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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 1
© Tata McGraw-Hill Publishing Company Limited, Management Accounting 1
FINANCIAL STATEMENTS
ANALYSIS
Ratio Analysis
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 3
Basis of Comparison
1) Trend Analysis involves comparison of a firm over a
period of time, that is, present ratios are compared with
past ratios for the same firm. It indicates the direction of
change in the performance – improvement, deterioration
or constancy – over the years.
Liquidity
LiquidityRatios
Ratios Capital
CapitalStructure
StructureRatios
Ratios
Profitability
ProfitabilityRatios
Ratios Efficiency
Efficiencyratios
ratios
Integrated
Integrated Growth
GrowthRatios
Ratios
Analysis
AnalysisRatios
Ratios
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 5
Net Working Capital
Net working capital is a measure of liquidity calculated by
subtracting current liabilities from current assets.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 7
Current Ratio
Current Ratio is a measure of liquidity calculated dividing
the current assets by the current liabilities
Current Assets
Current Ratio =
Current Liabilities
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 8
Acid-Test Ratio
The quick or acid test ratio takes into consideration
the differences in the liquidity of the
components of current assets
Quick Assets
Acid-test Ratio =
Current Liabilities
Cash Rs 2,000
Debtors 2,000
Inventory 12,000
Total current assets 16,000
Total current liabilities 8,000
(1) Current Ratio 2:1
(2) Acid-test Ratio 0.5 : 1
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 10
Supplementary Ratios for
Liquidity
Inventory
Inventory Turnover
Turnover Debtors
Debtors Turnover
Turnover Ratio
Ratio
Ratio
Ratio
Creditors
Creditors Turnover
Turnover Ratio
Ratio
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 11
Inventory Turnover Ratio
The ratio indicates how fast inventory is sold. A high ratio is good
from the viewpoint of liquidity and vice versa. A low ratio
would signify that inventory does not sell fast and stays
on the shelf or in the warehouse for a long time.
A firm has sold goods worth Rs 3,00,000 with a gross profit margin of
20 per cent. The stock at the beginning and the end of the year
was Rs 35,000 and Rs 45,000 respectively. What is the
inventory turnover ratio?
12 months
Inventory
= = 2 months
holding period Inventory turnover ratio, (6)
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 13
Debtors Turnover Ratio
The ratio measures how rapidly receivables are collected. A high
ratio is indicative of shorter time-lag between credit sales and
cash collection. A low ratio shows that debts are not
being collected rapidly.
A firm has made credit sales of Rs 2,40,000 during the year. The
outstanding amount of debtors at the beginning and at the end
of the year respectively was Rs 27,500 and Rs 32,500.
Determine the debtors turnover ratio.
Rs 2,40,000
Debtors 8 (times per
= =
turnover ratio (Rs 27,500 + Rs 32,500) ÷ 2 year)
12 Months
Debtors 1.5
= =
collection period Debtors turnover ratio, (8) Months
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 15
Creditors Turnover Ratio
A low turnover ratio reflects liberal credit terms granted by
suppliers, while a high ratio shows that accounts are to be settled
rapidly. The creditors turnover ratio is an important tool of
analysis as a firm can reduce its requirement of current assets by
relying on supplier’s credit.
(Rs 1,80,000)
Creditors 4 (times
= =
turnover ratio (Rs 42,500 Rs 47,500) ÷ 2 per year)
12 months
Creditor’s
= = 3 months
payment period Creditors turnover ratio, (4)
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 17
The summing up of the three turnover ratios (known as a cash
cycle) has a bearing on the liquidity of a firm. The cash cycle
captures
the interrelationship of sales, collections from debtors
and payment to creditors.
The combined effect of the three turnover ratios
is summarised below:
Liquid assets
Defensive-
=
interval ratio Projected daily cash requirement
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 19
Example 5: Defensive Interval Ratio
Rs 1,82,500
Projected daily cash requirement = = Rs 500
365
Rs 40,000
Defensive-interval ratio = = 80 days
Rs 500
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 20
Cash-flow From Operations Ratio
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 21
Leverage Capital Structure Ratio
There are two aspects of the long-term solvency of a firm:
(i) Ability to repay the principal when due, and
(ii) Regular payment of the interest .
Capital structure or leverage ratios throw light on the
long-term solvency of a firm.
If the D/E ratio is high, the owners are putting up relatively less
money of their own. It is danger signal for the lenders and
creditors. If the project should fail financially, the
creditors would lose heavily.
A low D/E ratio has just the opposite implications. To the creditors, a
relatively high stake of the owners implies sufficient safety
margin and substantial protection against
shrinkage in assets.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 23
For the company also, the servicing of debt is less
burdensome and consequently its credit standing
is not adversely affected, its operational flexibility
is not jeopardised and it will be able to
raise additional funds.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 24
Trading on Equity
Trading on equity (leverage) is the use of borrowed funds in
expectation of higher return to equity-holders.
Total debt
Debt to total capital ratio =
Permanent capital
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 26
III. Debt to total assets ratio
Total debt
Debt to total assets ratio =
Total assets
Proprietary Ratio
Proprietary ratio indicates the extent to which assets
are financed by owners funds.
Proprietary funds
Proprietary ratio = X 100
Total assets
n
∑ EATt + Interestt + Depreciationt + OAt
t=1
DSCR = n
∑ Instalmentt
t=1
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 33
Profit Margin
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 34
Net Profit Margin
Net profit margin measures the percentage of each sales rupee
remaining after all costs and expense including interest
and taxes have been deducted.
Rs 1,00,000
(1) Gross profit margin = = 50 per cent
Rs 2,00,000
Rs 50,000
(2) Net profit margin = = 25 per cent
Rs 2,00,000
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 36
Expenses Ratio
Cost of goods sold
i. Cost of goods sold = X 100
Net sales
Administrative exp. + Selling exp.
ii. Operating expenses = X 100
Net sales
Administrative expenses
iii. Administrative expenses = X 100
Net sales
Selling expenses
iv. Selling expenses ratio = X 100
Net sales
Cost of goods sold + Operating expenses
v. Operating ratio = X 100
Net sales
Financial expenses
vi. Financial expenses = X 100
Net sales
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 37
Return on Investment
Return on Investments measures the overall effectiveness
of management in generating profits with
its available assets.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 39
Efficiency Ratio
Activity ratios measure the speed with which various
accounts/assets are converted into sales or cash.
Inventory turnover measures the efficiency of various types
of inventories.
i. Debtors
Inventoryturnover
Turnover Credit sales
i. = measures the activity/liquidity of inventory
of a firm; the speedAverage
with which
debtors
inventory
+ Average
is soldbills receivable (B/R)
Income-tax Plus
Current liabilities
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 45
Return on Assets
Earning Power
Earning power is the overall profitability of a firm; is computed
by multiplying net profit margin and
assets turnover.
i. Inventory Earning
Turnover after taxes
measures the Sales of inventory
activity/liquidity EAT
Earning Power = x x
of a firm; the speed withSales
which inventoryTotal
is sold
Assets Total assets
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 46
EXAMPLE: 8
Assume that there are two firms, A and B, each having total assets
amounting to Rs 4,00,000, and average net profits after
taxes of 10 per cent, that is, Rs 40,000, each.
Limitations
Ratio analysis in view of its several limitations should be
considered only as a tool for analysis rather than as an end in
itself. The reliability and significance attached to ratios will largely
hinge upon the quality of data on which they are based. They are
as good or as bad as the data itself. Nevertheless, they are an
important tool of financial analysis.
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© Tata McGraw-Hill Publishing Company Limited, Management Accounting 50