Ratio Analysis

Types: 1. 2. 3. 4. 5. Liquidity Ratio Leverage/Capital Structure/Gearing/Solvency Ratio Profitability Ratios Activity/Efficiency Ratios Integrated Ratios

Liquidity Ratios
1. Current Ratio

Current Ratio = (Current Assets) (Current Liabilities) Interpretation: If current ratio of a company is 2:1, it implies for every one rupee of current liabilities, current assets of two rupees are available to meet them. In interfirm comparison, the firm with higher current ratio has better liquidity/short-term solvency. High ratio = good liquidity Ideal ratio- 2:1

2. Acid Test/Quick Ratio

Acid Test/Quick Ratio = (Quick assets) (Current Liabilities) Quick assets = Current assets (Prepaid expenses + Inventory) Interpretation: Measures for every rupee of current liability, how much quick assets is available to meet them.

3. Turnover Ratios: Determines how quick current assets are converted into cash i) ii) iii) Inventory Turnover Ratio Debtors Turnover Ratio Creditors Turnover Ratio

Inventory Turnover Ratio = (Cost of goods sold) (Average inventory) Cost of goods sold = Sales Gross profit Average inventory = (Opening stock + Closing stock)/2

Inventory holding period = 12 months (365 days) (Inventory turnover ratio) Interpretation: Indicates how fast inventory is sold. A low ratio would indicate inventory does not sell fast and stays on shelf or in warehouse for a long time. High ratio = good liquidity

Debtors Turnover Ratio = (Net credit sales) (Average debtors) Net credit sales = Gross credit sales Returns from customers Average debtors = (Opening bills receivable + Opening debtors + Closing bills receivable + Closing debtors)/2

Debtors collection period = 12months(365 days) (Debtors turnover ratio) Interpretation: Indicates how rapidly receivables are collected. High ratio indicates shorter time-lag between credit sales and cash collection. Low ratio shows debts not collected rapidly. High ratio = good liquidity

Creditors Turnover Ratio = (Net credit purchases) (Average creditors) Net credit purchases = Gross credit purchases Returns to suppliers

Average creditors = (Opening bills payable + Opening creditors + Closing bills payable + Closing creditors)/2

Creditors collection period = 12months(365 days) (Creditors turnover Ratio) Interpretation: High ratio shows accounts are to be settled rapidly. Measures the extent to which trade creditors are willing to wait for payment. High ratio = good liquidity

4. Defensive-Interval Ratio Defensive-Interval ratio = (Liquid assets) (Projected daily cash requirement) Projected daily cash requirement = (Projected cash operating expenditure) 365 Interpretation: Measures the timespan a firm can operate on present liquid assets without resorting to next years income. Higher ratio favorable as it would reflect the ability of a firm to meet cash requirements for a longer period of time.

5. Cash Ratio Cash Ratio = (Cash + Marketable securities) (Current Liabilities) Interpretation: High ratio indicates that a business enterprise is not using its resources to its best advantage. Low ratio indicates immediate problem with paying bills. Interpretation: Higher ratio, better is the firm from liquidity point of view

Leverage/Capital Structure/Gearing/Solvency Ratio

1. Debt-Equity Ratio Debt-Equity ratio (in terms of long-term debt) = (Long-term debt) (Shareholders equity) Debt-Equity ratio (in terms of total debt) = (Total debt) (Shareholders equity) Interpretation: Measures the extent to which debt financing has been used in a business. It indicates the proportionate claims of owners and the outsiders against the firms assets. 1:1 ratio is satisfactory. Higher the ratio, greater is the risk to the creditors.

2. Debt to Total Capital Ratio Debt to Total Capital ratio = (Long-term debt) (Permanent capital) Interpretation: Measures what proportion of permanent capital of a firm consists of long-term debt. 1:2 ratio is satisfactory.

3. Debt to Total Assets Ratio Debt to total assets ratio = (Total debt) (Total assets) Interpretation: Measures what portion of total assets are financed by outside funds. Low ratio is desirable.

4. Proprietary Ratio Proprietary ratio = (Proprietors funds) (Total assets) * 100% Proprietors fund = Shareholders funds/equity

Interpretation: Indicates what portion of total assets are financed by owners capital. Higher ratio = better is the long term solvency position of the company.

5. Capital gearing Ratio Capital gearing ratio = (Equity funds) (Fixed income bearing funds) Equity funds = Net worth Fixed income bearing funds = Preference shares + Debentures + Other borrowed funds Interpretation: Shows the effect of the use of fixed-interest/dividend source of funds on the earnings available to the equity shareholders.

6. Coverage Ratios Interest Coverage Dividend Coverage Total fixed charge coverage Total cash flow coverage Debt-Service Coverage Ratio(DSCR)

i)

Interest Coverage Ratio = (EBIT) (Interest) Measures firms ability to make contractual interest

Interpretation: payments.

ii)

Dividend Coverage Ratio = (EAT) (Preference dividend)

Interpretation: Measures the firms ability to pay dividend on preference shares which carry a stated rate of return.

iii)

Total Fixed Charge Coverage Ratio = A B

A = EBIT + Lease payment B = Interest + Lease payment + (Preference dividend + Instalment of

principal) (1-t) Interpretation: Measures the firms ability to meet all fixed payment obligations.

iv)

Debt Service Coverage Ratio(DSCR) = C D

C = EAT + Interest + Depreciation + Other non-cash expenditures like Amortization D = Fixed interest charges (Interest on debentures and long term loans) + Principle obligation Interpretation: Ability of firm to make the contractual payments required on a scheduled basis over the life of the debt. Higher the ratio, better it is.

Profitability Ratios

Profitability Ratios related to sales: Gross Profit Margin Net Profit Margin/Net Margin Expenses Ratio

1. Gross Profit Margin Gross Profit Margin = (Gross profit) (Sales) * 100% Gross profit = Sales Cost of goods sold Interpretation: Measures the percentage of each sales rupee remaining after the firm has paid for its goods. Higher gross profit = better results

2. Net Profit Margin/Net Margin: Measures the percentage of each sales rupee remaining after all costs and expenses including interest and taxes have been deducted.

Net Profit Margin is computed in 3 ways: i) Operating profit ratio = (EBIT) (Net sales) * 100%

EBIT = Earnings before Interest and Taxes Interpretation: High operating ratio: Not favorable because it would have a small margin to cover interest, income tax, dividend and reserves. ii) Pre-tax profit ratio = (EBT) (Net sales) * 100%

EBT = Earnings before taxes Interpretation: High ratio not favorable

iii)

Net profit ratio = (EAT) (Net sales) * 100%

EAT = Earnings after interest and taxes Interpretation: It expresses the cost price effectiveness of the operation. High ratio would ensure adequate return to the owners as well as enable a firm to withstand adverse economic conditions when selling price is declining, cost of production is rising and demand for the product is falling.

3. Expenses Ratios Interpretation: Lower the ratio : Greater the profitability Higher the ratio : Lower the profitability

i)

Cost of goods sold ratio = (COGS) (Net sales) * 100%

ii)

Selling expenses ratio = (Selling expenses) (Net sales) * 100%

iii)

Administrative expenses ratio = (Administrative expenses) (Net sales) * 100%

iv)

Operating expenses ratio = (Administrative expenses + Selling expenses) (Net sales) * 100%

v)

Operating ratio = (COGS + Operating expenses) (Net sales) * 100%

vi)

Financial expenses ratio=(Financial expenses) (Net sales) * 100%

Profitability ratios related to Investments: Return Return Return Return on on on on assets Capital employed Proprietors/Shareholders Equity Ordinary Shareholders Equity (Net worth)

Return on Investments: Measures the overall effectiveness of management in generating profits with its available assets.

1. Return on assets (ROA) = (Net profit after taxes) (Average total assets) * 100% Net profit may be Net profit after tax Net profit after tax + Interest Net profit after tax + Interest Tax savings Assets may be defined as Total assets Fixed assets Tangible assets Interpretation: Measures the profitability of the total funds/investments of a firm.

2. Return on Capital Employed(ROCE) = (EBIT) (Capital employed) * 100% EBIT = Earnings/Profit before Interest and Tax Capital Employed = Equity share capital + preference share capital + reserves and other undistributed profits + long term loans and debentures fictitious assets

Or, Capital Employed = Fixed assets cost Depreciation + Net working Capital Interpretation: Higher the ratio, the more efficient is the use of capital employed

3. Return on Shareholders Equity = (Net profit after Interest and taxes) (Shareholders fund) * 100% Interpretation: Measures the return on the owners (both preference and equity shareholders) investment in the firm. It reveals how profitably the owners funds have been utilized by the firm.

4. Return on Ordinary Shareholders Equity(Net worth) = (Net profit after taxes Preference dividend) (Equity shareholders funds) * 100% Interpretation: Measures the return on the total equity funds of ordinary shareholders.

5. Earnings Per Share(EPS) = (Net profit after taxes Preference Dividend) (No. of Equity Shares) Interpretation: Measures profit available to the equity shareholders on per share basis, i.e. the amount that they can get on every share held.

6. Dividend Per Share (DPS) = (Dividend paid to ordinary shareholders) (No. of ordinary shares Outstanding) Interpretation: It is the dividends paid to the equity shareholders on a per share basis. 7. Dividend Pay-out Ratio = (Dividend per share) (EPS) * 100% Interpretation: Measures Percentage of equity share earnings distributed as dividend to equity shareholders. Also measures the percentage of equity share earnings retained by the firm.

Retention ratio = 100% - (Dividend Pay-out Ratio)

8. Price Earnings (P/E) Ratio = (Market price of share) (EPS) Interpretation: Measures the amount investors are willing to pay for each rupee of earnings; higher the ratio, larger the investors confidence in the firms future.

Activity/Efficiency Ratios

1. Inventory(Stock) Turnover Ratio Inventory Turnover Ratio = (COGS) (Average inventory)

2. Raw materials Turnover Ratio Raw materials Turnover Ratio = (Cost of raw materials used) (Average raw material inventory)

3. Work-in-progress Turnover Ratio Work-in-progress turnover = (Cost of goods manufactured) (Average work-in-progress inventory)

4. Assets Turnover Ratio Total assets turnover ratio Fixed assets turnover ratio Capital turnover ratio Current assets turnover ratio

 Working capital turnover ratio Total assets turnover ratio = (COGS) (Average total assets) Fixed assets turnover ratio = (COGS) (Average fixed assets) Capital turnover ratio = (COGS) (Average capital employed) Current assets turnover ratio = (COGS) (Average current assets) Working capital turnover ratio = (COGS) (Net working capital) Interpretation: Indicates the efficiency with which firm uses all its assets to generate sales.

Integrated Ratios

1. Earning Power = Net profit margin * Assets turnover = (EAT) (Total assets) Net profit margin = EAT Sales Assets turnover = Sales Total assets

2. Return on Equity = Earning power * (Financial leverage or Equity multiplier) = EAT Equity Equity multiplier = Assets Equity