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Accounting ratio shows the relationship between two accounting figures. Ratio analysis is the process of computing and presenting the relationships between the items in the financial statement. It is an important tool of financial analysis, because it helps to study the financial performance and position of a concern. Classification of ratios based on function 1. Liquidity Ratios: show the relationship between the current assets and current liabilities of the concern. Examples are Liquid ratio and Current ratio. 2. Leverage Ratios: show the relationship between proprietor’s funds and debts used in financing the assets of the concern. Examples are Capital gearing ratio, Debt-Equity ratio and Proprietary ratio. These are also known as Solvency ratios. 3. Activity Ratios (also known as Turnover ratios or Productivity ratios) show the relationship between the sales and the assets. Examples are Stock turnover ratio, Debtors turnover ratio etc. 4. Profitability ratio show the relationship between Profits and sales; for example, Operating ratio, gross profit ratio, Operating net profit ratio, Expenses ratios etc.; or Profits and investments; for example, Return Return on capital employed., Return on investments, Return on equity capital etc. 5. Coverage ratios show the relationship between the profit on one hand and the claims of outsiders (dividend, interest etc.) to be paid out of such profits. Examples are Dividend payout ratio and Debt services ratio. Profit and loss account Ratio: GROSS PROFIT RATIO Meaning This ratio compares gross profit with net sales. It is usually expressed in the form of percentage. Formula Gross profit = Gross Profit x 100 Net Sales Function/Purpose Gross profit is a profitability ratio, which shows the relationship between profits and sales. This ratio helps to judge (i) how efficient the concern is in managing its production, purchase, selling and
inventory; (ii) how good its control is over the direct costs; (iii) how productive the concern is; and (iv) how much amount is left to meet other expenses and earn net profit. OPERATING RATIO Meaning Operating ratio expresses the relationship between total operating costs and net sales. It is expressed by way of percentage . Formula Operating Ratio = Cost of Goods Sold + Operating Expenses x 100 Net Sales Function/Purpose Operating ratio indicates cost of operations. Its purpose is to measure and to ascertain the efficiency of the management as regards operations. This ratio helps to judge (i) how efficient the concern is in controlling its costs of production, administration, selling expenses; and (iv) how much amount out of sales revenue is used up in carrying out the operations of the concern. EXPENSES RATIO Meaning This ratio expresses the relationship between each item of expenditure and sales. It is expressed as a percentage. Total of all Expenses ratios will be equal to operating ratio. Formula Expense Ratio = Expenditure x 100 Net Sales e.g. Cost of goods Sold ( Factory cost) = COGS × 100 Net sales Administrative Expenses Ratio = Administrative Expenses x 100 Net Sales Finance expenses= Finance expenses *100 Net sales
Selling Expenses Ratio OPERATING PROFIT RATIO
= Selling Expenses x 100 Net Sales
Meaning Operating profit ratio indicates the relationship between Operating profit and the sales. Formula Operating Profit = Operating Profit x 100 = Net Sales Components Operating profit [OP] = 1. Gross Profit 2. Less: Operating expense [OE] Function/Purpose Operating profit ratio is a profitability ratio, which shows the relationship between profits and sales. It indicates profits from operations. This ratio helps to judge (i) how efficient the concern is in managing all its operations of production, purchase, inventory, administration, selling, distribution etc.; and (ii) how much amount is left to meet non-operating expenses and earn net profits. NET PROFIT RATIO Meaning Net profit ratio indicates the relationship between net profit and the sales. It is usually expressed in the form of a percentage. Net Profit = Balance Sheet Ratio CURRENT RATIO Meaning This ratio compares the current assets with the current liabilities. It is expressed in the form of a pure ratio e.g. 2:1 Formula Net Profit x 100 Net Sales
Current Ratio = Current Assets = Current Liabilities Function/Purpose
Current ratio is a liquidity/solvency ratio which indicates the ability of the concern to meet its short-term liabilities. It measures the short term solvency of the concern. It is used by a creditor to judge the safely margin available and to decide the amount and the terms of the credit. The standard ratio is 2: 1. LIQUID RATIO Meaning Liquid ratio compares the quick assets with the quick liabilities. It is measures the immediate solvency position of the company. It is also known as Quick ratio or Acid test ratio. Formula Liquid ratio = Quick Assets Quick Liabilities = QA QL
Note: QA=Current Assets less Closing Stock less Prepayment QL=Current Liabilities less Bank Overdraft less income received in advance Note 1: Stock is excluded cash. Note 2: Bank overdraft is excluded because it is almost with bank and not required to be paid back is full as long as the concern exists. because it is uncertain as to when and how much it will realize. Prepayment (pre-paid expenses, advances etc) are excluded because they cannot be converted into
STOCK TO WORKING CAPITAL RATIO Meaning Formula: Stock Working capital *100
This ratio shows the relationship between the closing stock and the working capital. It helps to judge the quantum of inventories in relation to the working capital of the business. It is expressed as a percentage. It is also known as Inventory Working Capital Ratio. If the stock to working capital is 70%. It means 70% of the working capital is blocked in assets and 30% is blocked in other current assets. PROPRIETORY RATIO Meaning Proprietory ratio compares proprietor’s funds with total assets. It is usually expressed in the form of percentage. Formula Proprietory Ratio = Proprietors’ Funds or Shareholder’s Equity Total Assets Components Proprietor’s Funds [PF] will include 1. Paid up Equity capital (EC) 2. Reserves & Surplus (RS) including capital reserves, revenue reserves, P & L a/c Cr. Balance. Less: Accumulated losses (i.e. P & L a/c Dr. Balance) Less: Fictitious Assets like Miscellaneous Expenditure not written off. 3. Paid up Preference Capital (PC) Thus, PF = EC + RS + PC –Misc Exp Function/Purpose Proprietory ratio is a solvency ratio which indicates (i) the long term solvency; and (ii) the extent of funds invested by the owners in relation to total funds employed in the business (i.e. capitalization). DEBT – EQUITY RATIO Meaning This ratio compares the long-term debt with shareholders’ funds. It is usually expressed as a pure ratio. X 100 = PF X 100 TA
Formula Debt = Borrowed Funds = BF Equity Proprietors’ Funds PF Purpose/Function Debt –equity ratio is a solvency ratio which indicates the proportion of debt and equity in financing of the assets of the concern. Debt-equity ratio shows the (i) margin of safety for long term creditors; and (ii) the balance between debt and equity (i.e. capitalization). If the debt equity ratio is 2.5: 1, it indicates that for every 2.5 obtained from debt, the company has obtained Re 1 from the shareholder CAPITAL GEARING RATIO Meaning The Capital Gearing ratio shows the relationship between two types of capital viz (i) Funds not bearing fixed rate of interest and dividend- Equity capital including reserves less fictitious asset . and (ii) . Funds and dividend bearing fixed rate of interest Preference capital and Long Term Borrowing. This is also known as ‘Capital Structure ratio’. When the ratio is more than 1, the company is said to highly geared and when the ratio is less than 1 the company lowly geared. Formula= Funds bearing fixed rate of interest and dividend Funds not bearing fixed rate of interest and dividend Preference Share capital + Debenture + Long term Bank loan + Public deposit Equity share capital + Reserves and Surplus – Misc expenditure Combined Ratio: RETURN ON CAPITAL EMPLOYED Meaning This ratio measures the relationship between net profit (before interest and tax) and the capital employed to earn it. It is expressed as a percentage . This ratio is also known as ‘Return on Investment’ [ROI] Formula Return on Capital Employed = Profit (before Interest, Tax) x 100
Capital Employed Components Profit (before Interest, Tax) [PBIT] = 1. Profit before interest on long term borrowing tax & dividends. 2. Less abnormal, non-recurring items. Capital Employed (CE) = 1 Equity capital 2. Add. Preference capital + Reserves & Surplus 3. Add. Long term Borrowings (Terms loans + Debentures) 4. Less : Fictitious assets like Miscellaneous Expenses not written off 5. Less : Profit & loss A/c. Dr. Balance (loss). Note : Capital employed may be taken to mean Assets Employed, in which case, Capital Employed [CE] can also be computed as 1. Fixed Assets (Less depreciation) ( including investments) 2. Add : Current Assets 3. Less : Current Liabilities 4. Exclude Fictitious assets. Function / Purpose Return on capital employed ratio is a profitability ratio, which shows the relationship between profits and investments. Its purpose is to measure the overall profitability from the total funds made available by the owners and lenders. This ratio helps to judge how efficient the concern is in managing the funds at its disposal. RETURN ON PROPRIETORS’ FUNDS Meaning This ratio measures the relationship between net profit (after interest and tax) and the proprietors’ capital. It is usually expressed as a percentage. It is also known as Return on Proprietor’s Equity or Return on Net Worth Formula Return on Proprietor’s Funds = Net Profit (after Tax) x Proprietor’s Funds RETURN ON EQUITY SHAREHOLDER FUND Meaning This ratio measures the relationship between net profit (after interest, tax and preference dividend) and the equity shareholders funds. It is usually expressed as a percentage. 100 = NPAT x 100 PF
Formula Return on Equity Capital = Components : Equity shareholders’ Funds [EF] = Equity capital [EC] Reserves and Surplus [RS] Less: Fictitious assets like Miscellaneous Expenses not written off Less: Profit& Loss A/c Dr. Balance(loss) DEBTORS TURNOVER Meaning This ratio shows the relationship between net credit sales and average trade debtors .It is expressed as a times. Actual debtors turnover ratio of 6 times indicates that debtors turnover 6 times during the year Formula Debtors Turnover = Net Credit Sales Avg Accounts Receivable + Avg Bills receivable NPAT – Prefrence dividend X 100 = Equity Shareholder’s Funds
Debtors Velocity (Debt Collection Period) Debtors velocity means the period (months or days) taken by the debtors for settlement of their bills. It shows the number of days for which credit sales remain outstanding = 365 days/ 12 months Debtors Turnover Ratio Function / Purpose Debtors turnover ratio is a turnover ratio, which shows the relationship between credit sales and debtors. Its purpose is to (I) calculate the speed with which debtors get settled on an average during the year; (ii) calculate the debtors velocity to indicate the period of credit allowed to average debtor; and (iii) judge how efficiently the debtors are managed. CREDITORS TURNOVER RATIO Meaning Creditors turnover ratio shows the relationship between the net credit purchases and the average trade creditors. Actual debtors turnover ratio of 6 times indicates that debtors turnover 6 times during the year
Formula Creditors Turnover = Credit Purchases = Accounts Payable Net Credit Purchases Avg Creditors + Avg Bills Payable
Creditors Velocity (Debt Payment Period) Creditors velocity means the period (months or days) taken by the concern to pay off its creditors. Credit Period Enjoyed = 365 days or 12 months Creditors Turnover Function / Purpose Creditors turnover ratio is a turnover ratio, which shows the relationship between credit purchases and creditors. Its purpose is to (i) calculate the speed with which creditors are paid off on an average during the year; (ii) calculate the creditors velocity to indicate he period taken by the average creditor to be paid off; and (iii) judge how efficiently the creditors are managed. STOCK TURNOVER RATIO Stock turnover ratio shows the relationship between the cost of goods sold and the average stock. This ratio is normally expressed as a ‘rate’ Formula A. Stock Turnover Ratio = Cost of Goods Sold Average Stock
Function/ Purpose Stock turnover ratio is an activity ratio, which shows the relationship between sales and stock. Its purpose is to (i) calculate the speed at which stock is being turned over into sales; (ii) calculate the stock velocity to indicate he period taken by the average stock to be sold out; and (iii) judge how efficiently the stocks are managed and utilized to generate sales. Actual Ratio For example, a Stock turnover ratio of 8, indicates that the stock is being turned into sales 8 times during the year. The Inventory cycle makes 8 rounds during the year. It also helps to work out the Stock Holding Period (stock velocity). If the Stock turnover is 8 times, the Stock Holding Period is 1.5 months (12 months / Stock turnover ratio = 12 / 8). This indicates that it takes 1.5 months for the stock to be sold out. Stock velocity shows the duration of the inventory cycle.
Interest Coverage Ratio:
This ratio indicates sufficiency or deficiency of earnings to pay interest falling due within the period covered under profits. Interest coverage Ratio= NPBIT Interest DEBT SERVICE COVERAGE RATIO Note : Debt Service Coverage Ratio (which deals with the capacity to pay interest as well as loan installment) is different from Debt Service Ratio Meaning Debt Service Coverage Ratio shows the relationship between net profits and interest + installments payable on loans. It is expressed as a pure number. Debt Service means the payment of interest + installments on loans. Coverage means the availability of profits for debt servicing. Formula Debt Service Coverage Ratio = Net profit + Depreciation + Interest on Term loan Interest + Installment due on loans Function / Purpose Debt Service Coverage Ratio (DSCR) is a type of coverage ratio. A coverage ratio shows the relationship between the profit and the claims of outsiders to be paid out of such profits. The purpose of DSCR is to measure the debt-servicing capacity of the company. DIVIDEND PAYOUT RATIO Meaning Dividend Payout Ratio shows the relationship between the dividend paid to equity shareholders out of the profits available to the equity shareholders. It shows how much percentage of earnings are given as dividend Formula Dividend payout ratio = Dividend per share Earning per share x 100
EARNING PER SHARE: EPS= NPAT- Preference dividend No of Equity shares
Earning per share is most widely used financial data. Higher the ratio indicates that the company may pay dividend at a higher rate. It shows how much percentage of earnings are given as dividend Price –Earning ratio (P/E ratio) : This ratio is the market price of shares expressed as multiple of Earning per share: P/E ratio: Market price per share Earnings per share This ratio indicates the market price is how many times as the earning, A higher P/E ratio is good. Investor should invest in the company having low P/E ratio Dividend yield ratio Market price per share Earning per share It means the dividend is how percentage of market price per share ADVANTAGES OF RATIO ANALYSIS Advantages :
Useful in analysis of financial statements. Ratio analysis is the most important tool available for analysing the financial statements i.e. Profit and Loss Account and Balance Sheet. Such analysis is made not only by the management but also by outside parties like bankers, creditors, investors etc. Useful in improving future performance. Ratio analysis indicates the weak spots of the business. This helps management in overcoming such weaknesses and improving the overall performance of the business in future. Useful in inter-firm comparison. Comparison of the performance of one firm with another can be made only when absolute data is converted into comparable ratios. If A firm is earning a net profit of Rs. 50,000 while another firm B is earning Rs. 1.00,000, it does not necessarily mean that firm B is better off unless this profit figure is converted into a ratio and then compared. Useful in judging the efficiency of a business. As stated earlier, accounting ratios help in judging the efficiency of a business. Liquidity, solvency, profitability etc. of a business can be easily evaluated with the help of various accounting ratios like current ratio, liquid ratio, debtequity ratio, net profit ratio, etc. Such an evaluation enables the management to judge the operating efficiency of the various aspects of the business. Useful in simplifying accounting figures. Complex accounting data presented in Profit and Loss Account and Balance Sheet is simplified,
summarised and systematised with the help of ratio analysis so as to make it easily understandable. For example, gross profit ratio, net profit ratio, operating ratio etc. give a more easily understandable picture of the profitability of a business than the Absolute figures.
Limitations of Ratio Analysis Ratio analysis is a very useful technique. But one should be aware of its limitations as well. The following limitations should be kept in mind white making use of ratio analysis in interpreting the financial statements. 1. Reliability of ratios depends upon the correctness of the basic data. Ratios obviously will be only as reliable as the basic data on which they are based. If the balance sheet or profit and loss account figures are themselves unreliable, it will be a mistake to put any reliance on the ratios worked out on the basis of that Balance Sheet or Profit and Loss Account. 1. An individual ratio may by itself be meaningless. Except in a few cases, an accounting ratio may by itself be meaningless and acquires significance only when compared with relevant ratios of other firms or of the previous years. In fact, ratios yield their best advantage on comparison with other similar firms; also if ratios for a year are compared with ratios in the previous years, it will be a useful exercise. Comparison is the essential requirement for using ratios for interpreting a given situation in a firm or industry. 2. Ratios are not always comparable. When the ratios of two firms are being compared, it should be remembered that different firms may follow different accounting practices. For example, one firm may charge depreciation on straight line basis and the other on diminishing value. Similarly, different firms may adopt different methods of stock valuation. Such differences will not make some of the accounting ratios strictly comparable. However, use of accounting standards makes ratio comparable. 1. Ratios sometimes give a misleading picture. One company produces 500 units in one year and 1,000 units the next year; the progress is 100%. Another firm produces 4,000 units in one year and 5,000 in the next year, the progress is 25%. The second firm will appear to be less active than the first firm, if only the rate of increase or ratio is compared. It will be much more useful if absolute figures are also compared along with rate of increase—unless the firms being compared are equal in all respects. In fact, one should be extremely careful while comparing the results of one firm with those of another firm if the two figures differ in any significant manner, say in size, location, degree of automation or mechanisation. 2. Ratios ignore qualitative factors. Ratios are as a matter of fact, tools of quantitative analysis. It ignores qualitative factors which sometimes are equally or rather more important than the quantitative factors. As a result of this, conclusions from ratio analysis may be distorted. For example, despite the fact that credit may be granted to a customer on the basis of information regarding the financial position of business as disclosed by
certain ratios, but the grant of credit ultimately depends upon the credit standing, reputation and managerial ability of the customer, which cannot be expressed in the form of ratios. 3. Change in price levels makes ratio analysis ineffective. Changes in price levels often make comparison of figures for a number of years difficult. For example, the ratio of sales to fixed assets in 2003 would be much higher than in 1995 due to rising prices because fixed assets are stilt being expressed on the basis of cost incurred a number of years ago while sates are being expressed at their current prices. 2. There is no single standard for comparison. Ratios of a company have meaning only when they are compared with some standard ratios. Circumstances differ from firm to firm and the nature of each industry is different. Therefore, the standards will differ for each industry and the circumstances of each firm will have to be kept in mind. It is difficult to find out a proper basis of comparison. Therefore, the performance of one industry may not be properly comparable with that of another. Usually it is recommended that ratios should be compared with the average of the industry. But the industry averages are not easily available.
3. Ratios based on past financial statements are no indicators of future. Accounting ratios are calculated on the basis of financial statements of past years. Ratios thus indicate what has happened in the past. Since past is quite different from what is likely to happen in future, it is difficult to use ratios for forecasting purposes. The financial analyst is more interested in what will happen in future. The management of a company has information about the company's future plans and, policies and is, therefore, able to predict future to a certain extent. But an outsider analyst has to rely only on the past ratios which may not necessarily reflect the firms future financial position and performance.
COMPUTATION OF RATIOS Q1) Following is the Balance Sheet of Ranbaxy ltd. as on 31st March 2007. You are required to convert the same in Vertical formats and. calculate the following ratios: 1) Current Ratio 2) Liquid Ratio, 3) Stock to Working Capital Ratio, 4) Proprietory Ratio, 5) Capital Gearing Ratio, 6) Debt Equity Ratio Liabilities Rs. Assets Rs. Equity Share Capital (Rs. 10 2,00,000 Land & Bldg at WDV 1,00,000 each) Plant & Mach at WDV 1,20,000 10% Preference Share Capital 1,00,000 Long Term Investments 90,000 General Reserve 2,00,000 Capital WIP 75,000 12% Debentures 1,00,000 Inventories 2,00,000 Accounts Payable 1,60,000 Book Debts (last year Rs. 2,00,000 Bank Overdraft 1,00,000 1,80,000) Acceptances given 75,000 Current Investments 50,000 Income received in Advance 25,000 Prepaid Exp 10,000 Provision for Taxation 40,000 Cash at Bank 40,000
Advance Tax Bills Receivable Underwriting Commission ( To the extent not w/off) 10,00,000
30,000 75,000 10,000 10,00,000
Q.2) The following is the Profit & Loss A/c. of Reliance ltd. for the year ended 31st March 2007. You are required to convert the same in a suitable form for analysis and calculate the following ratios: 1) Gross Profit Ratio, 2) Operating Ratio, 3) Operating Expense Ratio, 4) Operating Profit Ratio; 5) Net Profit Ratio. Particulars Rs. Particulars Rs. To Opening Stock 1,50,000 By Sales (10% cash) 20,00,000 To Purchases 10,50,000 Less: Returns 2,00,000 To Factory Expenses 4,50,000 18,00,000 To Gross Profit 3,50,000 By Closing Stock 2,00,000 20,00,000 20,00,000 To Administrative Expenses To Rent To Interest paid on Debentures To Selling Expenses To Bad debts To Depreciation To Loss by fire To Provision for Tax To Net Profit 1,20,000 By Gross Profit 30,000 By Bad Debts Recovery 12,000 By Dividend/ Int. received 15,000 By Miscellaneous Income 10,000 30,000 40,000 1,21,500 1,21,500 5,00,000 To Proposed Equity Dividend 50,000 By Net Profit To Dividend on Preference 10,000 Share To Transfer to General Reserve 61,500 1,21,500 The Companies shares are quoted on stock exchange at Rs 44.60 3,50,000 50,000 25,000 75,000
From the financial statements given above (Q.1 & Q.2) you are required to calculate the following ratios: Overall Profitability Ratios: 1) Return on Capital Employed, 2) Return on Shareholders fund, 3) Return on Equity Shareholders fund. Turnover Ratios: 1) Stock Turnover ratio, 2) Debtors Turnover ratio & Debtors Velocity, 3) Creditors Turnover ratio & Creditors Velocity, 4) Fixed Asset Turnover Ratio, 5) Total Asset Turnover ratio .6) Working Capital Turnover ratio.
Ratios related to Equity Shares: 1) Earning Per Share (EPS), 2) Price Earning Ratio (P/E ratio), 3) Dividend Per Share (DPS), 4) Dividend Payout Ratio (D/P ratio), 5) Dividend Yield Ratio. Coverage Ratio: 1) Interest Coverage Ratio, 2) Dividend Coverage Ratio
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