CHAPTER 5

CLASSIFICATION, ANALYSIS & INTERPRETATION OF RATIOS

FUNCTIONAL CLASSIFICATION OF RATIOS

TEST OF LIQUIDITY PROFITABILITY TEST OF SOLVENCY

RATIO

(a) Liquidity ratio (a) General Ratio 1. Debt Equity Ratio

1. Current Ratio 2. Equity Ratio
1. Gross Profit Ratio
2. Quick Ratio
3. Solvency Ratio
2. Expenses Ratio
3. Absolute Ratio
4. Funded debt to Total
* Direct Expenses
Capitalization
* Indirect Expenses
5. Fixed Asset to long
* C.O.G.S Ratio
term debt
3. Net Profit Ratio

(b) Efficiency Ratio (b) Overall Profitability

Ratio
1. Inventory Ratio
1. Return on Capital
2. Debtors Ratio
3. Creditors Ratio Employed
4. Working Capital
2. Return on
Ratio
Shareholder’s

Fund.
(A) TEST OF LIQUIDITY OR ANALYSIS OF SHORT TERM

FINANCIAL POSITION

(a) LIQUIDITY RATIOS:-

Liquidity refers to the ability of a concern to meet its current obligations as and when
become due. It is the pre requirement for the survival of every concern. These ratios are
generally used by all financial statement users but are particularly useful to short term
creditors. Whether current assets are sufficient or insufficient should be assessed through
these ratios. To measure the short term liquidity of Verka following ratios are calculated.
These are calculated in ratio as a:b.

1. Current Ratio
2. Quick Ratio
3. Absolute Liquid Ratio

1. CURRENT RATIO:-

This ratio is widely used to know the short-term financial position of the concern. It
expresses the relationship between current assets and current liabilities. It is also known as
‘working capital ratio’.

Current Ratio = Current Assets / Current Liabilities

(Rs. In lakhs)

PARTICULARS 2016-17 2017-18 2018-19

Current Assets 507.98 868.68 1056.05

Current 416.91 904.49 527.97

Liabilities

Ratios (a:b) 1.22 .96 2.00

Current Assets at Milk Plant, Gurdaspur covers Current Assets, Loans & Advances,
Cash and Bank balances.

Current Laibilities cover Current Liabilities and Provisions.

2.5

1.5

0.5

0
2016-17 2017-18 2018-19

Interpretation:

Rule of Thumb says that current ratio should be 2:1. It means to every liability there are
double the assets. The position of Verka Milk Plant, Gurdaspur is double in 2018-19. This
shows how liquid this milk plant is. It is always in favor of the organization to have sound
liquid position for proper functioning i.e. current assets is enough to meet current liabilities

2. QUICK RATIO:-

Quick ratio may be defined as relationship between quick / liquid assets and current
liabilities. An asset is said to be liquid if it can be converted into cash within a short period
without loss of value. In that sense cash in hand, cash bank and debtors are liquid assets.

Quick Ratio = Quick Assets / Current Liabilities

PARTICULARS 2016-17 2017-18 2018-19

Current Assets 507.98 868.68 1056.05

Inventory 333.23 658.86 851.05

Quick Assets 174.75 209.82 205

Current liabilities 416.91 904.49 527.97

Ratios (a:b) .42 .23 .39

Quick Assets Cover: Current Assets – (Inventory + Prepaid Expenses)

0.45

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0
2016-17 2017-18 2018-19

Interpretation:

As a convention quick ratio of 1:1 is considered satisfactory. A high ‘acid test ratio’
indicates that union is liquid enough to meet its liquid liabilities in time. Liquidity ratio of the
milk plant is decreasing year by year. 2016-17 it is .42:1, but in 2017-18 it is below the
required. It means quick assets are not enough to meet liquid liabilities and liquidity position
of plant should be worked upon.

3. ABSOLUTE LIQUID RATIO:-

This ratio includes most liquid assets to find out liquidity of a firm. Although
receivables are more liquid, yet there may be doubt regarding their realization immediately in
time.

Absolute Liquid Ratio = Absolute Liquid Assets / Current Liabilities

(Rs. In lakhs)

PARTICULARS 2016-17 2017-18 2018-19

Cash and Bank 11.67 10.58 14.69

Balances

Current 416.91 904.49 527.97

Liabilities

Ratios (a:b) .028 .012 .029

Absolute Liquid Assets cover Cash& Bank balances + Marketable Securities +

Temporary Investments.

0.035

0.03

0.025

0.02

0.015

0.01

0.005

0
2016-17 2017-18 2018-19
Interpretation:

The acceptable norm for this ratio is 1:2. it indicates that liquid assets are half the
amount of current liabilities at the time and creditors are not expected to demand payments.,
but we can realize debtors during that time. This ratio at verka milk plant is not satisfactory
because it is less rule of thumb.

(B) EFFICIENCY RATIOS:-

Funds are invested in various assets to make sales and earn profits. These ratios reflect the
intensity with which firm uses its assets in generating profits by proper management of
assets. These ratios are called ‘Turnover Ratios’ because they indicate the speed with which
assets are converted into sales. It covers following ratios:-

1. Inventory Turnover Ratio

2. Debtors Turnover Ratio
3. Creditors Turnover Ratio
4. Working Capital Turnover Ratio

1. INVENTORY TURNOVER RATIO:-

This ratio is called ’stock velocity’ and indicates the number of times the stock has
been turned over during a period and evaluates the efficiency with which a concern is able to
manage its inventory.

Inventory Turnover Ratio = Cost of goods sold / Average Inventory.

(Rs. In lakhs)

PARTICULARS 2016-17 2017-18 2018-19

COGS 3203.56 3387.97 4436.48

Average 346.66 496.04 754.96

Inventory

Ratios (in times) 9.24 6.83 5.87

Cost of goods sold = Sales – Gross Profit

OR

Opening Stock + Purchases + Direct Expenses – Closing Stock

Average Inventory = (Opening Stock + Closing Stock) / 2

10

0
2016-17 2017-18 2018-19

There is no rule of thumb for this ratio. This ratio signifies the liquidity of inventory.
It shows how many times the stock is being turned into cash in a respective year because
more frequently the stocks are sold, lesser amount of money is required to finance the
inventory. Higher the stock turnover of a year, better the management of resources. A low
inventory turnover implies over-investment in inventories, dull business, poor quality of
goods, stock accumulation of obsolete and slow moving goods and low profits compared to
total investments. From last 3 years this ratio has been above 5. In 2016-17, it was highest
and is decreasing from there on. In 2018-19 the ratio is 5.8 which are satisfactory

2. DEBTORS TURNOVER RATIO:-

A firm may sell goods on cash or credit. Credit sales results in debtors and bills
receivables. So liquidity position of firm to pay its short-term obligations depends on the
quality of debtors. It is also known as ‘debtors velocity’ because it indicates the velocity of
debt collection. And ‘average collection period’ indicates the average number of days for
which a firm has to wait for its receivables to be converted in cash. Gurdaspur Milk Plant is
used to sell its product at cash bases.

Debtors Turnover Ratio =Net Credit Annual Sales / Average Debtors.

Note: Debtors information is not available

3. CREDITORS TURNOVER RATIO:-

This ratio is also known as ‘Creditors Velocity’, this indicates the velocity with which
creditors are turned in relation to purchases. As credit purchases result in creditors and bills
payable suppliers are interested in finding out how much time a firm is likely to take in
repaying its creditors and average payment period represents average number of days taken
by firm to pay its creditors.

Creditors Turnover Ratio = Net Credit Annual Purchases / Average Creditors.

Average Payment Period = No. of working days in a year /

Creditors Turnover Ratio

Note: Creditor information is not available.

4. WORKING CAPITAL TURNOVER RATIO:-

It indicates the velocity of utility of net working capital. Working capital means
excess of current assets over current liabilities. It is directly related to sales. So, this ratio
represents the number of times a unit invested in working capital, produces sales.

Working Capital Ratio = Cost of goods sold / Average Working Capital

 (Rs. In lakhs)

PARTICULARS 2016-17 2017-18 2018-19

COGS 3203.56 3387.97 4436.48

Average 91.07 236.08 246.14

Working
Capital

Ratios (in times) 35.17 14.35 18.02

Note : average working capital of 2016-17 is based on current year

Average Working Capital = (Opening Working Capital + Closing

Working Capital) / 2

Working Capital = Current Assets – Current Liabilities

40

35

30

25

20

15

10

0
2016-17 2017-18 2018-19

Interpretation:

Working capital turnover ratio indicates the velocity of the utilization of net working
capital. This ratio indicates the number of times the working capital is turned over in the
course of a year. This ratio measures the efficiency with which the working capital is being
used by a firm. A higher ratio indicates efficient utilization of working capital and a low ratio
indicates otherwise. This ratio is heading north year by year in milk plant. In 2016-17 it was
35.17 and decreased to 14.35in 2017-18which indicates that the utilization of working capital
is not efficient.

(C) PROFITABILITY RATIO OR ANALYSIS OF PROFITABILITY:-

A business needs profits not only for its existence, but for expansion and diversification. Lack
of control over the expenses results in poor profitability. Profits are index of economic
progress. Profitability ratios are calculated either in relation to sales or in relation to
investments. These ratios are shown in (%). In the words of Keynes, “Profit is the engine that
drives business enterprise.” Following types of profitability ratios are calculated.

(a) General Profitability Ratios

1. Gross Profit Ratio
2. Expense Ratio
a) Direct Expense Ratio
b) Indirect Expense Ratio
c) C.O.G.S Ratio
3. Net Profit Ratio.
(b) Overall Profitability Ratios

1. Return on net capital employed

2. Return on shareholder’s fund

(a) General Profitability Ratios:-

1. GROSS PROFIT RATIO:-

This ratio shows the relationship between gross profit and net sales. Two basic
concepts of this ratio are sales and cost of goods sold. As higher this ratio indicates low
C.O.G.S. and more sales.

Gross Profit Ratio = (Gross Profit / Net Sales)* 100

PARTICULARS 2016-17 2017-18 2018-19

Sales 3305.31 3513.33 4593.68

COGS 3203.56 3387.97 4436.48

GP 101.75 125.36 157.2

Ratios (%) 3.08 3.57 3.42

Gross Profit = Sales – C.O.G.S.

Net Sales = Total Sales – Sales Return

3.7

3.6

3.5

3.4

3.3

3.2

3.1

2.9

2.8
2016-17 2017-18 2018-19

Interpretation:

The gross profit ratio indicates the extent to which selling prices of goods per unit
may decline without resulting in losses on operations of firm. It reflects the efficiency with
which a firm produces its products. As gross profit is found by deducting cost of goods sold
from the net sales, higher the gross profit ratio (G/P ratio) better the result. There is no
standard norm for gross profit ratio and it may vary from business to business but the gross
profit should be adequate to cover the operating expenses and to provide for fixed charges,
dividends and accumulation of reserves. G/P ratio of verka milk plant is declining in last
years. In 2017-18 it was 3.57 and it came down to 3.42 in 2018-19.

2. EXPENSE RATIO:-

This ratio shows the relationship between a particular expense and sales and reveals the
average total variation in expenses. Some expenses may be increasing and some may be
decreasing so this ratio helps in studying the expenses individually as well as combined.
Under this various ratios are:

PARTICULARS 2016-17 2017-18 2018-19

Direct Expenses 3205.04 3723.33 4662.04

Indirect Expenses 274.07 267.52 210.54

COGS 3203.56 3387.97 4436.48

Sales 3305.31 3513.33 4593.68

DIRECT .97 1.05 1.05

EXPENSES
Ratio(%)

INDIRCET .08 .07 .04

EXPENSE
Ratio(%)

COGS Ratio(%) .97 .96 .96

Direct Expense Ratio = (Direct Expenses / Sales)* 100

Indirect Expenses Ratio = (Indirect Expenses / Sales)* 100

C.O.G.S Ratio = (C.O.G.S. / Sales)* 100

 0.972

0.97

0.968

0.966

0.964

0.962

0.96

0.958

0.956

0.954
2016-17 2017-18 2018-19

1.2

0.8

0.6 Direct Expense

Indirect Expense

0.4

0.2

0
2016-17 2017-18 2018-19

Interpretation:

Expenses ratio indicate the relationship of various expenses to net sales. The lower the
ratio, the greater is the profitability and higher the ratio, lower is the profitability. Direct
expenses are those which are incurred to affect the production process directly. In verka milk
plant this ratio has been somewhat same. In 2016-17 it was .97 but in 2017-18 it came out to
be 1.05. On the other hand indirect expenses are those which do not contribute directly to
production process but are needed otherwise. In milk plant this ratio is on decreasing trend. In
2016-17 it was .08, in 2017-18 it was .07 and in 2018-19 it was .04

C.O.G.S. ratio shows all the costs incurred in trading a/c. it is very important to calculate this
ratio to know how much part is covered by COGS in total costs. In verka this ratio is heading
up year by year. From .97 in 2016-17 it came to .96 in 2018-19.

3. NET PROFIT/LOSS RATIO:-

This ratio establishes a relationship between net profit/loss and sales. It shows the
efficiency of management of different activities of concern. This ratio is the overall measure
of firm’s profitability/loss. Increase in this ratio shows the improvement in the operational
efficiency.

Net Profit or Loss Ratio = (Net Profit or Loss / Sales)* 100

(Rs. In lakhs)

Particulars 2016-17 2017-18 2018-19

Net loss 171.15 142.16 53.34

Net Sales 3305.31 3513.33 4593.68

Ratio (%) -0.05 -0.04 -0.01

Net Profit or loss is considered after interest and tax

 0
2016-17 2017-18 2018-19

-0.01

-0.02

-0.03

-0.04

-0.05

-0.06

Interpretation:

The ratio is very useful as if the profit is not sufficient, the firm shall not be able to
achieve a satisfactory return on its investment. This ratio also indicates the firm’s capacity to
face adverse economic conditions such as price competition, low demand, etc. Obviously,
higher the ratio better is the profitability. But in verka milk plant net loss ratio is decreases
year to year. From -0.05 in 2016-17 it came down to -0.01 in 2018-19.

(b) Overall Profitability Ratios:-

Profits are the measure of overall efficiency of a business. The higher the profits, the
more efficient is the business considered the overall profitability or efficiency of a business
can be measured in terms of profit related to investments made in the business.

1. RETURN ON NET CAPITAL EMPLOYED:-

This ratio establishes the relationship between profits and the capital employed. It is
the primary ratio and is most widely used to measure the overall profitability and efficiency
of a business.
The term ‘capital employed’ refers to the total of investments made in a business and can be
defined in a number of ways

Return on Net Capital employed = Net Loss / Net Capital employed* 100

(Rs. In lakhs)

Particulars 2016-17 2017-18 2018-19

Net Loss 171.15 142.16 53.34

Net capital 1990.78 762.57 1360.08

employed

Ratio (%) -8.59 -18.64 -3.92

Net Capital employed = Total Assets – Current Liabilities

0
2016-17 2017-18 2018-19
-2

-4

-6

-8

-10

-12

-14

-16

-18

-20

Interpretation:

Return on capital employed establishes the relationship between profits/loss and the
capital employed. It is the primary ratio and is most widely used to measure the overall
profitability/loss and efficiency of a business. in loss Higher the return on capital it is not
better is the position of a firm. In the milk plant ratio is going up. It was highest in 2017-18 at
18.64 and in 2018-19 it was 3.92in the year 2018-19 so loss were minimum in 2018-19.

2. RETURN ON EQUITY SHAREHOLDER’S FUND:-

This ratio is popularly known as ‘return on proprietor’s fund’. This ratio is of great
importance for both present and future shareholders along with management. It reveals how
well the sources of business are used.

Return On Shareholders Fund = (Net Loss / Shareholder’s Fund)

(Rs. In lakhs)

Particulars 2016-17 2017-18 2018-19

Net loss 171.15 142.16 53.34

Shareholder Fund 133.33 126.82 120.23

Ratio(%) -1.28 -1.12 -0.443

Net Loss= Net loss after interest & tax.

Shareholder’s Fund = Ordinary shares + Reserves & Surplus

 0
2016-17 2017-18 2018-19
-0.2

-0.4

-0.6

-0.8

-1

-1.2

-1.4

Interpretation:

Interpretation:

This ratio is one of the most important ratios used for measuring the overall efficiency
of a firm. As the primary objective of business is to maximize its earnings, this ratio indicates
the extent to which this primary objective of business is being achieved. But in verka milk
plant this ratio is not satisfactory because it is declining. From 1.28 it came down to .443

(B) TEST OF SOLVENCY OR ANALYSIS OF LONG

TERM FINANCIAL POSITION:-

Solvency refers to the ability to meet its long-term obligations. These ratios indicate a
firm’s ability to meet the fixed interest and cost and repayment schedules associated with its
long term borrowings. The long-term creditors are primarily interested in knowing the ability
of principle amount on the maturity and security of their loan.

Verka Milk Plant calculates the following ratios to measure the solvency position:

1. Debt equity Ratio

2. Equity \ Proprietary Ratio
 3. Solvency Ratio
4. Funded debt to total capitalization
5. Fixed assets to long term funds
1. DEBT- EQUITY RATIO:-

Debt-equity ratio also known as external-internal equity ratio is calculated to measure the
relative claims of outsiders and owner against the firm’s assets.

Particulars 2016-17 2017-18 2018-19

Outsider’s 2854.59 3367.02 3628.44

funds

Shareholder’s 133.33 126.82 120.23

funds

Ratio (a:b) 21.4 26.54 30.18

Debt-Equity Ratio = Outsiders fund / Shareholders fund

Outsider’s fund = Secured & Unsecured loans + Current liabilities

Shareholder’s fund = Ordinary shares + Reserves & Surplus

35

30

25

20

15

10

0
2016-17 2017-18 2018-19
Interpretation:

The debt-equity ratio is calculated to measure the extent to which debt financing has
been used in a business. The ratio indicates the proportion claims of owners and the outsiders
against the firm’s assets.

2. EQUITY \ PROPRIETARY RATIO:-

This ratio is also known as net worth to total assets ratio, which establishes the
relationship between proprietors fund to total assets of concern. Higher the ratio, greater the
satisfaction for lenders and creditors.

Equity \ Proprietary Ratio = (Proprietary fund / Total assets)

(Rs. In lakhs)

Particulars 2016-17 2017-18 2018-19

Proprietor’s 133.33 126.82 120.23

funds

Total Assets 765.52 1129.27 1308.88

Ratio (%) .174 .112 0.091

Proprietary Fund = Ordinary shares + Reserves & Surplus

Total assets = Fixed assets + Current Assets + Loan & Advances +

Investment
 0.2

0.18

0.16

0.14

0.12

0.1

0.08

0.06

0.04

0.02

0
2016-17 2017-18 2018-19

Interpretation:

As equity ratio represents the relationship of owner’s funds to total assets, higher the
ratio or the share of the shareholders in the total capital of the company better is the long term
solvency position of the company. This ratio indicates the extent to which the assets of the
company can be lost without affecting the interest of creditors of the company. In the milk
plant this ratio was highest in 2016-17 i.e. 0.17 and in 2018-19 it was 0.091.

3. SOLVENCY RATIO:-

This ratio indicates the relationship between the total liabilities to outsiders to total
assets of a firm and can be calculated as follows:-

Solvency Ratio = (Total liabilities to outsiders / Total Assets)

 (Rs. In lakhs)

Particulars 2016-17 2017-18 2018-19

Outsider’s 2854.59 3367.02 3628.44

funds

Total assets 765.52 1129.27 1308.88

Ratio (%) 3.72 2.98 2.77

Outsider’s fund = Total Liability side excluding Shareholder’s funds

3.5

2.5

1.5

0.5

0
2016-17 2017-18 2018-19

Interpretation:

This ratio is a small variant of equity ratio and can be simply calculated as 100-equity
ratio. Generally lower the ratio of total liabilities to total assets, more satisfactory or stable is
the long term solvency position of a firm. In 2018-19 it was 2.77
4. FUNDED DEBT TO TOTAL CAPITALIZATION:-

This ratio shows a link between the long-term funds raised from outsiders and total
long-term funds available in the business.

Funded Debt to Total Capitalization = (Funded debt / Total Capitalization)

(Rs. In lakhs)

Particulars 2016-17 2017-18 2018-19

Funded Debt 2424.58 2462.53 3100.47

Total 2987.92 3493.84 3748.68

Capitalization

Ratio (%) .81 .70 .82

Funded debts = Secured & unsecured long term debts.

Total capitalization = Shareholders funds + Outsider’s funds

0.84

0.82

0.8

0.78

0.76

0.74

0.72

0.7

0.68

0.66

0.64
2016-17 2017-18 2018-19

Interpretation:
 Though there is no ‘rule of thumb’ but still the lesser the reliance on outsiders the
better it will be. If this ratio is smaller, better it will be. We can see that milk plant has
increase ratio. From .81 it increase to .82 in 2018-19, which means that it is not repaying
outsiders funds and is not a favorable position.

5. FIXED ASSETS TO LONG TERM FUNDS:-

A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to total
long term funds ratio which is calculated as:-

Fixed assets to Long Term Funds = Fixed Assets (after depreciation) / Total Long term
funds*100

(Rs. In lakhs)

Particulars 2016-17 2017-18 2018-19

Fixed 132.53 135.58 127.83

Assets

Total long- 2987.92 3493.84 3748.68

term funds

Ratio (%) 4.43 3.88 3.41

 5

4.5

3.5

2.5

1.5

0.5

0
2016-17 2017-18 2018-19

Interpretation:

The ratio indicates the extent to which the totals of fixed assets are financed by long
term funds of the firm. Generally, the total of the fixed assets should be equal to the total of
the long term funds or, say, the ratio should be 100%. But in case the fixed assets exceed the
total of the long term funds it implies that the firm has financed a part of the fixed assets out
of current funds or the working capital which is not a good policy. And if the total long term
funds are more than the total fixed assets, it means that a part of working capital requirements
is met out of the long term funds of the firms. In 2018-19 this ratio is 3.41 .
COMPARATIVE STATEMENTS