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Advantages
Financial ratio analysis is a useful tool for users of financial statement. It has following
advantages:
1.
2.
3.
It helps in trend analysis which involves comparing a single company over a period.
4.
It highlights important information in simple form quickly. A user can judge a company
by just looking at few numbers instead of reading the whole financial statements.
Limitations
Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits of
financial ratio analysis are:
1.
2.
3.
Ratio analysis explains relationships between past information while users are more
concerned about current and future information.
Ratios are worked out to analyse the following aspects of a business organization :
a)
b)
c)
d)
e)
f)
g)
h)
c) Activity Ratios : These ratios are designed to indicate the effectiveness of the firm in
utilizing its funds, its degree of efficiency, and its standards of performance. Hence, they are
also known as Efficiency and Performance Ratios.
d) Profitability Ratios : These ratios are intended to reflect the overall efficiency of the
organization, its ability to earn a reasonable return on capital employed or on shares issued and
the effectiveness of its investment policies.
This phenomenon occurs when borrowed capital is employed in the business. The essence of
Trading on Equity is to borrow and use external funds at an explicit cost and employ them
efficiently so as to obtain a return higher than the cost of such funds.
This results in higher returns on equity shareholders funds. Thus, the phenomenon of making
higher rates of return available to the Equity shareholders of the company by means of greater
utilisation of borrowed funds obtained at an explicit or lower cost is termed as Trading on
Equity.
Standard Ratio
It is always desirable to have external and proprietors funds well-balanced. The proprietary
ratio should neither be too high nor too low.
What is a safe ratio is a matter to be decided only after due consideration of various other
factors.
Stock working capital ratio
The stock working ratio brings out the relationship between stock and working capital. It is
alternatively known as inventory-working capital ratio or inventory net current assets ratio.
Standard Ratio
It is very difficult to lay down a standard stock-working capital ratio as the level of stock to be
maintained differs from business to business.
However, 1:1 may be considered as a reasonable standard.
The difficulty in fixing a standard for the ratio is due to the fact that it is necessary to build up
stock in the initial stages in case of a newly started business.
It expresses the relation between the external equities and internal equities or the relationship
between borrowed capital and owners capital.
a) Debt Equity Ratio =
Long Term Debts
Shareholders Funds
b) Debt Equity Ratio =
Long Term Debts
Shareholders Funds +Long Term Debts
it is very difficult to lay down the standard gross profit ratio as it refers from industry to
industry and from year to year in a firm.
In any case, the gross profit ratio must atleast be maintained at a consistent level if cannot be
Improved. Steps should be taken to earn gross profit atleast sufficient to cover the operating
expenses and fixed interest charges.
Operating Ratio
Operating ratio is the relationship between cost of activities and net sales. This ratio brings out
the relationship between total cost of goods sold and net sales.
In other words, operating ratio shows at what percentage the operating expenses are comprised
in net sales. This is expressed as a percentage.
High and low operating ratios
Lower the operating ratio, the better is the operational efficiency of the business. If the
operating ratio is higher, it would lead to lower profits and therefore will be less favorable
because what would be left out of operating profits for the shareholders will be meager. When
more capital is needed, the operating ratio should be low.
Standard ratio
Though a standard operating ratio cannot be precisely laid down, the ratio in the case of
manufacturing concerns is normally high, while in case of other firms, the ratio may be low.
Expenses Ratio
The ratio of each item of expenses or each group of expenses to net sales is known as an
Expense Ratio and such ratios are collectively known as Expense Ratios. Thus, expense ratio
brings out the relationship between various elements of operating costs and net sales.
Expense ratios analyse each individual item of expense or group of expenses and express them
as a percentage in relation to net sales.
Calculation
a) Ratio of Administrative expenses:
Administrative expenses 100
Net sales
b) Ratio of Selling expenses:
Selling expenses
100
Net sales
c) Material consumed ratio:
Material consumed 100
9
Net sales
d) Conversion cost ratio:
Manufacturing expenses 100
Net sales
e) Ratio of non-operating expenses:
Non-operating expenses 100
Net sales
Net Profit Ratio
Net Profit ratio indicates the relationship between net profit and net sales. Net profit can be
either operating net profit or net profit after tax or net profit before tax. This ratio is also known
as Margin on Sales Ratio.
Calculation
Net profit ratio is calculated as under :
a)
Net profit 100
Net sales
NAT
Net sales
100
b)
NBT
100
Net sales
This ratio is expressed as a percentage.
Net Operating Profit Ratio
It is a relationship between net operating profit and net sales which is expressed in percentage
Formula
Net Operating Profit Ratio =
Net Operating Profit 100
Net Sales
Stock Turnover Ratio
Stock Turnover ratio is also known as Inventory ratio or Inventory Turnover ratio or Stock
Turn ratio or Merchandise Turnover ratio or Stock Velocity ratio or simply Velocity of
Stock
This ratio measures the number of times stock turns or flows or rotates in an accounting period
compared to the sales effected during that period.
In other words, the ratio indicates the frequency of inventory replacement i.e., the number of
times inventory has been sold and replaced during a given period of time.
Calculation
Stock Turnover ratio is the relationship between inventory and cost of goods sold and is
calculated as under :
Stock Turnover Ratio =
10
Average Stock
Average stock on hand as at the end of a period is calculated by adding inventory in the
beginning of the period to the inventory at the close of the period and the product is divided by
two.
Average Stock =
This ratio explains the relationship between total profits earned by the business and total
investments made or total assets employed. This ratio, thus measures the overall efficiency of
the business operations.
This ratio is alternatively known as Return of Total Resources.
Calculation
Return on total resources is calculated by dividing Net Profit before preference dividend and
interest on loans and debentures by total assets (fixed and current). This is always expressed as a
percentage.
=
Net Profit before interest & tax
Capital Employed
100
be reduced by the amount necessary to pay preference dividend. It is calculated by the following
formula.
Formula
Earning per Share =
E.P.S
Meaning
It is similar to Debtors Turnover Ratio. It shows the speed with which payments are made to
the suppliers for purchases made from them. It is a relationship between net credit purchases
and average creditors.
Formula
Credit Purchases
Average Accounts Payable
Average Creditors
For the purpose of calculation of this ratio, average monthly balance of creditors and bills
payable should be taken. If this information is not available average of opening and closing
balances of creditors should be taken. If opening balance is not available, year end balance
should be considered.
Creditors turnover ratio may be further used to find out the average rate of payables by
using the following formula :
=
Days in a Year
OR
Creditors Turnover
Average Accounts Payable
No. of days or months in a year.
Credit Purchases in a Year
Debtors Turnover Ratio (Debtors Velocity)
Debtors Turnover Ratios is alternatively known as Turnover of Debtors Ratio or Accounts
Receivable Turnover Ratio. Some analysts prefer to call this ratio as Debtors Turnover
period or as Average collection period.
This ratio attempts to measure the collectability of debtors and other accounts
receivables. In other words, it shows the rate at which the trade debts are being collected.
Sundry Debtors and Other Accounts Receivable
These items represent the amount outstanding and receivable as on a particular date, usually as
on the balance sheet date. The total receivables will be the total of Sundry Debtors and bills
Receivable.
Accounts Receivable should not include debtors or bills arising from non-operating transactions
i.e., activities other than trading.
Debtors Turnover ratio is calculated as under :
=
Credit Sales
Average Accounts Receivables
Debt Collection Period
The ratio indicated the extent to which the debts have been collected in time. It gives the
average debt collection period. The ratio helps the lenders to known whether their borrowers are
collecting money from debtors within a stipulated period.
14
Formula
Debtors + Bills Receivable
Average daily or monthly Credit Sales
Average daily sales is calculated as follows :
=
Net Credit Sales
OR
Months or days in a year
No. of days in the year
Debtors Turnover
OR
Average Accounts Receivable
Months or days in a year
Credit Sales for the year
Assets Turnover Ratio
Fixed Assets Turnover Ratio
It is a relationship between Sales and Fixed Assets.
Formula
Fixed Assets Turnover Ratio :
Sales
Fixed Assets
Total Assets Turnover Ratio
Meaning
It shows the number of times total assets are being turned over in a year.
Formula
Total Assets Turnover Ratio
=
Sales
Total Assets
Working Capital Turnover Ratio
Formula
Sales
Working Capital
Capital Turnover Ratio
Meaning
It is a relationship between Sales and Capital employed.
Formula
Capital Turnover Ratio =
Sales
Capital Employed
Illustration 1 :
15
From the following financial statements of Sunshine Ltd., calculate the companys
accounting ratios and offer brief comments on the companys :
(1) Financial stability, (2) Financial management, and (3) Efficiency (profitability)
Trading and Profit & Loss A/c
For the year ended 31st March, 2006
Rs.
Sales (Net)
Opening Stock
Purchases
Rs.
6,00,000
65,000
3,35,000
4,00,000
40,000
1,36,280
10,000
6,200
500
2,520
3,60,000
2,40,000
1,55,500
84,500
8,700
93,200
37,280
55,920
10,580
1,000
11,580
67,500
10,000
5,000
15,000
Proposed Dividend :
5% Preference Dividend
30% Equity Dividend
Balance carried forward
500
12,000
27,500
40,000
50,000
35,000
15,000
3,000
Depreciation
Rs.
21,000
7,500
600
Net
Rs.
50,000
14,000
7,500
2,400
73,900
87,000
Prepaid Expenses
Stock in Trade
Debtors
Bills Receivable
Tax Credit Certificates
Bank
45,000
5,500
39,800
12,500
Proposed Dividend
Net Current Assets or Working Capital
10,000
40,000
4,000
90,000
5,000
40,000
2.
Liquid Ratio
3.
Proprietary Ratio
=
=
1,39,000
Stock
Working Capital
40,000
= 0.62:1
1,66,900 - 1,02,800
Fixed Interest Bearing Securities
Equity Capital + Reserves
=
5.
1,89,000
Current Assets
Current Liabilities
1,66,900
= 1.62:1
1,02,800
Liquid Assets
Current Liabilities
1,06,900
= 1.04:1
Proprietors Equity
Total Assets
1,89,000
= 0.58:1
3,27,800
=
Stock-Working
Capital Ratio
50,000
36,000
2,25,000
4.
64,100
2,25,000
1,02,800
Financed by :
Share Capital
100, 5% Preference Shares of
Rs. 100 each
40,000 Equity Shares of Rs. 1 each
Solution :
Financial Management Ratios :
1.
Current Ratio
20,000
40,000
50,000
1,100
16,000
39,800
1,66,900
17
46,000
= 0.27:1
1,79,000
OR
Fixed Interest Bearing Securities
Equity Capital
46,000
= 1.15:1
40,000
=
=
Profitability Ratio :
Gross Profit Ratio
Operating Ratio
=
=
Gross Profit
100
Net Sales
=
2,40,000
100 = 40%
6,00,000
Operating Cost 100
Net Sales
Cost of Goods sold + Operating Exps. 100
Net Sales
=
3,60,000
= 6086 times
65,000 +40,000
2
Opening Net Profit (before Tax & Interest)
Capital employed
87,020
100
= 38.68%
2,25,000
=
=
=
=
365
Net Sales
50,000 + 1,100
6,00,000
365 = 31 days
Comments :
a)
Financial Stability : Long-term : The long-term financial position of the company is
indicated by the proprietary ratio. The proprietary ratio of the company is 0.58:1. This indicates
that for every one rupee of the total assets, contribution of 58 paise has come from the
proprietors. The contribution made by the proprietors to total assets is more than that of the
outsiders. The ratio is satisfactory. Therefore, the firm can be considered financially stable in the
long run.
Short term : The short-term financial position of the company is indicated by the current and
liquid ratios. The current ratio of the Company is 1.62:1 which is not favourable. Hence, the
short-term financial position of the company is not strong, whereas the immediate solvency
position as revealed by liquid ratio (1.04:1) seems to be satisfactory. The company is in a
position to meet its current obligations out of its current assets as and when they fall due for
payment.
b)
Financial Management : The proportion of fixed interest bearing securities to equity
shareholders funds is 0.27:1. This indicates that the capital structure of the company is lowgeared. Considering the proportion of fixed interest bearing securities to equity capital, the
structure of capital seems to be slightly high geared. The gearing of capital structure of capital
structure has profound influence+ on the quantum of profits available to the equity shareholders.
The stock to Working Capital ratio is 62:1 which shows that out of every rupee of working
capital, 62 paise are locked up in inventories. This has influence on the working capital position
of the company and consequently on its liquid position.
The collection period of debtors is not very long. The average collection period of 31 days is
quite reasonable.
19
c)
Profitability : Gross Profit ratio is 40% and the net operating profit ratio is 14.5%.
This indicates that out of every Rs. 100 worth of sales Rs. 14.50 is operating profit and Rs.
85.50 is the operating cost.
The return on total resources is 36.14% and the return on equity capital is 138.55%. Equity
shareholders earn Rs. 138.55 on every Rs. 100/- of capital subscribed and paid by them and Rs.
29.59 on every Rs. 100/- employed by them as resources.
This shows that the profitability of the company seems to be satisfactory. However, whether
there is an improvement in the profitability or not depends on the comparative study of figures
of the previous accounting periods.
Illustration 2:
The following are the summarised Profit & Loss Account of Siddhartha Product Limited for the
years ending 31st December, 2005 and the balance sheet as on that date:
Profit & Loss A/c
To Opening Stock
To Purchases
To Incidental Expenses
To Gross Profit c/d
To Operating Expenses:
Selling and Distribution
Rs.
99,000
5,45,250
14,250
3,40,000
9,99,000
30,000
20
By Sales
By Closing Stock
Rs.
8,50,000
1,49,000
9,99,000
3,40,000
Administration
Finance
1,50,000
15,000
1,95,000
To Non-operating Expenses :
Loss on Sale of Assets
Net Profit
Incomes :
Interest
Profit on Sale
Of Shares
3,000
9,000
6,000
4,000
1,50,000
3,49,000
3,49,000
Rs.
Assets
Land & Building
Plant & Machinery
Stock-in-Trade
Sundry Debtors
Cash & Bank Balance
2,00,000
90,000
1,30,000
60,000
4,80,000
Rs.
1,50,000
80,000
1,49,000
71,000
30,000
4,80,000
From the above statements you are required to calculate the following ratios and state the
purposes they serve :
a) Current ratio,
b) Operating ratio
c) Stock turnover
d) Return on capital employed,
e) Earning per equity share,
f) Opening profit ratio.
Solution :
a) Current Ratio
=
Current Assets
Current Liabilities
=
1,49,000 + 71,000 + 30,000
1,30,000
=
2,50,000
1,30,000
= 1.92
The purpose is to test the short-term financial position of the company.
The ratio is near the standard ratio of 2:1. It appears that the short-term financial position of the
company is not bad. However, the position is not satisfactory as a large portion of current assets
is represented by stock-in-trade.
b) Operating Ratio
=
21
Operating Ratio
=
=
=
5,10,000 + 1,95,000
100
8,50,000
=
7,05,000
100
8,50,000
= 83%. (approx)
The purpose of the ratio is to test the operating efficiency of the company. This ratio is also used
to find out what portion of sales is absorbed by operating costs. In this case, out of every Rs. 83
is the operating cost.
c) Stock Turnover Ratio
=
=
=
Net Profit
100
Capital Employed
=
1,50,000
100
4,80,000
=
31% (approx)
Sometimes, the ratio is calculated by considering the operating profit. If this approach is
adopted, the ratio will be :
=
=
1,45,000
100
4,80,000
30% (approx)
Net Profit
Add : Non-operating Expenses
22
1,54,000
9,000
1,45,000
The purpose of this ratio is to test the manner in which the resources are utilized. It is also used
to test the overall profitability of the company.
In this case, the ratio is 31%. It means, that the company has earned Rs.31 on every Rs. 100
employed as resources.
e) Earning per Equity Share
=
=
=
The purpose is to find out possibility of dividend.
f) Net Operating Profit Ratio
=
Net Operating Profit
Net Sales
=
1,45,000
100
8,50,000
= 17.06%
The purpose is to judge the operating efficiency of the management.
100
Illustration 3 :
Shown below are the comparative balance sheets and operating data of Alpha Company
for the years ended on 31st December, 2004, 2005 and 2006 :
Comparative Balance Sheets
2004
Rs.
23
2005
Rs
2006
Rs.
Current Assets :
Cash
Debtors
Stock
[A]
1,200
14,800
14,800
30,800
1,900
12,400
16,200
30,500
400
10,400
19,800
30,600
[B]
[A + B]
9,800
15,700
5,000
30,500
61,300
12,000
16,300
5,000
33,300
63,800
12,800
18,000
5,000
35,800
66,400
7,500
6,300
1,200
15,000
3,000
11,200
1,600
15,800
5,000
13,400
2,900
21,300
30,000
16,300
46,300
61,300
30,000
18,000
48,000
63,800
30,000
9,600
39,600
66,4000
[A]
[B]
[C]
[A +B+C]
Total Liabilities
Additional Information :
2004
Rs.
1,00,000
5,000
3,000
Total Sales
Net Profit after Tax
Dividend paid
2005
Rs.
1,05,000
5,7000
3,000
2006
Rs.
93,000
2,400
1,000
2005 :
30,800
15,000
Current Assets
Current Liabilities
2.05:1
30,500
15,800
24
1.93:1
2006 :
2.
3.
2004 :
2005 :
2006 :
30,600
21,300
1.44:1
2004 :
Quick Assets
Current Liabilities
1.07:1
0.91:1
0.51:1
Net Profit
100
Proprietors Equity
16,000
15,000
2005 :
14,300
15,800
2006 :
10,800
21,300
Proprietary Ratio
5,000
46,300
5,700
48,000
2,400
39,600
100
10.8%
100
11.88%
100
6.06%
Comments :
a)
Short-term financial position : Short-term financial position is reflected in the
Current Ratio and Acid Test Ratio. The Current Ratio and Acid Test Ratio of the company for
2004 are favourable. The position of the company for 2004 seems to be satisfactory. In 2005
both the ratios have declined. The position of the company for 2006 has become worst as there
is a drastic decline in the ability of the company to meet its current obligations out of its current
assets.
b)
Long-term financial position : The proprietary ratio in 2004 was 1.76:1, in 2005,
0.75:1 and in 2006, 0.6:1.
The financial position of the company seems to be satisfactory as the proprietors contribution to
total assets is more than the contribution by outsiders.
However, the ratio is showing a downward tendency. This means that the interest of the
proprietors is decreasing. This should be checked.
c)
Profitability : The profitability position of the company showed improvement in 2005
as it is indicated by the increase in the return on proprietors equity and earnings per share as
compared to the previous year. However, ratios of both the years have decreased in 2006.
Return on proprietors equity has fallen from 11.88% in 2005 to 6.06% in 2006.
25
BIBLIOGRAPHY
Book :1. Advanced Financial management, L. N. Chopde, sheth publication, june, 2010.
Websites:1. http://accountingexplained.com/financial/ratios/advantages-limitations
2. http://www.investopedia.com/terms/r/ratioanalysis.asp
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