Ratio analysis

Learning objectives
Upon completion you will be able to: Understand classification of ratios. Understand usefulness of ratio analysis. Understand how to analyse numbers reported in financial statement. Various users of ratios

Agenda
Role of Ratio Analysis Classification of ratios Various types of ratios Liquidity, Solvency, Turnover and Profitability Exercise

Role of Ratio Analysis

Better clarity in terms of profitability and efficiency Tool for planning and control Helps in decision making insider as well as outsider

Classification of ratios
Understand classification of ratio Liquidity or Short-Term Solvency ratios Solvency ratios Turnover ratios Profitability ratios Understand the basics of financial instruments Understand the basics of deal evaluation

Our Day
Discuss each ratios:
Liquidity Current Ratio Liquid/Quick Ratio Solvency Debt Equity Ratio Proprietary Ratio Fixed Assets/Capital employed Interest Coverage Ratio Turnover Debtors Turnover Ratio Inventory Turnover Ratio Fixed Assets Turnover Ratio Profitability Gross Profit Ratio Net Profit Ratio Earnings Per Share

Liquidity Ratios
1. Current Ratio
Current ratio=Current assets/current liabilities Indications of Current ratio: Backing available to current liabilities in the form of current assets 2:1 ratio termed as ideal. Precautions to be taken while analyzing current ratio: Valuation of current assets and current liabilities are consistent and as per accepted accounting principles. Current assets should not include obsolete inventories, doubtful debts. Abnormal purchase and sales at the yearend which boosts inventory and debtors position. Higher current ratio is an indication that high investment in current assets (Inventory and receivables)

Liquidity Ratios (Continued)

2. Liquid/Quick Ratio
Liquid/Quick Ratio = Liquid assets/liquid liabilities Indications of Quick ratio: Backing available to liquid liabilities in the form of liquid assets Liquid assets indicate assets which can be converted in the form of cash without any reduction in value, on immediate basis. Liquid liabilities are those liabilities required to be paid almost immediately. 1:1 ratio termed as ideal Higher liquid ratio indicates higher liquid assets available with the entity. Precautions to be taken while analyzing current ratio: Valuation of liquid assets and liquid liabilities are consistent and as per accepted accounting principles. Liquid assets should not include doubtful debts.

Solvency Ratios
1. Debt equity ratio
a) External liabilities/shareholders fund or b) Long term liabilities/shareholders fund Indications of Debt equity ratio: Share holders stake vis a vis debt fund Higher debt equity ratio indicates higher financial stake by externals. Lower debt equity ratio means that the borrowing capacity is underutilized. Returns expected by externals are comparatively lower than that of share holders. Return on investment paid to externals is tax deductible expenses.

Solvency Ratios (Continued)

2. Proprietary Ratio
a) Total assets/Owners Funds or b) Fixed assets/Owners Funds or c) Current assets/Owners funds Indicators of Proprietary ratio: Relationship with total assets to owners fund. Owners fund invested in total assets, fixed assets, and current assets.

Solvency Ratios (Continued)

3. Fixed assets/Capital employed Ratio
(Fixed assets/Capital employed) x100

Indicators of this ratio: Long term funds are invested in fixed assets. High trend of this ratio indicated major portion of long term funds are used for investment in fixed assets and smaller portion to current assets.

Solvency Ratios (Continued)

4. Interest Coverage ratio
Profit before interest and taxes/Interest charges

Indicators of this ratio: Protection available to lenders High ratio indicates funds available to pay interest charges. Too high ratio indicates underutilization borrowing capacity. Low ratio indicates excessive long term borrowing and inefficient operations.

Turnover Ratios
1. Debtors turnover ratio
Net Sales/Average debtors

Net sales mean sales net of returns. Average debtors mean average of opening and closing debtors.
Indicators of this ratio: Speed at which sundry debtors are converted in the form of cash. Average collection period is calculated by dividing debtors turn with 365 days (365/debtors turn)

Turnover Ratios (Continued)

2. Inventory Turnover ratio
Net Sales/Average Inventory

Net sales mean sales net of returns. Average inventory means average of opening and closing inventory.
Indicators of this ratio: Speed at which inventories are sold. High ratio indicates maximum turnover achieved with minimum investment in inventory Inventory holding period and inventory management. Too high inventory resulting from lower investment in inventory may also tend to lose customers.

Turnover Ratios (Continued)

4. Fixed assets turnover ratio
Net Sales/Fixed assets

Net sales mean sales net of returns. Fixed assets should be considered after providing depreciation.
Indicators of this ratio: High ratio indicates maximum turnover achieved with minimum investment in fixed assets. Higher the fixed assets turnover ratio better will be the situation.

Profitability Ratios
1. Gross profit ratio
(Gross profit/Net sales) X 100

Net sales mean sales net of returns. Gross profit = Net sales Production cost including purchases
Indicators of this ratio: Relation between production cost and sales and the efficiency with which goods are produced or purchased. High gross profit ratio indicate that the organization able to produce/procure at relatively low cost. Higher the GP ratio reflects higher efficiency.

Profitability Ratios (Continued)

2. Net profit ratio
(Net profit/Net sales) X 100

Net sales mean sales net of returns. Gross profit = Net sales Production cost including purchases
Indicators of this ratio: Net profit ratio indicates that portion of sales available to the owners after the consideration of all types of expenses. High net profit ratio indicates higher profitability of the business.

Profitability Ratios (Continued)

3. Earnings per share
(Net profit after taxes-preference dividend)/Number of Equity shares outstanding Measure the profits available to the equity share holders on a per share basis. Increase in EPS indicates increasing trend of current profits per share per equity share. EPS is calculated on the basis of current profit and not on the basis of retained profits

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