YSI S

AN AL
TI O
R A
Learning Outcomes
 Develop an ability to interpret the liquidity, solvency and profitability
financial position of the business entities.
 Enable users to extract useful information from financial statements
for decision making
 Recommend how businesses could improve their liquidity, solvency
and profitability position.
 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
The study and interpretation of the relationships between
various financial variables, by investors or lenders.
Ratio
Ratio Analysis
Analysis -- Significance
Significance

A single ratio by itself is not very meaningful.

The discussion of ratios will

include the following types of comparisons.
Ratio
Ratio Analysis
Analysis -- Purpose
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
Ratio Analysis
Analysis -- Significance
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
 TERMS USED IN RATIO ANALYSIS
• Current Assets
• Quick Assets
• Absolute Liquid Assets
• Working Capital
• Receivables
• Payables
• Fixed Assets
• Fictitious Assets
• Intangible Assets
 TERMS USED IN RATIO ANALYSIS
• Capital Employed
• Investments
• Current Liabilities
• Debt
• Equity
• Cost of Goods Sold
• Cost of Sales
• Long term funds
• Long term loans
 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
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 up to 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
Cost of Goods Sold
Inventory Turnover (IT) IT =
Average Inventory

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

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

Total Asset Turnover (TAT) Sales

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
DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or
Average Collection Period or Period of Credit given .

DTR = Net Credit Sales/ Average Receivables

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

DTR
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
CREDITORS TURNOVER RATIO : This is also called Creditors Velocity Ratio,
which determines the creditor payment period.

CTR = Net Credit Purchase/ Average Payables

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

CTR
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
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
• gross profit margin
• operating profit margin
• net profit margin
• cash flow margin
• return on total assets (ROA) or return on investment
(ROI)
• return on equity (ROE)
• cash return on assets
 Profitability
• Gross Profit Margin = Gross profit / turnover
x 100
• The higher the better
• Enables the firm to assess the impact of its sales
and how much it cost to generate (produce)
those sales
• A gross profit margin of 45% means that for
every £1 of sales, the firm makes 45p in gross
profit
 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
• Operating Profit Margin = Operating Profit /
Turnover x 100
Measures overall operating efficiency and incorporates
all of the expenses associated with ordinary business
activities
 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
Cash Flow Margin

Measures ability to translate sales into

cash

Cash flow from operating activities

Net sales
 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 ration 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 good sales 6 lac
Operating expenses 40,000
Sales 8,20,000
Sales returns 20,000
 
 
Operating Ratio = Cost of good sold + operating expenses X 100
Net Sales
 
= 6 lac + 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,
• Interest Coverage Ratio,
• Debt to Total Funds Ratio,
• Fixed Asset Ratio,
 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,
• Interest Coverage Ratio,
• Debt to Total Funds Ratio,
• Proprietary Ratio 
1. 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.
• Long – term debts = Long term loans +
debentures + bonds + long term loans
from financial institutions

• Shareholder funds (in case of debt –

equity ratio) = equity share capital +
reserves and surplus – accumulated
losses
 Interpretation
Low debt – equity High debt – equity
ratio ratio

More equity than debt More debt than equity

Large margin of
Benefits of trading on
safety available to
equity
creditors
Debt servicing is less Debt servicing is
burdensome burdensome
 Interpretation
• Ratio less that 1 i.e. reflects the low – debt equity ratio.
– This shows more security available to creditors.
– This also implies a more financially stable business.
– Companies with low – debt equity ratio are less risky to creditors.
• Ratio greater that 1 i.e. reflects the high – debt equity ratio
– This shows that company has raised more debt compared to equity
to buy its’ assets.
– More debt means that the company is highly leveraged.
– The company is taking advantage of trading on equity.
– Companies with a higher debt to equity ratio are considered more
risky to creditors and investors
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 ;
Debt-equity Ratio = Debt
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
Dept-Equity ratio= 1,50,000
3,50,000
= 15:35= 3:7
2. Interest Coverage ratio:
when a business borrows money, the lender is interested
in finding out whether the business would earn
sufficient profit to pay periodically the interest charge. A
ratio which expresses this is called Interest Coverage
Ratio or Dept service Ratio or fixed charges cover.
This ratio is determined by dividing profit before interest
by the interest charges
 
Interest Coverage Ratio =Net profit before interest and tax
Interest on fixed (long-term) loans or Debentures
 Interpretation
• This ratio is expressed in times.
• It indicates number of times interest is
covered by profits available to pay interest
charges.
• Long term creditors are interested in
knowing the company’ ability to pay
interest charges.
• Higher the ratio, more safety available to
creditors.
Objective and Significance :
This ratio indicates how many
times the profit covers fixed
interest. It measures the margin
of safety for the lenders. The
higher the number, more secure
the lender is in respect of his
periodical interest income.
Example:
 
The operating profit of Exe. Ltd. After charging interest on
debentures and tax is Rs 1,00,000. The amount of interest
is Rs 20,000 and the provision for tax has been made at
Rs 40,000. Calculate the interest coverage ratio.
 
 
Solution:
 
Interest Coverage Ratio = net profit before interest and tax
Interest charges
 
= 1,60,000
20,000
3. DEBT TO CAPITAL
EMPLOYED RATIO
• The Debt to Total Funds Ratio is a measure for long
term financial soundness.
Long term Debts
• Debt Total Funds Ratio = Capital employed

• Objective and Significance:

The main purpose of the ratio is to
determine the relative stock of outsiders and
shareholders.
• Capital Employed = shareholders funds +
Long term borrowing
 Calculate Debt to Total
Funds Ratio:
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

A. 37.5%
B. 62.5%
C. 55%
D. Nil
 Calculate Debt to capital
employed Ratio:
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 =

= 30,00,000 + 20,00,000
20,00,000 + 10,00,000 + 30,00,000 + 20,00,000

= Rs. 50,00,000 = 5 : 8 or 62.5%.

Rs. 80,00,000
4.) Proprietary ratio or equity
ratio
• Meaning
Establishes the relationship b/w shareholder
funds to total assets in the company.

• Formula
Shareholder Funds *100
Total assets
 Interpretation
• The proprietary ratio shows the
contribution of shareholders in total capital
of the company.
• A high ratio indicates a strong financial
position of the company and greater
security for creditors.
• A low ratio proprietary indicates that the
company is already heavily depending on
debts for its operations.
• A large portion of debts in the total capital
Problem solving
• From the following information, calculate the:
a) Proprietary ratio

• Equity share capital = 400,000

• Reserves and surplus = 100,000
• Debentures = 150,000
• Current liabilities = 50,000
• Fixed assets = 400,000
• Investments = 100,000
• Current assets = 200,000
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
 
Dept = debentures = Rs. 1,50,000
Equity= Equity Share Capital + General Reserve- preliminary Expenses
= 2,00,000+1,60,000-10,000
= 3,50,000
Dept-Equity ratio= 1,50,000
3,50,000
= 15:35= 3:7
Interest Coverage ratio:
when a business borrows money, the lender is
interested in finding out whether the business would
earn sufficient profit to pay periodically the interest
charge. A ratio which expresses this is called
Interest Coverage Ratio or Dept service Ratio or
fixed charges cover.
This ratio is determined by dividing profit before
interest by the interest charges
 
Interest Coverage Ratio =Net profit before interest and tax
Interest on fixed (long-term) loans or
Debentures
Objective and Significance :
This ratio indicates how many times the profit
covers fixed interest. It measures the margin
of safety for the lenders. The higher the
number, more secure the lender is in respect
of his periodical interest income.
Example:
 
The operating profit of Exe. Ltd. After charging interest on debentures and
tax is Rs 1,00,000. The amount of interest is Rs 20,000 and the provision
for tax has been made at Rs 40,000. Calculate the interest coverage ratio.
 
 
Solution:
 
Interest Coverage Ratio = net profit before interest and tax
Interest charges
 
= 1,60,000
20,000
DEBT TO TOTAL FUNDS RATIO
• The Debt to Total Funds Ratio is a measure for long term
financial soundness.
Debt
• Debt Total Funds Ratio = 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
 RETURN ON EQUITY
 Common shareholders are entitled to the residual profit.
The rate of dividend is not fixed and earning may be
distributed to shareholders or retained in the business.
 A ROE is calculated to se the profitability of owner’s
investment.
 ROE indicates how well the firm has used the resources
of owners.
 It is a most important relationship in financial analysis.

Formula:
ROE= PAI .
Net Worth Equity
Investment/Shareholders
 Key Financial Ratios
Market Ratios
Market ratios measure returns to
stockholders and the value the
marketplace puts on a company’s stock.
Market ratios include
• earnings per common share
• price-to-earnings
• dividend payout
• dividend yield
 Market Ratios
Earnings per Common Share
Earnings per Common Share
Provides the investor with a common
denominator to gauge investment
returns

Net earnings
Average shares outstanding
• The lower the PEG number, the less you
pay for each unit of future earnings
growth. So even a stock with a high P/E,
but high projected earning growth may be
a good value.
 Market Ratios
Dividend Yield
Dividend Yield
Shows the relationship between cash
dividends and market price

Dividends per share

Market price of common stock
 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.
 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.
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 1600 1760 1600 1760
1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

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 200 Net Fixed Assets 800
Preference Capital 100 Inventory 300
Term Loan 600 Receivables 150
Bank CC (Hyp) 400 Investment In Govt. 50
Security.
Sundry Creditors 100 Preliminary Expenses 100
Total 1400 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 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