YS I S

A L
I O AN
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Lecture Outcomes

• Understand the purpose and meaning of

ratio analysis.
• Rationale of categorizing ratios based on
their functions and objectives.
• Understand the rationale of liquidity ratios.
Ratio Analysis
– Measure relationships between resources
and financial flows

– Show ways in which firm’s situation

deviates from
• Its own past
• Other firms
• The industry
Ratio Analysis - Significance

A single ratio by itself is not very meaningful.

The discussion of ratios will

include the following types of comparisons.
Ratio Analysis - Purpose

• To identify aspects of a business’s

performance to aid decision making
• Quantitative process – may need to be
supplemented by qualitative factors to get
a complete picture
• Standardize financial information for
comparisons
Ratio Analysis - Significance

• Provide the all-important early warning

indications that allow us to solve our business
problems before our business is destroyed by
those problems.
• Enables the business owner/manager to spot
trends in a business
How a Ratio is expressed?
⚫ As Percentage - such as 25% or 50% . For
example if net profit is Rs.25,000/- and the sales
is Rs.1,00,000/- then the net profit can be said to
be 25% of the sales.
⚫ As Proportion - The above figures may be
expressed in terms of the relationship between
net profit to sales as 1 : 4.
⚫ As Pure Number /Times - The same can also
be expressed in an alternatively way such as the
sale is 4 times of the net profit or profit is 1/4th of
the sales.
Ratio Analysis
Ratio Analysis
1. Liquidity – the ability of the firm to pay its way
2. Investment/shareholders – information to enable decisions to be
made on the extent of the risk and the earning potential of a
business investment
3. Gearing – information on the relationship between the exposure of
the business to loans as opposed to share capital
4. Profitability – how effective the firm is at generating profits given
sales and or its capital assets
5. Financial – the rate at which the company sells its stock and the
efficiency with which it uses its assets
 Classification of Ratios
Balance Sheet P&L Ratio or Balance Sheet and
Ratio Income/Revenue Profit & Loss
Statement Ratio Ratio

Financial Ratio Operating Ratio Composite Ratio

Current Ratio Gross Profit Ratio Fixed Asset Turnover
Quick Asset Ratio Operating Ratio Ratio, Return on Total
Debt Equity Ratio Expense Ratio Resources Ratio,
Net profit Ratio Return on Own Funds
Stock Turnover Ratio Ratio, Earning per
Share Ratio, Debtors’
Turnover Ratio,
 Format of balance sheet for ratio analysis
LIABILITIES ASSETS
NET WORTH/EQUITY/OWNED FUNDS FIXED ASSETS : LAND & BUILDING, PLANT &
Share Capital/Partner’s Capital/Paid up Capital/ MACHINERIES
Owners Funds Original Value Less Depreciation
Reserves ( General, Capital, Revaluation & Other Net Value or Book Value or Written down value
Reserves)
Credit Balance in P&L A/c

LONG TERM LIABILITIES/BORROWED FUNDS : NON CURRENT ASSETS

Term Loans (Banks & Institutions)
Debentures/Bonds, Unsecured Loans, Fixed Deposits,
Other Long Term Liabilities
Investments in quoted shares & securities
Old stocks or old/disputed book debts
Long Term Security Deposits
Other Misc. assets which are not current or fixed in
nature

CURRENT LIABILTIES CURRENT ASSETS : Cash & Bank Balance,

Bank Working Capital Limits such as Marketable/quoted Govt. or other securities, Book
CC/OD/Bills/Export Credit Debts/Sundry Debtors, Bills Receivables, Stocks &
Sundry /Trade Creditors/Creditors/Bills Payable, Short inventory (RM,SIP,FG) Stores & Spares, Advance
duration loans or deposits Payment of Taxes, Prepaid expenses, Loans and
Expenses payable & provisions against various items Advances recoverable within 12 months

INTANGIBLE ASSETS
Patent, Goodwill, Debit balance in P&L A/c, Preliminary
or Preoperative expenses
Some important notes
• Liabilities have Credit balance and Assets have Debit balance
• Current Liabilities are those which have either become due for payment
or shall fall due for payment within 12 months from the date of Balance
Sheet
• Current Assets are those which undergo change in their shape/form
within 12 months. These are also called Working Capital or Gross
Working Capital
• Net Worth & Long Term Liabilities are also called Long Term Sources
of Funds
• Current Liabilities are known as Short Term Sources of Funds
• Long Term Liabilities & Short Term Liabilities are also called Outside
Liabilities
• Current Assets are Short Term Use of Funds
Some important notes
• Assets other than Current Assets are Long Term Use of Funds
• Installments of Term Loan Payable in 12 months are to be taken as
Current Liability only for Calculation of Current Ratio & Quick Ratio.
• Investments in Govt. Securities to be treated current only if these
are marketable and due. Investments in other securities are to be
treated as Current if they are quoted. Investments in
allied/associate/sister units or firms to be treated as Non-current.
• Bonus Shares as issued by capitalization of General reserves and
as such do not affect the Net Worth. With Rights Issue, change
takes place in Net Worth and Current Ratio.
Groups of Financial Ratios

● Liquidity
● Activity
● Debt
● Profitability
REI Agro goes in for liquidation
• REI Agro, a firm that claims to have 22 per cent share in the
world’s basmati rice market, has gone in for liquidation after the
National Company Law Tribunal (NCLT) ordered it to do so.
• The company, which sells Rain Drops basmati rice, said in a BSE
filing that insolvency professional Anil Goel is the official liquidator of
the company. • http://www.bu
• It said the board and key managers have lost their powers and all siness-standa
employees have been discharged of their duties. REI Agro’s
insolvency case had been admitted by the Kolkata bench of the
rd.com/article/
NCLT in March. The NCLT can order liquidation if a firm fails to bring companies/rei
to the table a resolution plan within six months of admission of the -agro-goes-in-
case.
• The company ended FY16 with losses of Rs 1,076.13 crore. Its for-liquidation-
standalone turnover for that year was Rs 521.79 crore. According to 11709140003
the annual report, it owed 22 banks an amount of Rs 4,745.24 cr. It
has also not provided interest on loans availed from banks and
2_1.html
financial institutions. The firm’s slowdown started when it began
facing liquidity crunch. Due to the shortage of working capital funds,
processing units were running with marginal capacity and production
was suspended in many plants during the year under review.
• The annual report also showed that it attempted to restructure itself.
However, banks rejected the plan proposed by the company. It also
said several banks had initiated action against the company under
the SARFAESI Act.
• In 2015, it became a sick company after it filed an application with
the Board of Industrial and Financial Restructuring.
Liquidity
 Analyzing Liquidity
● Liquidity refers to the solvency of the
firm's overall financial position, i.e. a
"liquid firm" is one that can easily
meet its short-term obligations as they
come due.
● A second meaning includes the
concept of converting an asset into
cash with little or no loss in value.
1. Current Ratio : It is the relationship between the current
assets and current liabilities of a concern.
Current Ratio = Current Assets/Current Liabilities
If the Current Assets and Current Liabilities of a concern
are Rs.4,00,000 and Rs.2,00,000 respectively, then the
Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
 Current Ratio
• Ideal level? – 2 : 1
• The ideal Current Ratio preferred by Banks is 1.33 : 1
• A ratio of 5 : 1 would imply the firm has Rs.5 of assets to cover
every Rs.1 in liabilities
• A ratio of 0.75 : 1 would suggest the firm has only 75p in assets
available to cover every Rs.1 it owes
• Too high – Might suggest that too much of its assets are tied up
in unproductive activities – too much stock, for example?
• Too low - risk of not being able to pay your way
2. ACID TEST or QUICK RATIO : It is the ratio between Quick Current
Assets and Current Liabilities.

Quick Current Assets : Cash/Bank Balances + Receivables upto 12 months +

Quickly realizable securities such as Govt. Securities or quickly marketable/quoted
shares and Bank Fixed Deposits

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

(Current assets – stock-prepaid expenses) : liabilities

• 1.5:1 seen as ideal
• The omission of stock gives an indication of the cash the firm has in relation to its
liabilities (what it owes)
• A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it
owes – very healthy!
• A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash
to pay for those liabilities. This might put the firm under pressure but is not in
itself the end of the world!
3. ABSOLUTE LIQUIDITY TEST : It is the ratio between Absolute liquid
assets and Current Liabilities.

Quick Current Assets : Cash/Bank Balances + Quickly realizable securities such as

Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits
Absolute Liquidity Ratio = Absolute Liquid Assets/Current Liabilities
(Current assets – stock-receivables) : liabilities
0.5:1 seen as ideal
• The omission of stock and receivables gives an indication of the cash the firm
has in relation to its liabilities (what it owes)
• A ratio of 3:1 therefore would suggest the firm has 6 times as much cash as it
owes – very healthy!
• A ratio of 0.2:1 would suggest the firm has five times as many liabilities as it has
ready cash to pay for those liabilities. This might put the firm under pressure but
is not in itself the end of the world!

4. NET WORKING CAPITAL : Current Assets – Current Liabilities

Example :
Cash 50,000
Debtors 1,00,000
Inventories 1,50,000 Current Liabilities 1,00,000
Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3:1

Quick Ratio => 1,50,000/1,00,000 = 1.5:1
Absolute Liquidity Ratio = > 50,000/1,00,000 = .5:1
Net Working Capital => 300000-100000 = 200000
 Analyzing Activity
● Activity is a more sophisticated
analysis of a firm's liquidity,
evaluating the speed with which
certain accounts are converted
into sales or cash; also
measures a firm's efficiency
 Five Important Activity Measures
Inventory Turnover (IT) Cost of Goods Sold
IT =
Average Inventory

Accounts Receivable
Average Collection Period (ACP)
ACP =
Annual Sales/360

Accounts Payable
Average Payment Period (APP)
APP=
Annual Purchases/360
Sales
Fixed Asset Turnover (FAT) FAT =
Net Fixed Assets

Sales
Total Asset Turnover (TAT) TAT =
Total Assets
STOCK/INVENTORY TURNOVER RATIO

STR = COGS/ Average Stock

Average Conversion period = 365/12/52

STR

Average Inventory or Stocks = (Opening Stock + Closing Stock)

-----------------------------------------
2
• This ratio indicates the number of times the inventory is rotated during
the relevant accounting period
• A high stock turnover might mean increased efficiency? But: dependent on the
type of business – supermarkets might have high stock turnover ratios
whereas a shop selling high value musical instruments might have low stock
turnover ratio
• Low stock turnover could mean poor customer satisfaction if people are not
buying the goods
Choose the true interpretation of a higher Debtors Turnover ratio from the

following set of statements:

a) Debts are not being collected at all.

b) Debts are being collected at a slower speed.

c) Debts are being collected at an average speed.

d) Debts are being collected more quickly.

ANSWER: d) the debts are being
collected more quickly.
Debtors at the end are Rs. 1,00,000?
a) 63 days b) 73 days c) 83 days d) 93
days
ANSWER: DTR: 5,00,000/1,00,000 = 5 times Average
collection period= 365/DTR= 73 days
b) 73 days
Assume that the Sales of a Company is of
Rs. 13,00,000,Gross Profit 20% on Sales,
Land & Building Rs. 1,00,000, Plant &
Machinery Rs.1,00,000. Determine what
shall be the Fixed Assets turnover ratio
of the Company?
a) 4.2:1 b) 5.2:1 c) 6.3:1 d) 6.4:1
ANSWER: b) 5.2:1
Assume that the Profit of a Company after
charging Interest on Debentures and Tax is
Rs. 36,500, Interest charged Rs. 5,000,
Provision for tax Rs. 12,500.Decide what
will be the Interest Coverage Ratio?
a) 9.35 times b) 9.75 times c) 10.8
times d) 12 times
ANSWER: c) 10.8 times PBIT/Intt
Charges= 54,000/5,000=10.8 times
RECEIVABLES TURNOVER RATIO
RTR = Net Credit Sales/ Average Receivables

Average Collection Period (Debtors Days) = 365/52/12

PTR
This ratio tells about the time taken to collect money from the
debtors

ACP:
• Shorter the better
• Gives a measure of how long it takes the business to recover debts
• Can be skewed by the degree of credit facility a firm offers
PAYABLES TURNOVER RATIO

PTR = Net Credit Purchase/ Average Payables

Average Payment Period (Creditors Days) = 365/52/12

PTR
This ratio tells about the time available to make payment to the
creditors

APP:
• Higher the better
• Gives a measure of how long it takes the business to pay its
debts
ASSET TRUNOVER RATIO : Net
Sales/Tangible Assets

FIXED ASSET TURNOVER RATIO :

Net Sales /Fixed Assets

CURRENT ASSET TURNOVER RATIO :

Net Sales / Current Assets
 Asset Turnover
• Asset Turnover = Sales turnover / assets
employed
• Using assets to generate profit
• Asset turnover x net profit margin = ROCE
QUESTION
Particulars Amount

Share capital 450

• From the presented
information of the
Retained profits 240
company, you are
Debentures 700
required to calculate the
Trade creditors 620 following ratios and
Proposed dividend 45 comment on the results:
Net fixed assets 875

Stock 310 1. Quick assets ratio

Debtors 770 2.Receivables Collection
Bank balance 100 Period
Sales 3100 3.Inventory Turnover Ratio
Gross profit 1725 4. Current ratio
Expenses 805 5. Fixed Assets Turnover
Depreciation 250 Ratio
QUESTION
• Cost of goods sold Rs. 1,60,000, stock
turnover ratio is 5 times, closing stock is
Rs. 4,000 more than opening stock.
Calculate Opening Stock.
QUESTION
• A company supplies the following information:
Liabilities Amount Assets Amount
Share capital 200000 Good will 120000
Reserves 58000 Plant 150000
Debentures 100000 Stock 80000
Creditors 40000 Debtors 45000
Bills payable 20000 Cash 17000
Other current liabilities 2000 Other current assets 8000
Total 420000 420000

Credit sales for the year- Rs 400000, gross profit-

Rs160000

Calculate current ratio, liquid ratio, inventory turnover

ratio and average collection period
Lecture Outcomes

• Understand the rationale of profitability

ratios.
Indian Railways is on The Verge of
Bankruptcy, Says Dinesh Trivedi

• http://www.news18.com/news/india/indian-
railways-is-on-the-verge-of-bankruptcy-say
s-dinesh-trivedi-1380047.html
Profitability
 Key Financial Ratios
Profitability Ratios
Profitability ratios measure the
overall performance of a firm and
its efficiency in managing assets,
liabilities, and equity.
 Key Financial Ratios
Profitability Ratios
Profitability ratios include
• operating profit margin
• net profit margin
• return on total assets (ROA) or return on investment
(ROI)
• return on equity (ROE)
Profitability
• Operating Profit Margin = Operating Profit /
Turnover x 100

Measures overall operating efficiency and incorporates

all of the expenses associated with ordinary business
activities
Example
• Calculate Net Profit Ratio from the
following data:
• Sales less returns- Rs. 100000
• Gross Profit- Rs. 40000
• Administration Expenses- Rs. 10000
• Selling Expenses- 10000
• Income from Investments- Rs. 5000
• Loss on account of fire- Rs. 3000
Profitability
• Operating Ratio = Operating Cost/Net Sales x100

Indicator of the degree to which organisation expenses

are covered by its core business
Profitability
• Net Profit Margin = Net Profit / Turnover x 100

• Net profit takes into account the fixed costs involved

in production – the overheads

• Keeping control over fixed costs is important – could

be easy to overlook for example the amount of waste
- paper, stationery, lighting, heating, water, etc.
– e.g. – leaving a photocopier on overnight uses enough electricity to
make 5,300 A4 copies. (1,934,500 per year)
– 1 ream = 500 copies. 1 ream = £5.00 (on average)
– Total cost therefore = £19,345 per year – or 1 person’s salary
Profitability
Cash Profit Margin

Measures ability to translate sales into

cash
Earnings before Interest, Tax,
Depreciation and Amortisation
(EBITDA)
Net sales
Profitability
• Expense Ratio= Individual Expense/ Net
Salesx 100

• Makes a comparison related to the portion

of individual expenses in sales.
 Profitability
• Return on Capital Employed (ROCE) =
Profit / capital employed x 100
• Be aware that there are different
interpretations of what capital employed
means – see
http://www.bized.ac.uk/compfact/ratios/ror3.htm for more
information!
 Profitability Ratios
Overall Efficiency and Performance
Return on Total Assets (ROA) or Return
on Investment (ROI)

Measures overall efficiency of firm in

managing investment in assets and
generating profits

Net earnings
Total assets
 Profitability Ratios
Overall Efficiency and Performance
Return on Equity
(ROE)
Measures rate of return on stockholders’
investment
Net earnings
Stockholders’ equity
 Profitability Ratios
Overall Efficiency and Performance
Cash Return on
Assets
Measures firm’s ability to generate cash
from the utilization of its assets

Cash flow from operating activities

Total assets
 Operating Ratio
Thais ratio establishes relationships between operating cost & net
sales. This ratio indicates the proportion that the cost of sales.

Cost of sale included direct cost of good sold & as well as other
operating expenses administration, selling & distribution
expenses

Operating ratio = Cost of good sold + operating expenses X 100

Net sale

= Operating cost X 100

Net sale
Cost of good sold = opening stock + purchase + direct expenses –
closing stock – GP

Operating expenses = administrative expenses + selling &

distribution expenses
OBJECTIVE & SIGNIFICANCE
Operating ratio is the test of the operational
efficiency of the business .it shows the
percentage of sales that is absorbed by the cost
of sales & operating expenses.

This ratio serves following objective

1. To determine whether the cost content has

increased or decreased in the figure of sales.

2. To determine which element of the cost has

gone up.
Example:
Cost of goods sold 6 lac
Operating expenses 40,000
Sales 8,20,000
Sales returns 20,000

Operating Ratio = Cost of goods sold + operating expenses X 100

Net Sales

= 600000+40000 X 100
820000-20000
= 640000 X 100
800000

= 80%
 Profitability
• The higher the better
• Shows how effective the firm is in using its
capital to generate profit
• A ROCE of 25% means that it uses every
Rs.1 of capital to generate 25p in profit
• Partly a measure of efficiency in
organisation and use of capital
 Key Financial Ratios
Leverage Ratios

Leverage ratios measure the extent of a

firm’s financing with debt relative to equity
and its ability to cover interest and other
fixed charges.
 Key Financial Ratios
Leverage Ratios
Leverage ratios include
• Debt ratio
• Long-term debt to total capitalization
• Debt to equity
• Times interest earned
• Fixed charge coverage
• Cash flow adequacy
 Analyzing Debt
● Debt is a true "double-edged" sword as it
allows for the generation of profits with the
use of other people's (creditors) money, but
creates claims on earnings with a higher
priority than those of the firm's owners.
● Financial Leverage is a term used to
describe the magnification of risk and return
resulting from the use of fixed-cost financing
such as debt and preferred stock.
SOLVENCY RATIOS
The term ‘solvency’ implies ability of an
enterprise to meet its long-term indebtedness
and thus, solvency ratios convey an
enterprises ability to meet its long-term
obligations. Some important solvency ratios
are :

• Debt-Equity Ratio,
• Debt to Total Funds Ratio,
• Fixed Asset Ratio
Debt Equity Ratio
The debt-equity ratio is worked out to ascertain soundness of
the long-term financial policies of the firm.

The ratio ascertained as follows;

Debt-Equity Ratio = Debt (Long-Term Loans)

Equity (Shareholders’ Funds)

Dept – equity ratio indicates the proportion between

shareholders’ funds and the long-term borrowed funds. A
higher ratio indicates a risky financial position while a
lower ratio indicates safer financial position.
Objective and Significance

This ratio is sufficient to assess the soundness

of long-term financial position. It also
indicates the extent to which the firm
depends upon outsiders for its existence
Ascertain Dept-Equity ratio;

Equity share capital 2,00,000

General reserve 1,60,000
10% debenture 1,50,000
Current liabilities 1,00,000
Preliminary expenses 10,000
Solution:
Dept-equity Ratio = Dept
Equity

Debt = debentures = Rs. 1,50,000

Equity= Equity Share Capital + General Reserve- preliminary Expenses
= 2,00,000+1,60,000-10,000
= 3,50,000
Debt-Equity ratio= 1,50,000
3,50,000
= 15:35= 3:7
DEBT TO TOTAL FUNDS RATIO
• The Debt to Total Funds Ratio is a measure for long term
financial soundness.

• Debt Total Funds Ratio = Debt

Equity + Debt

• Objective and Significance:

The main purpose of the ratio is to
determine the relative stock of outsiders and
shareholders.
 Calculate Debt to Total Funds
Ratio:
9% Pref. Share Capital 10,00,000
Equity Share Capital 20,00,000
Reserves 10,00,000
10% Debentures 30,00,000
Loans From Industrial Finance corporation 20,00,000
Current liabilities 8,00,000
Debt to Total Funds Ratio = Long-term loans
Shareholders funds + Long-term loans
= 30,00,000 + 20,00,000
10,00,000 + 20,00,000 + 10,00,000 + 30,00,000
+ 20,00,000
= Rs. 50,00,000 = 5 : 9 or 0.56.
Rs. 90,00,000
 FIXED ASSETS RATIO

Fixed Assets Ratio

= Shareholders’ funds + Long-term loans
Net Fixed Assets

Objective and Significance.

This ratio indicates as to what extent
fixed assets are financed out of long-term
solvency.
 Calculate Fixed Assets Ratio:
Share capital 2,00,000
Reserves 50,000
9% Debentures 2,00,000
Trade Creditors 75,000
Plant and Machinery 2,00,000
Land and Building 2,00,000
Furniture 50,000
Trade Debtors 60,000
Cash Balance 40,000
Bills Payable 24,000
Stock 80,000
Fixed Assets Ratio = Long-term Funds
Fixed Assets
= 2,00,000 + 50,000 + 2,00,000 = 4,50,000 = 1
2,00,000 + 2,00,000 + 50,000 4,50,000
Investment/Shareholders
Return on Investment
✔ The term investment refer to total asset or net asset.
✔ the conventional approach of calculating ROI is to divide
PAT by investment, investment represents pool of funds,
supplied by shareholders and lenders,
✔ while pat represents residue income of shareholders.
✔ The formulae for calculating ROI is;
✔ ROI=Total Earnings/ Total Shareholder Funds

✔ Total Earnings=Earnings before Interest and taxes+ Non

Operating incomes like rents, interest and dividends
✔ Total Shareholder Funds = Equity Share Capital+ Preference
Share Capital+ reserves & Surplus- Accumulated Losses
Return on Equity
It shows the profitability of Equity funds invested in the
business

ROE= Earnings After Tax

Net Worth

Net Worth= Net Fixed Assets+ Net Working Capital-

External Liabilities (Long Term)
Return on Assets
It shows the Net Income per rupee of average fixed assets

ROA= Net Profit After Taxes

Average Total Assets

Average Total Assets= (Opening Balance+ Closing

Balance)/ 2
Earnings Per Share
Provides the investor with a common
denominator to gauge investment returns

PAT-Preference Dividend or Earnings available

for Equity Shareholders
Average number of equity shares outstanding
Diluted Earnings Per Share
Diluted EPS is a performance metric used to
gauge the quality of a company's earnings
per share (EPS) if all convertible securities
were exercised.

PAT-Preference Dividend or Earnings available

for Equity Shareholders+ Increase in PAT
Average number of equity shares outstanding+
Increase in equity shares
Price Earnings Ratio
Relates earnings per common share to the
market price at which the stock trades,
expressing the “multiple” that the stock market
places on a firm’s earnings

Market price of common stock

Earnings per share
Dividend Per Share
Amounts of dividend distributed per share

Dividends
Number of Equity Shares
Dividend Payout Ratio
Determined by the formula cash dividends
per share divided by earnings per share

Dividends per share

Earnings per share
 Analyzing the Data
There are five broad areas that would typically
constitute a fundamental analysis of financial
statements:
• Background on the firm, industry, economy, and
outlook
• Short-term liquidity
• Operating efficiency
• Capital structure and long-term solvency
• Profitability
Background: Economy, Industry, and Firm

Economic developments and the actions of

competitors affect the ability of any business
enterprise to perform successfully.
It is necessary to evaluate the environment in
which the firm conducts business.
This process involves blending hard facts with
guess and estimates.
 Short-Term Liquidity

Especially important to creditors, suppliers,

management, and others who are concerned
with the ability of a firm to meet near-term
demands for cash
Should include analysis of selected financial
ratios and a comparison with industry averages
Predicts the future ability of the firm to meet
prospective needs for cash
 Operating Efficiency

Turnover ratios measure the operating

efficiency of a firm.
The efficiency in managing a company’s
accounts receivable, inventory, and
accounts payable is discussed in the
short-term liquidity analysis.
Capital Structure and Long-Term Solvency

Analytical process includes an

evaluation of the amount and
proportion of debt in a firm’s capital
structure as well as the ability to
service debt.
Debt financing implies risk and
leverage.
 Profitability

Analysis of how well the firm has

performed in terms of profitability,
beginning with the evaluation of
several key ratios
 DuPont Framework
• The DuPont framework was developed
internally at DuPont around 1920.
• It provides a systematic approach to
identifying general factors causing ROE to
deviate from normal.
• It establishes a framework for computing
financial ratios to yield more in-depth analysis
of a company’s areas of strength and
weakness.
 The number of dollarsThe number of
The number in of dollars of assets a
sales generated by
pennies in profits company is able to
each dollar of assets
acquire using each
generated from dollar invested by
each dollar of sales stockholders
$180,000
$5,700,000
$5,700,000
$5,700,000
$2,278,000
$2,278,000
$2,278,000
$1,468,000
 DuPont Framework

Coleville’s ROE for 2011 is 12.3%. The ROE for 2010

would be calculated the same way.
 Relating the Ratios
The Du Pont System
Helpful to complete the evaluation of a firm by
considering the interrelationship among the
individual ratios
Looks at how the various pieces of financial
measurement work together to produce an
overall return
Helps analyst see how the firm’s decisions and
activities over the course of an accounting
period interact to produce overall return to
shareholders
 Relating the Ratios
The Du Pont System
The first three ratios reveal that return on
investment is a product of the net
profit margin and the total asset
turnover.
The second three ratios show how the
return on equity is the product of
return on investment and financial
leverage.
 Relating the Ratios
The Du Pont System
By reviewing this series of relationships, the
analyst can identify strengths and
weaknesses as well as trace potential
causes of problems in the overall financial
condition and performance of the firm.
Analyst can evaluate changes in condition and
performance.
Evaluation can then focus on specific areas
contributing to changes.
 Projections and
Pro Forma Statements
Pro forma financial statements are
projections based on a set of
assumptions regarding
• future revenues
• expenses
• level of investment in assets
• financing methods and costs
• working capital management
 Projections and
Pro Forma Statements
Pro forma financial statements are used
primarily for long-range planning and
long-term credit decisions.
Many firms have made up their own
definitions of pro forma statements,
which should not be confused with the
pro forma statement described above.
 Summary of Analysis

Analysis of any firm’s financial statements

consists of a mixture of steps and pieces
that interrelate and affect each other.
No one part of the analysis should be
interpreted in isolation.
The last step of analysis is to integrate the
separate pieces into a whole, leading to
conclusions about the business enterprise.
EXERCISE 1

LIABILITES ASSETS
Capital 180 Net Fixed Assets 400
Reserves 20 Inventories 150
Term Loan 300 Cash 50
Bank C/C 200 Receivables 150
Trade Creditors 50 Goodwill 50
Provisions 50
800 800

a. What is the Net Worth : Capital + Reserve = 200

b. Tangible Net Worth is : Net Worth - Goodwill = 150
c. Outside Liabilities : TL + CC + Creditors + Provisions = 600
d. Net Working Capital : C A - C L = 350 - 250 = 50
e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1
f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1
 EXERCISE 2

LIABILITIES 2005-06 2006-07 2005-06 2006-07

Capital 300 350 Net Fixed 730 750
Assets
Reserves 140 160 Security Electricity 30 30
Bank Term Loan 320 280 Investments 110 110
Bank CC (Hyp) 490 580 Raw Materials 150 170
Unsec. Long T L 150 170 S I P 20 30
Creditors (RM) 120 70 Finished Goods 140 170
Bills Payable 40 80 Cash 30 20
Expenses Payable 20 30 Receivables 310 240
Provisions 20 40 Loans/Advance 30 190
s
Goodwill 50 50
Total
1. Tangible Net Worth for 1600
1st Year : (1760
300 + 140) - 50 = 390 1600 1760

2. Current Ratio for 2nd Year : (170 + 20 + 240 + 2+ 190 ) / (580+70+80+70)

820 /800 = 1.02
3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
Exercise 3.

LIABIITIES ASSETS
Equity Capital 2 Net Fixed Assets 800
0
0
Preference Capital 1 Inventory 300
0
0
Term Loan 6 Receivables 150
0
0
Bank
1. CCEquity
Debt (Hyp) Ratio will be : 6004 / Investment
(200+100) In =Govt.
2:1 50
0 Secu.
2. Tangible Net Worth : Only equity0 Capital i.e. = 200
Sundry Creditors 1 Preliminary Expenses 100
0
3. Total Outside Liabilities / Total Tangible
0 Net Worth : (600+400+100) / 200
= 11 : 2
Total 1 1400
4
4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1
0
 Exercise 4.
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Current Ratio ? Ans : (125 +128+1+30) / (38+26+9+15)

: 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW

= 100 / ( 362 – 30)
= 100 / 332 = 0.30 : 1
 Exercise 4. contd…
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100

[ (362 - 30 ) / (550 – 30)] x 100
(332 / 520) x 100 = 64%
Q . What is the Net Working Capital ?
Ans : C. A - C L. = 255 - 88 = 167

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover
Ratio in Times ? Ans : Net Sales / Average Inventories/Stock
1500 / 128 = 12 times approximately
 Exercise 4. contd…
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12

= 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?

Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
Exercise 5. : Profit to sales is 2% and amount of profit is say
Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100

2 = (5 x100) /Sales
Therefore Sales = 500/2 = Rs.250 Lac
Exercise 6. A Company has Net Worth of Rs.5 Lac, Term
Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and
Current Assets are Rs.25 Lac. There is no intangible Assets
or other Non Current Assets. Calculate its Net Working
Capital.
Answer
Total Assets = 16 + 25 = Rs. 41 Lac
Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac
Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L

= 25 – 26 = (- )1 Lac
Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net
Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities

hence the NWC would be NIL

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What

is the amount of Current Assets ?

Answer : 4 x - 1 x = 30,000
Therefore x = 10,000 i.e. Current Liabilities is Rs.10,000
Hence Current Assets would be 4x = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per

month, monthly average interest on TL is Rs.5000/-. If the amount of
Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What
would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment

= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2
Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is
1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of
Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long
Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac
i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current
Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net
Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity
Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs.
Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being

Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10
Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10
i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure
which should be Rs. 10 Lac
 THANK YOU

11