Ratio Analysis for Class

8/8/2019 Ratio Analysis for Class

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Ratio Analysis

Ratio analysis is a widely used tool of financial analysis. Itis defined as the systematic use of ratio to interpret the

financial statements so that the strengths and

weaknesses of a firm as well as its historical

performance and current financial

condition can be determined.


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Financial Ratio Analysis

Objectives:

The purpose of the financial ratio analysis is to

ascertain-

1. whether the financial condition of the business unitis basically sound,

2. whether the profitability of the business unit is

satisfactory,

3. and, finally to know whether the management runs

the business efficiently or not.


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Use of ratio

Net profit of the three Firms are given below:

Firm X Y Z

Net Profit Rs.10,000 Rs. 15,000 Rs. 20,000

Which firm is the most efficient?


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If investment is given as:

Firm X Y Z

Investment 1,00,000 2,00,0004,00,000

(Capital)

Rate of return on

Investment (ROR) 10% 7.5% 5%

The most efficient firm is X having highest rate of return onInvestment.

Thus it is only by ratio analysis that we are able to finally judge theefficiency of one firm over the other.


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What is Ratio?

Relationship between two numerical

values. What is Financial Ratio?

The relationship between two accounting

figures expressed mathematically isknown as financial ratio.


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CLASSIFICATION OF RATIOS

1. Ratio to assess financial soundness

2. Ratio to assess profitability

3. Ratio to assess efficiency


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Ratio to assess financial

soundness

Liquidity Ratio

Long-term Solvency Ratio

Coverage Ratio


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Liquidity ratios measure the abilityof a firm to meet its short-term

obligations

Liquidity RatiosLiquidity Ratios


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Particulars Firm A Firm B

Current Assets Rs 1,80,000 Rs 30,000

Current Liabilities Rs 1,20,000 Rs 10,000

Current Ratio = 3:2 (1.5:1) 3:1

Current Ratio is a measure of liquidity calculated dividing

the current assets by the current liabilities

Current Ratio

Current Ratio = Current AssetsCurrent Liabilities


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The quick or acid test ratio takes into consideration

the differences in the liquidity of the

components of current assets

Quick Assets = Current assets Stock

Pre-paid expenses

Acid-Test Ratio

Acid-test Ratio =Quick Assets

Current Liabilities


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Example 1:Acid-Test Ratio

Cash

Debtors

Inventory

Total current assets

Total current liabilities

Rs 2,000

2,000

12,000

16,000

8,000

(1) Current Ratio(2) Acid-test Ratio

2 : 10.5 : 1


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Supplementary Ratios forLiquidity

Inventory TurnoverRatio

Debtors Turnover Ratio

Creditors Turnover Ratio


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Inventory Turnover Ratio

The cost of goods sold means sales minus gross profit.

The average inventory refers to the simple average of the opening

and closing inventory.

The ratio indicates how fast inventory is sold. A high ratio is good

from the viewpoint of liquidity and vice versa. A low ratio

would signify that inventory does not sell fast and stays

on the shelf or in the warehouse for a long time.

Inventory turnover ratio =Cost of goods sold

Average inventory


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Debtors Turnover Ratio

Net credit sales consist of gross credit sales minusreturns, if any, from customers.

Average debtors is the simple average of debtors (including

bills receivable) at the beginning and at the end of year.

The ratio measures how rapidly receivables are collected. A high

ratio is indicative of shorter time-lag between credit sales and

cash collection. A low ratio shows that debts are not

being collected rapidly.

Debtors turnover ratio =Net credit sales

Average debtors


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Example 3: Debtors Turnover Ratio

A firm has made credit sales of Rs 2,40,000 during the year. The

outstanding amount of debtors at the beginning and at the end

of the year respectively was Rs 27,500 and Rs 32,500.

Determine the debtors turnover ratio.

Debtors

turnover ratio=

Rs 2,40,000=

8 (times

per year)(Rs 27,500 + Rs 32,500) 2

Debtors

collection period=

12 Months=

1.5

MonthsDebtors turnover ratio, (8)


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Creditors Turnover Ratio

Net credit purchases = Gross credit purchases - Returns tosuppliers.

Average creditors = Average of creditors (including bills payable)

outstanding at the beginning and at the end of the year.

A low turnover ratio reflects liberal credit terms granted by

suppliers, while a high ratio shows that accounts are to be settled

rapidly. The creditors turnover ratio is an important tool of

analysis as a firm can reduce its requirement of current assets by

relying on suppliers credit.

Creditors turnover

ratio=

Net credit purchases

Average creditors


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Example 4: Creditors Turnover Ratio

The firm in previous Examples has made credit purchases of Rs

1,80,000. The amount payable to the creditors at the beginning

and at the end of the year is Rs 42,500 and Rs 47,500

respectively. Find out the creditors turnover ratio.

Creditors

turnover ratio=

(Rs 1,80,000)=

4 (times

per year)(Rs 42,500 Rs 47,500) 2

Creditors

payment period=

12 months= 3 months

Creditors turnover ratio, (4)


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The summing up of the three turnover ratios (known as a cash cycle)

has a bearing on the liquidity of a firm. The cash cycle captures

the interrelationship of sales, collections from debtors

and payment to creditors.

Inventory holding period

Add: Debtors collection period

Less: Creditors payment period

2 months

+ 1.5 months

3 months0.5 months

As a rule, the shorter is the cash cycle, the better are the liquidity

ratios as measured above and vice versa.

The combined effect of the three turnover ratios

is summarized below:


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Cash-flow from operation ratio measures liquidity of a

firm by comparing actual cash flows from operations

(in lieu of current and potential cash inflows from

current assets such as inventory and debtors)with current liability.

Cash-flow From Operations Ratio

Cash-flow from

operations ratio=

Cash-flow from operations

Current liabilities


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LeverageCapital Structure Ratio

Capital structure or leverage ratios throw light on the

long-term solvency of a firm.

There are two aspects of the long-term solvency of a firm:

(i) Ability to repay the principal when due, and

(ii) Regular payment of the interest .

Accordingly, there are two different types of leverage ratios.

First type: These ratios are

computed from the balance

sheet

Second type: These ratios are

computed from the Income

Statement(a) Debt-equity ratio

(b) Debt-assets ratio

(c) Equity-assets ratio

(a) Interest coverage ratio

(b) Dividend coverage ratio


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I. Debt-equity ratio

Debt-equity ratio measures the ratio of long-

term or total de3bt to shareholders equityDebt-equity ratio =Total Debt

Shareholders equity

Long-term Debt + Short

term debt + OtherCurrent

Liabilities = Total external

Obligations

Debt-equity ratio measures the ratio of long-term or totaldebt to shareholders equity.

If the D/E ratio is high, the owners are putting up relatively less

money of their own. It is danger signal for the lenders and

creditors. If the project should fail financially, the

creditors would lose heavily.

A low D/E ratio has just the opposite implications. To the creditors, a

relatively high stake of the owners implies sufficient safety

margin and substantial protection against

shrinkage in assets.


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For the company also, the servicing of debt is less

burdensome and consequently its credit standingis not adversely affected, its operational flexibility

is not jeopardized and it will be able to

raise additional funds.

The disadvantage of low debt-equity ratio is that

the shareholders of the firm are deprived

of the benefits of trading on equity

or leverage.


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Trading on Equity

Trading on Equity (Amount in Rs thousand)

Particular A B C D

(a) Total assets 1,000 1,000 1,000 1,000

Financing pattern:

Equity capital 1,000 800 600 200

15% Debt 200 400 800

(b)Operating profit (EBIT) 300 300 300 300

Less: Interest 30 60 120

Earnings before taxes 300 270 240 180

Less: Taxes (0.35) 105 94.5 84 63

Earnings after taxes 195 175.5 156 117

Return on equity (per cent) 19.5 21.9 26 58.5

Trading on equity (leverage) is the use of borrowed funds inexpectation of higher return to equity-holders.


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Conclusion:

We are thus led to an important conclusion: (i) thefinancial leverage will have a favorable impact onEPS only when the firms return on investment (r)exceeds the interest cost of debt (kd). (ii) the impact

will be unfavorable if r < kd. (iii) The financialleverage will have no impact on EPS, when r = kd

Effect of leverage

Favorable r > kd Unfavorable r < k

d Neutral r = kd


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II. Debt to Total Capital

The relationship between creditors funds and

owners capital can also be expressed using

Debt to total capital ratio.

Debt to total capital ratio =Total debt

Permanent capital

Permanent Capital = Shareholders equity +

Long-term debt.


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III. Debt to total assets ratio

Debt to total assets ratio =Total debt

Total assets

Proprietary ratio indicates the extent to which assetsare financed by owners funds.

Proprietary ratio =Proprietary funds

Total assetsX 100

Capital gearing ratio is used to know the relationship between equity

funds (net worth) and fixed income bearing funds (Preference

shares, debentures and other borrowed funds.

Proprietary Ratio

Capital Gearing Ratio


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Coverage Ratio

Interest Coverage Ratio measures the firms ability to make

contractual interest payments.

Interest coverage ratio =EBIT (Earning before interest and taxes)

Interest

Dividend coverage ratio =EAT (Earning after taxes)

Preference dividend

Dividend Coverage Ratio measures the firms ability to pay dividendon preference share which carry a stated rate of return.

Interest Coverage Ratio

Dividend Coverage Ratio


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Profitability Ratio

Profitability ratios can be computed either from

sales or investment.

Profitability Ratios

Related to Sales

Profitability Ratios

Related to Investments

(i) Profit Margin

(ii) Expenses Ratio

(i) Return on Investments

(ii) Return on Shareholders

Equity


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Profit Margin

Gross profit margin measures the percentage of each sales

rupee remaining after the firm has paid for its goods.

Gross profit margin = Gross ProfitSales

X 100

Gross Profit Margin


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Net profit margin can be computed in three ways

iii. Net Profit Ratio =Earning after interest and taxes

Net sales

ii.P

re-taxP

rofit Ratio =

Earnings before taxes

Net sales

i. Operating Profit Ratio =Earning before interest and taxes

Net sales

Net profit margin measures the percentage of each sales rupeeremaining after all costs and expense including interest

and taxes have been deducted.

Net Profit Margin


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Example 7: From the following information of a firm,

determine (i) Gross profit margin and (ii) Net profit

margin.1. Sales

2. Cost of goods sold

3. Other operating expenses

Rs 2,00,000

1,00,000

50,000

(1) Gross profit margin =Rs 1,00,000

= 50 per centRs 2,00,000

(2) Net profit margin = Rs 50,000 = 25 per centRs 2,00,000


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Expenses Ratio

i. Cost of goods sold =Cost of goods sold

Net salesX 100

ii. Operating expenses =Administrative exp. + Selling exp.

Net salesX 100

iii. Administrative expenses =Administrative expenses

Net salesX 100

iv. Selling expenses ratio =Selling expenses

Net salesX 100

v. Operating ratio = Cost of goods sold + Operating expensesNet sales

X 100

vi. Financial expenses =Financial expenses

Net salesX 100


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Return on Investment

Return on Investments measures the overall effectiveness

of management in generating profits with

its available assets.

i. Return on Assets (ROA)

ROA =EAT + (Interest Tax advantage on interest)

Average total assets

ii. Return on Capital Employed (ROCE)

ROCE =EAT + (Interest Tax advantage on interest)

Average total capital employed


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Return on Shareholders Equity

Return on total shareholders equity =

Net profit after taxes

Average total shareholders equityX 100

Return on ordinary shareholders equity (Net worth) =

Net profit after taxes Preference dividend

Average ordinary shareholders equityX 100

Return on shareholders equity measures the return on the

owners (both preference and equity shareholders )

investment in the firm.


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Efficiency Ratio

Activity ratios measure the speed with which various

accounts/assets are converted into sales or cash.

i. Inventory Turnover measures the activity/liquidity of

inventory of a firm; the speed with which inventory is soldInventory Turnover Ratio =

Cost of goods sold

Average inventory

i. Inventory Turnover measures the activity/liquidity ofinventory of a firm; the speed with which inventory is soldRaw materials turnover =Cost of raw materials used

Average raw material inventory

i. Inventory Turnover measures the activity/liquidity of

inventory of a firm; the speed with which inventory is soldWork-in-progress turnover =

Cost of goods manufactured

Average work-in-progress inventory

Inventory turnover measures the efficiency of various types

of inventories.


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Liquidity of a firms receivables can be examinedin two ways.

i. Inventory Turnover measures the activity/liquidity of inventory of

a firm; the speed with which inventory is soldi. Debtors turnover =

Credit sales

Average debtors + Average bills receivable (B/R)

2. Average collection period =Months (days) in a year

Debtors turnover

i. Inventory Turnover measures the activity/liquidity of inventory of a

firm; the speed with which inventory is sold

Alternatively =Months (days) in a year (x) (Average Debtors + Average (B/R)

Total credit sales

Debtors Turnover RatioDebtors Turnover Ratio


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Assets Turnover Ratio


a firm; the speed with which inventory is soldi. Total assets turnover =

Cost of goods sold

Average total assets

ii. Fixed assets turnover = Cost of goods soldAverage fixed assets


a firm; the speed with which inventory is soldiii. Capital turnover =

Cost of goods sold

Average capital employed

iv. Current assets turnover = Cost of goods soldAverage current assets


a firm; the speed with which inventory is soldv. Working capital turnover =

Cost of goods sold

Net working capital

Assets turnover indicates the efficiency with which firmuses all its assets to generate sales.


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1) Return on shareholders equity = EAT/Average total shareholders equity.

2) Return on equity funds = (EAT Preference dividend)/Average ordinary

shareholdersequity (net worth).

3) Earnings per share (EPS) = Net profit available to equity shareholders

(EAT Dp)/Number of equity shares outstanding (N).

4) Dividends per share (DPS) = Dividend paid to ordinary

shareholders/Number of ordinary shares outstanding (N).

5) Earnings yield = EPS/Market price per share.

6) Dividend Yield = DPS/Market price per share.

7) Dividend payment/payout (D/P) ratio = DPS/EPS.

8) Price-earnings (P/E) ratio = Market price of a share/EPS.

9) Book value per share = Ordinary shareholders equity/Number of equity

shares outstanding.


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Integrated Analysis Ratio

Integrated ratios provide better insight about financial and

economic analysis of a firm.

(1) Rate of return on assets (ROA) can be decomposed in to

(i) Net profit margin (EAT/Sales)

(ii) Assets turnover (Sales/Total assets)

(2) Return on Equity (ROE) can be decomposed in to

(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)


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Rate of Return on Assets

EAT as percentage of

sales

Assets

turnover

EAT SalesDivided by Sales Total AssetsDivided by

Current assetsFixed assets

Gross profit = Sales lesscost of goods sold

Minus

Expenses: Selling

Administrative Interest

Minus

Income-tax

Shareholder equity

Plus

Long-term borrowedfunds

Plus

Current liabilities

Plus

Alternatively


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AssumeA has a profit margin of 20 % and

B has profit margin of 25%. It is therefore

obvious that B is a better investment than

A.


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Not necessarily.

i) Profitability is affected by turnover of

total assets and not by profit only.

ii) stable dividend policy may be a factor.

iii) The future prospects of the two

companies may be different.


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Difficulty in comparison.

Accounting policies

Life of assets.


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1. The information below is taken from the records of two companies in the same

industry. The companies are X Ltd and Y Ltd; and the data is as follows:

Particulars X Ltd Y LtdCash

Debtors (net)

Stock

Planet and equipment

Total assets

Sundry creditors

8% Debentures

Equity share capital

Retained earnings

Total liabilities

Sales

Cost of goods sold

Other operating expenses

Interest expenses

Income taxes

Dividends

Rs 2,10,000

3,30,000

12,30,000

16,95,000

34,65,000

9,00,000

5,00,000

11,00,000

9,65,000

34,65,000

56,00,000

40,00,000

8,00,000

40,000

2,66,000

1,00,000

Rs 3,20,000

6,30,000

9,50,000

24,00,000

43,00,000

10,50,000

10,00,000

17,50,000

5,00,000

43,00,000

82,00,000

64,80,000

8,60,000

80,000

2,73,000

1,80,000


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Contd

Answereach of the following questions by making a comparison of one, or

more, relevant ratios.

(i) Which company is using theequity shareholders money more

profitably?

(ii) Which company is better able to meet its current debts?

(iii) If you were to purchase the debentures of one company, which

companys debentures would you buy?

(iv) Which company collects its receivables faster, assuming all sales to be

credit sales?

(v) Which company is extended credit for a long period by the creditors,

assuming all purchases (equivalent to cost of goods sold) to be credit

purchases?

(vi) How long does it takeeach company to convert an investment in stock to

cash?

(vii) Which company retains the larger proportion of income in the business?


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Solution

(i) Rate of return (ROR) on shareholders funds

= (Rs 4,94,000/Rs 20,65,000) 100 = 23.9 per cent (X Ltd)

= (Rs 5,07,000/Rs 22,50,000) 100 = 22.5 per cent (Y Ltd)

X Ltd is using the shareholders money more profitably.

(ii) (a) Current ratio = Rs 17,70,000/Rs 9,00,000 = 1.97 (X), Rs 19,00,000/

Rs 10,50,000 = 1.81 (Y)

(b) Acid test ratio = Rs 5,40,000/Rs 9,00,000 = 0.6 (X), Rs 9,50,000/

Rs 10,50,000 = 0.9 (Y)Y Ltd is better able to meet its current debts.

(iii) (a) Debt-equity ratio = Rs 14,00,000/Rs 20,65,000 = 0.68 (X), Rs 20,50,000/

Rs 22,50,000 = 0.91 (Y)

(b) Interest coverage ratio = Rs 8,00,000/R 40,000 = 20 times (X), Rs 8,60,000/

Rs 80,000 = 10.75 times (Y)The debentures of X Ltd should be bought.

(iv) Debtors collection period = (360 Rs 3,30,000)/Rs 56,00,000 = 21days (X Ltd),(360 Rs 6,30,000)/Rs 82,00,000 = 28 days (Y Ltd)

X Ltd collects its receivables faster.


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Contd

(v) Creditors payment period = (360 Rs 9,00,000)/ R 40,00,000 = 81 days (X Ltd),

(360 Rs 10,50,000)/Rs 64,80,000 = 58 days (Y Ltd)

X Ltd is extended credit for a longer period by the creditors.

(vi) Stock turnover ratio = Rs 40,00,000/Rs 12,30,000 = 3.25 times (X), Rs 64,80,000/

Rs 9,50,000 = 6.82 times (Y)

= 360 days/3.25 = 111 days (X), 360 days/6.82 = 53 days (Y)

Length of time required for conversion of investment in stock to cash:

111 days + 21 days = 132 days (X)53 days + 28 days = 81 days (Y)

(vii) Dividend payout ratio = Rs 1,00,000/Rs 4,94,000 = 20.2 per cent (X), Rs 1,80,000/

Rs 5,07,000 = 35.5 per cent (Y)

Retention ratio = 100 20.2 = 79.8 per cent (X), 100 35.5 = 64.5 per cent (Y)

X Ltd retains the larger proportion of its income in the business

Ratio Analysis for Class

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