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Compute the standard financial ratios

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Accounting Ratio

• Arithmetical relation between two accounting variables, having a cause and effect relationship • Accounting ratios can be expressed as:

– Pure or as a quotient – Percentage – Times – Fraction – Number of days

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**Types of Accounting Ratios
**

Accounting ratios can be classified into –Liquidity or Short-Term Solvency ratios –Activity or Asset Management Ratios –Financial Structure or Capitalisation Ratios –Profitability Ratios –Market Test Ratios

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Liquidity / Solvency Ratios • Measures the firms ability to pay off the current dues – Current Ratio/Working capital ratio – Quick Ratio/Acid test Ratio • Current Ratio of 2 is ideal • Debtors outstanding for more than 6 months not normally considered • Prepaid expenses are treated as current assets. 4 .

Ability to Pay Current Liabilities • Working capital – measure of amount of current asset remaining after all current liabilities have been paid Current assets – Current liabilities 5 .

Ability to Pay Current Liabilities • Current ratio – measures ability to pay current assets with current liabilities Current assets Current liabilities 6 .

Example From the following compute Current Ratio Sundry Debtors 100000 Prepaid expenses 10000 Cash in hand and bank 30000 Short term investments 20000 Machinery 7000 Bills payable 20000 Sundry Creditors 40000 Debentures 200000 Stock 40000 Expenses payable 40000 7 .

Ability to Pay Current Liabilities • Quick Ratio (Acid test ratio) – if the entity could pay all its current liabilities if they came due immediately – Quick assets . short-term investments.cash. net current receivables – Exclude stock and prepaid expenses Quick assets Current liabilities 8 .

2002 Liabilities Rs Assets Rs. Equity Share Capital Profit and Loss A/c 10% Debentures Sundry Creditors Provision for taxation 24000 Machinery and equipment 6000 Stock 15000 Sundry Debtors 23400 Cash at Bank 600 Prepaid expenses 69000 45000 12000 9000 2280 720 69000 9 .Following is the balance sheet of XYZ Limited as on 31st December.

Activity Ratios • Also termed as Performance or Turnover ratios • Measures the effectiveness with which the concern uses resources at its disposal • Higher the turnover ratio – better the use of resources – better profitability ratio • This ratio represents the efficiency of asset usage to generate sales revenue 10 .

Ability to Sell Inventory & Collect Receivables • Inventory turnover – how many times a year the company sells its average level of inventory Cost of goods sold Average inventory* Cost of good sold = Sales – Gross Profit *Average inventory = (Beginning inventory + Ending Inventory)/2 11 .

• Higher the ratio. indicates more sales are being produced by a unit of investment in stocks • Purpose : to check if the investment in stocks is optimal • Industries in which the inventory turnover ratio is high usually work on a comparatively lower profit margin Note: Sometimes this ratio is calculated from sales also .

Debtors/Receivables Turnover Ratio • how quickly the company collects cash from credit customers Net credit sales Average net accounts receivable* Accounts Receivables includes Trade Debtors and Bills Receivable *Average net accounts receivable = (Beginning receivables + Ending receivables)/2 13 .

Important points to note…. • Doubtful debts are not deducted from total debtors • In case details regarding opening and closing receivables and credit sales is not given. then the ratio is worked out as Total sales Accounts Receivable .

the better the quality of debtors 15 .Average Collection Period or Debtor days • how many days’ sales remain uncollected in accounts receivable Accounts Receivable (Credit Sales for the year/360) • The shorter the average collection period.

Creditors Turnover Ratio Net credit Purchases Average accounts payables* *Average accounts payable = (Beginning creditors + Beginning Bills Payable + Ending receivables + Ending Bills Payable)/2 Average Payment Period Accounts Payable (Credit Purchases/360) .

Capital Turnover Ratio • Efficient rotation of capital leads to higher profitability • Relation between sales and capital employed Sales Capital Employed* *Capital Employed= Fixed Assets + Net Working Capital .

Depreciation Working Capital Turnover Ratio Sales Net Working Capital .Fixed Asset Turnover Ratio Sales Net Fixed Assets* *Net Fixed Assets = Fixed Assets .

.The following is the Balance Sheet of K Co.160. as on 31st December 2008 Liabilities Share Capital General Reserve Profit & Loss A/c Loan @ 10% Creditors Bills Payable Rs. (b) Fixed Asset Turnover Ratio and (c ) Working Capital Turnover Ratio . 160000 60000 20000 50000 10000 300000 Sales during the year amounted to Rs.000. Calculate (a) Capital Turnover Ratio. Ltd. Assets 80000 Fixed Assets 30000 Debtors 50000 Bills Receivable 80000 Cash at Bank 40000 Preliminary Exps 20000 300000 Rs.

70 230000 Fixed Asset Turnover Ratio = 160.000 = 2.000 Working Capital Turnover Ratio = 160.Capital Turnover Ratio = 160000 = 0.000 .29 70.000 = 1 160.

but creates claims on earnings with a higher priority than those of the firm's owners • There are two types of Debt Measures – Degree of Indebtedness – Ability to Service Debts .Financial Structure or Capitalisation Ratios • Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money.

Degree of Indebtedness • Debt ratio – proportion of company’s assets financed with debt Total liabilities Total assets • Debt – Equity Ratio – Ascertains the soundness of the financial policies of the company Debt (Long term loans) Equity (shareholders funds) 22 .

Ability to Service Debt • Times-interest-earned (interest coverage) – how many times operating income covers interest expense • Debt Service Ratio or Fixed Charges Cover Income from operations* Interest expense *Income from operations = Income before income tax & interest expense 23 .

Fixed Asset Ratio • Fixed Assets should be financed only through long term loans Shareholders funds + Long term Loans Net Fixed Assets • If ratio < 1 means firm has used short term funds to finance long term assets 24 .

creditors and management • A Common-Size Income Statement. which expresses each income statement item as a percentage of sales.Profitability Ratios • Profitability Ratios assess the firm's ability to operate efficiently • Of concern to owners. allows for easy evaluation of the firm’s profitability relative to sales 25 .

Profitability Ratios • Rate of return on net sales (Gross profit ratio Gross Profit x 100 Net sales • Net Profit Ratio Net Profit x 100 Net sales 26 .

tax and Dividends Capital Employed • Return on Equity – profits available to the equity shareholders Net Profit Equity Shareholders funds* 27 *Equity Shareholders funds = Paid up capital and reserves .Overall Profitability Ratios • Return on Investment – relation between profit earned and capital employed • Measures the earning power of the net assets in business Profit before Interest.

Profitability • Trading on the equity (using leverage) – company borrows at a lower rate then invests the money to earn a higher rate • A company is favorably leveraged if return on assets > return on stockholders’ equity 28 .

. the higher the perceived quality of the earnings by the share market. • The higher the ratio.Market Test Ratios • Based on the share market's perception of the company.

Market Test Ratios • Earnings per share = Net Profit after tax Number of issued ordinary shares • Dividends per share = Dividends Number of issued ordinary shares • Dividend payout ratio = Dividends per share *100 Earnings per share • Price Earnings ratio = Market price per share Earnings per share .

inventory. and receivables • Earnings problems • Decreased cash flow • Too much debt • Inability to collect receivables • Inventory buildup 31 .Red Flags • Strange movement of sales.

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