
Liabilities Amount ` Assets Land and Buildings Plant and Machinery Furniture and fittings Long term investments Stock in trade Sundry debtors Bills receivable Cash at bank Cash in hand Total 55,00,000 Total Amount ` 20,00,000 10,00,000 1,00,000 5,00,000 10,00,000 4,00,000 1,50,000 3,00,000 50,000 55,00,000
Share Capital: 25,000 equity shares of 25, 00,000 `100 each Reserves and Surplus 10% Debentures (Long Term) Bank overdraft Bills payable Sundry creditors 11,00,000 10,00,000 3,00,000 50,000 5,50,000
Assume EBIT for the year 2009-2010 at `5,50,000. Calculate (1) debt-equity ratio, (2) total assets to debt ratio, (3) proprietary ratio, (4) interest coverage ratio and (5) comment on the ratios calculated.
554
Solution 1. Debt to Equity ratio = Long-Term Debt Shareholders fund Debentures Equity Share Capital + Reserve and Surpluses `10,00,000 10,00,000 = = 0.28 ` 25,00,000 + `11,00,000 36,00,000
= =
Therefore, debt to equity ratio = 0.28: 1 Comment: Since equity is nearly four times than that of the debt, the company is relaying more on equity funds than debts. This ratio 0.28:1 is favourable to lenders as their funds are secured. Total Assets Total Assets = 2. Total Assets to Debt Ratio = Long-term Debts Debentures = 55,00,000 = 5.5 10,00,000
Therefore, total assets to debt ratio = 5.5:1 Comment: Since the value of total assets is more than five times the debt, the lenders are fully secured. This high ratio indicates that the enterprises assets are financed by equity funds to a large extent. This ratio 5.5:1 is extremely good from the view point of both lenders and equity shareholders. Shareholders Funds 3. Proprietary Ratio = Total Assets = = Equity Share Capital + Reserves and Surplus Total Assets 25,00,000 + 11,00,000 36,00,000 = = 0.65 or 65% 55,00,000 55,00,000
Therefore, proprietary ratio = 0.65:1. Comment: 65% of the assets of the enterprise are financed by owners funds. The ratio 0.65:1 indicates that the lenders are more secured. This ratio also indicates that the company is relaying more on owners fund than debt. EBIT 4. Interest Coverage Ratio = Interest Charges = 5,50,000 5,50,000 = = 5.5 10% on 10,00,0000 1,00,000
Therefore, interest coverage ratio = 5.5:1 Comment: EBIT of the company is 5.5 times more than the interest charges. That means, the company has strong earnings source to service the debts. This indicates that the company enjoys long-term solvency.
4. Activity ratios: Otherwise called as assets utilization ratios, activity ratios are the ratios of cash elasticity of current assets. Cash elasticity depends upon enterprises current operations. That means, the quickness with which the enterprise is able to convert the current assets into cash decides cash elasticity. How quickly are the
555
inventories (stock) converted into sales? How quickly the account receivables are converted into cash? What is the quantum of cash sales and credit sales? If the quantum of credit sales is high, within what (short) period the debtors settle their accounts? Answers to such questions decide the cash flows and the ability of the enterprise to meet the current liabilities. It is the stock turnover, debtors turnover, creditors turnover, working capital turnover and finally the total assets turnover that decide not only the cash flow but also the profitability. Turnover means the frequency or the number of times the item has turned over during the year. Thus, the important activity ratios that are to be examined are as follows: (a) Stock turnover ratio. It measures, how frequently the inventory is sold or how many times the stock of the business has turned over. This is a ratio of cost of goods sold to average inventory in stock during the year. This ratio is expressed as Cost of Goods Sold Stock Turnover Ratio = = Number of Times Average Inventory (stock) Cost of Goods Sold = Opening Stock + Purchases + Carriage Inwards + Direct Expenses Closing Stock [or Sales Gross profit]. Average Inventory = Opening Stock + Closing Stock 2. Increase in the frequency of stock turnover indicates increased profits and low level of inventory in the stock and high cash inflows. Conversely, decrease in the frequency of stock turnover means, decreased profits and high level of inventory in the stock and low cash inflows. Most importantly, the validity of the stock turnover ratio depends on the assumption that cost of goods sold is wholly the cost of materials drawn from the stock of inventory. In fact, stock turnover is an average measure which may not reveal differences in types of stock. For example, there may be a few obsolete items in the stock which do not find a ready market. The stock turnover ratio fails to serve the purpose, unless such items are separated and the ratio is obtained. To ascertain the expected time between purchases of stock and sales of such stocks stock turnover in days is obtained. This indicates the average age of the inventory in stock. A low holding period indicates the high frequency of stock turnover, whereas a high holding period indicates a potentially greater risk of obsolescence. Stock turnover in days or months, or average age of stock is calculated as: 365 days = Number of days Stock Turnover Ratio = Stock Turnover Alternatively, = 12 months = Number of months Stock turnover
Note: It is customary to use 360 days instead of 365 days while calculating the average age of stock.
Thus, stock turnover ratio is an important measure that helps the manager to decide as to when to buy the inventory to meet the sales demand, so that large volumes of inventory do not remain in stock, causing lower cash inflows. The age of the stock or the stock turnover in days indicates the stock holding period, based on which buying frequency can be decided. (b) Debtors turnover ratio. It is used to measure the frequency of the collection of accounts receivables (Debtors + Bills Receivables). This is a ratio between the credit sales and average accounts receivables. High debtors turnover ratio is
556
favourable to business because the frequency of collection is high due to credit periods which results in better cash inflows. Conversely, low debtors turnover ratio indicates long credit periods resulting in slow realization of accounts receivables and lower cash inflows. The debtors turnover ratio is calculated as: Credit Sales = Average Debtors + Average Bills Receivables = Number of times debtors are collected during the year Generally, debtors turnover ratio is compared with the industry debtors turnover ratio to decide the efficiency of this ratio in the enterprise. Further, debtors collection period is also calculated to make the comparison easy. Debtors collection period is either calculated in number of days or number of months based on the industry practice. Debtors collection period in number of days 365 days = Number of days = Debtors turnover Debtors collection period in number of months 12 months = Number of months = Debtors turnover Debtors turnover ratio and debtors collection period are considered to be very significant measures, because these ratios are able to indicate the ability of the enterprise to meet the short-term current obligations and measure strength of current operations as well. See Illustration 9.6.
Illustration
9.6
Calculate debtors turnover ratio and average collection period in terms of months from the following: Credit sales for the year `4,80,000, debtors `80,000, B/R `40,000. See Illustration 9.6. Solution: 1. Debtors turnover ratio: = = Credit Sales Average Debtors + Average B/R 4,80,000 4,80,000 = = 4 times 80,000 + 40,000 1,20,000
2. Average collection period: 12 months 12 = = = 3 months Debtors Turnover 4
(c) Creditors turnover ratio. It is the ratio between credit purchases and average accounts payable (average creditors + average bills payable). How many times the accounts payables are paid in a year is measured by preparing this ratio. Higher creditors turnover ratio is an indication of strict credit policy and lower ratio is an indication of liberal credit policy by the suppliers. Frequent payment to creditors increases the cash requirement for outflow of cash.
557
This ratio is calculated as: Creditors Turnover Ratio =

Credit Purchases Average Creditors + Average Bills Payables
= Number of times creditors are paid during the year. Generally, average payment period, in terms of days or in terms of months is calculated along with creditors turnover ratio. Average payment period or current debt payment period is calculated to know the average time taken to pay to accounts payable. This ratio is calculated by dividing either 365 days or 12 months by creditors turnover ratio. The average payment period is calculated as: 365 days Current Debt or Average Payment Period = Creditors Turnover = Number of days Alternatively, =
12 months = Number of months Credit Turnover Ratio
Creditors turnover ratio and average payment period measures help the managers to know cash outflows, i.e., how often cash is required to pay to accounts payables. (c) Working capital turnover ratio. This ratio is ascertained by dividing the turnover (sales) by working capital. Working capital means current assets minus current liabilities. This ratio indicates how effectively the working capital is utilized to generate sales revenue during the accounting period. A high ratio indicates the efficient use of working capital, whereas a low ratio indicates inefficient use of working capital. This ratio is calculated as: Turnover (Net sales) Working Capital Turnover Ratio = Working Capital = Number of Times Since, working capital is a key source for generating sales revenue, if it turns over more number of times, the enterprise is able to earn more. Further, working capital turnover ratio is considered as most significant from the view point of generating sales revenue and inflow of cash.
Note: Current Assets = cash, bank balance, short-term investment, trade debtors, bills receivables, short-term loans and advances, inventories and expenses paid in advance. Current Liabilities = trade creditors, bills payables, bank overdraft, interest due on loans and debentures. Provision for taxation proposed dividends, unclaimed dividends, incomes received in advance, outstanding expenses, any debts due during the year.
(d) Total assets turnover ratio. This ratio is used to measure the level of future income flows. This ratio is calculated by dividing turnover (net sales) by total assets. This ratio is important because, it is intended to reflect the intensity with which assets are turned over. A high ratio is an indication of the efficient use of assets, whereas a low ratio is an indication of inefficient use of assets. This ratio is calculated as: Total Assets Turnover Ratio = Turnover (Net sales) = Number of times Total assets Any enterprise which intends to assess the intensity of the use of assets or efficient use of assets is bound to rely on this ratio.
558
Illustration
9.7
Calculation of Activity Ratios From the following balance sheet of Matrix Ltd and other information provided to you calculate (1) stock turnover ratio, (2) debtors turnover ratio, (3) creditors turnover ratio, (4) working capital turnover ratio and (5) total assets turnover ratio. Balance Sheet of Matrix Ld as on March 31, 2010
Liabilities Equity share capital 1,00,000 shares of `.10 each Reserves and Surplus Sundry Creditors Bills payable Provision for Income Tax 4,00,000 4,40,000 Investments (short-term) 60,000 Stock 1,00,000 Sundry Debtors Bills Receivable Cash at Bank Cash in Hand Total 20,00,000 Total Amount ` Assets Fixed Assets 10,00,000 Less: Accumulated Depreciation Amount ` 10,00,000 2,00,000 8,00,000 2,00,000 2,00,000 4,00,000 1,00,000 1,00,000 2,00,000 20,00,000
Additional Information: (a) Total purchases during the year were `52,00,000 of which `2,00,000 were cash purchases, (b) sales were fully on credit basis which amounted to `62,00,000 of which sales returns were `2,00,000, (c) opening stock recorded in the books was `2,00,000. Solution 1. Stock Turnover Ratio = = Cost of Goods sold Average Inventory 52,00,000 = 26 times 2,00,000
Therefore, stock has turned over 26 times in this accounting year. Comment: Stock turnover ratio amounts to 26 times. This ratio is really good, because the increased frequency with which the stock has turned over (26 times) will have contributed for increased profits and cash inflows. Working Notes (a) Cost of Goods sold = Opening Stock + Purchases Closing Stock = (`2,00,000 + `52,00,000 `2,00,000) = `52,00,000 (b) Average Inventory = Opening Stock + Closing Stock 2 = (`2,00,000 + `2,00,000 2) = ` 4,00,000 = `2,00,000 2 365 days Stock Turnover Ratio 365 = 14 days 26
(c) Average Age of Stock = =
559
Therefore, average age of the stock is 14 days. Comment: Stock turnover in days or average age of stock is 14 days. That means inventory has not been in stock for more than 14 days after purchase. This ratio indicates the fast movement of goods (sales) contributing for increased profits and cash inflows. Credit Sales 2. Debtors Turnover Ratio = Average Debtors + Average B/R = 60,00,000 60,00,000 = = 12 times 4,00,000 + 1,00,000 5,00,000
Therefore, on an average debtors are collected 12 times in a year. Further, if we calculate the debtors collection period, it shows the number of days or months in which debtors are collected. Here, the debtors collection period is 365 days = Debtors Turnover Ratio = 365 = 30.4 or 30 days approximately. 12
Therefore, debtors collection is not delayed beyond one month. Comment: Both the measures indicate a favourable sign because debtors turnover ratio of 12 times and debtors collection period of 30 days indicate the fast frequency with which debtors are collected. That means the company is able to meet its shortterm liabilities whenever they fall due and the cash inflows are so strong that the company is able to meet any challenge of its operational activities. Working Notes (a) Credit Sales = Total sales (Returns + Cash sales) = `62,00,000 (`2,00,000 + NIL) = `62,00,000 `2,00,000 = `60,00,000 Moreover, the information given by the enterprise shows that sales were fully on credit basis. (b) Average Debtors = [Opening Debtors + Closing Debtors 2] In the absence of the opening debtors, it is assumed that the closing debtors are equal to average debtors. (c) Average B/R = [Opening B/R + Closing B/R 2] In the absence of opening B/R, it is assumed that the Closing B/R is equal to Average B/R. Credit Purchases 3. Creditors Turnover Ratio = Average Creditors + Average B/P = `50,00,000 `50,00,000 = = 10 times ` 4,40,000 + `60,000 `5,00,000
Therefore, creditors are paid ten times in this accounting year. Further, if we calculate, the average payment period it shows the number of days or months taken on an average to pay to the creditors. Here, the average creditors payment period is 365 days = Creditors Turnover Ratio
560
365 = 36.5 or 37 days apprx. 10 times
Therefore, on an average, creditors are paid within 37 days time. Comment: Both the measures indicate a favourable sign, i.e., creditors payment is not delayed beyond 37 days from the date of the credit. That means the company is able to maintain good relationship with creditors which enables the company to get more credit based on the requirement. Another important feature of this company is that the debtors are collected in 30 days time and creditors are paid in 37 days time. That means the company enjoys better cash inflows, which provides more confidence to the manager to enhance operational activities to earn more. Working Notes (a) Credit Purchases = Total Purchases (Purchase Returns + Cash Purchase) = `52,00,000 (Nil + 2,00,000) = `52,00,000 `2,00,000 = `50,00,000 (b) Average Creditors = [Opening Creditors + Closing Creditors 2] In the absence of opening creditors, it is assumed that closing creditors are equal to average creditors. (c) Average B/P = [Opening B/P + Closing B/P 2] In the absence of the opening B/P, it is assumed that closing B/P are equal to average B/P. 4. Working Capital Turnover Ratio Turnover (Net Sales) = Number of times = Working Capitals = = Total Sales Sales Returns Current Assets Current Liabilities `62,00,000 ` 2,00,000 `60,00,000 = = 10 times `12,00,000 `6,00,000 `6,00,000
Therefore, working capital has turned over 10 times during the accounting year. Comment: Working capital turnover ratio is quite high (10 times in a year). That means, the company has been able to earn more sales revenue and increased cash inflows, which have contributed for earning more profits and to gain more strength. Working Notes (a) Current Assets = Total Assets Fixed Assets `20,00,000 `8,00,000 = `12,00,000
Note: Except fixed assets, all other assets given here fall under current assets.
(b) Current Liabilities = Sundry Creditors + Bills Payable + Provision for Income Tax = `4,40,000 + `60,000 + `1,00,000 = `6,00,000 (c) Net Sales or Turnover = Total Sales Sales Returns = `62,00,000 `2,00,000 = `60,00,000
561
5. Total Assets Turnover Ratio = Turnover (Net sales) Total Assets = `60,00,000 = 3 times ` 20,00,000
Therefore, total assets have turned over three times during the accounting year. Comment: Total assets turnover ratio of three times in a year is fairly good. The intensity of total assets turnover being moderately high, we can infer that the company has used the assets efficiently.
5. Gearing ratio: Gearing ratio establishes a relationship between the Equity Capital and Interest bearing Loan Capital + Fixed dividend carrying preference capital. [Here, equity capital means paid up equity share capital + reserves + surplus fictitious assets]. In the sense, the relation of equity capital to interest bearing long-term loans (debentures, bonds, public debts, etc.) and preference share capital is described as capital gearing. A company can raise funds by the issue of equity shares, or /and by the issue of preference shares and by the issue of debentures, loan, bonds and inviting public debts. If a company has raised capital by the issue of debentures or by inviting public debts which bear fixed rate of interest or by the issue of preference shares which carry fixed rate of dividend, the company is said to have geared the capital. If the interest bearing borrowed capital (including preference share) is more than the equity capital, it indicates that capital gearing is high and if the equity capital is more than the borrowed capital, the capital gearing is low. The intensity of gearing depends upon the ratio of borrowed capital and equity capital. Equity shares form owners equity on which dividends are paid out of profits, whereas, debentures and long-term loans bear interest which is a charge on the profit and loss account. On the pretext that borrowed capital is cheaper, the financial managers prefer to opt for capital gearing. The paradox is that highly geared companies find it difficult to raise additional funds through borrowed capital, as the potential investors feel that the profits of the company (earned at present) are not sufficient to pay the interest on future borrowings. Similarly, the potential investors in equity also hesitate to invest in the company as the present profits of the company do not enthuse them to invest. In the case of low-geared companies the major burden of financing the capital lies on equity shareholders which amount to raising of funds through costly source. Since dividend is not a charge on the profit and loss account and the entire profit attracts tax, the distributable profits will be very much less. This situation may not encourage the potential investors of both the categories. Therefore, the financial manager should be extra cautious while indulging in capital gearing. In the sense, proportionate matching of the equity capital and borrowed capital is a tight rope walking exercise. Most commonly used methods of measuring gearing ratio are: (a) Measuring relationship between fixed charge capital and equity capital; (b) measuring relationships between fixed charge capital and total long-term capital. (i) Fixed Charge Capital (Long-term Loan + Preference Shares) 100 Equity Capital (Paid up Capital + Reserves Fictitious Assets)
Scale of measuring capital gearing under first method: (a) If gearing is less than 100, the business is low geared.
562
(b) If the gearing is equal to 100, the business is neutrally geared. (c) If the gearing is more than 100, the business is high geared. (ii) Fixed Charge Capital (Long-term Loans + Preference Shares) 100 Total Long-term Capital (Equity + Preference + Borrowed) Scale of measuring capital gearing under second method is as follows: If gearing is less than 50, the business is low geared. If the gearing is equal to 50, the business is neutrally geared. If the gearing is more than 50, the business is high geared. Example for high gearing and low gearing. * Figures are hypothetical
Particulars Equity share capital 10% Preference shares 9% Redeemable Preference share capital 8% Debentures General Reserves Profit and loss Appropriation account Gearing ratios High gearing (`) 12,00,000 8,00,000 16,00,000 8,00,000 2,00,000 2,00,000 48,00,000 16:32 1:2 32: 16 2:1 Low gearing (`) 30,00,000 8,00,000 2,00,000 6,00,000 2,00,000 48,00,000
Exhibit 9.8
Working Notes
Particulars Equity Capital Equity + General Reserves +P/L Account (`12,00,000 + `2,00,000 + 2,00,000) (`30,00,000 + `2,00,000 + Nil) Borrowed Capital 10% Preference shares + 9% Redeemable preference shares + 8% Debentures (`8,00,000 + `16,00,000 + 8,00,000) (`8,00,000 + `2,00,000 + 6,00,000) 16,00,000 32,00,000 High gearing (`) Low gearing (`)
32,00,000 16,00,000 Ratio = 16: 32 or 1:2 Ratio = 32:16 or 2:1
Notes: (i) The exhibit has shown the extreme situations. (ii) Both the extremes are not good. (iii) Proper matching of equity capital with that of borrowed capital depends on the intelligence of the financial manager. (iv) The balancing act depends on internal situation of the company and the external market environment, i.e., the potential investors behaviour.
mARKET VALUE / mARKET STRENGTh / INVESTORS RATIOS ANALYSIS

Market strength is ascertained by comparing different ratios, such as earnings per share, dividend per share, dividend yield, dividend cover, dividend payout ratio, dividends to cash flow, price/earning ratio, earning yields, net asset value per share and cash flow per share.
563
Market value/market strength analysis is very important for the present equity investors (present shareholders) and potential investors. That is why it is called investors ratio analysis. As these investments (shares) are traded and the price is determined in the stock exchange, they are also called stock market ratios. This analysis helps the present investors to decide on the issue of whether to continue with the company as investor or not and should additional investments be made in the company for getting better benefits and security. The potential investors are able to decide on their investment strategy. Market strength analysis is used to appraise the performance of the companies in terms of share prices and yields. Earning efficiency ascertained in relation to market prices serves as a better measure to be relied upon for taking a strategic decision relating to equity investment. The important market value/market strength/stock market/ investors ratios are: (a) Earnings per share. This ratio is calculated as: EPS = Earnings after Tax Preference Dividend Number of Equity Shares
Earnings mean the net earnings/net income/net profit available for distribution to equity shareholders. Based on the recommendation of the Board of Directors of the company, the entire net earnings may be distributed to the shareholders in the form of dividends or a part may be distributed. Nevertheless, the total net earnings belong to equity shareholders. That is why earnings per share is derived by dividing the net profit (after payment of tax and preference dividends) of the company by the total number of equity shares outstanding. Earnings per share may be primary or diluted. Earnings per share is primary when the net earnings are divided by the existing number of equity shares. Earnings per share is diluted when the net earnings are divided by the existing number of equity shares plus the number of converted debentures and bonds into equity shares. If, debentures and bonds are converted into equity shares any time during the year, they are considered, as though they were converted in the beginning of the accounting year, the interest paid upto the date is added back to the net earnings and then, such total net earnings are divided by the number of existing plus converted debentures and bonds into shares. Earnings per share ratio is very important from the view point of both investors and the management, because this ratio forms the basis for predicting the values of equity shares. EPS serves as Return on Investment (ROI) per share. When ROI exceeds the interest charge on long-term debts (debt servicing cost), the impact of debt financing is favourable on EPS. Conversely, if ROI does not exceed debt servicing cost, the impact of debt financing is unfavourable on EPS. Therefore, EPS contributes for strategic decision making, i.e., the management to decide on the pattern of debt financing and the investors to decide on their investment pattern. (b) Dividend per share. It is the return a shareholder is able to get on each share in the form of dividend. The dividend per share can be gross dividend per share or net dividend per share. Net Dividend per Share = Gross Dividend Dividend Tax. Conversely, Gross Dividend per Share = Net Dividend per Share + Dividend Tax Credit.
564
Dividend per share is calculated as Dividend paid to equity shareholders (i) Net Dividend per share = Number of equity shares outstanding (ii) Gross Dividend per share = Net Dividend 1 Basic rate of tax
(c) Gross dividend yield: Dividend yield is the ratio between current dividend per equity share and current market price per equity share. Gross dividend yield is expressed as percentage to facilitate easy comparison. It is calculated as: Gross Dividend per share Gross Dividend Yield = 100 Market Value per share Gross dividend yield reflects the current level of income from a share and facilitates better comparison with other types of investments income. Further, the dividend yield also reflects the market estimates of future dividend growth and risk which helps in investment decision strategy. (d) Dividend cover. It establishes a relationship between earnings per share and dividend per share. It describes the number of times dividend per share is covered by earning per share. Dividend cover helps to assess the prospects for dividend, i.e., possibility of dividend increase or dividend decrease based on the increase or decrease of profits. For calculating dividend cover total net earnings per share is taken into consideration irrespective of the net earnings used for distribution of dividends. Dividend cover is calculated as: Earnings per Share Dividend Cover = Dividend per Share (e) Payout ratio/Dividend payment ratio. Payout ratio is expressed in percentage to indicate the proportion of earnings per share paid to equity shareholders. Percentage of available earnings paid to equity shareholders as dividends has a greater influence on the market behaviour on the issues not in growth category. A company may pay dividends in the form of stock and cash. Then, for calculating payout ratios, only the cash dividends should be taken into consideration and not the dividend paid in the form of stock (when the dividend is paid in the form of stock there is no outflow of cash, there is only conversion of earnings into share capital). Dividend payout ratio is calculated as: Net Dividend per Share 100 Payout Ratio = Net Earnings per Share (f) Dividends to cash flow. Dividends to cash flow is an absolute measure, which indicates the outflow of cash in the form of dividend paid to net earnings available for equity shareholders. On comparison, this ratio helps in understanding the past trend and estimates the future dividends. Though, this ratio looks similar to pay out ratio, it differs from it, as it is able to show the cash outflow. This ratio is calculated as: Dividend Paid on Equity Shares Dividend to Cash Flow = Net Earnings Available to Equity Shares (g) Price/earning ratio or P/E ratio. P/E ratio establishes a relationship between EPS and current price of the share. It is an expression of market price of shares as a multiple of earnings per share. It is the reciprocal of earning yield multiplied
565
by 100. In the sense, P/E ratio gives the number of rupees paid for one rupee of companys annual net earnings. P/E ratio is considered by many as the best indicator of the on going performance of a company. The shares that have high P/E ratio are considered as high growth shares. Conversely, shares that have low P/E ratio are considered as low growth shares. Investors are prepared to pay a greater multiple of current earnings to achieve higher growth in future. If the shares are found to suffer from risk, market price reduces and in turn P/E ratio also reduces. Payout ratios have an influence on P/E ratios which in turn influence market price of shares to be either high or low. A steady high market price contributing for high P/E ratio will strengthen the future growth which in turn influences to pay more for the shares now and earn more in the future. Therefore, P/E ratio is considered as a best measure for strategic investment decisions. This ratio is calculated as: Market Price per Equity Share Price/Earning Ratio = Earnings per Equity Share (h) Net assets value per share/Book value per share. Net assets value per share is obtained by dividing net (tangible) assets by number of equity shares outstanding at the balance sheet date. Its expression denotes the value of net (tangible) assets attributable to one equity share. Though this ratio represents the net asset value per share, the price of the share in the market may be very different (i.e., market price may be higher or lower than this ratio). Net asset value per share is useful for comparing the shares of one company with the other companies operating in the same industry. On comparison, you find a companys share can be bought at price less than its net asset value. It indicates that the share will have good value in future. Generally, mutual fund companies rely on net assets value per share ratio for their buying and selling activities. This ratio is calculated as: Net Asset Value per share Equity Share Capital + Reserves and Surplus Intangible Assets = Number of Equity Shares Outstanding at the Balance Sheet Date (i) Cash flow per share. Cash flow per share is in a way a leverage ratio which indicates the ability of the company to its earnings and cash to pay the dividends. No doubt the entire earnings belong to equity shareholders but not the cash flow because cash flow should be used to pay the expenses and claims prior to the payment of dividend. However, the cash flow from operations remaining after the payment of taxes is used to ascertain cash flow per share. This ratio is ascertained as: Cash flow from operation after taxes Cash flow per share = Equity shares outstanding at the balance sheet date The different ratios discussed under investors analysis are the ratios which are interlinked and used to appraise the performance of companies in terms of share prices and yields. Let us understand these ratios through Illustration 9.11.
566
Illustration
9.8
The following information is extracted from the books of Kshema Company Ltd for the year ended on March 31, 2010.
Particulars Share capital: 1,00, 000 equity shares of `10 each 9% Preference shares of `10 each General reserve Profit (after tax @ 30%) Equity Dividend paid Market price for equity shares ` 10,00,000 5,00,000 3,45,000 5,00,000 20 `50 per share
There are no fictitious assets in the company. You are required to calculate the following market strength ratios: 1. Dividend yield on equity shares 2. Dividend per equity share and preference share 3. Dividend cover for equity and preference shares 4. Dividends to cash flow 5. Payout ratio 6. Earnings per equity shares 7. Price earning ratio 8. Cash flow per share 9. Net assets value per share Solution
1. Dividend yield on equity shares = Dividend per Share Market Value per Share (20% of `10) = `2 100 = 4% `50 Dividend paid to Equity Share Number of Equity Shares (20% of 10,00,000) = 2,00,000 100 1,00,000
= 2. (a) Dividend per equity shares = =
= `2 per share Dividend Paid to Preference Share (b) Dividend per preference shares = Number of Preference Shares =
(9% of 5,00,000) = 45,000 100 50,000
= `0.90 per share Earnings per Equity Share 3. (a) Dividend cover for equity shares = Dividend per Equity Share =
`8,00,000 1,00,000 = 8 `2
= `4 per share
567
Net earnings: `3,45,000 + `5,00,000 `45,000 preference dividend = `8,00,000 Earnings per Preference Share (b) Dividend Cover for Preference Shares = Dividend per Preference Share =
` 45,000 50,000 `0.90
= `0.10 per share

Dividend Paid to Equity Shares 4. Dividend to cash flow = Net Earnings Available to Equity Shares
= 5. Payout ratio = =
` 2,00,000 = `0.25 per share `8,00,000
Net Dividend per Equity Shares 100 Net Earnings per Equity Shares
`2 100 = 50% `4 Earnings after Tax Preference Dividend 6. Earnings per share = Number of Equity Shares
= = 7. Price earning ratio = =
`5,00,000 45,000 1,00,000 4,55,000 = `4.55 per share 1,00,000 Price per Equity Shares Earnings per Share
`50 = 10.99 ` 4.55 Cash Flow from Operations after Tax 8. Cash flow per share = Number of Equity Shares Outstanding
`5,00,000 = `5 per share 1,00,000 Equity Share Capital + Reserve Intangibles Number of Equity Shares Outstanding `10,00,000 + `3,45,000 Nil 1,00,000 `13,45,000 = `13.45 per share 1,00,000
9. Net assets value per share = = =
Note: These ratios are appropriately interpreted to assess the market strength.
STABILITY AND GROWTh ANALYSIS (RATIOS)

Stability and growth can be tested by comparing the performance and financial strength of the company apart from market valuation over a period of time (say, three years). Therefore, these ratios are calculated over time and relate to sales, total returns, earning per share, etc. In fact, these ratios are useful in evaluating the quality of preference
568
shares, debentures and bonds. Primarily, management is interested in these ratios. Of course, investors may also be inquisitive to know the stability and growth. Generally, a base period is selected for comparison. The ratios obtained for the final period are compared with the base period ratios. Whether the ratios are declining, increasing, stable are taken into account for drawing inference on growth and stability. Comparing the average of the ratios over time (say, three years) with the respective ratios of the worst period or lower year ratios are also computed to know the decline in growth during the worst period. Generally, growth in sales, growth in total returns, growth in earnings along with worst year comparisons are the ratios that are used to assess the stability and growth.
Note: Selection of the ratios of comparison is left to the discretion of the user.
Such ratios are calculated as follows: 1. Growth in sales = Sales in final period Sales in base period Net earnings for total capital in final period Net earnings for total capital in base period
2. Growth in total return = 3. Growth in earnings =
Earnings per Share in final period Earnings per Share in base period
4. Percentage decline in return on total capital Worst year (or Lower year) return on total capital = Average of previous three years return on total capital 5. Percentage decline in return on equity capital Worst year (or Lower year) return on total capital = Average of previous three years return on total capital 6. Percentage decline in earnings per share = Worst year or lower year EPS Average of previous three years EPS
7. Maximum decline in coverage of interest charges Worst year or lower year interest charges = Average of previous three years interest charges
Note: Interest charges may include any of the following combinations: (i) Interest on short- and long-term debts, including capital leases. (ii) Interest on expenses plus an interest component for operating leases. (iii) Interest on expenses on short- and long-term debts. (iv) Total fixed charges, rentals and preference dividends
Stability and growth ratios specifically help the management to take stringent policy measures to ensure growth and generally the investors to decide on the investment strategy. Illustration 9.9 helps us in understanding these ratios.
569
Illustration
9.9
The following information is extracted from Dera Steel Ltd. for four years from 2007 to 2010. Calculate the growth ratios and comment on the result.
Particulars Growth in Sales (%) Growth in Total Returns (%) Growth in Earnings (%) Interest Cover Ratio Returns on Equity Capital Final Period 2009 15.32 18.46 20.41 25.92 36.79 Worst Period 2008 4.43 0.73 0.93 31.03 51.13 2007 35.42 74.66 98.95 24.15 63.79 Base period 2006 22.72 62.85 72.50 12.74 38.18
Solution 1. Growth in Sales = =
Sales in final period Sales in base period 15.2 = 0.67 22.72 Net earnings for total capital in final period Net earnings for total capital in base period 18.46 = 0.29 62.85
2. Growth in Total Return = = 3. Growth in Earnings = =
Earnings per Share in final period Earnings per Share in base period 20.41 = 0.28 72.50 Worst year (or Lower year) return on total capital Average of previous three years return on total capital 0.73 = 0.016 46.00
Final period 2009 18.46 Worst period 2008 0.73 2007 74.66 Base period Average 2006 62.85 46.00
4. Percentage decline in return On Total Capital = Working Notes

Average of three years
5. Percentage decline in returns on equity Capital = =
Worst year (or lower year) return on total capital Average of previous three years return on total capital 50.13 = 0.988 50.73
Final period 2009 36.79 Worst period 2008 50.13 2007 63.79 Base period Average 2006 38.18 50.73
Working Notes
570

6. Percentage decline in earnings per share = =
Worst year or lower year EPS Average of previous three years EPS 0.93 = 0.016 57.46
Final period 2009 20.41 Worst period 2008 0.93 2007 98.95 Base period 2006 72.50 Average 57.46
Working Notes
7. Maximum decline in coverage of interest charges = =
Worst year or lower year interest charges Average of previous three years interest charges 33.03 = 1.37 22.64
Final period 2009 25.92 Worst period 2008 31.03 2007 24.15 Base period 2006 12.74 Average 22.64
Working Notes
Comments Growth in sales has come down by 0.67 percentage point in final period (2009) compared to base period sales (2006). This has resulted in decline in growth return by 0.29 percentage point and growth in earnings by 0.28 percentage point. Marginal decline in the growth of total returns and growth in earnings compared to sales may be due to managements strategic decision to keep the investors to go along with the company despite the decline in growth. Comparison of the worst period results indicate that decline in return in total capital and earnings per share at 0.016 percentage point, where as, returns on equity capital at 0.988 percentage point, which indicates that major share of decline is passed on to equity shareholders. Maximum decline in coverage of interest charges amount to 1.37 percentage point under worst year comparison.
CRITICISmS OF FINANCIAL STATEmENT ANALYSIS OR PUBLIShED ACCOUNTS

The last part of the accounting information system is its criticism. Criticism means understanding the financial statement through their analysis and interpretation to form an opinion or to draw interference to make a decision. Therefore, criticism depends upon the purpose for which the reported information is analysed and interpreted. For example, a potential investor intends to decide whether to invest in a company, what security is favourable (equity, preference, debenture), etc. Broadly, criticisms are based on these three general areas: (1) Form in which it is presented; (2) Reliability of the information, and (3) Future prospects of the enterprise.
571
1. Criticism of the form: If the following factors are satisfactory, then one can consider the financial statements presented as true and fair. (a) Whether the information presented is in accordance with law, i.e., the form and the contents satisfy the legal norms. (b) Whether the accounts are properly classified. (c) Whether the accounts bear a proper title. (d) Whether the information provided is true and fair. (e) Whether the balance sheet is drawn in accordance with Schedule VI Part I and the profit and loss account in accordance with Schedule VI Part II. (f) Whether the income statement is able to provide necessary details required for analysis. (g) Whether the assets, liabilities and capital are properly and systematically shown in the balance sheet. (h) Whether the necessary working notes, schedules, etc., are enclosed. 2. Criticism of reliability: It is said rarely published accounts tell the full story expected to be told. That means, even though legal formalities are fulfilled, certain figures presented in the financial statements are subject to criticism. For example, treatment of depreciation, valuation of stock, capitalization of expenses. A careful scrutiny of every item recorded, its background and its treatment (with or without intention), the relationship between income and utilization of assets will ensure the reliability of information presented. 3. Criticism on future prospects: To ascertain the future prospects of the enterprise, different tests for different purposes are suggested. By applying these tests, individually or in combination, one can assess the future prospects of the enterprise. For example, tests relating to profitability, liquidity, solvency, stability, growth, etc., may be conducted to predict the future prospects. The shareholders, debenture holders, banks, creditors, prospective investors and management and employees of the enterprise are interested in future prospects.
Illustration 9.10
The following are the summarized profit and loss account of Power products Ltd for the year ending on March 31, 2010 and balance sheet as on that date. Power Products Profit and Loss Account for the Year Ending March 31, 2010
Particulars To Opening Stock To Purchases To Incidental Expenses To Gross Profit c/d Operating Expenses: To Selling and Distribution Expenses To Administration Expenses To Financing expenses 90,000 4,50,000 45,000 ` 2,98,500 16,35,750 42,750 10,20,000 29,97,000 By Gross Profit b/d Non-operating Income Interest Profit on sale of shares 9,000 18,000 (Contd.) 29,97,000 10,20,000 Particulars By Sales By Closing Stock ` 25,50,000 4,47,000
572
(Contd.)

Particulars To Non-Operating expenses Loss on sale of assets To Net profit Total ` 12,000 4,50,000 10,47,000 Total 10,47,000 Particulars `
Balance Sheet as on March 31, 2010

Liabilities Issued Capital 2,000 equity shares of `100 each Reserves Current liabilities Profit and loss account Total ` Assets Land and buildings 6,00,000 Plant and machinery 2,70,000 Stock in trade 3,90,000 Sundry debtors 1,80,000 Cash and bank balances 14,40,000 Total ` 4,50,000 2,40,000 4,47,000 2,13,000 90,000 14,40,000
From the above statements, you are required to calculate the following ratios and state the purpose they serve: 1. Gross profit ratio 2. Net profit ratio 3. Operating profit ratio 4. Operating ratio 5. Current ratio 6. Acid-test ratio Solution 1. Gross profit ratio = Gross profit Sales `10,20,000 = 100 = 40% ` 25,50,000
Purpose: The purpose of this ratio is to test profitability of an enterprise relating to trading activity. Net profit 100 2. Net profit ratios = Sales ` 4,50,000 100 = 17.64% = ` 25,50,000 Purpose: The purpose of this ratio is to test profitability of an enterprise. Operating profit 100 3. Operating profit ratio = Sales ` 4,35,000 100 = 17.05% = ` 25,50,000 Purpose: The purpose of this ratio is to test profitability of an enterprise from operations.
573
Note on Operating Profit

Particulars Net Profit Non-operating expenses (+) Less: Non Operating Income Operating profit ` 4,50,000 12,000 4,62,000 27,000 4,35,000
6. Operating ratio =
Cost of Goods Sold + Operating Expenses 100 Sales `15,30,000 + `5,85,000 100 = ` 25,50,000 = ` 21, 15,000 100 ` 25,50,000
= 82.95% Purpose: The purpose of this ratio is to test operating efficiency of an enterprise. Note on goods sold
Particulars Opening Stock Purchases Incidental expenses Less: Closing Stock Cost of Goods Sold ` 2,98,500 16,35,750 42,750 19,77,000 4,47,000 15,30,000
Note on Operating Expenses

Particulars Selling and Distribution Expenses Administration Expenses Financing expenses Operating Expenses ` 90,000 4,50,000 45,000 5,85,000
8. Current ratio = =
Current Assets Current Liabilities `7,50,000 = 1.9:1 `3,90,000
Purpose: The purpose of this ratio is to test liquidity of an enterprise. Calculation of total Current Assets
Particulars Stock in trade Sundry Debtors Cash and Bank Balances Total Current Assets ` 4,47,000 2,13,000 90,000 7,50,000
574

10. Acid test ratio =
Liquid Assets Current Liabilities 3,03,000 = 0.77: 1 = 3,90,000
Purpose: The purpose of this ratio is to test liquidity of an enterprise considering cash and cash equivalents as numerator. Calculation of Liquid Assets
Particulars Sundry Debtors Cash and Bank Balances Total Liquid Assets ` 2,13,000 90,000 3,03,000
Illustration 9.11
The following are the accounting reports prepared and presented by Dhanyalaksmi Ltd. for the year ending March 31, 2010. Dhanyalakshmi Ltd Income Statement (` in thousands)
Particulars Sales (all Credit) Less: Cost of Goods Sold Opening Inventory urchases Less: Closing Inventory Gross Margin Less: Operating Expenses Profit before tax Less: Provision for taxation Profit After Tax ` ` 1,500
500 1,025 1,525 400
1,125 375 285 90 40 50
Dhanyalakshmi Ltd Balance Sheet as on March 31, 2010 (` in thousands)

Particulars I. Sources of Funds 1. Shareholders Funds: (a) Paid up Capital (b) Reserves and Surplus 2. Loan Funds: (a) Secured loans (b) Unsecured loans Total (Capital Employed) Schedule ` `
1 2 3 4
400 225 125 -
625
125 750 (Contd.)

(Contd.) Particulars II. Application of Funds 1. Fixed Assets (a) Gross block (b) Less: depreciation (c) Net block (d) Capital work-in-Progress Total Fixed Assets 2. Investments: 3. Current Assets, Loans and Advances: Current Assets (a) Inventories (b) Sundry Debtors (c) Cash and Bank Balances (d) Other Current Assets Loans and Advances (e) Loans and Advances Total Current Assets , Loans and Advances Less: Current Liabilities and Provisions: (a) Current liabilities (b) Provisions Total Current Liabilities and Provisions Net Current Assets 4. (a) Miscellaneous expenditure to the extent not written-off or adjusted. (b) Profit and Loss account (debit balance, if any) Total 11 [CL] [CA- CL] 10 8 [CA] 9 (-) 460 (-) 40 500 850 7 400 300 150 6 Schedule 5 525 125 400 ` `
575
400 -
350
750
Schedule 1: Shareholders Fund

Particulars Paid up Capital `000 400
Schedule 2: Reserves and Surplus

Particulars Reserves Un-appropriated Profit Total `000 150 75 225
Schedule 3: Secured Loans

Particulars Loan on Mortgage `000 125
576
Schedule 5: Fixed Assets

Particulars Land Buildings Plant Total `000 325 200 525
Schedule 5: Depreciation
Particulars Provision for depreciation on Plant Total `000 125 125
Schedule 9: Current Liabilities and Provisions Current Liabilities

Particulars Accounts Payable Accrued expenses Total `000 435 25 460
Provisions
Particulars Provision for Income tax Total Total Current Liabilities and Provisions `000 40 40
`000
500
Name and calculate the ratios which indicate: 1. The speed at which accounts receivables are collected 2. The ability of the company to meet its current obligations 3. What mark-up has been attained 4. The efficiency with which funds presented by inventories are being utilized and managed 5. The ability of the company to meet quickly demands for payment of amounts due 6. The relative importance of proprietorship and liabilities as source of funds Solution
1. Debtors turnover ratio: It is used to calculate the speed at which accounts receivables are collected.
Debtor turnover ratio = Net annual credit sales Debtors `15,00,000 = 5 times `3,00,000 Number of days in a year Debtor turnover ratio
Debt collection period =
577
Debt collection period =
365 days = 73 days 5 Times
Comment: On an average, debtors are collected in 73 days. Inference: The longer the debt collection period, the more will be the requirement for working capital. Also it implies that there are possibilities of doubtful and bad debts. 2. Current ratio: It is used to ascertain the ability of the company to meet its current obligations. Current Ratio = Current assets Current liabilities `8,50,000 = 1.7: 1 `5,00,000
Comment: Company has `1.7 of current assets as against `1 current liabilities. Inference: Standard current ratio is 2:1. In this case it implies that the company can pay its current liabilities with little difficulty. 3. Gross profit ratio and net profit ratio: They are used to ascertain the mark up (the percentage of gross profit to sales and net profit before tax to sales). Gross profit ratio = Gross profits 100 Sales `3,75, 000 100 = 25% `15,00,000
Comment: Gross profit of the company is 25% on sales. Inference: Higher GP ratio implies better earning capacity of the firm. But 25% GP ratio implies average trading efficiency. Percentage of net profit to sales = Net profit before tax 100 Sales `90,000 = 6% `15,00,000
Comment: Net profit before tax of the company is 6%. Inference: High percentage of net profit to sales denotes higher operating efficiency of the company. But 6% net profit implies that the companys operating efficiency is not up to the mark. 4. Inventory turnover ratio: It is used to calculate the efficiency with which the funds represented by investors are used and managed. Inventory turnover ratio = Cost of goods sold Average inventory `11,45,000 = 2.54 times ` 4,50,000
Comment: Inventory turnover of the company is 2.54 times. Inference: The more the number of times, the greater will be the profitability of the company. But 2.54 times inventory turnover is far below the requirement to increase profitability.
578
5. Acid test ratio: It is used to ascertain the ability of the company to pay its dues quickly. Acid test ratio = Current assets inventory Current liabilities `8,50,000 4,00,000 = 0.9:1 `5,00,000
Comment: Acid test ratio of the company is 0.9. Inference: Generally, a standard ratio of 1:1 is preferred. It means for every one rupee of current liability, there should an equal amount of current asset. In this case acid test ratio is little shorter than the standard ratio, indicating marginal shortage of liquidity. 6. Debt equity ratio: It indicates the relative importance of proprietorship and liabilities as source of funds. Debt equity ratio (total debts) = Total debts Equity `6,25,000 = 1:1 `6,25,000
Comment: The company has equal amount of debt and equity in its capital structure. Inference: Generally, it is advisable to have more amount of debt than equity to take advantage of trading on equity. In this case, there is balanced trading on equity. Debt equity ratio (long-term debts) = Long-term debts Equity `1,25,000 = 0.2: 1 `6,25,000
Comment: Company has `1 of equity as against `0.2 of debt. Inference: It implies that company is depending more on equity then on long-term debts.
Illustration 9.12
You are given the following figures obtained from the books of Ideal Company Ltd for the year ending March 31, 2010 Current Ratio Liquid Ratio Net Working Capital Stock Turnover Ratio Rate of Gross Profit to sales Turnover to Fixed Assets (Net) Average Debt Collection Period 2.5 1.5 `15,00,000 6 20% 2 times 2 months
579
Fixed assets to net worth Reserves and surplus to capital Prepare a balance sheet from the above information.
0.80 0.50
Solution Given, net working capital = `15,00,000 Current ratio is known to be 2.5. It means, Current Asset: Current liability = 2.5: 1 Working capital = Current Asset Current Liabilities 15,00,000 = 2.5 1 15,00,000 = 1.5 `15,00,000 2.5 = `25,00,000 Current assets = 1.5 `15,00,000 1 = `10,00,000 Current liabilities = 1.5 Liquid ratio is known to be 1.5 Liquid assets, i.e., Current assets Stock Liquid ratio = Current Liabilities Liquid Assets 1.5 = `10,00,000 Liquid assets = `10,00,000 1.5 = `15,00,000 Calculation of Stock Stock = Current Assets Liquid Assets Stock = `25,00,000 `15,00,000 = `10,00,000 Calculation of Cost of Goods Sold Cost of Goods Stock turnover ratio = Stock Stock turnover ratio is known to be six times Cost of Goods Sold 6 = Stock Cost of Goods Sold 6 = `10,00,000 Cost of Goods sold = `10,00,000 6 = `60,00,000 Calculation of Sales Given that the GP ratio is 20%. Also, Sales = Cost of Goods sold + Gross profit Or Cost of goods sold = Sales Gross profit As GP is 20%, cost of goods sold is 80% (i.e. 100 20). Cost of goods sold 100 Therefore, sales = 80 `60,00,000 100 = `75,00,000 = 80 Calculation of Fixed assets Given, fixed assets turnover ratio is two times Cost of goods sold Also, fixed asset turnover ratio is = Fixed assets
580
2 =
60,00,000 Fixed assets
2 Fixed Assets = 60,00,000 60,00,000 Fixed Assets = 2 Fixed assets = `30,00,000 Calculation of Debtors Given, debt collection period is two months. Therefore, debtors velocity = 12 2 = 6 Sales Debtors Velocity = Debtors `75,00,000 6 = Debtors `75,00,000 Debtors = = `12,50,000 6 Shareholders net worth Given, fixed assets to net worth is 0.80. `30,00,000 1 Therefore, shareholders net worth is = 0.80 = `37,50,000 Share Capital + Reserves = Net Worth 1 + 0.5 1.5 `37,50,000 1 = `25,00,000 Therefore, share capital= 1.5 `37,50,000 0.5 = `12,50,000 Reserves and surplus = 1.5 Calculation of Cash Balance Current Assets = `25,00,000 (Debtors + Stock + Cash) `25,00,000 = `12,50,000 + `10,00,000 + Cash Therefore, cash balance = `25,00,000 22,50,000 = `2,50,000 Calculation of Long-term debts Assets = Liabilities (Fixed assets + Current Assets) = (Shareholders fund + Current Liabilities + Long-term Debts) (`30,00, 000 + `25,00,000) = ( `37,50,000 + `10,00,000 + Long-term debts) `55,00,00 = `47,50,000 + Long-term debts Therefore, long-term debt = `55,00,000 `47,50,000 = `7,50,000 Ideal Company Limited Balance Sheet as on March 31, 2010
Particulars I Sources of Funds 1. Shareholders Funds: (a) Share capital 1 25,00,000 (Contd.) Schedule ` `

(Contd.) Particulars (b) Reserves and Surplus 2. Loan Funds: (a) Secured loans (b) Unsecured loans Total (Capital Employed) II. Application of Funds 1. Fixed Assets: (a) Gross block (b) Less: Depreciation (c) Net block (d) Capital work-in-Progress Total Fixed Assets 2. Investments: 3. Current Assets, Loans and Advances: Current Assets (a) Inventories (b) Sundry Debtors (c) Cash and Bank Balances (d) Other Current Assets Loans and Advances (e) Loans and Advances Total Current Assets Loans and Advances Less: Current Liabilities and Provisions: (a) Current liabilities (b) Provisions Total Current Liabilities and Provisions Net Current Assets 4. (a) Miscellaneous expenditure to the extent not written-off or adjusted. (b) Profit and Loss account Total [CL] [CA-CL] 10 11 [CA] 9 10,00,000 10,00,000 25,00,000 8 7 10,00,000 12,50,000 2,50,000 6 5 30,00,000 30,00,000 3 4 7,50,000 Schedule 2 ` 12,50,000 `
581
37,50,000
7,50,000 45,00,000
30,00,000 -
15,00,000 45,00,000
Illustration 9.13
Prepare balance sheet and profit and loss account from the following information presented to you by Swastic Ltd at the end of the year March 31, 2010. ` Capital 32,00,000 Working Capital 14,40,000 Bank overdraft 2,40,000 There are no fictitious assets. In current assets there is no asset other than stock, debtors and cash.
582
Closing stock is 20% higher than opening stock 1. Current Ratio 2.5 2. Quick Ratio 2 3. Proprietary Ratio 6 (Fixed assets: Proprietary fund) 4. Gross Profit Ratio 20% on sales 5. Stock Velocity 5 6. Debtors Velocity 73 days 7. Net Profit Ratio 10% (to average capital employed) Solution Calculation of current assets and current liabilities Given, current ratio is 2.5. It means, current asset: current liability is 2.5: 1 Also, working capital is known to be `14,40,000 Working Capital = Current Assets Current Liabilities `14,40,000 = 2.5 1 `14,40,000 = 1.5 `14,40,000 2.5 = `24,00,000 Current Asset = 1.5 `14,40,000 1 = `9,60,000 Current Liabilities = 1.5 Components of Current Liabilities Bank Overdraft `2,40,000 Other Current Liabilities `7,20,000 `9,60,000 Calculation of Stock Given, Quick ratio = 2 Quick Ratio Liquid Assets, i.e. (Current Assets Stock) = Quick Liabilities, i.e. (Current Liabilities Bank OD) other Current Liabilities 2= Liquid Assets `7,20,000
Liquid Assets = `7,20,000 2 = `14,40,000 Stock = Current Assets Liquid Assets = `24,00,000 `14,40,000 = `9,60,000 Opening Stock Given, Closing Stock is 20% higher than the opening stock `9,60,000 100 = `8,00,000 Therefore, opening stock = 120 Calculation of average stock Opening Stock + Closing Stock Average Stock = 2 `8,00,000 + 9,60,000 = 2 = `8, 80,000
583
Calculation of Cost of Goods Sold and Sales Cost of Goods Sold Stock Turnover Ratio = Average Stock 5 = Cost of Goods Sold `8,80,000
Cost of Goods Sold = `8,80,000 5 = `44,00,000 Cost of Goods sold = Opening Stock + Purchases Closing Stock 44,00,000 = `8,00,000 + Purchases `9,60,000 Purchases = `45,60,000 ` 44,00,000 100 = `55,00,000 Sales = 80 Amount of Gross Profit = `55,00, 000 `44,00,000 = `11,00,000 Calculation of Debtors Given, debtors velocity = 73 days ` 44,00,000 100 Debtors = 80 73 = `55,00,000 = `11,00,000 365 Calculation of Cash Total current assets are known to be `24,00,000 Components of Current Assets: ` Stock 9,60,000 Debtors 11,00,000 Cash (Balancing figure) 3,40,000 24,00,000 Calculation of Fixed Assets Fixed assets to Proprietary funds is given to be 0.6 or 60% Therefore, working capital to Proprietary fund = 1 - 0.60 or 0.40 or 40% Hence, fixed assets = `14,40,000 60 = `21,60,000 40
Calculation of Proprietary funds Proprietary funds = Fixed Assets + Working Capital = `21,60,000 + 14,40,000 = `36,00,000 Calculation of Net Profit Given, net profit is 10% of average capital employed Average Capital Employed Opening Capital Employed + Closing Capital Employed = 2 Assume net profit as X X = 10% of 1/2 (Opening Capital X +Closing Capital) X = 10% of 1/2 (`36,00,000 X + 36,00,000) X = 10% of 1/2 ( `72,00,000- X) X = `3,60,000 1/20 X X = `3,44,000 approximately
584
Expenses = Gross Profit Net Profit 10,00,000 3,44,000 = `7,56,000 Calculation of Reserves Net worth (Proprietary fund) = Capital + Reserves + Profit and Loss Account 36,00,000 = `32,00,000 + Reserves + `3,44,000 Reserves = `56,000 Swastic Ltd Profit and Loss Account for the year ending March 31, 2010
Particulars To Opening Stock To Purchases To Gross Profit c/d To Expenses To Net Profit Total ` 8,00,000 45,60,000 11,00,000 64,60,000 7,56,000 3,44,000 11,00,000 Total 11,00,000 By Gross Profit b/d 64,60,000 11,00,000 Particulars By Sales By Closing stock ` 55,00,000 9,60,000
Swastic Ltd Balance Sheet as on March 31, 2010

Liabilities Capital Reserves and Surplus Profit and Loss Account Current Liabilities Bank OD Other Current liabilities Total 2,40,000 7,20,000 45,60,000 Total 45,60,000 ` 32,00,000 56,000 3,44,000 Assets Fixed assets Current Assets Stock Debtors Cash 9,60,000 11,00,000 3,40,000 ` 21,60,000
Alternative Solution When bank Overdraft is considered as part of current liabilities Current assets = `24,00,000 Current liabilities = `9,60,000 Quick Ratio is = 2 Liquid Assets Quick Ratio is = Current Liabilities Liquid Assets 2= `9,60,000 Liquid Assets = `9,60,000 2 = `19,20,000 Stock in trade = Current Assets Liquid Assets = `24,00,000 `19,20,000 = `4,80,000 ` 4,80,000 100 = `4,00,000 Opening Stock = 120
585
Average Stock =
` 4,80,000 + 4,00,000 2
= `4,40,000 Calculation of Cost of Goods Sold and Sales Cost of Goods Sold Stock turnover ratio = Average Stock 5 = Cost of Goods Sold ` 4,40,000
Cost of Goods Sold = `4,4 0,000 5 = `22,00,000 ` 22,00,000 100 = `27,50,000 Sales = 80
Amount of gross profit = 27,50,000 22,00,000 = `5,50,000 Calculation of Sundry Debtors Debtors = Sales Debtors Velocity 365 73 = `27,50,000 = `5,50,000 365
Net Profit as calculated above `3,44,000 Gross Profit Net Profit = Expenses `5,50,000 `3,44,000 = `2,06,000
Illustration 9.14
Certain items of annual accounts of BIMA Ltd are missing as shown below: Trading and Profit and Loss Account for the Year Ending March 31, 2010
Particulars To Opening Stock To Purchases To Other Expenses To Gross Profit c/d To Office Expenses To Interest on Debentures To Provision for Taxation To Net Profit for the year To Proposed Dividend To Transfer to General Reserve To Balance transferred to Balance sheet ` 17,50,000 ? 4,37,500 ? 18,50,000 1,50,000 ? ? ? ? ? By Balance b/d By Net Profit for the year 3,50,000 By Gross Profit b/d By Commission ? 2,50,000 Particulars By Sales By Closing Stock ` ? ?
586
Balance sheet as on March 31, 2010

Liabilities Paid up capital General Reserves: Balance at the beginning of the year Addition during the year Profit and Loss Appropriation Account 10% Debentures Current Liabilities ? ? ? ? ` 25,00,000 Assets Fixed Assets Plant and Machinery Other Fixed Assets Current Assets Stock Debtors Bank Balance ? ? 3,12,500 35,00,000 ? `
You are required to supply the missing figure with the help of the following information: 1. Current ratio 2: 1 2. Closing stock is 25% of sales 3. Proposed dividend are 40% of paid up capital 4. Gross profit ratio is 60% 5. Ratio of current liabilities to debentures is 2:1 6. Transfer to general reserves is equal to proposed dividend 7. Profit carried forward are 10% of the proposed dividend 8. Provision for taxation is 5% of profits 9. Balance to the credit of general reserves at the beginning of the year is twice the amount transferred to that account from the current profits. Working note should form part of your answer Solution BIMA Ltd Trading and Profit and Loss account for the year ended March 31, 2010
Particulars To Opening Stock To Purchases To Other Expenses To Gross Profit c/d To Office Expenses To Interest on Debentures To Provision for Taxation To Net Profit for the year To Proposed Dividend To Transfer to General Reserve To Balance transferred to Balance sheet total ` Particulars ` 59,86,840 14,96,710 17,50,000 By Sales 17,03,945 By Closing Stock 4,37,500 35,92,105 74,83,550 18,50,000 By Gross Profit b/d 1,50,000 By Commission 92,105 17,50,000 38,42,105 10,00,000 By Balance b/d 38,42,105 3,50,000 74,83,550 35,92,105 2,50,000
By Net profit of the current 10,00,000 year 17,50,000 1,00,000 21,00,000 total 21,00,000
587
BIMA Ltd Balance Sheet as on March 31, 2010

Liabilities Paid up capital General Reserves: Balance at the beginning of the year Addition during the year Profit and Loss Appropriation Account 10% Debentures Current Liabilities total 20,00,000 10,00,000 ` ` Assets Plant and Machinery Other Fixed Assets 30,00,000 Current Assets 1,00,000 Stock 15,00,000 Debtors 30,00,000 Bank Balance 1,01,00,000 total 14,96,710 41,90,790 3,12,500 1,01,00,000 ` 35,00,000 6,00,000
25,00,000 Fixed Assets:
Working Capital 1. Debentures Interest on debentures @ 10% is `1,50,000. Therefore debentures is `15,00,000, i.e., [(1,50,000 10 ) 100)]. 2. Current liabilities Twice the amount of debentures = `15,00,000 2 = `30,00,000 3. Current Assets Current Ratio = 2:1 Current Assets Current Ratio = Current Liabilities 2= Current Assets 30,00,000
Current Assets = `30,00,000 2 = `60,00,000 4. Proposed Dividend (40% of paid up capital) = `25,00,000 40% = `10,00,000 5. Transfer to General Reserves Transfer to General Reserves = Proposed Dividend i.e., `10,00,000 6. Profit carried forward (10% of Proposed Dividend) `10,00,000 10% = `1,00,000 7. Net Profit for the year Net profit = Proposed Dividend + Transfer to Reserve + Profit c/d Profit b/d) = (`10,00,000 + `10,00,000 + `1,00,000 `3,50,000) = `17,50,000 8. Provision for taxation (5% of profits) 17,50,000 5 = `92,105 = 95 9. Gross Profit (GP + Commission) = (Office Exp. + Int. on debentures + Provision for tax + Net profit) (GP + `2,50,000) = (`18,50,000 + `1,50,000 + `92,105 + `17,50,000) GP = `38,42,105 `2,50,000 = `35,92,105
588

10. Sales Given GP Ratio is 60% `35,92,105 100 = `59,86,840 Therefore, sales = 60 11. Closing Stock (25% of sales) `59,86,840 25% = `14,96,710 12. Purchases = (Sales + Closing Stock) = ( Opening Stock + Purchases + Expenses + GP) = (`59,86,840 + `14,96,710) = (`17,50,000 + Purchases + `4,37,500 + `35,92,105) = `17,03,945 13. Opening Balance of General Reserves (twice the amount transferred during the year) = `10,00,000 2 = `20,00,000 N ote: Thorough understanding of financial statement is required to solve such problems.
SUmmARY
Financial statements are historical in nature. Investors would like to know the present and are concerned about what will happen in future. Creditors are concerned with the ability of the enterprise to pay its debts. Managers are concerned with the ability of the enterprise to finance future expansion. Therefore, it is essential for all the stakeholders to analyse and interpret financial statements presented by enterprises. Financial statement analysis involves careful selection of data from financial statements for forecasting the future financial health of the company. Important objectives of analysis and interoperation are to assess: financial health, performance, growth potential, ability to repay the debt, solvency, and such other factors of the enterprise. Horizontal analysis, vertical analysis, trend analysis and ratio analysis are the important tools for analysing financial statements of an enterprise. Horizontal analysis compares absolute data or percentage for two or more years. Vertical analysis or structural analysis calculates increase or decrease in absolute data or in percentages of that year. Trend analysis or dynamic analysis calculates percentage change over number of years with the base years figures. Ratio analysis is an expression of relationship between two figures which are mutually interdependent. These analyses can be done individually or in combination depending upon the purpose. Selection of the components, application of statistical treatment and drawing appropriate conclusion are the three important aspects of financial statement analysis. While analysing and interpreting the results, proper care should be exercised, as the decision is based on these factors.
589
SELF-EVALUATION qUESTIONS
I. Fill in the Blanks
1. Formula for calculating ROCE is _______________. 2. _______________, _______________ and _______________ are the components of net worth. 3. Quick assets excludes _______________ and _______________ from current assets. 4. _______________ ratio expresses the relationship between current assets and current liabilities. 5. _______________ refers to the expenses incurred on finished goods minus closing stock of finished goods. 6. Debt-equity ratio is an example for _______________ ratio. 7. Proprietary ratio is expressed as _______________. 8. _______________ ratio expresses the relationship between cost of goods sold and inventory.
II. multiple Choice questions

1. _______________ compares absolute data or percentage of two or more years. (a) Horizontal Analysis, (b) Vertical Analysis (c) Trend Analysis (d) Ratio Analysis 2. _______________ determines increase or decrease in absolute data or percentages. (a) Horizontal Analysis, (b) Vertical Analysis (c) Trend Analysis (d) Ratio Analysis 3. _______________ calculates percentage change over number of years with the base year figures. (a) Horizontal Analysis, (b) Vertical Analysis (c) Trend Analysis (d) Ratio Analysis 4. _______________ is an expression of relationship between two figures which are mutually interdependent. (a) Horizontal Analysis, (b) Vertical Analysis (c) Trend Analysis (d) Ratio Analysis
590
5. Stock turnover ratio is used to determine _______________ of an enterprise. (a) Profitability, (b) Liquidity and solvency, (c) Efficiency, (d) Growth 6. Working capital is expressed as _______________. (a) Current Assets Fixed assets, (b) Fixed Assets Current Liabilities, (c) Current Assets Current Liabilities (d) Share capital Fixed Assets 7. Dividend yield is an example for _______________ ratio. (a) Solvency (b) Liquidity (c) Market Strength (d) Net Worth 8. Price/earning ratio is expressed as _______________. (a) Market Price Dividend, (b) Face value Dividend (c) Earnings Market price (d) Dividend Market Price
III. Conceptual questions

1. What are the objectives of analysis and interpretation of financial statements? 2. What are the limitations of financial statements? 3. Explain vertical and horizontal analyses of financial statements. 4. Explain how trend analysis is an effective tool for an investment decision. 5. Ratios are just a means and not an end. Justify the statement. 6. What are the advantages and disadvantages of ratio analysis? 7. Explain some of the important balance sheet ratios. 8. Comment on some of the important profit and loss account ratios. 9. Write an explanatory note on combined ratios. 10. Explain some of the important activity ratios in detail with their relevance. 11. Explain some of the important market strength ratios in detail. 12. Comment on some of the important growth ratios. 13. What are the criticisms levelled against published accounts?
IV. Practical Exercises

1. Investments during the years 2007-08, 2008-09 and 2009-10 were `3,00,000, `2,50,000 and `1,80,000, respectively. (a) Keeping 2007-08 as base year, perform horizontal analysis. (b) If base year is shifted to 2008-09, what is your comment
591
2. From the following income statement of Blue Star Limited for the year ended March 31, 2010, perform vertical analysis.
Particulars Net sales Cost of gods sold Gross profit ( Income) A Operating expenses Selling expenses Administrative expenses Total operating expenses (B) Operating income (A-B) Less: Interest expense Income before income tax Less: Income tax Net profit (Income) 72,000 90,000 1,62,000 2,34,000 7,200 2,26,800 64,800 1,62,000
Blue Star Limited Income statement for the year ending March 31, 2010
` 9,00,000 5,04,000 3,96,000
3. Following is the information of sales and net profit of Good Going Ltd for the past five years from 2005-06 to 2009-10.
Years Sales Net profit 2005-06 34,50,000 3,68,000 2006-07 41,40,000 4,83,000 2007-08 48,30,000 5,75,000 2008-09 57,50,000 7,70,500 2009-10 69,00,000 10,35,000
You are required to (a) Show the trend keeping year 2005-06 as the base year. (b) Calculate percentage increase or decrease in sales and net profit. 4. The following data are obtained from the books of Sun Ltd and Moon Ltd for the period ending March 31, 2010
Particulars Net profit after tax Plant and machinery Equity capital (`100 per share fully paid) Sales Creditors Land and building Inventory Other current assets General reserves Longterm debt Bank loan (Short term) Sun Ltd ` 7,70,500 71,500 39,00,000 57,50,000 2,88,600 4,81,000 15,60,000 5,17,400 1,46,250 13,00,000 9,10,000 Moon Ltd ` 10,35,000 2,47,000 36,40,000 69,00,000 7,95,600 7,00,700 13,00,000 754,000 1,92,400 9,75,000 7,28,000
592
You are required to prepare statement of comparative ratios showing liquidity, profitability (including activity) and financial position of the above companies. Also comment on each ratio. 5. The following information is supplied to you from the books of Good Luck Ltd for the year ending March 31, 2010. Gross Profit Ratio EPS No. of equity shares of the face value `10 Profit Current Ratio Acid Test Ratio quick Assets Inventory Turnover 20% `2 `25,000 25% of share capital 3: 1 1.5: 1 `30,000 10 times
Operating ratio 90% Closing stock is less by `6,000 than opening stock From the above information, derive as much additional information as you can 6. From the following information, prepare a summarized balance sheet at March 31, 2010. Stock Velocity Fixed assets turnover ratio Capital turnover ratio Gross profit Debt Collection Period Creditors payment period The gross profit was `60,000 Closing stock was `5,000 in excess of opening stock
Note: Difference in Balance sheet represents Bank Balance
6 4 2 20% 2 months 73 days
7. Brilliant Company Ltd. has net working capital of `2,80,000 on March 31, 2010. From the following particulars, prepare balance sheet with as much as information possible. Current Ratio Liquidity Ratio Inventory turnover (based on cost of sales) Gross Profit Ratio 2.4 1.6 8 20%
Credit allowed in months 1.5 The companys fixed assets are equivalent to 90% of its net-worth (share capital plus reserves) while reserves amounted to 40% of share capital
593
8. Following information is drawn from the books of Well Known Ltd.

Particulars Stock Debtors Payment in advance Cash in hand Sundry Creditors Acceptances Bank OD Assets ` 10,000 30,000 2,000 20,000 2009 Liabilities ` 2010 Assets Liabilities ` ` 2,00,000 30,000 15,000 30,000 12,000 5,000 2,45,000 47,000
25,000 15,000 62,000 40,000
Sales amounted to `3,50,000 in 2009 and `3,00,000 in 2010. You are required to calculate the following ratios (a) Current ratio (b) Liquid Ratio (c) Inventory Turnover Ratio (d) Inventory to Current Assets Ratio (e) Average Collection Period (f) Debt- Equity Ratio (g) Proprietary ratio 9. The summarized balance sheet of No Problem Limited for the year ended March 31, 2010 is given below.
Capital and Liabilities Equity share capital (Paid up) Reserves and Surplus Profit and Loss Account Provision for taxation Sundry Creditors ` 1,40,000 45,000 20,000 10,000 40,000 2,55,000 Assets Fixed asset at cost Less: Depreciation Current Assets: Stock Debtors Cash ` 2,10,000 25,000 25,000 30,000 15,000 ` 1,85,000
70,000 2,55,000
The following particulars are also available ` Sales 1,20,000 EBIT 30,000 Net Profit after tax (PAT) 20,000 Calculate the following ratios for the company and explain and comment on these ratios. (a) Current ratio (b) Liquid ratio (c) Profitability ratio (d) Debtors turnover ratio (e) Stock Turnover ratio (f) Average collection period (g) Return on equity (h) Profitability on funds employed
594
CASE STUDY
Case 9.1: Colourful Limited
Colourful Ltd has been working from the past 10 years. Shareholders are not very happy with the return on their investments because the company has not been able to declare dividend beyond 10% from the beginning. Keeping this factor in mind shareholders had voted for reconstructing the Board and had taken a drastic step to change the finance manager last year. The stakeholders are interested to know whether these changes have brought in efficiency into the company. Following is the profit and loss account of Colourful Ltd. for the year ended March 31, 2010 and balance sheet as on that date. Colourful Ltd Profit and Loss Account for the year ended March 31, 2010
Particulars Net Sales Less: Cost of Goods Sold Gross Profit Operating Expenses Selling General and administrative Rent of office Gross operating profit Depreciation Net operating profit Other Income : Interest on Government Securities Gross Income Other Expenses Interest on Bank Overdraft Interest on Debentures Net Income Before tax Tax @ 50% of Net Income Net Income after tax 26,400 48,000 33,600 ` ` 36,00,000 30,96,000 5,04,000
1,08,000 3,96,000 1,20,000 2,76,000 18,000 2,94 ,000
3,600 50,400
54,000 2,40,000 1,20,000 1,20,000
Colourful Ltd Balance Sheet as on March 31, 2010

Particulars I Sources of Funds 1. Shareholders Funds: (a) Paid up Capital (b) Reserves and Surplus 2. Loan Funds: (a) Secured loans (b) Unsecured loans Total (Capital Employed) 3 4 8,40,000 8,40,000 20,40,000 (Contd) 1 2 7,20,000 4,80,000 12,00,000 Schedule ` `

(Contd) Particulars II. Application of Funds 1. Fixed Assets: (a) Gross block (b) Less: depreciation (c) Net block (d) Capital work-in-Progress Total Fixed Assets 2. Investments: 3. Current Assets, Loans and Advances: Current Assets (a) Inventories (b) Sundry Debtors (c) Cash and Bank Balances (d) Other Current Assets Loans and Advances (e) Loans and Advances Total Current Assets , Loans and Advances Less: Current Liabilities and Provisions: (a) Current liabilities (b) Provisions Total Current Liabilities and Provisions Net Current Assets 4. (a) Miscellaneous expenditure to the extent not written-off or adjusted. (b) Profit and Loss account (debit balance, if any) Total 20,40,000 11 [CL] [CA- CL] 10 8 [CA] 9 2,04,000 1,56,000 3,60,000 3,00,000 6,60,000 7 3,60,000 2,40,000 60,000 6 5 21,60,000 6,00,000 15,60,000 15,60,000 1,80,000 Schedule ` `
595
Schedule 1: Share Capital

Particulars 7% Preference Share capital Equity Shares Total ` 1,20,000 6,00,000 7,20,000
Schedule 2: Reserves and Surplus

Particulars Reserves and Surplus Total ` 4,80,000 4,80,000
Schedule 3: Secured Loans

Particulars 6% Mortgage Debentures Total ` 8,40,000 8,40,000
596
Schedule 5: Fixed Assets

Particulars Fixed Assets Total ` 21,60,000 21,60,000
Schedule 5: Depreciation
Particulars Depreciation on Fixed Assets Total ` 6,00,000 6,00,000
Schedule 6: Investments
Particulars Investment in Government Securities Total ` 1,80,000 1,80,000
Schedule 9: Current Liabilities and Provisions Current Liabilities

Particulars Sundry Creditors Bills Payable Outstanding Expenses Total ` 72,000 1,20,000 12,000 2,04,000
Provisions
Particulars Provision for Taxation Total Total Current Liabilities and Provisions ` 1,56,000 1,56,000 3,60,000
Posers
1. Calculate: (a) Profitability Ratio, (b) Liquidity Ratio, (c) Stock Turnover Ratio, (d) Turnover to total assets, (e) Solvency Ratio, (f) Proprietary Ratios, (g) Capital Gearing ratio, (h) Debt-equity ratio, (i) Creditors turnover ratio, and (j) Turnover to capital employed. 2. Based on the ratios obtained comment on the efficiency of the management
Case 9.2 : Excellent Company Ltd

Excellent Company Ltd has newly entered into business which is highly competitive. This is just the second year in business. They had recruited young MBA graduate with innovative ideas. This years performance is the test of the time for them. The years performance results are presented to you. The financial statements of Excellent Company Ltd. for the year 2009-10 reveal the following information:
597
Ratio of Current assets to Current Liabilities Liquidity Ratio (Debtors and Bank balances to current liabilities) Issued capital in equity shares of `10 each Net current assets (as over current liabilities) Fixed assets (net block) percentage of share holders equity as on the closing date Gross profit Percentage of turnover Annual rate of turnover of stock (based on cost on March 31, 2010) Average age of outstanding debtors for the year 2009-10 (Industry Standard 45 days) Net profit percentage on issued share capital
1.75 to 1 1.25 to 1 `24,00,000 `12,12,000 60% 20% 5.26 times 2 months 16%
Note: On March 31, 2010, current assets consisted of stock, debtors and bank balance
Posers
You are required to re-compute , in as much detail as possible: 1. The trading profit and loss account for the year ended March 31, 2010. 2. The balance sheet as on March 31, 2010 (working should be clearly shown to form a part of the answer). 3. Comment on each of the ratios given. 4. Comment on the efficiency of the management.

Cenegage - Financial Statement AnalysisCh09

Caricato da

Informazioni sul documento

Descrizione originale:

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Cenegage - Financial Statement AnalysisCh09

Caricato da

Copyright:

Formati disponibili

Chapter

Analysis and Interpretation of Information for Decision I: Decision Determinant

Financial Accounting for Management

OBJECTIVES OF ANALYSIS AND INTERPRETATION

Finger Tips 9.1 Financial Statements

Analysis and Interpretation of Information for Decision I

Financial Accounting for Management

Analysis and Interpretation of Information for Decision I

TOOLS AND TEChNIqUES OF FINANCIAL STATEmENT ANALYSIS AND INTERPRETATION

Finger Tips 9.3 Features and Limitations of Analysis and Interpretation

Financial Accounting for Management

when compared to 2008-09

Analysis and Interpretation of Information for Decision I

Financial Accounting for Management

Zenith Company Ltd

Analysis and Interpretation of Information for Decision I

(120) 20% (140) 40% (167) 67%

(131) 31% (156) 56% (209) 109% (281) 181%

Financial Accounting for Management

Finger Tips 9.4 Important Four Techniques of Analysis

Objectives of ratio analysis

Merits of ratio analysis

Limitations of ratio analysis

Analysis and Interpretation of Information for Decision I

How to make effective use of ratio analysis

COmmON SIZE STATEmENTS AND RATIO ANALYSIS

Financial Accounting for Management

Vertical Common Size Statement

Analysis and Interpretation of Information for Decision I

Horizontal Common Size Statement

Balance Sheet Ratios

Profit and Loss Account Ratios

Figure 9.2 Classification of Ratios Based on Need

Financial Accounting for Management

(b) Net profit ratio

i) Earning per share ii) Dividend per share

Analysis and Interpretation of Information for Decision I

Finger Tips 9.5 Who, Why and What Ratios

4. Shareholders - Long-term investors - Potential investors - Management - Others

To test growth and stability

Financial Accounting for Management

Net Profit ` 4,50,000 100 = 100 = 37.5% Net Sales `12,00,000

Analysis and Interpretation of Information for Decision I

`6,48,000 + `72,000 100 = 60% `12,00,000

Financial Accounting for Management

3. Earnings before interest and tax or EBIT

` 28,00,000 10,00,000 18,00,000

Analysis and Interpretation of Information for Decision I

Financial Accounting for Management

Solution Working Notes 1. Current Assets

Analysis and Interpretation of Information for Decision I

(a) Current Ratio =

Current Assets `1,00,000 = = 1.32 `76,000 Current Liabilities

Current liabilities remain the same as calculated before, i.e., `76,000.

(b) Acid Test Ratio =

Quick Assets ` 43 ,000 = = 0.57 Current Liabilities `76,000

Financial Accounting for Management

Analysis and Interpretation of Information for Decision I

Financial Accounting for Management

Analysis and Interpretation of Information for Decision I

Financial Accounting for Management

2. Average collection period: 12 months 12 = = = 3 months Debtors Turnover 4