RATIO ANALYSIS

Tools of Financial Analysis.

Financial statement analysis Funds flow analysis Cash flow analysis Costing techniques Budgetary control Management Reporting Ratios Analysis

Ratio Analysis is one of most important & powerful tools of financial analysis. It is the Process of establishing and interpreting various ratios. Accounting ratios expresses the relationships expressed in mathematical terms between accounting figures which are connected with each other in some manner Ratios due to their conciseness and help comparability to summarize large data to draw quantitative judgment about firms performance.

Ratio Analysis
R-----------------Righteous, A----------------- Accurate T------------------ Thorough I------------------- Inclusive Os-------Orderly &Systematic.

Ratio Analysis Introduction

Ratio-analysis is a concept or technique which is as old as accounting concept. Financial analysis is a scientific tool. It has assumed important role as a tool for appraising the real worth of an enterprise, its performance during a period of time and its pit falls. Financial analysis is a vital apparatus for the interpretation of financial statements. It also helps to find out any crosssectional and time series linkages between various ratios.

Why We Need Ratio analysis ?

Unlike in the past when security was considered to be sufficient consideration for banks and financial institutions to grant loans and advances, nowadays the entire lending is need-based and the emphasis is on the financial viability of a proposal and not only on security alone. Further all business decision contains an element of risk. The risk is more in the case of decisions relating to credits. Ratio analysis and other quantitative techniques facilitate assessment of this risk.

Ratio & Analysis Meaning

Ratio is an expression of the quantitative prelateship between two numbers. Ratio-analysis means the process of computing, determining and presenting the relationship of related items and groups of items of the financial statements. They provide in a summarized and concise form of fairly good idea about the financial position of a unit. They are important tools for financial analysis.

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.

Before looking at the ratios there are a number of cautionary points concerning their use that need to be identified : a. The dates and duration of the financial statements being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn. b. The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results. c. In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.

The utility of ratio analysis will get further enhanced if following comparison is possible. 1.Between the borrower and its competitor 2.Between the borrower and the best enterprise in the industry 3.Between the borrower and the average performance in the industry 4.Between the borrower and the global average

Traditional Classification of Ratios

Balance Sheet Ratio P&L Ratio or Income/Revenue Statement Ratio
Operating Ratio

Balance Sheet and Profit & Loss Ratio

Financial Ratio

Composite Ratio

Current Ratio Quick Asset Ratio Proprietary Ratio Debt Equity Ratio

Gross Profit Ratio Operating Ratio Expense Ratio Net profit Ratio Stock Turnover Ratio

Fixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors Turnover Ratio,

Modern Classification of Financial Ratios

Liquidity ratios Solvency ratios Turnover ratios Profitability ratios Equity-related ratios

Liquidity Ratios
Liquidity ratios measure a firms ability to meet its current obligations.
Current assets Current ratio = Current liabilities Current assets Inventories Quick ratio = Current liabilities Cash + Marketable securities Cash ratio = Current liabilities

Current assets Cash in hand Cash at bank Marketable securities Short term investment Bills receivable Sundry debtors Inventories Prepaid expenses

Current Liabilities Outstanding expenses Bills payable Sundry creditors Advances and loans Income tax Payable Dividend Payable Bank Overdraft

Solvency Ratios
Solvency ratios measure the dependence of a firm on borrowed funds. Debt can be inclusive of current liabilities Debt Debt-equity ratio Equity (Net Worth)

Debt Debt Debt ratio Debt Equity Capital employed Earnings before interest and tax Interest coverage Interest

Interest coverage ratio or Debt service Coverage ratio or Fixed charges coverage

ratio(DSCR,FCCR,ICR) Debt ** Long term Outsiders liabilities Debentures or Bonds Short term loan Shareholders funds Equity share capital Preference share capital Capital And revenue reserve Accumulated profits

Debt ratio (long term only ) Capital employed :Share holders fund +Outsiders Debt i.e. Eq.share capital , preference sh.capital ,reserves surplus , debentures ,Mortgage loans , loans (long term only) (Fictitious assets +Non Business assets . Or Total Assets Current liabilities

Turnover Ratios/Efficiency ratios/Activity ratios

Turnover ratios measure the firms efficiency in utilizing its assets. Speed with which assets are turned into sales
Cost of goods sold or net sales Average (or closing) inventory Number of days in the year (say, 360) Days of inventory holding Inventory turnover Credit sales or net sales Debtors turnover Average (or closing) debtors Number of days in the year (say, 360) Collection period Debtors turnover Inventory turnober

Creditors Turnover ratio =Net credit purchases / Average trade creditors Average payment period = No of working days in year / Creditors turnover ratio Working Capital Turnover ratio =Cost of sales / Average working capital Here working capital is current assets current liabilities

Current assets turnover

Net sales Current assets Net sales Net current assets turnover Net current assets Net sales Fixed assets turnover Net fixed assets Net sales Net assets turnover Net assets or capital employed
Here capital employed is Total assets current liabilities or Liabilities current liabilities

Profitability Ratios
Profitability ratios measure a firms overall efficiency and effectiveness in generating profit.
Profit before interest and tax (PBIT) Margin Net sales Profit after tax (PAT) Net margin Net sales PBIT Before tax return on investment Net assets Profit after tax Return on equity Equity (net worth)

Operating ratio =Operating cost /Net sales *100 Here operating expenses refer to COGS +operating expenses (admin ,selling , office ) Operating profit ratio = 100-operating ratio Return on investment ratio =(Operating Profit /Capital employed )*100

Dupont Analysis Ratio

It is the break down of ROE into its constituent elements and helps to understand the reasons for an increase or decrease in ROE by identifying its variable = 1*2*3 (Profit after tax/sales ) * (Sales/total Assets)*(Total assets/Shareholders funds)

Question no 1
Current Ratio : 2.5 Liquidity ratio : 1.5 Net working capital :Rs 3,00,000 Stock turnover ratio :6 times Gross profit ratio 20 % Fixed asset turnover ratio 2 Times Average debt collection period :2 Months Fixed assets :shareholders fund Net worth : 1:1 Reserves :share capital : .5 :1

Market Growth / Equity-related Ratios

Equity-related ratios measure the shareholders return and is calculated to see appreciation in the value of share of company . EPS is most widely used for indicating the profitability from the shareholders point , DPS shows the percentage of profits is being distributed , where as DY shows the return to the shareholder by the way of dividend on the current market price .
Profit after tax Number of ordinary shares Dividends DPS Number of ordinary shares DPS Dividends Payout ratio EPS Pr ofit after tax DPS Dividend yield Market value per share EPS

Price Earning ratio = Market price of equity share /EPS This ratio indicates the relative pricing of a stock. Higher growth firms indicates a higher PE multiple .

Importance /Utility of Ratio Analysis

Assessment of the firms financial conditions and capabilities. Diagnosis of the firms problems, weaknesses and strengths. Credit analysis Security analysis Comparative analysis Time series analysis

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. If there is profit it shall become part of Net Worth under the head Reserves and if there is loss it will become part of Intangible Assets Investments in Govt. Securities to be treated current only if these are marketable and due. Investments in other securities are to be treated 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.

EXERCISE 1 LIABILITES Capital Reserves ASSETS 180 Net Fixed Assets 20 Inventories 400 150

Term Loan
Bank C/C Trade Creditors Provisions

300 Cash
200 Receivables 50 Goodwill 50 800

50
150 50 800

a. b. c. d. e. f.

What is the Net Worth : Capital + Reserve = 200 Tangible Net Worth is : Net Worth - Goodwill = 150 Outside Liabilities : TL + CC + Creditors + Provisions = 600 Net Working Capital : C A - C L = 350 - 250 = 50 Current Ratio : C A / C L = 350 / 300 = 1.17 : 1 Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2 LIABILITIES Capital Reserves Bank Term Loan Bank CC (Hyp) Unsec. Long T L 2005-06 300 140 320 490 150 2006-07 350 Net Fixed Assets 160 Security Electricity 280 Investments 580 Raw Materials 170 S I P 2005-06 730 30 110 150 20 2006-07 750 30 110 170 30

Creditors (RM)
Bills Payable Expenses Payable Provisions Total

120
40 20 20 1600

70 Finished Goods
80 Cash 30 Receivables 40 Loans/Advances Goodwill 1760

140
30 310 30 50 1600

170
20 240 190 50 1760

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390 2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 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
Preference Capital Term Loan Bank CC (Hyp) Sundry Creditors Total

200 Net Fixed Assets

100 Inventory 600 Receivables 400 Investment In Govt. Secu. 100 Preliminary Expenses 1400

800
300 150 50 100 1400

1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1 2. Tangible Net Worth : Only equity Capital i.e. = 200 3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 2 4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

Exercise 4. LIABILITIES Capital + Reserves P & L Credit Balance Loan From S F C Bank Overdraft Creditors 355 ASSETS Net Fixed Assets 265 1 125 128 1 7 Cash 100 Receivables 38 Stocks 26 Prepaid Expenses

Provision of Tax
Proposed Dividend

9 Intangible Assets
15

30 550

550
Q. What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15) : 255/88 = 2.89 : 1

Q What is the Quick Ratio ?

Ans : (125+1)/ 88 = 1.43 : 11

Ans : LTL / Tangible NW = 100 / ( 362 30) = 100 / 332 = 0.30 : 1

Q. What is the Debt Equity Ratio ?

Exercise 4. contd LIABILITIES Capital + Reserves P & L Credit Balance Loan From S F C Bank Overdraft Creditors 355 ASSETS Net Fixed Assets 265 1 125 128 1 7 Cash 100 Receivables 38 Stocks 26 Prepaid Expenses

Provision of Tax
Proposed Dividend

9 Intangible Assets
15

30 550

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
Capital + Reserves 355

ASSETS
Net Fixed Assets 265

P & L Credit Balance

Loan From S F C

7 Cash
100 Receivables

1
125

Bank Overdraft
Creditors

38 Stocks
26 Prepaid Expenses

128
1

Provision of Tax
Proposed Dividend

9 Intangible Assets
15 550

30
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 ( since NWC = C.A - C.L ) Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the amount of Current Assets ? Answer : 4a - 1a = 30,000 Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000 Hence Current Assets would be 4a = 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

Exercise 12. From the following financial statement calculate (i) Current Ratio (ii) Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v) Average Creditors payment period. C.Assets Sales 1500 Inventories 125 Cost of sales 1000 Debtors 250 Gross profit 500 Cash 225 C. Liabilities Trade Creditors 200
(i) Current Ratio : 600/200 = 3 : 1 (ii) Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1 (iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times (iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 = 61 days (v) Average Creditors payment period : (Trade Creditors/Cost of sales) x 365 (200/100) x 365 = 73 days