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financial ratios

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14-09-2017

FINANCIAL STATEMENTS

ANALYSIS

Ratio Analysis

Ratio Analysis

Ratio Analysis

is defined as the systematic use of ratio to interpret the

financial statements so that the strengths and

weaknesses of a firm as well as its historical

performance and current financial

condition can be determined.

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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.

firm with those of others in the same lines of business or

for the industry as a whole. It reflects the firms

performance in relation to its competitors.

Types of Ratios

Integrated

Growth Ratios

Analysis Ratios

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Net working capital is a measure of liquidity calculated by

subtracting current liabilities from current assets.

Particulars Company A Company B

Total current assets Rs 180 Rs 30

Total current liabilities 120 10

NWC 60 20

Table 2: Change in Net Working Capital (Rs. in Lakh)

Particulars Company A Company B

Current assets Rs 150 Rs 300

Current liabilities 75 200

NWC 75 100

Liquidity Ratios

of a firm to meet its short-term

obligations

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Current Ratio

Current Ratio is a measure of liquidity calculated dividing

the current assets by the current liabilities

Current Assets

Current Ratio =

Current Liabilities

(Rs. in Lakh) (Rs. in Lakh)

Particulars Firm A Firm B

Current Assets Rs 180 Rs 30

Current Liabilities Rs 120 Rs 10

Current Ratio = 3:2 (1.5:1) 3:1

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

Pre-paid expenses

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14-09-2017

(Rs. in Lakh)

Cash Rs 20

Debtors 20

Inventory 120

Total current assets 160

Total current liabilities 80

(1) Current Ratio 2:1

(2) Acid-test Ratio 0.5 : 1

Liquidity

Inventory Turnover

Debtors Turnover Ratio

Ratio

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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.

Inventory turnover ratio =

Average inventory

and closing inventory.

A firm has sold goods worth Rs 300 lakh with a gross profit margin of

20 per cent. The stock at the beginning and the end of the year

was Rs 35 lakh and Rs 45 lakh respectively. What is the

inventory turnover ratio?

= =

turnover ratio (Rs 35 + Rs 45) 2 per year)

Inventory 12 months

= = 2 months

holding period Inventory turnover ratio, (6)

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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.

Debtors turnover ratio =

Average debtors

returns, if any, from customers.

bills receivable) at the beginning and at the end of year.

A firm has made credit sales of Rs 240 lakh during the year. The

outstanding amount of debtors at the beginning and at the end

of the year respectively was Rs 27.5 lakh and Rs 32.5 lakh.

Determine the debtors turnover ratio.

= =

turnover ratio (Rs 27.5 + Rs 32.5) 2 per year)

= =

collection period Debtors turnover ratio, (8) Months

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14-09-2017

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 suppliers credit.

=

ratio Average creditors

Net credit purchases = Gross credit purchases - Returns to

suppliers.

outstanding at the beginning and at the end of the year.

lakh. The amount payable to the creditors at the beginning

and at the end of the year is Rs 42.5 lakh and Rs 47.5 lakh

respectively. Find out the creditors turnover ratio.

= =

turnover ratio (Rs 42.5 Rs 47.5) 2 per year)

Creditors 12 months

= = 3 months

payment period Creditors turnover ratio, (4)

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14-09-2017

has a bearing on the liquidity of a firm. The cash cycle captures

the interrelationship of sales, collections from debtors

and payment to creditors.

is summarised below:

Add: Debtors collection period + 1.5 months

Less: Creditors payment period 3 months

0.5 months

As a rule, the shorter is the cash cycle, the better are the liquidity

ratios as measured above and vice versa.

assets and projected daily cash requirement.

=

interval ratio Projected daily cash requirement

=

cash requirement Number of days in a year (365)

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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.

First type: These ratios are Second type: These ratios are

computed from the balance computed from the Income

sheet Statement

(a) Debt-equity ratio (a) Interest coverage ratio

(b) Debt-assets ratio (b) Dividend coverage ratio

(c) Equity-assets ratio

I. Debt-equity ratio

Debt-equity ratio measures the ratio of long-term or total

debt to shareholders equity.

Totalthe ratio of long-

Debt

Debt-equity ratiode3bt

term or total = to shareholders equity

Shareholders equity

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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14-09-2017

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.

the shareholders of the firm are deprived

of the benefits of trading on equity

or leverage.

Trading on Equity

Trading on equity (leverage) is the use of borrowed funds in

expectation of higher return to equity-holders.

Particular A B C D

(a) Total assets 1,000 1,000 1,000 1,000

Financing pattern:

Equity capital 1,000 800 600 200

15% Debt 200 400 800

(b)Operating profit (EBIT) 300 300 300 300

Less: Interest 30 60 120

Earnings before taxes 300 270 240 180

Less: Taxes (0.35) 105 94.5 84 63

Earnings after taxes 195 175.5 156 117

Return on equity (per cent) 19.5 21.9 26 58.5

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The relationship between creditors funds and

owners capital can also be expressed using

Debt to total capital ratio.

Total debt

Debt to total capital ratio =

Permanent capital

Long-term debt.

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

Capital gearing ratio is used to know the relationship between equity

funds (net worth) and fixed income bearing funds (Preference

shares, debentures and other borrowed funds.

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14-09-2017

Coverage Ratio

Interest Coverage Ratio

Interest Coverage Ratio measures the firms ability to make

contractual interest payments.

Interest coverage ratio =

Interest

Dividend Coverage Ratio measures the firms ability to pay dividend

on preference share which carry a stated rate of return.

Dividend coverage ratio =

Preference dividend

Profitability Ratio

Profitability ratios can be computed either from

sales or investment.

Related to Sales Related to Investments

(i) Profit Margin (i) Return on Investments

Equity

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14-09-2017

Profit Margin

rupee remaining after the firm has paid for its goods.

X 100

Sales

Net profit margin measures the percentage of each sales rupee

remaining after all costs and expense including interest

and taxes have been deducted.

i. Operating Profit Ratio =

Net sales

ii. Pre-tax Profit Ratio =

Net sales

iii. Net Profit Ratio = Net sales

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14-09-2017

determine (i) Gross profit margin and (ii) Net profit

margin. (Amount in Rs Lakh)

1. Sales Rs 200

2. Cost of goods sold 100

3. Other operating expenses 50

Rs 100

(1) Gross profit margin = = 50 per cent

Rs 200

Rs 50

(2) Net profit margin = = 25 per cent

Rs 200

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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14-09-2017

Return on Investment

Return on Investments measures the overall effectiveness

of management in generating profits with

its available assets.

EBIT

ROA =

Average total assets

EBIT

ROCE =

Average total capital employed

Return on shareholders equity measures the return on the

owners (both preference and equity shareholders )

investment in the firm.

Net profit after taxes

X 100

Average total shareholders equity

Net profit after taxes Preference dividend

X 100

Average ordinary shareholders equity

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14-09-2017

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.

measures theof goods sold

activity/liquidity of

Inventory Turnover Ratio =

Average

inventory of a firm; the speed with whichinventory

inventory is sold

measures theofactivity/liquidity

raw materials usedof

Raw materials turnover =

inventory of a firm; the speed with which

Average inventory

raw material is sold

inventory

the activity/liquidity of

Work-in-progress turnover =

Average

inventory of a firm; the speed work-in-progress

with which inventory isinventory

sold

Liquidity of a firms receivables can be examined

in two ways.

i. Credit sales

i. Inventory Turnover

Debtors turnover = measures the activity/liquidity of inventory of

a firm; the speed with

Average

whichdebtors

inventory

+ Average

is sold bills receivable (B/R)

2. Average collection period =

Debtors turnover

Months (days)

i. Inventory Turnover in a year

measures (x) (Average Debtors

the activity/liquidity + Average

of inventory of a(B/R)

Alternatively =

Total credit

firm; the speed with which inventory is sold sales

slow paying debtors.

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14-09-2017

Assets turnover indicates the efficiency with which firm

uses all its assets to generate sales.

i. Inventory Turnover

Total assets measures

turnover = the activity/liquidity

a firm; the speed with which inventory

Average total

is sold

assets

Cost of goods sold

ii. Fixed assets turnover =

Average fixed assets

Cost of goods sold

i. Inventory

iii. Turnover

Capital turnover = measuresAverage

the activity/liquidity of inventory of

a firm; the speed with which inventory iscapital

sold employed

Cost of goods sold

iv. Current assets turnover =

Average current assets

v. Inventory Turnover

Working capital measures

turnover = the activity/liquidity of inventory of

Net working

a firm; the speed with which inventory capital

is sold

shareholders equity (net worth).

(EAT Dp)/Number of equity shares outstanding (N).

shareholders/Number of ordinary shares outstanding (N).

shares outstanding.

19

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