RATIO ANALYSIS

Ratio-analysis is a concept or technique which is as old as accounting concept. Financial analysis is a scientific tool. It has assumed important role as a tool for appraising the real worth of an enterprise, its performance during a period of time and its pit falls. Financial analysis is a vital apparatus for the interpretation of financial statements. It also helps to find out any cross-sectional and time series linkages between various ratios.

RATIO ANALYSIS
Unlike in the past when security was considered to be sufficient consideration for banks and financial institutions to grant loans and advances, nowadays the entire lending is need-based and the emphasis is on the financial viability of a proposal and not only on security alone. Further all business decision contains an element of risk. The risk is more in the case of decisions relating to credits. Ratio analysis and other quantitative techniques facilitate assessment of this risk.

RATIO ANALYSIS
Ratio-analysis means the process of computing, determining and presenting the relationship of related items and groups of items of the financial statements. They provide in a summarized and concise form of fairly good idea about the financial position of a unit. They are important tools for financial analysis.

Lenders need it for carrying out the following Technical Appraisal Commercial Appraisal Financial Appraisal Economic Appraisal Management Appraisal

Its a tool which enables the banker or lender to arrive at the following factors : Liquidity position Profitability Solvency Financial Stability Quality of the Management Safety & Security of the loans & advances to be or already been provided

Before looking at the ratios there are a number of cautionary points concerning their use that need to be identified : a.The dates and duration of the financial statements being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn. b.The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results. c.In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.

The utility of ratio analysis will get further enhanced if following comparison is possible. 1.Between the borrower and its competitor 2.Between the borrower and the best enterprise in the industry 3.Between the borrower and the average performance in the industry 4.Between the borrower and the global average

As

For example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales. As Proportion - The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4. As Pure Number /Times - The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Percentage - such as 25% or 50% .

Balance Sheet P&L Ratio or Balance Sheet Ratio Income/Revenue and Profit & Statement Ratio Loss Ratio
Financial Ratio Operating Ratio Composite Ratio

Current Ratio Gross Profit Ratio Fixed Asset Quick Asset Ratio Operating Ratio Turnover Ratio, Proprietary Ratio Expense Ratio Return on Total Debt Equity Ratio Net profit Ratio Resources Ratio, Stock Turnover Ratio Return on Own Funds Ratio, Earning per Share Ratio, Debtors Turnover Ratio,

LIABILITIES

ASSETS

NET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS : LAND & BUILDING, PLANT Share Capital/Partners Capital/Paid up& MACHINERIES Capital/ Owners Funds Original Value Less Depreciation Reserves ( General, Capital, Revaluation &Net Value or Book Value or Written down Other Reserves) value Credit Balance in P&L A/c LONG TERM LIABILITIES/BORROWEDNON CURRENT ASSETS FUNDS : Term Loans (Banks & Investments in quoted shares & securities Institutions) Old stocks or old/disputed book debts Debentures/Bonds, Unsecured Loans, FixedLong Term Security Deposits Deposits, Other Long Term Liabilities Other Misc. assets which are not current or fixed in nature CURRENT LIABILTIES CURRENT ASSETS : Cash & Bank Balance, Bank Working Capital Limits such asMarketable/quoted Govt. or other securities, CC/OD/Bills/Export Credit Book Debts/Sundry Debtors, Bills Sundry /Trade Creditors/Creditors/BillsReceivables, Stocks & inventory (RM,SIP,FG) Payable, Short duration loans or deposits Stores & Spares, Advance Payment of Expenses payable & provisions againstTaxes, Prepaid expenses, Loans and various items Advances recoverable within 12 months INTANGIBLE ASSETS Patent, Goodwill, Debit balance in P&L A/c, Preliminary or Preoperative expenses

Liabilities have Credit balance and Assets have Debit balance Current Liabilities are those which have either become due for payment or shall fall due for payment within 12 months from the date of Balance Sheet Current Assets are those which undergo change in their shape/form within 12 months. These are also called Working Capital or Gross Working Capital Net Worth & Long Term Liabilities are also called Long Term Sources of Funds Current Liabilities are known as Short Term Sources of Funds Long Term Liabilities & Short Term Liabilities are also

Assets other than Current Assets are Long Term Use of Funds Installments of Term Loan Payable in 12 months are to be taken as Current Liability only for Calculation of Current Ratio & Quick Ratio. If there is profit it shall become part of Net Worth under the head Reserves and if there is loss it will become part of Intangible Assets Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other securities are to be treated Current if they are quoted. Investments in allied/associate/sister units or firms to be treated as Non-current. Bonus Shares as issued by capitalization of General reserves and as such do not affect the Net Worth. With

1.

Current Ratio : It is the relationship between the current assets and current liabilities of a concern. Current Ratio = Current Assets/Current Liabilities If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1 The ideal Current Ratio preferred by Banks is 1.33 : 1 Net Working Capital : This is worked out as surplus of Long Term Sources over Long Tern Uses, alternatively it is the difference of Current Assets

2.

Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished Goods, Debtors, Bills Receivables, Cash. Current Liabilities : Sundry Creditors, Installments of Term Loan, DPG etc. payable within one year and other liabilities payable within one year. This ratio must be at least 1.33 : 1 to ensure minimum margin of 25% of current assets as margin from long term sources. Current Ratio measures short term liquidity of the concern and its ability to meet its short term obligations within a time span of a year. It shows the liquidity position of the enterprise and its ability to meet current obligations in time. Higher ratio may be good from the point of view of creditors. In the long run very high current ratio may affect profitability ( e.g. high inventory carrying cost) Shows the liquidity at a particular point of time. The position can change immediately after that date. So trend of the current ratio over the years to be analyzed. Current Ratio is to be studied with the changes of NWC. It is also necessary to look at this ratio along with the Debt-Equity ratio.

3. ACID TEST or QUICK RATIO : It is the ratio between

Quick Current Assets and Current Liabilities. The should be at least equal to 1.
Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits Acid Test or Quick Ratio Liabilities = Quick Current Assets/Current

Example : Cash 50,000 Debtors 1,00,000 Inventories 1,50,000 1,00,000 Total Current Assets 3,00,000

Current Liabilities

Current Ratio

=>

3,00,000/1,00,000

4. DEBT EQUITY RATIO : It is the relationship between borrowers fund (Debt) and Owners Capital (Equity).
Long Term Outside Liabilities / Tangible Net Worth Liabilities of Long Term Nature Total of Capital and Reserves & Surplus Less Intangible Assets For instance, if the Firm is having the following : Capital Free Reserves & Surplus Long Term Loans/Liabilities Debt Equity Ratio will be = Rs. 200 Lacs = Rs. 300 Lacs = Rs. 800 Lacs => 800/500 i.e. 1.6 : 1

5. PROPRIETARY RATIO : This ratio indicates the extent to which Tangible Assets are financed by Owners Fund. Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100 The ratio will be 100% when there is no Borrowing for purchasing of Assets. 6. GROSS PROFIT RATIO : By comparing Gross Profit
percentage to Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, it can also be interpreted as below :

Gross Profit Ratio = [ (Sales Cost of goods sold)/ Net Sales] x 100

7. OPERATING PROFIT RATIO : It is expressed as Sales ) x 100 => (Operating Profit / Net

Higher the ratio indicates operational efficiency 8. NET PROFIT RATIO : It is expressed as x 100 => ( Net Profit / Net Sales )

It measures overall profitability.

9.

STOCK/INVENTORY TURNOVER RATIO :

(Average Inventory/Sales) x 365 for days (Average Inventory/Sales) x 52 for weeks (Average Inventory/Sales) x 12 for months Average Inventory or Stocks = (Opening Stock + Closing Stock) -----------------------------------------

10. DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or Average Collection Period or Period of Credit given . (Average Debtors/Sales ) x 365 for days (52 for weeks & 12 for months) 11. ASSET TRUNOVER RATIO : Sales/Tangible Assets 12. FIXED ASSET TURNOVER RATIO : Sales /Fixed Assets Net Net

13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets 14. CREDITORS TURNOVER RATIO : This is also called Creditors Velocity Ratio, which determines the

15. RETRUN ON ASSETS : Taxes/Total Assets

Net Profit after

16. RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period.

Composite Ratio
17. RETRUN ON EQUITY CAPITAL (ROE) : Net Profit after Taxes / Tangible Net Worth 18.EARNING PER SHARE : EPS indicates the quantum of net profit of the year that would be ranking for dividend for each share of the company being held by the equity share holders. Net profit after Taxes and Preference Dividend/ No. of Equity Shares 19. PRICE EARNING RATIO : PE Ratio indicates the number of times the Earning Per Share is covered by its market price.

20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most important one which indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals and forms the basis for fixation of the repayment schedule in respect of the Term Loans raised for a project. (The Ideal DSCR Ratio is considered to be 2 ) PAT + Depr. + Annual Interest on Long Term Loans & Liabilities -------------------------------------------------------------------------------Annual interest on Long Term Loans & Liabilities + Annual Installments payable on

EXERCISE 1 LIABILITES Capital Reserves Term Loan Bank C/C Trade Creditors Provisions ASSETS 180Net Fixed Assets 20Inventories 300Cash 200Receivables 50Goodwill 50 800 800 400 150 50 150 50

a. b. c. d. e. f.

What is the Net Worth : Capital + Reserve = 200 Tangible Net Worth is : Net Worth - Goodwill = 150 Outside Liabilities : TL + CC + Creditors + Provisions = 600 Net Working Capital : C A - C L = 350 - 250 = 50 Current Ratio : C A / C L = 350 / 300 = 1.17 : 1 Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2 LIABILITIES Capital Reserves Bank Term Loan Bank CC (Hyp) Unsec. Long T L Creditors (RM) Bills Payable Expenses Payable 2005-06 2006-07 300 140 320 490 150 120 40 20 350Net Fixed Assets 160Security Electricity 280Investments 580Raw Materials 170S I P 70Finished Goods 80Cash 30Receivables 2005-06 2006-07 730 30 110 150 20 140 30 310 30 750 30 110 170 30 170 20 240 190

Provisions 20 40Loans/Advances 1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70) Goodwill 50 50 820 /800 = 1.02 Total 1600 1760 1600 1760 3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21

Exercise 3. LIABIITIES Equity Capital Preference Capital Term Loan Bank CC (Hyp) Sundry Creditors Total ASSETS 200Net Fixed Assets 100Inventory 600Receivables 400Investment In Govt. Secu. 100Preliminary Expenses 1400 = 2:1 800 300 150 50 100 1400

1. Debt Equity Ratio will be : 600 / (200+100)

2. Tangible Net Worth : Only equity Capital i.e. = 200 3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 2 4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

Exercise 4. LIABILITIES Capital + Reserves P & L Credit Balance Loan From S F C Bank Overdraft Creditors Provision of Tax Proposed Dividend Q. What is the Current Ratio ? Q What is the Quick Ratio ? ASSETS 355 Net Fixed Assets 7Cash 100Receivables 38Stocks 26Prepaid Expenses 9Intangible Assets 15 550 550 Ans : (1+125 +128+1) / (38+26+9+15) : 255/88 = 2.89 : 1 265 1 125 128 1 30

Ans : (125+1)/ 88 = 1.43 : 11 Ans : LTL / Tangible NW = 100 / ( 362 30) = 100 / 332 = 0.30 : 1

Q. What is the Debt Equity Ratio ?

Exercise 4. LIABILITIES

contd ASSETS 355 Net Fixed Assets 7Cash 100Receivables 38Stocks 26Prepaid Expenses 9Intangible Assets 15 550 550 265 1 125 128 1 30

Capital + Reserves P & L Credit Balance Loan From S F C Bank Overdraft Creditors Provision of Tax Proposed Dividend

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100 [ (362 - 30 ) / (550 30)] x 100 (332 / 520) x 100 = 64% Q . What is the Net Working Capital ? Ans : C. A - C L. = 255 - 88 = 167 Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover Ratio in Times ? Ans : Net Sales / Average Inventories/Stock 1500 / 128 = 12 times approximately

Exercise 4. LIABILITIES

contd ASSETS 355 Net Fixed Assets 7Cash 100Receivables 38Stocks 26Prepaid Expenses 9Intangible Assets 15 550 550 265 1 125 128 1 30

Capital + Reserves P & L Credit Balance Loan From S F C Bank Overdraft Creditors Provision of Tax Proposed Dividend

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac. Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12 = 1 month Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ? Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months

Exercise 5. : Profit to sales is 2% and amount of profit is say Rs.5 Lac. Then What is the amount of Sales ? Answer : Net Profit Ratio = (Net Profit / Sales ) x 100 2 = (5 x100) /Sales Therefore Sales = 500/2 = Rs.250 Lac Exercise 6. A Company has Net Worth of Rs.5 Lac, Term Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25 Lac. There is no intangible Assets or other Non Current Assets. Calculate its Net Working Capital. Answer Total Assets = 16 + 25 = Rs. 41 Lac Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac Current Liabilities = 41 15 = 26 Lac Therefore Net Working Capital = C. A C.L = 25 26 = (- )1 Lac

Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net Working Capital ? Answer : It suggest that the Current Assets is equal to Current Liabilities hence the NWC would be NIL ( since NWC = C.A - C.L ) Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the amount of Current Assets ? Answer : 4a - 1a = 30,000 Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000 Hence Current Assets would be 4a = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per month, monthly average interest on TL is Rs.5000/-. If the amount of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What would be the DSCR ? DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment = (270000 + 30000 + 60000 ) / 60000 + 120000 = 360000 / 180000 = 2

Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long Term Liabilities? Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs. Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10 Lac. What would be the Current Liabilities? Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 10 i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which should be Rs. 10 Lac

EXERCISE 12. A firm sold its stocks in CASH, in order to meet its liquidity needs. Which of the following Ratio would be affected by this? 1.Debt Equity Ratio 2.Current Ratio 3.Debt Service Coverage Ratio 4.Quick Ratio EXERCISE 13. A company is found to be carrying a high DEBT EQUITY Ratio. To improve this, a bank may suggest the company to : 1.Raise long term interest free loans from friends and relatives 2.Raise long term loans from Institutions 3.Increase the Equity by way of Bonus Issue 4.Issue Rights share to existing share holders. EXERCISE 14. Which of the following is a fictitious Asset? 1.Goodwill 2.Preliminary Expenses 3.Pre-operative expenses 4.Book Debts which have become doubtful of recovery

EXERCISE 15. Under which of the following methods of depreciation on Fixed Assets, the annual amount of depreciation decreases? 1.Written Down Value method 2.Straight Line method 3.Annuity method 4.Insurance policy method EXERCISE 16 Debt Service Coverage Ratio (DSCR) shows : 1.Excess of current assets over current liabilities 2.Number of times the value of fixed assets covers the amount of loan 3.Number of times the companys earnings cover the payment of interest and repayment of principal of long term debt 4.Effective utilization of assets EXERCISE 17. Which of the following is not considered a Quick Asset? 1.Cash and Bank balances 2.Bank Fixed Deposits 3.Current Book Debts 4.Loans and Advances

Exercise 18. From the following financial statement calculate (i) Current Ratio (ii) Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v) Average Creditors payment period. C.Assets Sales 1500 Inventories 125 Cost of sales 1000 Debtors 250 Gross profit 500 Cash 225 C. Liabilities Trade Creditors 200 (i) Current Ratio : 600/200 = 3 : 1 (ii)Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1 (iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times (iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 = 61 days (v)Average Creditors payment period : (Trade Creditors/Cost of sales) x 365 (200/100) x 365 = 73 days