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.

RATIO ANALYSIS

WHY RATIO ANALYSIS?

Ratios are used for carrying out the following :

Technical Appraisal (for overall performance)

Commercial Appraisal (by the creditors) Financial Appraisal (by banks, stock

holders) Economic Appraisal (for M&A) Management Appraisal (for improving

efficiency)

RATIO ANALYSIS

It’s a tool which enables the analyst 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

CLASSIFICATION OF RATIOSBalance

Sheet RatioP&L Ratio or

Income/Revenue Statement

Ratio

Balance Sheet and Profit & Loss Ratio

Financial Ratio Operating Ratio Composite Ratio

Current RatioQuick Asset RatioProprietary RatioDebt Equity Ratio

Gross Profit RatioOperating RatioExpense RatioNet profit RatioStock Turnover Ratio

Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors’ Turnover Ratio,

FORMAT OF BALANCE SHEET FOR RATIO ANALYSISLIABILITIES ASSETS

NET WORTH/EQUITY/OWNED FUNDSShare Capital/Partner’s Capital/Paid up Capital/ Owners FundsReserves and Surpluses

FIXED ASSETS : LAND & BUILDING, PLANT & MACHINERIES Original Value Less Depreciation

LONG TERM LIABILITIES/BORROWED FUNDS : Term Loans (Banks & Institutions)Debentures/Bonds, Unsecured Loans, Fixed Deposits, Other Long Term Liabilities

NON CURRENT ASSETSInvestments in quoted shares & securitiesLong Term Security DepositsOther Misc. assets which are not current or fixed in nature

CURRENT LIABILTIESBank Working Capital Limits such as CC/OD/Bills/Export CreditSundry /Trade Creditors/Creditors/Bills Payable, Short duration loans or depositsExpenses payable & provisions against various items

CURRENT ASSETS : Cash & Bank Balance, Marketable/quoted Govt. or other securities, Book Debts/Sundry Debtors, Bills Receivables, Stocks & inventory Advance Payment of Taxes, Prepaid expenses, Loans and Advances recoverable within 12 months

INTANGIBLE ASSETSPatent, Goodwill

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

Net Working Capital : it is the difference of Current Assets and Current Liabilities.

NWC = Current Assets – Current Liabilities

Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished Goods, Debtors, Bills Receivables, Cash.

Current Liabilities : Sundry Creditors, Installments of Term Loan, payable within one year and other liabilities payable within one year.

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.

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 = Quick Current Assets/Current Liabilities

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

Current Ratio = > 3,00,000/1,00,000 = 3 : 1Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1

4. DEBT EQUITY RATIO or LEVERAGE RATIO : It is the relationship between borrower’s fund (Debt)

and Owner’s 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 = Rs. 200 Lacs Free Reserves & Surplus = Rs. 300 Lacs Long Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1

5. PROPRIETARY RATIO : This ratio indicates the extent to which Tangible Assets are financed by Owner’s 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 A higher Gross Profit Ratio indicates efficiency in production of

the unit.

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

Sales ) x 100

Higher the ratio indicates operational efficiency

8. NET PROFIT RATIO :

It is expressed as => ( Net Profit / Net Sales ) x 100

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) -----------------------------------------

2

. This ratio indicates the number of times the

inventory is rotated during the relevant accounting period

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. TOTAL ASSET TRUNOVER RATIO:Net Sales/Tangible Total Assets

12. FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets

13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets

14. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets 15. 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

16. RETRUN ON EQUITY CAPITAL (ROE) : Net Profit after Taxes / Tangible Net Worth

17.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

18. PRICE EARNING RATIO : PE Ratio indicates the number of times the Earning Per Share is covered by its market price.

Market Price Per Equity Share/Earning Per Share

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.

EBITD (earning before interest tax and deprciation) --------------------------------------------------------------------------------- Annual interest on Long Term Loans & Liabilities + Annual

Installments payable on Long Term Loans & Liabilities

LIABILITES ASSETS

Capital 180 Net Fixed Assets 400

Reserves 20 Inventories 150

Term Loan 300 Cash 50

Bank C/C 200 Receivables 150

Trade Creditors 50 Goodwill 50

Provisions 50

800 800

EXERCISE 1

a. What is the Net Worth : Capital + Reserve = 200b. Tangible Net Worth is : Net Worth - Goodwill = 150 c. Outside Liabilities : TL + CC + Creditors + Provisions = 600

d. Net Working Capital : C A - C L = 350 - 250 = 50 e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2

LIABILITIES 2005-06

2006-07

2005-06

2006-07

Capital 300 350 Net Fixed Assets

730 750

Reserves 140 160 Security Electricity

30 30

Bank Term Loan 320 280 Investments 110 110

Bank CC (Hyp) 490 580 Raw Materials 150 170

Unsec. Long T L 150 170 S I P 20 30

Creditors (RM) 120 70 Finished Goods

140 170

Bills Payable 40 80 Cash 30 20

Expenses Payable

20 30 Receivables 310 240

Provisions 20 40 Loans/Advances

30 190

Goodwill 50 50

Total 1600 1760 1600 1760

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) 820 /800 = 1.02

3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21

Exercise 3.

LIABIITIES ASSETS

Equity Capital 200 Net Fixed Assets 800

Preference Capital 100 Inventory 300

Term Loan 600 Receivables 150

Bank CC (Hyp) 400 Investment In Govt. Secu.

50

Sundry Creditors 100 Preliminary Expenses 100

Total 1400 1400

1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1

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

LIABILITIES ASSETS

Capital + Reserves 355 Net Fixed Assets 265

P & L Credit Balance 7 Cash 1

Loan From S F C 100 Receivables 125

Bank Overdraft 38 Stocks 128

Creditors 26 Prepaid Expenses 1

Provision of Tax 9 Intangible Assets 30

Proposed Dividend 15

550 550

Q. What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15) : 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW = 100 / ( 362 – 30) = 100 / 332 = 0.30 : 1

Exercise 4.

LIABILITIES ASSETS

Capital + Reserves 355 Net Fixed Assets 265

P & L Credit Balance 7 Cash 1

Loan From S F C 100 Receivables 125

Bank Overdraft 38 Stocks 128

Creditors 26 Prepaid Expenses 1

Provision of Tax 9 Intangible Assets 30

Proposed Dividend 15

550 550

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. contd…

LIABILITIES ASSETS

Capital + Reserves 355 Net Fixed Assets 265

P & L Credit Balance 7 Cash 1

Loan From S F C 100 Receivables 125

Bank Overdraft 38 Stocks 128

Creditors 26 Prepaid Expenses 1

Provision of Tax 9 Intangible Assets 30

Proposed Dividend 15

550 550

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 4. contd…

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 Ratio2. Current Ratio3. Debt Service Coverage Ratio4. 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 relatives2. Raise long term loans from Institutions3. Increase the Equity by way of Bonus Issue4. Issue Rights share to existing share holders.

EXERCISE 14. Which of the following is a fictitious Asset?

1. Goodwill2. Preliminary Expenses3. Pre-operative expenses4. Book Debts which have become doubtful of recovery