CH.

3 ANALYSIS OF FINANCIAL STATEMENTS 49

h can be described by studving its prolitability, its long light on the firm's ability to pay its current liabilities out
ol
1erm and short term lhquidity position and its operational of its current assets. For example, if the current assets
activities. Therefore, the ratios can be studied by classifying a lirm are 7 5,00,000 and its current liabilities are
into the following groups: 2,00,000, then the Current Ratio is 7 5,00,000
() Liquidity Ratios. 2,00,000 2.5. It means that the current assets ot the
=

firm are 2.5 times that of the current iabilities. The

(in Activity Ratios. which the
current ratio, therefore, shows the extent to
(in) Leverage Ratios. current assets which are quickly convertible
into cash

( ) Profitability Ratios.
exceeds the liabilities which will be shortly payable.
is considered
Generally, a Current Ratio of 2 times or 2:1
to be satisfactory, though this is not applicable to all
cases.
LIQUIDITY RATIOS
This standard current ratio may vary from one industry
to the maintenance of cash, bank balance another and therefore a firm's current ratio should
be
The liquidity reters to

and those assets which are easily convertible into cash in compared with the standard for the specific industry
order to meet the liabilities as and when arising. The Liquidity only.
its ability to value of
Ratios study the firm's short term solvency and The Current Ratio gives the margin by which the
pay off the
liabilities. It should be intuitive to observe that a the current assets may go down without creating any
it cannot continue to exist
firm, no matter how protitable is, payment problem for the firm.
This represents a margin

unless it is able to meet its obligations as they

arise. The day-
of safety for the liabilities. The higher the Current Ratio,
of financial management consists of highly the available and the less is the
to-day problems the greater is margin
sufticient cash to met current commitments in time.
important task of finding chance of firm's failure to meet its
shortterm liquidity risk arises primarily from the Current Ratio considers only the
obligations. The Itmust benoted that
the need to finance current operations.
To the extent that the
quantity of current assets and ignores the quality of
firm has to make payments to
its suppliers before it is paid for current assets. For example, as against a standard ot 2:1,
the goods and services it provides,
a cash short fall has to be ifa firm is having a Current Ratio of 3:1 signifying that the
the short term borrowings. Although that of its current
met, usualy through firm's current assets are 3 times
done in if the current assets are
this financing of working capital needs is routinely liabilities. But what happens
ratios have been devised to keep a stock or defaulting debt
most firms, the liquidity primarily consisting of obsolete
to the risk that it will ors. Obviously, the
firm's payment ability will not be as
track on the extent of the firm's exposure Ratio.
basis of the Current
not be able to meet its
short term obligations. good as it seems to be on the
That is why, the Current Ratio is considered to be an
to provide information
These ratios as a group a r e intended The real ability
concern is the firms overall and a broad measure of liquidity.
about a firm's liquidity and the primary can be measured with
the help of Quick Ratio.
these ratios to pay
ability to pay its current liabilities. Consequently,
liabilities. The Liquidity also called the Acid Test Ratio or

focus current assets and current (i) Quick Ratio It is

establishes the relationship be-
on
of liquidity of the firm by Liquid Ratio. This ratio
Ratios provide a quick measure
its current liabili-
the
assets and
between its current assets and tween quick/liquid current
establishing a relationship sufficient liquidity, considered to be liquid if it is
liabilities. If a firm does not have ties. A current assets is
current
commitments and convertible into cash without loss
of time and value. On
meet its
It may not be in a position to
assets, the inventory
creditworthiness. The Liquidity
Ratios
the basis of this definition of liquid
thereby may loose its because the total current assets as the inventory is
Balance Sheet ratios is singled out of
may also be called the is The reason for keep-
calculation of Liquidity
Ratios considered to be potentially illiquid.
information required for the
Some of the common out is that itmay become obsolete,
available in the Balance Sheet only. ing inventory
unsaleable or out of fashion and always requires time for
liquidityratios are the inventories have ten-
most common and popular
realizing into cash. Moreover,
Current Ratio Il is the Another item which is gener-
(1)
of a firm. It is calculated dency to fluctuate in value.
measure of studying the liquidity because by nature
ally kept out is the prepaid expenses in cash. So, the
as follows: these prepaid expenses are not realizable
Total Current Assets o r convertibil-
Quick Ratio looks for the ready availability
Current Ratio= Ratio may be calculated as
Total Current Liabilities ity into cash. The Quick
in follows:
include those assets which are
The total current assets convertible into cash within a
Quick/Liquid Assets
form of cash, cash or
near Quick Ratio =

term current assets

also include
period of 1 year. The Total Current Liabilities
term investments, if any. The
prepaid expenses and short is also
of liabilities which will Sometimes, a variations in the above formula
Current liabilities include all types those
mature for payment within a period
of 1 year eg, bank suggested. Instead of total current liabilities, only
current liabilities are taken in the denominator, which are
Overdraft, bills payable, trade creditors, outstanding ex within aperiod of 1 year. So, the of
dividend, unclaimed
penses, provision for tax, proposedCurrent Ratio throws really payable amount
The bank overdraft which is by nature a current liabilities, but
dividend, accrued interest, etc.
50
PART II:USING FINANCIAL STATEMENTS
whih is usnally availed by the lirm (ii) Absolute Llquldity Ratlo : This ratio is also knowna
on more or less a
egulu basis, and is not pavable in Super Onick Ratio or Cash Ratioor Cash Reservoir Rati,
realsense, is
dedutedl lom the amomt ol totalewrent therelore,
liabilitics. So, This ratio considers only the absolute liquidity available
Quick/Liquid Assets with the firm. The cash and bank balance are no doub,
Quick Ratio the most liquid asscts and the marketable securities are
Quick Liabilities also considered as highly liquid asset. In order to have an
Sar, ineluded in the total Curent Assets idea of immediate/super liquidity, therefore, the cash
an inventory of
ofl R5,00,000, 1here is
1,50,000 and out of the total current liabili- +bank balance t marketable securities are compared
tiesolR 2,00,000, there is an amount with the current liabilities. The Absolute Liquidity
the bank ovendraft. ln this
of 50,000 representing Ratio
case, the Quick Ratio may be Cash Ratio is calculated as follows
aleulated as
Cash and bank + Marketable Securities
Quick Ratio = 5,00,000- 1.50,000 Cash Ratio=-
1.75 Total Current Liabilities
2,00,000
The Cash Ratio of magnitude upto 5, or 1:2 may be
Or, Quick Ratio =- 5,00,000-7 1,50,000
= 2.33 satisfactory and a firm need not maintain too much of
2,00,000-7 50,000 highly/super liquid assets. If the super liquid assets are
So, the too much in relation to the current liabilities then it may
quick of the firm are 1.75 times of total
assets
affect the profitability of the firm as these super
current liabilities and 2.33 times of the
quick liabilities. liquid
assets are the most
Generally, a Quick Ratio of 1:1 is considered to be unproductive assets of all. Moreover,
factory because this means that the quick assets of the
satis every firm has a reserve borrowing capacity. The firm
can borrow for a short
firm are just equal to the
quick liabilities and there does period from the banks or other
sources to meet any
not seem to be a
possibility of default in payment by the contingency. Therefore, it is not the
firm. The Quick Ratio is considered to be a Cash ratio which is relevant, but what is more
better test of is the total cash reservoir which includes the
important
liquidity than the Current Ratio. However, the Quick reserve
Ratio is itself not a conclusive test of borrowing capacity also.
inventories which have been
liquidity. The
ignored in the Quick ratio (iv) Defensive Interval Ratio : All the
liquidity ratios given
may not always be so illiquid. The receivables and mar- above measure and
ketable securities which are considered to be
emphasize the liquidity and the
capacity of the firm to meet its commitment with refer-
not be so
liquid, may
liquid. Therefore, a firm having a Quick Ratio of ence to the current liabilities.
These ratios however, do
1:1 higher may still face problems in meeting its
or even not consider the
capacity of the firm to meet its day-to-
commitments if the liquid assets are consisting of slow day requirements of liquidity to pay expenses, etc. Instead
paving or defaulting customers. To conclude, the Quick of looking at the firm's
liquid assets, it is better to measure
Ratio is definitely a better measure of the whether the liquid assets are large
firm as compared to the Current ratio.
liquidity of the enough relative to the
However, a more firm's regular cash
rngorous test of liquidity is the Absolute Liquidity Ratio.
outgoing. For this purpose another
measure is available, known as the
Defensive Interval
Ratio (DIR), which is calculated as follows :

Defensive Interval Ratio Total Defensive Assets

Projected daily cash requirement
Total Liquid Assets
Projected daily cash requirement
Cash +Bank
+Debtors +Marketable Securities
Projected daily cash requirement
C. Assets- Inventory - Prepaid Exp.
Projected daily cash requirement
It may be noted that the
projected daily cash requirement is liabilities, the safer the firm would be, other being
equaltothe(cost of goods sold +General Exp.- Depreciation) equal. The Quick Ratio imposses a tough measurethings
of
365. Thus, the DIR measuresthe capacity of the lirm to meet It removes the inventory from its liquidity.
its immediate cash requirements without calculations to identify how
resorting to sales or much money the lirnm can
generate from its current assets 10
other sources ie., the time lag for which the firm can
operate pay current liability without relying on the
without resorting to the sales receipts. inventories. The
significance of the Liquidity Ratios can be explained in terms
Conclusion on the Liquidity Ratios : The Liquidity Ratios of the consequensive which the firm
may have to face other
measure the ability of the firm to meet its current liabilities. wise e.g.() Inability of the firm to meet its
commitments and
The greater the amount of current assets relative to current thus loosing goodwill and
creditworthiness, (it) Loosing
the
 CH 3 ANALYSIS OF FINANCIAL STATEMENTSs 51

also
profitable opportunities. For obvious reasons, the liquidity () Inventory Turnover Ratlo (1/T Ratio): This ratio,
atios are particularl interesting to short ten creditors. known as stock turnover ratioestablishes the relationship
between the cost sold during the year and the
of goods
Further, the interpretation of the liquidity ratios is not as average inventory held during
the yecar by the firm. It is
simple as the calculation. An analyst must have an ability not calculated as follows:
only to visualise the message communicated by a ratio but Cost of Goods Sold
also to make an indepth analysis about the quality of the Ratio
Inventory Turnover
=

figures before interpreting a particular ratio. The Liquidity Average Inventory

Irom the following limitations which
Ratios, however, sutter + Closing Stock
must be considered by an analyst Opening Stock
where, Averageinventory
2
(aThevalue ofcurrent assets can be manipulated by chang-
of valuation of -Closing
ing the accounting policies eg, method
Purchase
Cost of Goods Sold
=
Opening Stock +
inventones or markctable securitics etc. Stock
date Net Sales - Gross profit.
()The figure of current liabilities on the balance sheet
can also be manipulated by postponing
the paymcnt of formula follows:
points are worthnoting about this
as
Two
iabilities by a tew days beyond the balance sheet date.
Sold (ie. Net Sales
is (a)The denominatoris the Cost of Goods
(The liquidity position depicted by the liquidity ratios -
GrossProfit) and not the net sales. This is because the
sheet date
essentially static in nature ie, on the balance inventory account is carried at
cost and it must be

onhy. It mav happen that the firm might have faced cost level only. How-
severe
at
difficulties in paving the liabilities throughout the year compared with the other figure
ever, in case the value
of cost of goods sold is not
at the
and the liquidity position might have improved only available, then it may be replaced by
the amount of net
calculated on the
end of the vear. So, the liquidity ratios sales. It must be noted that the option of using the figure
the vear-end figures will not disclose this fact. of necessity in a
basis of of net sales be exercised only out
liabilities ie, provision for will be logically
Similarly, two specific current
particular case. The ratio in that
case not
dividends only on the last the selling price
consistent as the net sales figure is
tax and proposed appear at

working day. Hence, the liquidity ratios are unnecessarily whereas the average inventory is at
the cost price and
affected by these current liabilities which were not there hence not comparable.
throughout the year. ot yearly
(b) The average stock may be taken as the average
the fact that these in case the
(d) The Liquidity Ratios also suffer from opening stock and closing
stock. However,
ratios show only the stock position on the
balance sheet of
firm is dealing in seasonal goods, then the average
assets and
date. The different components of the current
monthly opening and closing stock may
be preferred.
current iabilities may change even
next day and the the monthly data which is
This monthly average require
out of date. financial state-
measures of may rapidly become
liquidity generally not available in usual published
ments.
ACTIVITY RATIOS For examnple, a firm has an opening stock
of 7 2,00,000
The net sales made
also called the Turnover Ratios o r Per- and the closing stock of 7 2,50,000.
Activity Ratios are
during the year amounted to 12,00,000 give gross
to a
it
formance Ratios. In the discussion on the liquidity ratios, this the
has been pointed out that more and more on the composition profit of 25% of the selling price. In case, average
ie., F2,00,000 +2,50,000)+2. The
of current assets and current liabilities should
be known if the inventoryis T2,25,000 of
cost of goods sold is 9,00,000 ie., F 12,00,000 25
-

of the
analyst really wants toknow about the liquidity position
firm. It is in this reference that the analyst should also look 12,00,000). Therefore,
in order to assess the
beyond the measures of the liquidity Cost of Goods Sold
current liability. A
Inventory Turnover Ratio
=F
activity of a specific current assets o r a Average lnventory
number of ratios a r e available for measuring
the activities of
lines the
ndividual current assets/liabilities. On the 9,00,000
same

other items
of fixed assets, working capital and
can
activity 72,25,000
also be measured.
ol move-
So, the firm has an Inventory Turnover Ratio of4
A Turnover Ratio or an Activity Ratio is a measure

ment and indicates as to how frequently an account has
moved/turned over during a period. It shows as to how
efficiently and effectively the assets of the firm are being
utilized. The Activities Ratios measure the elfectiveness with
which the firm uses its resources. These ratios are usually
calculated with reference to sales/cost of goods sold and are
expressed in terms of rate or times. The Activity Ratios may
be calculated for all the specific assets, however, some of the
mportant activity ratios are as follows:
There is no ideal standard for evaluating an 1/T Ratio of
a firm and it should be compared with the I/T Ratio of
other firms or past 1/T Ratios of the same tirm. Differ-
ences in 1/T Ratios of dilferent industries may result
from the differing characteristics of various industries.
The concept of 1/T Ratio can be extended to find out
the number of Days of Inventory Holding (DIH) as
follows
 PART II: USING FINANCIAL STATEMENTS

terms ol average collection period which is calculated

360/365
DIH= as follows :
1/T Ratio
360/365
where 360/365 is the number of days in Av. Collection Period =
a
year (optional) R/T Ratio
In the above example, the 1/T Ratio was 4 and DIH is :

360 Av. Collection Period= 360/365 Average Debtors

DIH = 9 0 90 Days Net Credit Sales
4
It means ihat the firm is maintaining stock for the sales To continue with the same example, the average collec
requirements of 90 days. If number of days in a year is tion period for the firm is 73 days ie, 365 + 5. It means
taken at 365, the DIH =91.25 days (ie, 365 + 4). The DIH that on an average the firms has collected its debtors ina
is also known as the period of 73 days. The average collection period can be
average age of inventory. In any firm,
the inventory may consist of Raw Materials (R/M), Work- meaningfuly evaluated in terms of the credit policy of
in-Progress (W/P) and Finished Goods (FG). The Activity the firm. If the firm has apolicy of allowing a credit of say
Ratio may be calculated for each of these individual 70 or 75 days, then the average collection period of 73
components as follows: days may be acceptable. However, if the firm has a credit
Annual Material Consumed policy of allowing credit only for 60 days, then the aver.
R/M Turnover Ratio= age collection period of 73 days indicates a poorly man
Average R/M Inventory aged credit policy and that the collection department is
Annual Cost of Production| not operating efficiently.
W/PTurmover Ratio= The R/T Ratio and the average collection period can be
Averagework-in-progress supplemented by Aging Schedule of Receivables tostud
Annual Cost of Production the quality of closing receivables. The Aging Schedule is
FG Turnover Ratio =
Average Finished Goods
a
technique to evaluate the composition or age of the
receivables. In the Aging Schedule, the total receivables
(i) Receivables (or Debtors) Turnover Ratio (R/TRatio):If at the end of the year (or at
any particular date) are
the firm sells goods on credit, the realization of sells classified according to the number of days for which
revenue is delayed and the receivables different receivables have been outstanding. Suppose, a
(both debtors
and/or bills) are created. The cash is realized from these firm has total debtors of
receivables at a later stage. The speed with which these
75,00,000on Dec.31,2011.Some
of these debtors may only be one
receivables are collected affects the liquidity position of day old while others
may be as old as say 100 days or so. The different debtors
the firm. The R/T Ratio attempts to throw according to the age may be classified as presented in
light on the
collection and credit policies of the firm. The R/T Ratio Table 3.3.
reveals the velocity of receivables collection by
matching TABLE 3.3: THE AGING SCHEDULE OF
the annual credit sales to the average receivables as DEBTORS
follows: AGING SCHEDULE ON DEC. 31, 2011

Annual Net Credit Sales Outstanding days Recelvables % of Total

Receivable Turnover Ratio= 0-30
Average Receivables 1,00,000
30-35
L,80,000
For example, a firm has a total sales of 7 10,00,000 in a
35 40 1,20,000
year, out of which 80% sales were made on credit and
40-50 60,000
there was no sales return. The firm has opening and
closing debtors of 1,50,000 and 7 1,70,000 respectively. 50 and above 40.000
Find out the R/T Ratio. In this case the average deblors 5,00,000 I00
are 1,60,000 ie. ( 1,50,000 +7 1,70,000) +2. The credit
sales are 80% of 7 10,00,000 ie., 7 8,00,000 only. So, the Suppose, this firm has a policy of allowing a credit of
R/T Ratio is: days. A cursory look on the Table 3.3 shows that 44o
the total debtors
Annual Net Credit Sales (249%+12%+86) are older than 35 davs
This is an indicative of defective collection
|Receivable Turnover Ratio=-
Average Receivables
policyo
improper selection of customers. Further, 36% of he
debtors are just going to mature as they are
78,00,000 already older
5 than 30days. The firm has 8% of the debtors older than50
1,60,000 days and there must be problem with the collection
these debtors. The firm may initiate legal action agaist
So, the firm has debtors turnover of 5. Evaluation of
these debtors.
the R/T Ratio can be made better and meaningful in
 CH. 3 ANALYSIS OF FINANCIAL STATEMENTSCce <cionSOC 25 9
Payables(or Creditors) Turnover Ratio (P/TRatlo):The
P/T Ratio is calculated in the same manner and on the
same lincs as the R/T Ratio is calculated. The P/T
shows the velocity ol debt payment by the firm. It com-
pares the annual credit purchases with the average
payables (creditors and bills) as follows:
Annual Net Credit
Payables Turnover Ratio= Purchases
Average Payables
For example,
a firm makes total credit
purchases of
5,00,000 during a year and the opening and closing
creditors were50,000
The average creditors are
and
65,000 ie,
80,000 respectively.
50,000 +
80,000)+2, and the P/T Ratio is:
Annual Net Credit Purchases
Pavables Turnover Ratio =-
Average Payables
5,00,000
Payables Turnover Ratio= - = 7.69
R65,000
So, the pavable of the firms have been turned over 7.69
times during the years. This can be supplemented with
Average Payment Period (APP) as follows:
360/365 365
Average Payment Period
P/T Ratio 7.69
= 47.5 days
The average payment period can be meaningfully evalu-
ated by comparing it with the credit period allowed by the
suppliers. To the extent possible, a firm should try to
maintain the APP which is approximately equal to the
credit terms of the supplier. This will help improvingthe
goodwill and credit worthiness of the firm in the market.
(tv) Working Capital Turnover Ratio (WCT Ratio): The
wCT Ratio studies the velocity or utilization of the
working capital of the firm during a year, the working
capital here refers to the net working capital which is
equal to the total current assets less total current liabili-
ties. The WCT Ratio is calculated by comparing the net
working capital of the firm with the net sales as follows
Annual Net Sales
WCT Ratio =
Average Working Capital
The higher the WCT Ratio, the lower is the investment in
the working capital and higher would be the profitability.
A high WCT Ratio reflects the better utilization of the
WCT Ratio
Working capital of the firm. However, a high
also implies a low net working capital in relation to the
volume and thercfore implies over trading by the
sales
firm in relation is its net working capital. This may be a
risky proposition for the firm.
()OtherActivity Ratlos: All the above Activity Ratio have
been calculated with reference to the current assets and
current liabilities and so they focuses attention on the
53
Na
liquidity position of ihe fith. Horer, n e other Acti-
vity Ratios may also be calculated hrary, D A.
follows: as
Ratio
Net Sales
Total Asset Turnover Ratio=
Average Tangible Assets
This ratio measures the per rupee sales generated by per
rupee of tangible assets being maintained by the firm. It
may be noted that (i) intangible assets such as goodwill
elc. are not considered and (i) that the tangible assets are
taken at their written down values. In time series analysis
of ratios, if the Total Assets Turnover Ratio increases
over a period, it means that more sales have been gener
ated per rupee of tangible assets. This ratio must be
analysed together with some other ratio/information.
For example, if a firm depends heavily on intangible
assets such as patents, trade marks, copyrights etc. for its
sales and if these assets are ignored, then the Assets
Turnover Ratio may give the distorted picture.
LEVERAGE RATIOS
The financial position of the firm can be studied and analyzed
in two perspective ie, the short term financial position and
the long term financial position. The short term financial
position, which is also known as the short term liquidity
position or simply the liquidity of the firm has already been
discussed with the help of the Liquidity Ratios. In the follow-
ing section, the long term financial position, its composition
and implications have been considered.
The long term sources of funds for any firm are comprising
of the shareholder's funds and the long term borrowings. In
other words, the long term resources of funds may consists of
the following:
(a) Preference Share Capital.
(b) Equity Share Capital.
(c)Accumulated Profits (Retained Earnings).
(d) Long Term Debts (Debentures + Loans).
Out of these, the debts gets the return in terms of interest at
fixed coupon rate. From the point of view of the firm, this
interest is provided before making provision for tax. This
interest is considered as a charge against profit and is there-
fore, tax deductible. The return to the preference shareholder
is available in the form of dividend at fixed rate. The equity
shareholders get residuary profits.
The debt position of a firm indicales the amount of loans and
borrowings (i.e. external funds) used in generating profits. It
the resources raised from debts earn more than the cost of
these funds, then the surplus ultimately belongs to the equity
shareholders. For example, a lirm has raised 10,00,000 by the
issue of 12% debentures and is earning a return of 14% on its
capital employed. The dilflerence of 2% will now be available
to equity shareholders without any lurther investment on
their parts. The use of cheaper source of finance to increase
 STATEMENTS
54 PART IIUSING FINANCIAL
? 70,00,000

the retum availablethe cquity shareholders is known as

to Now, Debt-Fquity Ratio 15,00,000 5,00,000+ 25,00,000
ading on Equity But does it mean that the firm should go
on inereasing thedebt (Le, thecheaper source)to increase the 70,00,000
1.55
retum to cquity shareholder? 45,00,000
As the debt involves firm's commitment to pay interest over Long Term Deht
This meansthat the firm has employed
the long run and cventually to repaytheprincipal amount, the
times that of shareholder funds. The
to the extcnt of 1.55
financial analyst, the debtlender, the preference sharehold- with the industr
eTs, the equity sharcholders and the management will all pay DE Ratio of a firm should be compared
every industry
has its o n
average. The reason being that
cdose attention to the degrec of indcbtedness and capacity of characteristic relating to capital requirements.
For ex

the firm to serve the dcbt. The more the dcbt a firm uses, the industries the DE Ratio,
higher is the probability that the firm may be unable to fulfil ample, in case of basic and heavy
will be higher as compared to general manufacturing
its commitments towards its debtlenders. The position of the
concerns.
debts and its implications can be analysed in two different
the DE ratio may also be
wavs()as degrec of indcbtcdncss and (i) as ability toservice Sometimes, other variations of
the debt calculated such as:
Total Long Term Debts (D D

Measures of the Degree of Indebtedness Debt-Equity Ratio L.T. DebtsD)+ D+S

The measures of identifving the degree of indebtedness at
tempt to establish the relationship of the total liabilities or
(b)
only long term liabilities with the shareholders funds
or total
assets of the firm. Different measures are available to analyze
the degree of indebtedness.
(a) Debt-Equity Ratio (DE Ratio): The DE Ratio is the basic
and the most common measure of studying the indebted-
ness of the firm. The DE Ratio is based on the assumption
that the extent to which a firm should employ the debt
should be viewed in terms of the size of the cushion
provided by the shareholders funds. The DE Ratio is
calculated by comparing the long term debts with the
total shareholders funds as follows
Debt
Debt-Equity Ratío =
Net Worth
Total Long Term Debts
Shareholders Funds
Where, the long term debts include the long term loan,
borrowings and debentures, and the term shareholders
funds include the eguity share capital, the preference
share capital and all accumulated reserves and surplus.
There may be a difference of opinion on the inclusion of
preference share capital in the denominator of the DE
Ratio. It may be noted that though the preference share
capital has fixed dividend rate yet it is not in the nature of
a debt. The preference share capital does not bring any
financial risk to the firm, which is the basic characteristic
of a debt. Therefore, if a firm has issued preference share
capital then it should be included in the net worth/
shareholders fund. For example, the Balance Sheet ofa
firm shows the following:
Equity Share Capital 715,00,000
Preference Share Capital 5,00,000
Reserves 25,00,000
70,00,000
Debt
Current Liabilities 20,00,000
1,35,00.000
Shareholders Funds(S)
Total Debt Ratio (TD Ratio): The TD Ratio compares the
totaldebts (long-term as well as short-term)with the tota
assets. It is computed as follows:
Total Debts
Total Debt Ratio
Total Assets
Long term Debts + C. Liabilities
Total Debts + Net Worth
In the above example, the TD Ratio is :
70,00,000+ 20,00,000
Total Debt Ratio =
1,35,00,00o
= 67 or 67%
The Total Debt Ratio depicts the proportion of tota
assets financed by the total liabilities. Impliedly, the
assets are financed by the shareholder funds
remaining
In the above example, 67% of the total assets are financed
by the liabilities and therefore remaining 33% assets are
financed by the shareholders funds. The higher the Total
Debt Ratio the more risky is the situation because all
liabilities are to be repaid sooner or later. Moreover
higher liabilities imply greater financial risk also.
The measures of the degree of indebtedness of the firm
given above basically measure the extent of debt financ
ing out of the total financing of the firm. A large debt
financing implies that larger are the claims of the cred
tors against the assets of the firm. The DE
Ratio throw
light on the margin of safety available to the debtlendei
of the firm. If a firm with a high DE Ratio fails then a
chunk of the financial loss (if any)
may have to be borne
by the debtholders of the firm. The greater the DE
Rati.
higher would be the risk of the lenders. Consequently the
lenders may also demand a
participations in the decision
making process of the firm say, in the form of a nominee
director on the Board. Gradually, as the debt
increases, the terms of credit will also be proportion
unfavourable to the firm. expectedly
 CH. 3 ANALYSIS OF FINANCIAL STATEMENTS 55

However, from the point of view of the shareholders a lt meansthat the operating profits of the firm are 4times
high DERatio implies that the firm is having a high degree that of its interest liability. The higher the IC Ratio, better
of financial leverage and hence is getting benefit of it is both for the firm and for the lenders. For the firm
the
Trading on Equity. In case, the rate of return of the fim reduced and for the
probability of committing default is
low IC
is more than the cost of debt then higher degrec of lenders the firm is considered to be less risky. The
financial leverage implies relatively higher return to the Ratio, on the other hand, indicates low profitability of the
shareholders. commitments.
irm in relation to its interest payment
on the accrual
It may be noted that the IC Ratio is based
Measures of the Ability to Service Debts andignores the cash flows relating
concept of accounting
fo interest payment. The figure of
EBIT indicates only the
The emplovment of debt financing by a fim should be be
interest payment is to
examined not only in relation to the sharcholders fund, but opcrating profits out of which be in
made. However, in practice the
interest is to paid
cQuall important is the consideration of the firm's ability/ the
cash form and therefore, it is
better to compare
canacity to service the debt. The measures of the degree of of the firm. Further, the
interest liability with cash profits
indebtedness of the in the preccding section
tirm, discussed
as of the firm.
IC Ratio also ignores the repayment liability
do not consider the tim's ability to pay interest and repay- This
Ratio (PC Ratio):
amount. The ability to service the debt (b) Preference Dividend Coverage
ment of the principal Ratio from the point of
to how easily and readily the firm will be able to meet ratio is the counterpart of the IC
refers shareholders. This ratio attempts
its commitments in respect of the contractual interest pay view of the preference
to m e a s u r e the ability of
prefer
the firm to pay the fixed
ment and the repayment schedule. In addition to the interests as to how secure
the preference
the sched- ence dividend and tells
and the repayments, a firm may also have to pay of the firm.
dividends at dividend is in relation to the earning power
uled lease rentals. The payment of the preference dividend is not com-
considered scheduled payment. Though the payment of preference the
fixed rate is also payment of such
as a
believed that
pulsory, it is generally
service debt may include The calculation of the PC
So,in a broader sense, the ability
debt
to
lease rentals,
dividend is impliedly necessary.
that the payment of
on loan, repayment, Ratio is based on the assumption
paynent of interest made. As
such which is contractual and must be
fixed preference dividends and any payment
preference dividend is
contractual in nature. The firm's ability
the preference dividend is payable
only out of profit after
more or less fixed and the amount
to service the fixed
liabilities can be measured with the help taxes, thePCRatio is
calculated by comparing
of profit after
Ratios establish the rela- of preference dividend with
the figure
of Coverage Ratios. The Coverage
the firm's profitability out
tionship between fixed claims and taxes as follows:
these measures try to
of which these claims a r e to be paid. So, Profit After Tax
debt payments to assess the
relate profitability to the level of PC Ratio Preference Dividend
which the firm can meet these pay-
degree of comfort with
ments. The following Coverage
Ratios help us to analyze the of interest for the preference
The PC Ratio is a matter
claims. PC Ratio, better it is for
firm's ability to service the fixed shareholders only. The higher the
also
(a) Interest Coverage Ratio (IC Ratio): This ratio is preference shareholders.
ratio and it measures the (FC Ratio): The IC
Ratio
called the times interest earned () Fixed Payment Coverage Ratioabove consider only the
fixed interest liability. ThelC
ability of the firm to pay the discussed
and the PC Ratio
of prefer
Ratio may be calculated as follows: coverage of
interest liability and the coverage
these ratios
EBIT ence dividend liability
respectively. Both
the principal repayment. The FC
IC Ratio ignore the coverage of
Interest of the principal repay
Ratio incorporates the coverage
between the operat
Interest and Taxes, and ment also. It shows the relationship
where, EBIT =
Earnings Before liabilities in respect of
the fixed
Fixed interest liability of the firm ing profits of the firm and It may be
Interest =
etc.
interest, preference dividend repayment,
the operating profit of the
It may be observed that EBIT is how many
calculated as follows:
m e a s u r e s as to
firm, therefore, the IC Ratio covered with the EBIT
of the firm is
time the interest liability
an idea as to FC Ratio
profits of the firm. This ratio gives I+(PR +PD) (1 -)
operating firm can sustain before
it
how much fall in EBIT, the
of the interest liability. For where, I Interest Liability
Commits a default in payment fixed
has EBIT of 7 25,00,000 and its PR Principal Repayment
cxample, if a firm
then thelCRatio is
interestliabilityamountsto76,25,000, PD Fixed Preference Dividend, and
EBIT Tax Rate
IC Ratio Interest For example, a firm has an operating profit of 4,50,000
which is subject to interest charge of 7 90,000 and tax
25,00,000
=4 liability at 30%. It also has torepay debts of? 70,000 during
76,25,000
6 PART II : USING FINANCIAL STATEMENTS

the vear and preference dividend payable for the vcar is which is a residual balance, is affected by the change in
10,000 The FC Ratio for the fon is: EBIT. The Financial Leverage ratio measures the rela
tionship between the EBIT and the EBT (carnings before
EBIT
FC Ratio = axes) and is calculated as follows:
I+(PR+PD) + (1 -t) EBIT
4,50,000 FL Ratioo
= 2.2 EBT
90,000+ (70,000+10,000)+(1-.3)
The FL Ratio tells about the extent of change in EBT as
Thus,the firm has a FC Ratio of 2.2 and it appears to have aresult of change in EBIT. The FL Ratio may be favourable
ability to mect its fixed payment obligations easily. In or unfavourable. The FL Ratio is favourable if return on
casc, the firm has fined liability in respect of lease rentals assets is more than the cost of funds used to acquire the
also than the FC Ratio can be modified to include the
assets and is unfavourable in the other situation. A
lease obligations as follows: favourable FL Ratio is also known as Trading on Equity.
EBIT+LP
FC Ratio
I+LP +(PR +PD) +(1-t) PROFITABILITY RATIOS
where. LP Lease Payments (Rentals) The last group of financial ratios and probably the most often
In the above case, if the firm has lease obligations of used group of ratios is the Profitability Ratios (P Ratios). The
7 40,000 per annum then the FC Ratio will be : P Ratios measure the profitability or the operational effi.
4,50,000- ciency of the firm. There are two groups of persons who may
40,000
be specifically interested in the analysis of the profitability of
90,000 40,000 (70,000+ 10,000)+(1 -.3) the firm. These are () the management which is interested in
Therefore, the coverage is less if the firm has a fixed lease the overall profitability and operational efficiency of the firm
rental obligation also. and (i) the equity shareholders who are interested in the
ultimate returns available to them. Both of these parties and
(d) Cash Flow Coverage Ratio (CC Ratio) : It has been
any other party such as creditors can measure the profitabil
mentioned earlier that the IC Ratio (as well as the PC
Ratio and the FC Ratio) is based on the accrual concept ity of the firm in terms of the PRatios. Different P Ratios have
of accounting. The better position would be reflected by been suggested to assess the profitability of the firm from
a coverage ratio based on cash profit. The differencee different angles. The performance of the firm can be evalu-
between EBIT and the cash profit may arise because of ated in terms of its earnings with reference to a given level of
non cash expenses such as depreciation, etc. Therefore, assets or sales or owner interest etc. Broadly, the P Ratios are
the FC Ratio may be modified to take care of the cash calculated by relating the returns with the () sales of the firm
coverage of fixed liabilities. (i) assets of the firm and (i) the owner's contribution.
For this purpose the CC Ratio may be calculated as 1. Profitability Ratios based on Sales of the firm: Profit is a
factor of sales andis earned indirectly as a part of the sales
follows:
revenue. So, whenever a firm makes sales, it earns profit
EBIT + LP + Non-Cash Expenses
CC Rati = (in general). But how much? How is the total sales revenue
is going to be used for meeting the cost of goods sold.
I+LP+(PR + PD) (1-t)
The CC Ratio reflects the payment ability of the firm in
depreciation, indirect expenses, tax liability and return to
shareholders, etc. All this and other aspects can be ana-
terms of the coverage provided by the cash profits of the
lyzed with the help of the P Ratios. The P Ratios based on
firm. sales c a n be further divided in to (a) Profit Margins and (b)
Conclusion : The coverage ratios measure the risk of Expense Ratios as follows:
default in payment by the firm. The lower the coverage
(a) Profit Margin Ratios : The Profit Margin refers to the
the m o r e
ratio, the firm would be from the point of
risky profit contributed by per rupee of sales revenue and
view of the lenders/investors. Thus, the analysis
of the
therefore, the Profit Margin ratios measure the relation
the IC Ratio) would
coverage ratios (and in particular ship between the profit and the sales. Different Prolit
to service the
reveal whether the firm has the capacity Margin ratios have been suggested as follows:
additional debts or not.
() Gross Profit Ratio (GP Ratio): The GP Ratio is also
financial
Financial Leverage Ratio (FL Ratio): The term called the average mark up ratio. It is calculated by
fixed charge securities such
Jeverage refers to the u s e of such as
comparing the Gross Profit of the firm with the
Net

as debentures and the

variables charge securities Sales as follows:
structure to finance the total
equity shares in the capital
financial leverage refers to the
Gross Profit
assets of the firm. So, the GP Ratio 100
the
the form of interest) in Net Sales
presence of fixed charge (in in
fixed charge is fixed
income statement of the firm. This Net Sales - Cost of Goods Sold
the change in the EBIT, x 100
amount and do not vary with Net Sales
whereas the return available to the equity shareholders,
 CH.3 ANALYSIS OF FINANCIAL STATEMENTs 57

For example, a firm has made sales of 10,00,000 for caused manufacturing efficiency or
by change in
which the cost of goods sold was 7,00,000. The GP administrative efficiency. It can help to identify the

Ratio is: corrective measures to improve the profitability.

NP Ratio estab-
10,00.000-7 7,00,000 (in) Net Profit Ratio (NP Ratio): The
GPRatio net profit (after
x 100 30% lishes the relationship between the
10.00.00 sales and be calcu-
tax) of the firm and the net may

The GP Ratio of 30% means that on every 1 rupee lated as follows:

sale. the firm is earning a gross profit of 30% or 30 Profit (After Tax) 100
paise. The gross profit is the difference between the NP Ratio Net Sales
sales revenue and the cost of generating that sales.
of the manage-
Therefore, the gross profit amount and the GP Ratio The NP Ratio m e a s u r e s the efficiency
additional revenue over and
depends upon the relationship between the selling ment in generating
The NP Ratio
and the cost of production including direct above the total cost of operations.
price in manufacturing, ad-
shows the overall efficiency
expenses. the product.
ministrative, selling and distributing
The GP Ratio reflects the efficiency with which the This ratio also shows the net
contributions made by
firm produces/purchases the goods. Given the con- of sales to the owner funds.
The NP
rawmaterial every 1 rupee
stant level of selling price, cost price and of sales revenue avail-
Ratio indicates the proportion
consumption per unit, the GP Ratio would also r e firm and the extent to which
able to the owners of the
main same from one year to another. If there is a decrease o r the cost can in
the sales revenue can
from to another then a loss on the
o w n e r s . So, the
change in the GP Ratio one year
crease without inflicting

reasons must be looked

for. If the efficiency of the to face the ad-
NP Ratio shows the firm's capacity
Ratio may result
firm is same then the change in GP verse economic situations.

because of change in selling price o r cost price

o r raw
employed to
The NP Ratio can be meaningfully
material consumption per unit. of the firm when this ratio is
study the profitability A
and studied as a Ratio and the OP Ratio.
The GP Ratio should be analyzed used together with the GP the
and
the GP Ratio may not GP Ratio, OP Ratio
time series. For a single year, time series analysis of the
indicate much about the efficiency
level of the firm. the r e a s o n s for varia-
NP Ratio can help to identify be-
time series, it may give Since the difference
However, when studied as a tions in the profitability. arises
trend and hence an idea and the net profit
the increasing o r decreasing tween the operating profit
of the firm. A high financial charges and the taxes,
an
of the level of operating efficiency only because of
for a particular period show as to how
GP Ratio o r a low GP Ratio insight into their comparison may how well the
unless compared with financed and
does not have any eaning efficiently the firm is of
the s a m e industry or to hold down taxes (which
other firm operating in is
finance manager able
some
is in his control to a limited extent only).
compared with the industry average. course
measure of
Ratio (OP Ratio): The operating The Expense Ratios are the
(i) Operating Profit (b) Expense Ratios: rela-
profit of the firm cost control and are computed
by establishing the
profit refers to the pure operating the sales.
difference expense items and
firm
the operation of the
Le, the profit generated by fi- tionship between the cost of raw
and hence is calculated
before considering any In any firm, the total expenses (including
non-oper can be sub-divided
into () Cost of
interest payment),
nancial charge (such as materials) of operations
and tax liability etc. The operating Goods Sold, (i) Administrative Expenses,
(ii) Selling Ex-
ating income/loss Interest and therefore, differ-
the Earnings Before penses, and (iv)
Financial Expenses
profit is also termed as calculated deal with each of
Ratio may be
as
ent Expense Ratios can
be calculated to
and Taxes (EBIT). The OP Ratios are
these items. Some of the Expense
expense
follows:
Cost of Goods Sold
EBIT X100 100
OP Ratio ( Cost of Goods Sold Ratio Net Sales
Net Sales
It may be observed that this ratio is a complementary
to
of pure profit
The OP Ratio shows the percentage than the cost
of sales made. The OP Ratio GP Ratio. For example, if the GP Ratio is 30%,
earned on every 1 rupee 70% ie., (100-30)%. This ratiocan
less than the GP Ratio as
will be
the indirect expenses ofgoods sold ratio will be
administrative expenses, selling be analyzed to identify the rate of consumption of raw
such as general and deducted
charge, etc, are material in the production process.
expenses and depreciation at the operating profits
from the gross profit to arrive Administrative Expenses
measures the efficiency X 100
ie, EBIT. Thus, the OP Ratio (i)Administrative Expense Ratio= Net Sales
only manutactures/pur-
With which the firm not
also sells the goods. The OP Selling Expenses
chases the goods but Ratio can depict
(i) Selling Expense Ratio X 100
Ratio in conjunction with the GP Net Sales
of the firm are
whether changes in the profitability
 PART II USING FINANCIAL STATEMENTS

ploved to earn that profit. Usually the profit ot th

n Oeratime Fapenst Ratio Operating Eepenses fim is measured in terms of the net profit after t
100
Net Sales and the assets are measured in term of total assetu
cm Finahcinl Financial Eperises total tangible assets or total fixed assets.Con ept
Expense Ratio 100
Net Sales allv, the ROA mav be measured as follows
Total Operating Cost
(DneratingRatio Net Sales
x 100 Net Profit After Taxes
ROA x 100 or,
Average Total Assets
where the total
operating cost include cost of goods sold,
adminisratine and seling expenses, and the Net Profit After Taxes
Cpenses a r inclusive of administrative and
operating X 100 or,
sclling cx Average Tangible Assets
pense onh
t
ma be obsernved that the
Opcrating Profit Ratio and the Net Profit After Taxes 100
Operating Ratio are the complementary to cach other. If Average Fixed Assets
the Operating Ratio is the firm is 85% then the Operating
Proft Ratio will be 15. All these versions of the ROA show as to how much
Similarly, the sum of Operating is the profit earned by the firm per rupee of assets
Ratio and the Financial Expense Ratio is
to thc NP Ratio (before
complementary used. Sometimes the amount of financial charge
tax). On the same lines, a manufac- (interest, etc) is added back to the net profit figure to
turing concerms can calculate some other ratios as tol-
relate the net operating profit with the operatin
assets of the firm. By separating the financing etfeet
Raw Materials Consumed from the operating effect, the ROA provides acleaner
( v Ra Naterias Ratio
Net Sales x 100 measure of the profitability of these assets. In such a
Direct Expenses case, the ROA can be calculated as follows
(va) Direct Expense Ratio X 100
Net Sales

ma be observed that the total of these last two ratios is ROA NP+Interest (1-) 100
Total Assets
equa to the Cost of Goods Sold Ratio.

Since, most of the Expense Ratios are complementary to or,

EBIT (1 -t) X 100
Profi Margin Ratios, by calculating one set of ratios, the Total Assets
Other sel ui ratios can be
ascertained easily. However, by The ROA the overall
calculating the Expense Ratios for different individual
measures
efticieney ot the

management in generating protits given a level ot

eiemenis af expenses, the analyst can better understand
assets at its disposal. The ROA
the behaviour and variability of these essentially relate th
expense items for a profits to the size of the firm (which is measured un
gven change in the sales terms of the assets). If a firm increases its size but
Profitability Ratios based on Assets/Investments A is
unable to increase its profits
financial analyst can employ another set of financial ratios the ROA will decrease. In such
proportionately, then
to find out how
a case, increasing the
efficienly the firm is using its assets size of the assets ie., the size ot the firm will not
because he prulitability of a firm can also be itself advance the tinancial weltare of the
h
analyzed ownei
with relerence to assets employed to earn a return. Nor- The ROA of a particular firm should be
nally, the more the assels employed, greater should be the conmpared
with the industry average as
profits and vice versa. The ratios calculated in the preced.
the amount of assels
required depends upon the nature and charactei
ing section, help w ind out the prolit margin contributed istics of the industry.
per rupee of sales. The prolitability can also be analyzed
with reference 1o prolits earned per rupee of investment
(i Return on Capltal Employed (RCE): The protitabl
ity of the tirm can also be
made in the firm. There are dilferent concepts of assels view of the total funds
analyzed from the point
employed/investments made in the firm such as total term funds
employed in the tirn th
asets, tangible assets, net assets, lixed assets, capital to the total
employedor the capital
employed reteis
long term sources of funds. It means thi
empluyed, elc. So, there can be dillerent profitability the
ratios based on assets/investment of the firm. The follow capitalemployedeomprises of shareholders tuns
plus long term debts. Alternatively, it can also bhe
ing are two important such profitability ratios defined as tixed assets plus net
working capital
() Return on Assets (ROA) : The ROA measures the As a matler of fact, theamount of capital emplovel
profitability of the firm in terms of assels employed calculated in either way will be same
in the firm. The ROA is calculated by establishing the
because these
figures are based on the balancesheet of the firm.an
relationship between the profits and the assets em are part of the basic
accounting equation ie.,
 CH. 3 ANALYSIS OF FINANCIAL STATEMENTS 59

Sharcholder Funds +L Term Deb

+C. Liabilities Fixed Assets+C. Assets
Sharehokder Funds + L Term Debts = Fixed Assets+(C. Assets-C. Liabilities).
Shareholder Funds+L Term Debts Fixed Assets +Net Working Capital.

The RCE mar be calculated as tollows alter tax interest rate it pays on its debts, will be able to
increasc its ROE by borrowings. This is known as Trading
Net Profit Atter Taves+ Interest (1-t) on Equity. The ROE can also be written as follows :
RCE 100
Average Capital Employod
EBIT ROE ROA +D/E[ROA-i(1 -1)]
or RCE= X 100 where, ROOA EBIT (1-t)/(BV of Debt +BV
Average Capital Employed of Equity)
D/E BV of Debt/BV of Equity
Proftability analysis from the point of view of Owners
Interest Expense on Debt)/BV|
The profit of the tirm belongs to the owners who have
of Debt
invested their funds in the torm of equity share capital or
T a x rate on Ordinary Income.
reference share capital or retained earnings. Therefore,
the profits of a firm should be analyzed from the point of
The ROE indicates as to how well the funds of the o w n e r
view of the owners also. As a matter of fact, the net profit the
have been used by the firm. It also examines whether
after tax (PAT) belongs to the shareholders. In case the return tor the
tirm has been able to earn satistactory
firm has preference share capital also then the amount owners/shareholders of the
owners or not. Therefore, the
arailable to equity shareholders is PAT less preference interested in the ROE
firm would probably be most
dividend. This profit belongs to them, irrespective ofthe
analysis. Together with ROE analysis, the profitability
can

fact whether it is distributed now in the form of dividends measures as

or retained in the tirm tor reinvestment purpose. These
reinvested protits will ultimately result in growing profits
in the future. The profitability of a firm can be analyzed
from the point of view of owner's funds in different
perspectivs as folows
Return on Equity (ROE): The ROEexamines profitability
from the perspective of the equity investors by relating
profits available for the equity shareholders with the book
value of the equity investment. The return from the point
of view of equity shareholders may be calculated by
dividend with
comparing the net profit less preference
their total contribution in the firm.
PAT Preference Dividend
Return on Equity= 100
Equity Shareholders Funds
PAT-Preference Dividend
Return on Equity= X 100
Net Worth
It may be noted that these two equation are s a m e as the
net worth denotes theequity shareholder funds (in
there is no preference share capital)
the returm
Sometimes, the ROE is also calculated to show
on total shareholders funds (both equity and preference).
In such a case, the ROE is as follows
Net Profit After Taxes
Return on Equity
Total Shareholders Funds
X100
As the ROE is based on earnings after interest
payments,
1 is affected by the financing mix the firm uses to fund its
to finance
projects. In general, a firm that borrows money
projects and earns ROA on those projects that exceeds the
also be assessed with the help of other
follows
(i) Earnings Per Share (EPS) : The ROE
measures the prof-
the
itability in terms of the total funds and explains
return
as a percentage of the funds. The profitability
of a firm can
shares.
also be measured in terms of number of equity
PAT
This is known as EPS which is derived by dividing the
by the number of equity shares. So,
PAT Preference Dividend
Earnings Per Share Number of Equity Shares
The EPS calculations in a time series analysis indicate
whether the firm's EPS is increasing or decreasing. How
ever, the interpretation of the EPS
is subject to two
considerations:
(a) If the firm has issued bonus shares in the particular
yearthen the number ofstanding equity shares at the
end of the year will increase and consequently the
EPS for that year will be affected. Therefore, the EPS
for that year as well as for all subsequent years
case
should be adjusted. For example, a firm having
10,000 equity shares has reported a PAT of?1,00,000
Hence, the EPS of the firms is R 10 ie., R 1,00,000
10,000). Next year, the firm earns the PAT of
1,50,000 and the EPS is 15 ie, & 1,50,000
+710,000). However,if the firms issues bonus shares
in the ratio of 2:5 during next year then the number
of equity share would be 14,000 and the EPS would
be 10.70 ie,R 1,50,000 *14,000). But this is not the
correct EPS for a time series analysis. The EPS of
710.70 should be adjusted for bonus share ie. by the
 PART USING FINANCIAL STATEMENTS

ath S(ie 5+2 S)and the conect EPS is 10. 70 x
75)15
T h e inereavr in EPSver the vears does not necesSnt
eter tothe ineease in politability. Over the yeais
hettm mmght have netanod the profits as a result of
whh the total tunds have inercased. The percent
carmngs (ROE) even il constant with still resul
greate absolute amount ot PAT Which divided by
mstant number of oquity share will indicales an
nd the market price of a share and Is calculate
(ollows
Market Price Per Share
PE Ratio Earning Per Share
The PE Ratio indicates the expectations of the equu.
investors about the carnings of the firm. The investe
expectations are reflected in the market price of

mnasing EPS. This incvase in EPS is ernOncous i share and therefore the PE Ratio gives an idea.
the sense that the real carnings (ROE) have not investors perception of the EPS. The PE Ratio is t.

inrasd of the most widely used measure of financial analy

in practice. Companies having high and growth pr
(z Dividend Per Share (DPS) : Sometimes the cquity
share pects have higher PE Ratio as compared to ,
holders mar not be interested in the EPS but in the return
whh ther are actually receiving from the firm in the growth or slow growth firms.
dividends The of Thus, a high PE Ratio may indicate () that the shar
torm of amount profits distributed to
has a low risk and therefore the investors are content
sharcholders per share is known as DPS and may be
aleulatod as follows : with low prospective return or(i)theinvestor expe
high dividend growth and are ready to pay a higher
Total Profits Distributed price for the share at prescnt
Dividend Per Share
Number of Equity Shares (b) Market to Book Value Ratlo : Another mcasure
Generalh. companies declare dividends in terms of per- based on market price of the equity is Market to
centage of paid up capital For example, if a company Book Value, Calculated as follows:
a dividends of 25+ on cquity shares of face value
deciares
of R100 each then the DPS is 25 ie, 25% of7 100. In this MP Per Share
Market to Book Value=
case. if the paid up value of the shareis80 only then the Book value Per Share
DPS is 20 ie. 25 of 80. In the time series analysis of
DPS. the analyst should make adjustments for bonus In this ratio, the book value per share in equal to net
share etc. in the same way as noted earlier. worth divided by No. of equity shares. Book value is
( Dividend Payout Ratio (DP Ratio) : The DP Ratio is the based on balance sheet information this ratio com
ratio between the DPS and the EPS of the firm ie., it refers pares the market value of the share with its book
to the proportion of the EPS which has been distributed value. A value less than mean that the firm is not
by the company as dividends. For example, if the firm has successful in creating shareholders' value.
an EPS and DPS of 7 5 and 7 3 respectively, then the DP (c)Yleld: The Yield is defined as the rateofreturn on the
Ratio is: amount invested. With reference to the equity shares
the Yield may be defined as the rate of return on the
Dividend Per Share market price of equity shares. In order to find out the
DP Ratio X 100
Earnings Per Share Yield of an equity share, the market price may be
compared with the EPS or the DPS to find out the
X 100 =7 60%
5
Earnings Yield or Dividend Yield respectively as

follows:
So. the firm has distributed 60% of its PAT as dividends
Earnings Per Share
among its shareholders. It may
be noted that the DPS and Earnings Yield=
the DP Ratio both depend upon the statutory provisions Market Price Per Share
relating to compulsory appropriation of profits, etc. Dividends Per Share
management is defined as
Dividends Yield= Market Price Per Share
Since the objective of financial
the maximization the shareholders wealth as reflected in
It may be observed that the Earnings Yield is the
of the firm
the market price of the share, the profitability inverse of the PE Ratio. The Earnings Yield is alsu
of market price or market
may also be viewed in terms known as Earnings Price Ratio. The Earnings Yielu
expectations, etc
and the Dividend Yield evaluate the profitability o
For this purpose, the following measures based o n Market the firm in terms of the market price of the share and
Price are available hence are useful measures from the point of view o
shate
(a) Price Earnings Ratio (PE Ratlo): This
is the ratio a prospective investor who is evaluating a

the EPS worth to take a buy or not to buy decision.

which establishes the relationship between